Risk management

Smiths is exposed to a wide range of risks in running its businesses. The Company and its divisions consider these risks on a regular basis and seek to put in place appropriate risk management processes, policies and other measures, including insurance where appropriate.

However, there can be no assurance that these measures will be effective in any particular case. If any of these risks, or other unforeseen risks, materialise, they could have a significant adverse effect not only on our business and financial condition but also on our reputation and the trading prices and liquidity of our securities. This could lead to a loss for investors of part of or, in a worst case scenario, all of their investment.

The Group’s process for identifying, evaluating and managing significant business risks is reviewed by the Audit Committee and monitored by the Group Internal Audit Department. During the year, we undertook an additional corporate risk review, to augment our divisional risk management review processes. An outline of this year’s review process by the Board and Audit Committee is set out in the Statement of the independent non-executive directors. A description of the Company’s internal controls and risk management processes is given in the Corporate governance statement.

Further information is provided below on our principal risks and the mitigating activities in place to address them. The Group is exposed to a larger number of risks than those listed. However, we have made a conscious effort to disclose those risks that have been debated at recent Board or Audit Committee meetings and are of most concern to the business at this time.

  • Financial risks (foreign exchange, funding, tax and insurance)

  • Risk

  • Foreign exchange: Exchange rate fluctuations have had, and could continue to have, a material impact on the reported results. Smiths is exposed to two types of currency risk: transaction and translation.

    Funding: Smiths ability to refinance its borrowings in the bank or capital markets is dependent on market conditions and the proper functioning of financial markets.

    Tax: The Group’s future profitability, particularly if in the US where there are higher rates of corporation tax, may cause the headline tax rate to increase over time. Changes in tax and fiscal regulations and transfer pricing rules in the countries in which we operate could affect the Group, particularly at times when public sector debt is high, as could the uncertainty surrounding the basis of taxation of foreign profits under the UK’s controlled foreign companies regulations.

    Insurance: Smiths cannot be certain that it will be able to obtain insurance on acceptable terms or at all. Furthermore, Smiths cannot be certain that its insurance will cover losses arising from events or that insurers will not dispute coverage. In addition, even if our coverage is sufficient, the insurance industry is subject to credit risk, particularly in the event of a catastrophe or where an insurer has substantial exposure to a specific risk.

  • Potential impact

  • Foreign exchange: The Group’s reported results will fluctuate as average exchange rates change. The Group’s reported net assets will fluctuate as the year-end exchange rate changes.

    Funding: The Group may be unable to refinance its debt when due.

    Tax: Taxation costs could rise and earnings per share could deteriorate, which could affect the Group’s market valuation.

    Insurance: If insurance cover is inadequate or does not pay out as expected, Smiths could be exposed to an unexpected material cash outflow, which may impact on the Group’s liquidity and/or share price.

  • Risk management

    • Foreign exchange: The Group’s hedging strategy, whereby larger transactions are hedge accounted, mitigates the risk to profitability to some extent. Net investment hedging of overseas assets of approximately 50% through borrowing in non-sterling currencies mitigates the impact of exchange rate fluctuations on net assets.
    • Funding: The Group’s debt maturity is staggered so that the refinancing risk is minimised. As at 31 July 2011, we had an undrawn revolving credit facility of $800m.
    • Tax: The Group’s taxation staff co-ordinate tax management to mitigate possible increases in the effective tax rate. Regular reporting to the Board of tax risks and exposures provides good visibility of issues.
    • Insurance: Insurance risk is spread across a number of carriers to minimise individual insured risk and counterparty risk.

  • Government customers

  • Risk

  • We derive a significant proportion of our revenues in mature Western economies. Additionally, over 40% of the Group’s revenues are from governments and their agencies or are influenced by government regulation.

    Smiths Detection, Smiths Medical and Smiths Interconnect frequently tender for government contracts. The timing of contract awards and payments under these contracts may be uncertain and uneven over a given financial year.

    Any significant disruption or deterioration in relationship with these governments could result in fewer contracts and lower revenues.

  • Potential impact

  • At a time when government finances are under pressure, these headwinds may lead to slower growth across the business.

