17
CASE STUDY 4
Development of a Typical Risk Statementto Shareholders
17.1 INTRODUCTION
The theoretical model for performing risk management, as described here, consists of risk identification, analysis, and response and the application of this model in the construction of a risk register for UUU. As this is a largely qualitative analysis due to lack of project level information, there will be more risks listed at the corporate level and fewer at the project level. A risk statement to shareholders is developed based on a summary of typical risks at each level of the corporation.
17.2 UUU OVERVIEW AND RISK REGISTER
UUU is a corporation which deals with heating and air conditioning systems, aerospace and industrial systems, elevators and escalators, aircraft engines, helicopters, fire and security protection services, and power systems. It has over 3000 locations in 52 countries and conducts business in 120 countries. Figure 17.1 gives a brief overview of the organization levels.
17.3 CORPORATE RISK REGISTER
The corporate risk register deals with the macro-level risks that have the largest impacts on the organization. Although these risks may not be prominent for each individual project, they are risks because of the cumulative effects they can have on the corporation.
17.3.1 Foreign Exchange Risk
UUU’s involvement in the world economy has grown tremendously as its share of domestic revenues has declined relative to its European and East Asian revenues. UUU has a large volume of foreign currency exposures that result from international sales, purchases, investments, borrowings, and other international transactions. As a result, the strengthening of foreign currencies actually contributes to additional revenue for UUU but a sudden depreciation could result in a loss of revenues. Therefore, it is best to retain this risk and in areas of weak exposure use currency hedging.
* Reproduced by permission of A. Merna.
Figure 17.1 Organisational structure of UUU Corporation
17.3.2 Political/Country Risk
UUU has physical infrastructure throughout its worldwide locations and is therefore subject to a high degree of political or country risk. Countries in emerging markets like Russia, China, and Argentina bring with them a higher level of political risk. In addition, risk in one emerging market can lead to contagion in other markets. As a precautionary measure, UUU’s investment in any particular country does not ‘exceed 2.5% of consolidated shareowners’ equity’.
17.3.3 Market Performance Risk (Demand Risk)
UUU’s overall performance is driven by general economic conditions. There is significant fluctuation across international markets over time. Some of these fluctuations spill over into important determinants of demand like residential and commercial construction activity, labour costs, and customer attrition. However, this risk is not unique and impacts the competition across the market. The only means to manage it is to continually improve productivity despite market conditions.
17.3.4 Commodity Prices (Supply Risk)
UUU is subject to fluctuations in the international commodities market. One of the commodities with volatile prices is oil. In addition, titanium and copper, which are important commodities for UUU’s commercial and aerospace projects, also experience price fluctuations. Although there is the opportunity to gain on purchasing raw materials as the price declines, this is a high impact risk on cash flow variability and can be managed by means of forward contracts. However, forward contracts will not be used in every circumstance and sometimes part of the risk will be held.
17.3.5 Interest Rates
Interest rates can have a significant impact on both short-term and long-term debt. For example, in 2005 UUU had higher interest costs due to higher average rates for commercial paper and short-term borrowings In addition UUU carries a significant amount of long-term debt that is mostly at a fixed rate. Therefore, a means to manage this risk is fixed-forfloating interest rate swaps for a portion of the long-term debt portfolio. This is an effective tool particularly when interest rates can experience significant fluctuation.
17.3.6 Government Contract Risk (Demand Risk)
Defence spending provides a sizeable portion of demand for UUU products. In fact, in 2004 UUU was responsible for nearly $6 billion in sales to the US Government. Although this carries risk based on Department of Defence needs, there has been a recent increase in military expenditures due to the global war on terrorism, particularly for aviation procurement. In addition, contracts with the government are subject to frequent contract audits that may have legal implications. This contract risk can be tolerated because of the recent increase in defence spending and is reduced by the fact that UUU is diversified among multiple industries.
