(N.B.: These descriptions are to be considered as an elucidation of the Annual
Report; they will not be updated during the year.)
The following section contains a selection of important risks that have been
identified and for the management of which strategies, controls and/or
mitigating measures have been put in place as part of our risk-management
practices. They nevertheless involve uncertainties that may lead to the actual
results differing from those projected. There may also be current risks that
the company has not yet fully assessed and that are currently qualified as
“minor” but that could have material impact on the company’s performance at a
later stage. The company’s risk-management and internal-control system has
been designed to signal and respond to these developments on time, but 100%
assurance can never be achieved, of course. The risks marked with an asterisk
are considered to be the company’s main strategic risks. The responses to
these risks are described in the Annual Report, page 85.
Generic risks
Global financial and economic developments*
Being a global
company, DSM is subject to business risks associated with macroeconomic trends
and events. The global financial crisis and economic downturn has become one
of the most important risks for the remainder of the Vision 2010 period.
General market developments and commoditization*
DSM operates
in many different business segments with contingent risk profiles reflecting
the different business environments, the diverse nature of the businesses and
the distinctive competitive positions those businesses target for. DSM’s
Vision 2010 aims at further reducing the cyclical element, but a substantial
portion of its current activities is still experiencing a material impact in
sales and results due to the economic downturn and competition from low cost
countries. Margins may erode under the influence of commoditization, a risk
that may be aggravated by low global utilization rates.
Political risks
DSM has subsidiaries in more than 45 countries.
These subsidiaries can be exposed to changes in government regulations and
potentially unfavorable political developments that might hamper the
exploitation of certain opportunities or might impair the value of the local
business.
Currency risks and interest risk
All DSM sales that are priced
in currencies other than the Euro are subject to economic transaction and/or
translation risks that may significantly impact on the financial results, as
the company’s reporting unit is the Euro.
The volatility of the US dollar in relation to the Euro and the Swiss franc
can have a significant impact on the company’s results. Although the
production base still has its center of gravity in Europe, a large portion of
DSM’s product sales are in US dollars or are based on US-dollar-denominated
world-market prices. Consequently, from a currency perspective there is a
mismatch between revenue and costs. In the 2008 business mix a 1 cent change
in the Euro-US dollar rate and the US dollar-Swiss franc rate has on aggregate
a € 6-9 million theoretical impact on gross margin level (=sales minus
variable costs). However DSM experiences natural hedges and therefore the
impact on gross margin is less and is estimated to be in the range of € 4-6
million.
Fluctuations in the relative values of other currencies (such as the yen) have
a limited impact on DSM’s results.
DSM companies are obliged to hedge their open currency positions via the DSM
In-house Bank in order to protect the operating result against effects of
currency fluctuations. Only under strict conditions are DSM companies allowed
to hedge firm commitments in order to protect the cash flow of the contract
value against currency fluctuations. Hedging of forecast transactions is only
allowed after the approval of the Managing Board.
The long term foreign currency transaction hedging strategy of DSM, adopted in
2007, follows a systematic, risk management oriented approach. Based on the
optimal return-risk ratio in the last 17 years DSM decided that a risk
appetite of 50% is appropriate and consequently DSM hedges 50% of the risk.
DSM will follow this hedging strategy for the US dollar transaction exposure.
Each year DSM will determine if currencies other than the US dollar have
material impact on the result and, if so, will follow the same approach for
these currencies. For 2008 and 2009 the Japanese yen was added. The US dollar
and Japanese yen together determine around 93% of the total foreign currency
transaction exposure of DSM. End of 2008 DSM has hedged 50% of the US dollar
and Japanese yen transaction exposure in 2009.
Due to the fact that a portion of the borrowings are floating interest
bearing, fluctuations in the interest rates have an impact on the net result.
The impact on the DSM result is capped by the company’s policy of not allowing
the floating interest position to exceed 60% of net debt.
Risks of derivatives used for hedging purposes
DSM uses
financial derivatives to hedge various currency and interest rate risks. Under
IFRS, all derivatives are recognized as either assets or liabilities. In line
with IAS 39 financial derivatives are recognized at fair value. Changes in
fair value go to the income statement either contemporaneously or, if hedge
accounting is applied, at the moment that the hedged item impacts on the
income statement. These changes normally consist of a currency and an interest
rate component. To limit the volatility deriving from the use of derivatives,
hedge accounting is applied in certain cases. Hedge accounting is only allowed
under strict conditions, which are different per hedge type.