    A decrease in spending by key government customers could materially affect the Group’s results and financial condition.

    Delays in awarding government contracts can affect the Group’s sales, margins and cash conversion in a particular reporting period.

  • Risk management

    • The Group has a diversified portfolio of businesses that mitigates against exposure to any one country or sector.
    • Some of our government-related business has a services or consumables component, which can be more resilient during an economic downturn.
    • The Group has enhanced its government relations function so that it can inform policy and maintain close relationships with customers. This supports the monitoring of lead indicators and helps us to position our businesses appropriately for the economic cycle.

  • Information technology

  • Risk

  • Smiths information systems, personnel and facilities are subject to security risk. Smiths is dependent on information technology systems for both internal and external communications and for the day-to-day management of its operations.

  • Potential impact

  • Any disruption to the information systems could have significant adverse consequences for the Group’s operations or its ability to trade.

  • Risk management

    • Extensive controls and reviews are undertaken to maintain the integrity and efficiency of IT infrastructure and data.
    • There are also processes to deal with significant IT security incidents.

  • Compliance with legislation and regulations

  • Risk

  • There is a risk that Smiths may not always be in complete compliance with laws, regulations or permits, for example concerning environmental or safety requirements.

    Smiths operates in highly regulated sectors. Smiths Detection, Smiths Interconnect and Smiths Medical are particularly subject to regulation, with certain customers, regulators or other enforcement bodies routinely inspecting the Group’s practices, processes and premises.

    Due to their products’ security functions, Smiths Detection and Smiths Interconnect are subject to numerous export controls, technology licensing and other government regulations.

    In addition, new legislation, regulations or certification requirements may require additional expense, restrict commercial flexibility and business strategies or introduce additional liabilities for the company or directors. There also appears to be a growing trend for legislation that could be described as ‘protectionist’, which may affect our businesses.

  • Potential impact

  • Smiths could be held responsible for liabilities and consequences arising from past or future environmental damage, including potentially significant remedial costs. There can be no assurance that any provisions for expected environmental liabilities and remediation costs will adequately cover these liabilities or costs.

    Should a regulator’s approval process take a particularly long time, our products may be delayed in getting to market, which could lead to a loss of revenue or benefit a competitor with a similar product.

    Failure to comply with certain regulations may result in significant financial penalties, debarment from government contracts and/or reputational damage.

  • Risk management

    • Environmental, health and safety data are reported to the Quarterly Business Reviews, Executive Committee and the Board, along with actions to improve performance over time.
    • Smiths Medical has dedicated staff who maintain close contact with the US Food and Drug Administration and other key regulators.
    • All divisions have trade compliance advice and training. This includes training on the Group’s Code of Business Ethics and assessments to support compliance.
    • Divisional and Group General Counsel monitor legislative changes (assisted by Government Relations staff) and report and monitor actions as necessary. This may require modifications to our supply chains and customer arrangements.

  • Product liability and litigation

  • Risk

  • In the ordinary course of its business, Smiths is subject to litigation such as product liability claims and lawsuits, including potential class actions, alleging that the Group’s products have resulted or could result in an unsafe condition or injury.

    In addition, manufacturing flaws, component failures or design defects could require us to recall products. Many of our products are used in critical applications where the consequences of a failure could be extremely serious and, in some cases, potentially catastrophic.

    Products sold to the aviation, security, healthcare, energy and consumer/domestic industries are particularly critical in nature.

    Furthermore, over half the Group’s sales are in the US, where there is potentially increased litigation risk.

  • Potential impact

  • Any liability claim against Smiths, with or without merit, could be costly to defend and could increase our insurance premiums. Some claims might not be covered by our insurance policies, either adequately or at all.

    An adverse event involving one of our products could damage our reputation and reduce market acceptance and demand for all of our products.