17.3.7 Legislative Risk
There is another kind of risk associated with the government known as legislative risk. This occurs when there is a change in corporate tax laws or accounting procedures. For instance, the Bush administration tax cuts have led to higher operating profits for many corporations. In contrast, the Sarbanes-Oxley Act (2002) was an accounting ‘tax’ on corporations for the additional reporting procedures necessary. This risk is ultimately retained because no corporation has a means to avoid or transfer it.
17.3.8 EH and Safety Risk
Like every corporation, UUU is subject to environmental regulation by federal, state, and local authorities in the US and abroad. In terms of health and safety, UUU must ensure a safe work environment for its employees and mistakes in this area can lead to litigation with high costs. This risk can be reduced in some areas by ensuring workers are protected against potential hazards in terms of protective clothing and working areas and transferred in other areas through accident insurance for employees.
17.3.9 Information Technology Risk
Since UUU deals with government contracts, there is the increased propensity for hackers to try to infiltrate its network. The company also faces legal risks associated with the theft or release of personnel data such as an employee’s social security number or bank account number. Part of this risk can be reduced by firewall software and addition access codes, but part of it must be retained as technology is constantly changing.
17.3.10 Leadership Risk
Leadership decisions pose one of the most significant risks to UUU. Whilest there are potential downsides, this risk can be viewed mainly in a positive light in that strong leadership will enhance the productivity of UUU. UUU has consistently outperformed the market and has an experienced board of directors which makes this a manageable risk. Leadership in an ever-changing market is a core function of UUU.
17.3.11 Reputation/Product Quality Control Risk
Reputation poses a large risk for UUU because of the quality associated with its product line. Therefore product quality control is an important challenge for management. It is particularly difficult from the legal perspective because of the product use such as helicopters and jet engines. This is a risk that cannot be transferred away entirely; instead it can only be reduced through good management.
17.3.12 Compliance Risk
Given the size and scale of UUU, there is the chance of compliance risk. This includes non-conformance with laws, rules, regulations or prescribed practices, internal policies, or ethical rules. This can result in a diminished reputation for UUU or a loss of business opportunities, as well as other legal implications. UUU’s primary method to reduce this risk is its Code of Ethics which is mandatory for all employees to read, sign, and comply.
17.3.13 Audit Risk
The number of government contracts associated with the sale of UUU’s products makes it subject to intense scrutiny and more frequent audits. There is also significant liability if UUU is audited and is not compliant with the current tax structure. However, this risk can be transferred by hiring an external auditor.
17.3.14 Legal Risk
In addition to the legal risks associated with EH and Safety discussed above, UUU has to deal with government litigation as well as defend its intellectual property. UUU is also exposed to legal risks in many of its contracts which if not properly dealt with could result in a significant loss in revenues. However, this risk can be reduced by hiring experienced corporate lawyers.
17.3.15 Terrorism/Security Risk
UUU’s worldwide locations could create potential targets for a terrorist attack, particularly in a smaller country where radicals might view UUU buildings as ‘Western imperialism’. In addition, security is also a general risk with regards to designs, product shipment, product tampering, and physical infrastructure. This risk can be reduced through UUU’s own security products as well as taking further security precautions.
17.3.16 Human Capital Risk
UUU, by nature of its technical products, demands highly skilled labour. UUU could suffer a loss of skilled labour in either domestic or foreign markets. Other human capital risks include labour rate fluctuations, unionisation of labour with a hostile position towards company operations, rising labour costs, such as healthcare and pensions, and labour strikes. One way UUU can reduce this high risk is the Employee Scholar Program which pays the tuition of additional education for employees, gives them paid leave to finish their education, and then awards company stock for completion of the accredited programme.
17.3.17 Merger and Acquisitions Risk
UUU is constantly expanding operations by purchasing or merging with smaller companies in an effort to increase its competitiveness and market share. However, mergers and acquisitions have many risks such as firm integration, which can pose challenges for UUU. This can best be reduced by hiring advisers and a strong legal team.