DSM applies the following hedge accounting models: fair value hedge
accounting, cash flow hedge accounting and net investment hedge accounting.
The goal of a fair value hedge is to fix the value of an asset/liability
(hedged item). Changes in fair value of a designated derivative that is highly
effective as a fair value hedge, together with the change in fair value of the
corresponding asset, liability or firm commitment attributable to the hedged
risk, are included directly in earnings. So both fair value changes are offset
in the income statement.
The goal of a cash flow hedge is to limit the variability of highly probable
future cash flows due to foreign currency or interest rate movements. Changes
in fair value of a designated derivative that is highly effective as a cash
flow hedge are included in equity and reclassified into income in the same
period during which the hedged forecast cash flow affects income. In this way
volatility in the income statement is avoided.
The goal of a net investment hedge is to fix the value of an investment in a
foreign entity. Changes in fair value of a designated derivative that is
highly effective as a net investment hedge are included in equity. So
volatility of the hedged part of the net investment is offset in equity.
Under IFRS hedge accounting through combined derivatives is not allowed. For
this reason DSM has chosen to hedge the interest and foreign currency risk
with separate derivatives and not to use combined derivatives to hedge both
risks.
Any ineffectiveness of hedges is reflected directly in income. DSM aims to
mitigate these risks by closely monitoring the effectiveness of the hedges
through effectiveness testing. Ineffectiveness only occurs when fair value
changes of the hedging instrument compared to fair value changes of the
underlying risk are outside an 80 – 125 % bandwidth. There was no material
ineffectiveness in relation to these hedges in 2008.
Strategic risks
Divestments*, acquisitions* and joint ventures
The success of
DSM’s strategy is partly dependent on the company’s ability to spot and
implement opportunities for divestments and acquisitions. Risks in this field
are connected to the company’s failure to identify interested buyers for its
divestments or relevant acquisition targets, or its failure to do so in time,
or its lack of success in bid processes or in the integration of acquired
businesses needed to safeguard its path of growth. This risk is aggravated by
the financial crises which negatively influences the financing possibilities.
DSM uses joint ventures and other strategic alliances whenever it is
beneficial to do so (for example to combine strengths and to share investments
and inherent risks). Although joint ventures and strategic alliances are
always intended to add value, situations can arise that result in a conflict
of interests that could potentially damage the business.
Ability to turn innovation efforts into profitable business*
In
its Vision 2010 strategy, DSM is increasing its focus on innovation in order
to develop new technologies and products and explore new markets. To this end,
the company is strengthening its market intelligence and enhancing its market
and customer orientation. Nevertheless, the actual developments in the
targeted markets, the speed with which new products and technologies are
accepted and the emergence of new competition will always constitute risks to
the success of the chosen strategy.
A multitude of actions have been taken to ensure success in the R&D and market
development processes and in product launch efforts. There is a risk that
goals nevertheless will not be achieved and that the company will have to
abandon projects on which it has already spent substantial sums of money. The
company may reach a point where its overall sales volume does not justify the
company’s R&D expenditure. This risk may be aggravated by the economic
downturn, amongst others because potential customers may re-prioritize their
needs.
People, organization and culture*
DSM’s ability to attract and
retain the right people and create an entrepreneurial yet responsible culture
is key to the achievement of the Vision 2010 targets. In the year under review
the recruitment, management development and learning practices have been
revised in order to answer to these requirements. Organizational changes have
been set in motion and programs to support the entrepreneurial spirit and
cultural change have been initiated. Nevertheless, the company may have to
adjust the timing of its growth path, due to constraints in this field.
Specific risks
Corporate reputation risks
Any failure by any of its business
units to meet production safety, social, environmental and/or ethical
standards could harm DSM’s corporate reputation and thereby impact on its
business and results. DSM values such as good corporate citizenship, open
communication and transparency should reasonably assure appropriate employee
conduct. Moreover, the company mitigates its reputation risk by making
substantial efforts to reduce the probability that any of its units fails to
comply with internal requirements and/or external laws and regulations.
Customer risks
The company makes considerable efforts to
delight its customers. Compliance with customer agreements and commitments is
measured regularly. Appropriate process and product quality checks and
balances are in place to mitigate the risk of non-compliance with customers’
and with DSM’s sales conditions. Nevertheless it cannot be totally excluded
that issues in this area could arise.
Production-process risks
DSM tries to mitigate production
process risks by spreading production where possible, but concentration is
necessary in order to achieve economies of scale. The design of any new
facilities and/or production processes is required to include state-of-the-art
safety and security facilities. Plants are regularly and systematically
inspected against predefined risk, maintenance and engineering standards.
