Risks and uncertainties
Smiths operates globally in varied markets and manages the risks inherent in its activities. The Group seeks to mitigate exposure to all forms of risk, both external and internal, where practicable, and to transfer risk to insurers, where cost-effective.
Principal risks
Foreign exchange
The Group is exposed to two types of currency risk: transaction risk in respect of products manufactured in one currency region and sold in another currency; and translation risk in that the results of non-UK businesses will translate into differing pounds sterling values depending on the exchange rate. The Group’s practices for managing currency risk generally mitigate transaction risk in the short term. Over the longer term, Smiths remains exposed to both transaction and translation risk.
Longer-term transaction risks are partially mitigated by manufacturing or sourcing components in the same currency as that of the sale.
Raw material prices
Smiths products contain various raw materials or purchased components including electronic components, metals and plastics. Any increases or volatility in prices and shortages in supply can affect the Group’s performance. The diversity of operations both geographically and in terms of product area reduces the dependence on any single item or supplier. Purchasing policies take into account and seek to mitigate such risks where practicable.
Pension funding
The Group operates significant pension plans. The average funding level of the funded plans at 31 July 2007 was 110% measured by IAS 19 methodology. Funding of pension liabilities at that date was some 55% by equities and 45% by other assets. Smiths is subject to various funding risks, principally poor performance of the equity investments and other investments, and increased longevity of members.
Litigation
Smiths is subject to litigation from time to time in the ordinary course of business, and makes provision for the expected cost based on appropriate professional advice. In particular, John Crane, Inc., a subsidiary of Smiths, is currently one of many defendants in litigation relating to products previously manufactured which contained asbestos and in respect of which a provision for defence costs has been made.
The outcome of legal action is always uncertain and there is always the risk that it may prove more costly and time consuming than expected. There is a risk that additional litigation could be instigated in the future which could have a material impact on the Group. In some liability cases, legal expenses are covered by insurance.
Other risks
In addition to the principal risks, other external risks include global political and economic conditions; natural catastrophe; actions of competitors; the effect of legislation or other regulatory action; credit and environmental issues.
Internal risks include investment in new products, projects and technology; acquisitions; controls failure; inability to supply and business continuity.
External risks
Global political and economic conditions
Smiths operates in over 50 countries, although some 90% of the Group’s employees are located in North America, the EU and Japan. The Group is exposed to political risk, natural catastrophe and possible terrorist action.
Some 45% of total sales are to customers in the US, and the Group is therefore particularly affected by US economic conditions. Demand for products from the detection business is mainly dependent on spending by governments and government agencies.
Smiths may be adversely impacted by changes in general economic conditions including interest rates, exchange rates and inflation.
The diverse nature of the Group’s products, services and customers helps mitigate the effects of adverse changes in political and economic risk on the demand that Smiths experiences.
Natural catastrophe
Because of the location of operations, Smiths is exposed to a number of natural catastrophe risks, such as earthquake, flood and windstorm. Where cost-effective, such risks are mitigated through physical measures designed to counter the impact of a catastrophe. The value of assets and associated profits are also protected by insurance.
Actions of competitors
Smiths operates in highly competitive markets. Product innovations or technical advances by competitors could adversely affect the Group. The diversity of operations reduces the possible effect of action by any single competitor.
The Group invests some 4% of revenues in research and development in order to sustain competitive advantage, and works continually to ensure that the cost base is competitive.
Effect of legislation or other regulatory action
Smiths is subject to a broad range of laws, regulations and standards in the jurisdictions in which it operates. Unexpected changes in these laws or regulations could significantly impair performance; equally a failure to comply with these laws, regulations or standards could damage the reputation of the Group.
The Detection and Medical businesses are particularly subject to regulation, with certain customers and regulatory or other enforcement bodies routinely inspecting the Group’s practices, processes and premises. Certain legal liability risks, such as product liability and employer’s liability, are transferred to insurers, subject to policy limits and conditions. However, the Group and its subsidiaries have been in business for many years and there is a risk of latent injury claims which may not be fully covered by insurance.
Credit
Smiths is exposed to credit risk in relation to customers, banks and insurers. Credit control practices take into account the perceived risk. The customer base is relatively diverse.
Where appropriate, Smiths seeks to insure business risks with insurers of good standing. The insurance industry is, however, subject to credit risk, particularly in the event of catastrophe or where an insurer has substantial exposure to a specific risk. Occasionally insurer credit risk may be mitigated through policy commutation.
Environmental issues
The environmental laws of the jurisdictions in which Smiths operates impose actual and potential obligations on the Group to remediate contaminated sites, including some sites no longer owned by Smiths. The Group makes provision for the expected cost of remediation based on independent professional advice. There is a risk that remediation could prove more costly than expected and that further contamination could be discovered.
Internal risks
Investment in new products, projects and technology
Smiths develops new technologies and introduces new products, in some cases contracting to supply the products to the customer before the design is established or proven. All new technologies and products involve business risk both in terms of possible abortive expenditure, reputational risk, and potential customer claims or onerous contracts. The same is true for investment in new facilities, in transferring production and in information systems. Such risks may have a material impact on the Group.
Security
Smiths information systems, personnel and facilities are subject to security risk; failure to adequately mitigate this risk could have a material impact on the Group and its reputation.
Taxation
In recent times Smiths has had an effective tax rate of approximately 26%. There can be no guarantee that Smiths effective tax rate will remain below the prevailing tax rate applicable in the territories in which it operates.
Acquisitions
Smiths is an active acquirer of other businesses and companies: acquisitions may involve risks that might have a material impact on the Group. These risks are mitigated by extensive due diligence, and, where practicable, by representations and warranties and indemnities from the vendors.
Controls failure
Smiths operates various corporate governance controls. Failures in these controls might have a material impact on the Group.
Inability to supply and business continuity
Inability to supply against contractual commitments is a risk, which could be material in relation to larger contracts. Smiths mitigates this risk by implementing effective business continuity plans throughout the Group and, where practicable, transferring them through business interruption insurance.
Sale of Smiths Aerospace
The sale and purchase agreement governing the sale of the aerospace business to GE Aviation UK contains certain warranties and indemnities in favour of GE Aviation UK. If Smiths should incur costs under any of these warranties or indemnities, these costs could have an adverse effect on its business, financial condition and results of operation.