  • Risk management

    • Quality assurance processes are embedded in our manufacturing locations for critical equipment, supporting compliance with industry regulations.
    • A global best practice programme is underway to enhance product quality processes across the Group. This is sponsored by the Executive Committee and leverages the ongoing work in Smiths Medical and John Crane.
    • The divisions have procedures for dealing with product liability issues and potential product recalls. These procedures are being informed by crisis management planning workshops and rehearsals.
    • The Group has insurance cover for product liability. The US ‘Safety Act’ provides legislative protection for certain Smiths Detection products in the US; and we support efforts to implement similar legislation in other markets.
    • Any litigation is managed under the supervision of the Group’s General Counsel. We have detailed action plans to manage actual or threatened litigation.

  • Economic outlook

  • Risk

  • Smiths operates in more than 50 countries and is affected by global economic conditions, particularly in the US. Our business is also affected by government spending priorities, in particular in the US and UK, and the willingness of governments to commit substantial resources to homeland security and defence.

    Current global economic and financial market conditions, and the potential for a significant and prolonged global recession, may materially and adversely affect the Company’s performance and financial condition. A recession may also materially affect its customers, suppliers and other parties with which it does business. Adverse economic and financial market conditions may cause our customers to terminate existing orders, to reduce their purchases from Smiths, or to be unable to meet their obligations to pay outstanding amounts due to Smiths. These market conditions may also cause our suppliers to be unable to meet their commitments to Smiths or to change the credit terms they extend to us.

  • Potential impact

  • A significant and sustained economic downturn, or any similar event, could have a material adverse effect on the Group’s operational performance and financial condition.

  • Risk management

    • The Group has a diversified portfolio of businesses that mitigates against exposure to any one country or sector.
    • The divisions regularly monitor their order flows and other leading indicators, where available, so that they may respond quickly to a deterioration in trading conditions.
    • In the event of a significant economic downturn, there may be opportunities to identify and implement cost reduction opportunities to offset the impact on margins from a deterioration in sales.

  • Global supply chain/concentration of manufacturing

  • Risk

  • Smiths business depends on the availability and timely delivery of raw materials and purchased components, and could be affected by a disruption to its supply chain. In particular, we rely on sole suppliers to provide raw materials or components for some of our products.

    The Group’s manufacturing facilities are exposed to a number of natural catastrophe risks, which, like other external events such as terrorist attacks or a disease pandemic, could have significant adverse consequences. Smiths is also affected by the social, economic, regulatory and political conditions in the countries where it operates, which are often unpredictable and outside its control, particularly in developing countries.

  • Potential impact

  • The concentration of manufacturing in lower cost countries, in particular in Mexico and China, increases the length of the supply chain and means that an adverse event could have more significant consequences for our ability to supply customers on time.

    A longer supply chain also affects transport costs, which could be exacerbated by energy cost inflation.

  • Risk management

    • Business continuity and disaster recovery plans are in place and tested for critical locations, to reduce the impact of an event.
    • Single source supplier risks are identified and, where possible, key materials or components are dual sourced to mitigate the impact of an event.
    • The Group regularly evaluates its key sites for a range of risk factors using externally benchmarked assessments, and takes action to improve these ratings, where appropriate.
    • Smiths has business interruption and property damage insurance.

  • Acquisitions and disposals

  • Risk

  • The success of the Group’s acquisition strategy depends on identifying targets, obtaining authorisations and having the necessary financing. Even if an acquisition is completed, the acquired products and technologies may not be successful or may require significantly greater resources and investment than anticipated.

    Smiths may not be able to integrate the businesses that it acquires. If integration is unsuccessful, anticipated benefits are not realised or trading by acquired businesses falls below expectations, it may be necessary to impair the carrying value of these assets.

    In recent years, Smiths has disposed of a number of businesses, including its Aerospace operations, where it has given indemnities, warranties and guarantees to counterparties. Smiths is also party to a number of contracts relating to formerly owned businesses which it has not yet novated to the purchasers of these businesses.

  • Potential impact

  • The Group’s return on capital employed may fall if acquisition hurdle rates are not met.

    The Group’s financial performance may suffer from goodwill or other acquisition-related impairment charges.

    Insufficient allowance for indemnities and warranties given at disposal may affect our financial position.