Nevertheless, technical and technological risks as well as safety, health and
environmental elements may not always be sufficiently well known or controlled
as to exclude any mishaps.
Raw material / energy price and availability risks*
It may not
always be possible to off-set the effect of raw material and energy price
increases by adaptations in sales prices. A commodity hedging policy has been
put in effect but this will never ensure that price changes may not negatively
influence margins. Although single source situations are avoided as much as
possible, the risk of incidental shortages of raw materials cannot be
completely excluded. Single source situations may become more risky because of
the economic situation affecting supplier’s stability.
Product-liability risks
As a result of the progress made
towards DSM’s current corporate goals following from the Vision 2010 strategy,
the company’s product portfolio has shifted and is still shifting. This has
been accompanied by a corresponding shift in DSM’s risk profile. DSM is aware
of this ongoing process, putting more emphasis on managing product liability
exposures. To protect itself against these risks, DSM has put in place highly
demanding process and product requirements and is putting in a great deal of
effort on an ongoing basis to assure that all its units comply with internal
and external regulatory requirements (e.g. FDA). Nevertheless,
product-liability issues can never be totally excluded.
Insurable risks
Global insurance policies are in place to
reduce the risk of damage to property, business interruption loss and general
liability exposures, including the liability risks related to the products
produced. Especially the ongoing change in the product portfolio makes product
liability an issue that needs and receives careful monitoring. At the moment,
all of the products in DSM’s total portfolio are covered under our corporate
liability insurance programs. For losses covered by the several policies the
self retention at corporate level in 2008 for any one incident will not exceed
about €30 million per occurrence with an annual aggregate maximum of €45
million.The possible excess is being transferred to external insurers.
ICT risks
In order to control potential ICT risks DSM employs a
policy of using the latest proven hardware and software solutions. Group-wide,
DSM works with integrated and standardized ICT infrastructures, back-up,
encoding and encryption systems, replicated databases, virus and access
protection and a fully compatible global network and intranet. Regular local
ICT-security assessments should assure adequate local applications. External
ICT-service providers have been contracted in and are required to report
regularly on the measures they are taking to reasonably assure that DSM’s IT
processes are not disrupted.
Although DSM has applied strict measures with regard to the security and
reliability of its IT systems, incidents regarding for example back-up
recovery, hot failover systems, virus attacks and international network
connections may still occur, and this can have a material impact on business
operations.
Intellectual property protection risks
A certain portion of the
company’s financial results is based on (legally) protected intellectual
property. New requirements have been introduced to help Business Groups in
effectively identifying, claiming and defending valuable intellectual property
rights. When these protection mechanisms expire or do not work properly and
the company is unable to follow up these situations appropriately, e.g.
through new valuable patents or litigation, there is a risk that the financial
results might deteriorate.
Project risks
The company is currently undertaking some major
projects whose success is important to the overall business results and
exposure. DSM has extensive experience in project management. It seconds its
best people to projects that are considered critical. Moreover, independent
Value Assurance Reviews are conducted and direct Board involvement and
monitoring are in place to mitigate the risk of failure of major projects.
Projects may nevertheless not always produce the (financial) results projected.
Financial risks
Financial risks additional to the currency,
interest and derivative risk mentioned above include commodity risk, credit
risk, tax risk and country risk. The major credit rating agencies may change
their assessments on DSM creditworthiness; thereby affecting the company’s
borrowing capacity and/or the conditions under which it can borrow money and
causing fluctuations in the cost of finance. The company aims to keep its
single-A credit rating.
The outcomes of ongoing disputes with tax authorities could impact on the
company’s tax position with retroactive effect. Although tax assets have been
recognized at fair value, future profits may not suffice to realize all
tax-loss carry-forwards.
Pension risks
With significant defined benefit obligations in
six countries DSM is exposed to volatility in financial markets that can cause
changes in future pension costs for the company and in the funded status of
the individual pension plans. To reduce these risks the investment strategies
of the respective pension plans are aligned to the risk profile of the
underlying pension obligations and the investment policies are closely
monitored by the company. The volatility in cash contributions to these plans
is limited due to contractual arrangements. The financial crisis, however, has
materially impacted the financial situation of the funds and will have a
considerable non-cash EBIT impact on DSM’s results.
Control failures
In our Triple P report some of the control
failures are mentioned that occurred in spite of our risk management efforts.
They can be found in the section: “What still went wrong”. All failures are
extensively analyzed and lessons learnt are implemented.
