Risks and uncertainties
Our business is exposed to a number of risks and uncertainties.
As part of the Group’s risk management process each business assesses the likelihood and potential impact of a range of events in the light of their current circumstances and processes, to determine the overall risk level and to identify actions necessary to mitigate their impact. A detailed description of the Group’s procedures to manage risk is given in the corporate governance statement.
This section highlights those risks which could have a material impact on our future financial performance and cause results to differ materially from expected and historical results. Additional risks not currently known or which are regarded as immaterial could also affect future performance.
Financial risk
The Group is exposed to a variety of market related risks, including the effects of changes in foreign currency exchange rates and interest rates. In the normal course of business, the Group also faces risks that are either non-financial or non-quantifiable, including country and credit risk.
The Group uses interest rate swaps, swaptions, forward rate agreements, netting techniques and forward exchange contracts as required to manage the primary market exposures associated with its underlying assets, liabilities and anticipated transactions.
Currency risk
The Group has transactional currency exposures arising from sales or purchases by operating subsidiaries in currencies other than the subsidiaries’ functional currency. Under the Group’s foreign exchange policy, such transaction exposures are hedged once they are known, mainly through the use of forward foreign exchange contracts. The Group has a significant investment in overseas operations, particularly in continental Europe and the Americas. As a result, the sterling value of the Group’s balance sheet can be affected by movements in exchange rates. The Group therefore seeks to mitigate the effect of these translational currency exposures by matching the net investment in overseas operations with borrowings denominated in their functional currencies, except where significant adverse interest differentials or other factors would render the cost of such hedging activity uneconomic. This is achieved by borrowing either directly (in either the local domestic or euro-currency markets) or indirectly through the use of rolling annual forward foreign exchange contracts. Borrowings created through the use of such contracts amounted to £762 million at 31 December 2007 and were denominated in US dollars (46%), euro (44%) and Japanese yen (10%).
Interest rate risk
The Group operates an interest rate policy designed to optimise interest cost and reduce volatility in reported earnings. To achieve this it maintains a target range of fixed and floating rate debt for discrete annual periods, over a defined time horizon, partly through the fixed rate character of the underlying debt instrument, and partly through the use of straightforward derivatives (forward rate agreements, interest rate swaps and swaptions). Interest rates on all debt capital market issues remain at fixed rates whilst the balance of debt is at floating rates. At 31 December 2007, 89% of the Group’s gross financial liabilities were at fixed rates of interest, whilst the weighted average period in respect of which interest has been fixed was 7.9 years.
Credit risk
The Group is exposed to credit-related losses in the event of non-performance by counterparties to financial instruments, which include trade debtors.
Credit risk relating to financial institutions is mitigated by the Group’s policy of selecting only counterparties with a strong investment graded long term credit rating, normally at least AA- or equivalent, and assigning financial limits to individual counterparties.
With the concentration of customers noted below, the financial failure of any one of them could have a material impact on results. The Group closely monitors credit exposures which are reported to divisional management, and overall divisional performance is reviewed regularly by the Executive Committee. At 31 December 2007 the largest individual debtor balance was 1.1% of Group sales.
In addition to the inherent specific financial risks and their management referred to above, there are other, more general, financial risks that could have a material adverse effect on our business, financial condition, or results of operations.
Pension and retiree medical risk
we operate both defined benefit (DB) and defined contribution (DC) pension plans, together with retiree medical arrangements. The majority of the DB plans are in the UK, North America and continental Europe. Retiree medical arrangements are limited to North America and the UK, where there is a closed scheme. In total, the DB pension and retiree medical schemes were in deficit by £331 million as at 31 December 2007. Deterioration in asset prices, changes to real long term interest rates or the strengthening of longevity assumptions could lead to an increase in the deficit or give rise to an additional funding requirement.
Taxation risk
The Group operates in over 30 countries and as a consequence is subject to many complex tax laws and administrative procedures. The Group’s interpretation and implementation of these laws and procedures may be subject to detailed scrutiny by tax authorities undertaking audits and ultimately litigation, which can take several years to complete.
Amounts accrued and provided for income tax liabilities are based upon management’s judgement taking into account their interpretation of tax law in each country and the likelihood of settlement where there is a tax dispute. However, actual tax liabilities could differ from the provisions made by management and the difference would give rise to an adjustment in a subsequent period which could have a material impact on the Group’s profit and loss and/or cash position.
