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.
Generic risks
Macro-economic trends
Being a global company, DSM is subject to
the usual business risks associated with macroeconomic trends and events. The
projected results from the Vision 2010 are sensitive for deviations from the
assumed and defined economic scenario on which the strategy is based.
General market developments
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 activities may experience material fluctuation in sales and results due
to changes in general market conditions, supply-driven overcapacity, economic
conditions, currency exchange rate fluctuations or other factors.
Low-cost competition
Counteracting the influence of low-cost
competitors and seizing opportunities in low-cost areas (especially China) is
one of the centerpieces of DSM’s strategy. There is always a risk, however,
that such low-cost competitors penetrate in DSM’s core markets.
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.
DSM’s aim is to mitigate its currency exposure by developing sales in certain
regions, through product mix improvements, by focusing manufacturing
activities and through increased dollar-based purchasing. However, these
‘natural hedges’ are never fully balanced. 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
2007 business mix a 1% change in the euro-US dollar rate and the US
dollar-Swiss franc rate has on aggregate a € 8 -10 million impact on gross
margin level (=sales minus variable costs). Fluctuations in the relative
values of other currencies (such as the yen or the pound sterling) 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.
In 2007 a new long term foreign currency transaction hedging strategy has been
approved by the Managing Board. The new strategy 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 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 2007 DSM has
hedged 50% of the US dollar and Japanese yen transaction exposure in 2008.
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 2007.
Strategic risks
Acquisitions, disposals and joint ventures
The success of DSM’s
strategy is partly dependent on the company’s ability to spot and implement
opportunities for acquisitions, disposals and joint ventures. Risks in this
field are connected to the company’s failure to identify relevant acquisitions
or alliances, 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. 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.
Innovation (new markets, products and technologies)
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 will strengthen its market intelligence and enhance 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.
Within DSM’s strategy there is extra focus on innovation. A multitude of
actions are being taken to ensure success in the R&D and market development
processes. There is a risk that goals nevertheless will not be achieved and
that the company will have to abandon a project 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.
Ability to attract and retain people
DSM’s ability to retain
highly specialized and committed technical staff as well as talented staff
working in sales, R&D, manufacturing, finance, general management and human
resources is critical to the company’s future success. Within the limits of
its strategic direction, the company is making huge and ongoing efforts are
directed to managing the required processes. The company may have to adjust
the timing of its growth path, due to constraints or opportunities in this
field.
Organizational and cultural risks
The shift in strategy causes
new demands on the organization and the attitude of the employees. Although
adjustments to the organization have been implemented and programs are in
place to create the outside-in focused view that is needed, decision processes
may still be too slow and the entrepreneurial spirit still not sufficient.
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.
No DSM customer represents more than 3% of DSM’s total sales.
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 and engineering standards. Nevertheless,
certain risks and the degree to which safety, health and environmental
elements are managed may not always be sufficiently well known.
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. Although single source situations
are avoided as much as possible, the risk of incidental shortages of raw
materials cannot be completely excluded.
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. From a product-liability point of view the
life-science business is more exposed than other businesses. This holds in
particular for the pharmaceutical industry, which today has to face the
situation that certain product liability exposures cannot be insured against,
or only at prohibitively high costs and very high retentions. 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).
Non-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 careful monitoring. At the moment, none of the
products in DSM’s total portfolio is excluded from cover under our corporate
insurance programs. Uninsured losses in 2007 for any one incident will not
exceed about €30 million per occurrence with an annual aggregate maximum of
€45 million, the possible excess 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. 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. In general these fall into three categories: pricing reinforcement
projects, reorganization projects and ICT projects. Apollo is a project that
assures uniform application of standard business processes designed in SAP
throughout DSM worldwide.
DSM has extensive experience in project management. It seconds its best people
to projects that are considered critical. Moreover, direct Board involvement
and monitoring are in place to mitigate the risk of project failure. 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 pension 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 policies of
the respective pension plans are closely monitored by the company and the
investment strategies are aligned to the risk profile of the underlying
pension obligations.
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.