  • Risk management

    • We perform comprehensive strategic and financial reviews of all opportunities. Detailed due diligence and integration work is undertaken and reviewed in accordance with Group policy.
    • Due diligence includes an assessment of the acquisition target’s talent and competencies. We also consider the integration process and management.
    • The Board only authorises acquisitions after completion of due diligence, and approval is subject to meeting the capital allocation and other financial hurdles set by the Board.
    • The Board regularly reviews post-acquisition performance and integration.
    • The Executive Committee and Board review the acquisition pipeline. There are monthly reviews with strategy leads for each division.
    • On disposals, the Company seeks to minimise its exposure to indemnities and warranties and any that are provided are reviewed on a regular basis.

  • Pension funding

  • Risk

  • At 31 July 2011, Smiths has legacy defined benefit pension plans, with aggregate liabilities in excess of £3bn. While on an accounting basis the reported net deficit is relatively modest, changes in discount rates, inflation, asset returns or mortality assumptions could lead to a materially higher deficit. For example, the cost of a buyout on a discontinued basis, and therefore using more conservative assumptions, is likely to be significantly higher than the accounting deficit.

    In addition, there is a risk that the plans’ assets, such as investments in equity and debt securities, will not be sufficient to cover the value of those benefits.

  • Potential impact

  • The implications of a higher pension deficit include a direct impact on valuation, credit rating and potential additional funding requirements at subsequent triennial reviews. Contingent payment commitments made in the 2009 triennial valuation may also be more likely to crystallise.

    In the event of a major disposal that generates significant cash proceeds that are returned to shareholders, the Group may be required to make additional cash payments to the schemes or provide additional security.

  • Risk management

    • All major schemes (US/UK) have been closed to future accrual.
    • Agreed funding plans are in place with the major UK schemes following the last triennial reviews. The Group seeks a good working relationship with the trustees through regular update meetings.
    • There are plans in place to reduce the mismatch between assets classes and liabilities, as relative outperformance of the assets versus liabilities is achieved, although there is no downside protection in place should this not occur.
    • Pension matters are regularly reported to the Board.

  • Technology and innovation

  • Risk

  • Developing new products and improving existing products is critical to our business and competitors may innovate more effectively.

    The emergence of a disruptive technology could have an impact on a major cash-flow contributor to the Group over time.

    The speed of innovation in certain markets may lead to shorter product lifecycles, increasing the need for innovation.

    Additionally, the entry of new competitors, the consolidation of existing competitors and changed or irrational competitor behaviour could all significantly affect the Group’s business.

  • Potential impact

  • The failure of the Group to develop its products and services, or more effective innovation by a competitor, could have a materially adverse affect on sales growth.

  • Risk management

    • The Group has a diversified technology portfolio in a range of sectors and geographies.
    • Our continued investment in R&D supports new product and service development.
    • The Group looks to expand the addressable markets of its key businesses by building capabilities in adjacent markets, through organic investment and targeted acquisitions.

  • Talent and succession planning

  • Risk

  • The loss of key personnel, or the failure to plan adequately for succession or develop new talent.

    Competition for personnel is intense and Smiths may not be successful in attracting or retaining qualified personnel, particularly engineering professionals. In addition, certain personnel may be required to receive security clearance and substantial training to work on certain programmes. The loss of key employees, Smiths inability to attract new or adequately trained employees, or a delay in hiring key personnel could seriously harm the Group’s business.

  • Potential impact

  • May impact the reputation of the group, or lead to a disruption in the leadership of the business.

    Over time, our competitive advantage is defined by the quality of our people – should we fail to attract, develop and retain key talent, in time our competitive advantage will erode, leading to weaker growth potential or returns.

  • Risk management

    • Each division or function holds talent and succession plan reviews at least annually. These plans are reviewed by the Nomination Committee.
    • Remuneration packages, including variable and long-term elements of the compensation arrangements are evaluated regularly against market practice.


Smiths Group divisions:
Smiths Detection, Smiths Medical, John Crane, Smiths Interconnect, Flex-Tek

 

Smiths Group plc:
Registered office 2nd Floor, Cardinal Place, 80 Victoria Street, London SW1E 5JL, UK
Incorporated in England No. 137013
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