Market and customer related risk
Global economic and political risk
GKN operates in over 30 countries including several in the emerging markets of Asia Pacific and Latin America and is, therefore, exposed to a wide range of risks including political, regulatory, environmental and socio-economic factors. However, we are also in a position to benefit from significant growth opportunities and a diversified business base.
Cyclical nature of the markets in which we operate
Approximately 56% of our 2007 sales were for automotive vehicle manufacturers and 20% for original equipment on aircraft or aircraft components.
The automotive industry, in common with other capital goods industries, is affected by macro-economic conditions and consumer demand and preferences. The military aircraft element of our business is affected by political considerations, particularly in the US, whilst civil demand is affected by the number of passenger miles flown which, in turn, is a function of economic growth and personal spending power and perceived security risk.
Customer concentration and relationships
Within the automotive and aerospace industries there is a significant degree of customer concentration. As a result the Group receives approximately 48% of its sales revenue from 11 major global customers. The loss of or damage to any of these relationships or a significant worsening of commercial terms with these customers could have a material impact on the Group’s results.
At the same time the Group enjoys good relationships with customers who have a strong market share and derives a significant benefit from trading with customers of this nature. Considerable resource is devoted to ensure that these good relationships are maintained and developed.
Technological change
The markets for our products and services are characterised by evolutionary change driven by consumer preference for increased safety and more focus on the environmental impact of motor vehicles and aircraft. We ensure that we are responsive to this by focused investment in technological development in all businesses.
The credit crunch
The credit crunch, which has impacted the world’s financial markets in the latter months of 2007 and the early part of 2008 and has contributed to uncertainties over near term macro-economic conditions, has not introduced new exposures for the Group. Rather, it has intensified certain of the financial and market risks noted above in response to which we have intensified our monitoring and controls in those areas.
Manufacturing and operational risks
Manufacturing strategy
Strategies are developed with the objective of aligning production with the lowest available cost base. Failure tomeet customer requirements as these are implemented would impact upon both short and longer term customer relationships. We have considerable experience of implementing operational change and a wealth of experience to draw on to minimise this risk.
Product quality and liability
The nature of our products means that we face an inherent risk of product liability claims if failure results in any claim for injury or consequential loss. However, our customers require high levels of quality assurance and manufacturing systems in place to ensure that our quality record is world class in both Automotive and Aerospace. Appropriate levels of insurance are in place covering product liability of third parties although the Group does not generally insure against the cost of product warranty or recall.
Supply chain
Our manufacturing processes may have dependencies on the availability of specific equipment and raw materials. An inability to supply because of their non-availability would affect our sales and relationships with our customers. Contingency plans exist to ensure continuity of supply, though in most cases this would result in additional costs which may or may not be recoverable through insurance.
IT systems reliability, security and change
Our IT systems and networks are secured by formalised back-up systems, hardware, virus protection and other measures but any interruption could lead to disruption in service. A breakdown of security or damage arising from any cause could affect our operational performance or revenue.
Management resources
Rapid growth in some of the emerging economies in which we operate has, in certain cases, given rise to an extremely competitive market for and shortages of appropriately qualified personnel. We address this through focused recruitment and a combination of education, training and retention/reward systems to attract and retain key staff in those countries together with the deployment of experienced GKN management on a secondment basis.
Technology risk
Many of the Group’s products are technologically advanced or use technologically advanced processes in their manufacture and continuous improvement takes place as new technology is developed. In order to maintain the competitiveness of our products we make focused investment in research and development so as to achieve or maintain technological leadership in our key businesses and retain the competitive advantage which such leadership gives.
Environmental risk
The environmental laws of various countries impose obligations on our businesses to operate in an environmentally friendly way. Failure to do so would result not only in financial consequences but also in damage to our reputation and may impact shareholder value as well as our employees and communities in which we operate. In environmental terms, our manufacturing processes are not inherently high risk; nevertheless, great care is taken to prevent any adverse impact arising.
Insurance
The Group insures against the impact of a range of unpredicted losses associated with business assets such as buildings, plant, machinery and ensuing financial impact arising from interruption to the business, as well as its liabilities (whether statutory or not) in connection with employees, products supplied or the public at large. This insurance takes the form of a significant level of capped self-insured retention at the Group level (within GKN’s own captive insurance company, Ipsley Insurance Ltd (Ipsley), which does not insure the risks of any other entity) and a much lower level of self-insurance at the subsidiary level. Catastrophe insurance is then purchased in the commercial market over and above this level of self-insured retention. Ipsley’s current participation in GKN’s insurance programme is £10 million per incident capped at £20 million in any one year.