Table 17.1 provides a summary of each corporate risk defined by its probability and impact and the appropriate response. Notice the majority of risks are reduced or managed instead of transferred to avoid unnecessary premiums. Figure 17.2 provides a visual summary of the probability impact distribution of the risks UUU faces.
17.4 STRATEGIC BUSINESS UNITS RISK REGISTER
Moving one step down the organisational structure, strategic business units also generate their own risks. Whilst some are linked to corporate risks, many are unique to the business unit or operating market. The following section looks at some of the specific risks faced by each of the strategic business units.
Table 17.1 Corporate risk register for UUU
Figure 17.2 Probability impact grid for risks at corporate level
17.4.1 Verspack
Verspack is an SBU of UUU and is a manufacturer and distributor of heating, ventilating and air conditioning (HVAC) systems. It also produces food service equipment and HVAC and refrigeration related controls for residential, commercial, industrial and transportation applications.
17.4.1.1 Residential Housing Construction Demand
A large portion of Verspack HVAC systems are installed in new houses which poses a market risk in the construction market. In 2005 a strong level of construction activity in North America contributed to high revenues.
17.4.1.2 Trucking Industry Performance
Verspack systems also have a large market share in the refrigerated trucking industry. Its demand is therefore tied to the performance of the truck and trailer business.
17.4.1.3 Weather and Seasonal Climate Patterns
Verspack systems perform well, particularly in areas that experience warm summers. For example, a hot summer for North American in 2005 was a favourable condition that had to offset a cooler summer in Europe which experienced a decline in HVAC resources. Fortunately, UUU is diversified across various continents so a warmer season in one region acts as a natural hedge to other areas. A general trend towards warmer climates favours Verspack, suggesting they have no choice but to retain the risk. In addition, weather derivatives are a high risk alternative.
17.4.2 Liftgro
Liftgro is engaged in elevator and escalator manufacturing, installation and services. It designs, manufactures, sells and installs a range of passenger and freight elevators for low, medium, and high speed applications, as well as a line of escalators and moving walkways.
17.4.2.1 International Urbanization Levels
As one of the most international of the strategic business units, Liftgro is heavily influenced by global urbanisation. Commercial industry construction is the main demand for its products and services. Particularly large markets like China or India are key players in driving demand.
17.4.2.2 Foreign Exchange/Foreign Currency
Foreign exchange risk exists because of Liftgro’s global footprint. 2004 proved to be a favourable year for exchange as 6% of the 13% revenue growth was due to foreign currency translation.
17.4.3 Fisal
Fisal provides security and fire safety products and services. Its products and services are used by governments, financial institutions, architects, building owners and developers, security and fire consultants, and other end-users requiring a high level of security and fire protection for their businesses and residences.
17.4.3.1 Foreign Exchange/Foreign Currency
Fisal operates in a large number of countries and faces a similar foreign exchange risk as Liftgro.
17.4.3.2 Information Technology
Fisal faces the constant challenge of integration of its various security systems, particularly systems that may be outdated in emerging economies. Also, there is the risk of hacking into the security network.
17.4.4 Jaypower
Jaypower manufactures fuel cell systems for on-site, transportation, space and defence applications. In addition it produces combined cooling, heating, and power systems for commercial and industrial applications.
17.4.4.1 Government Contract Risk
Many of Jaypower’s projects are procured through government contracts. If the government decides to allocate fewer resources toward efficient energy systems there would be a corresponding fall in Jaypower revenues.
17.4.4.2 Falling Energy Costs
One of the major incentives for companies to switch to Jaypower is its ability to lower energy costs associated with oil. If oil should become significantly cheaper, companies may have less incentive to shift to energy saving systems from Jaypower.
17.4.4.3 World Transportation Demand
Many of Jaypower’s projects are associated with fuel cells for transportation systems.
17.4.5 Aerobustec
The three strategic business units of Engco, Airframe, and Copter are grouped together under the Aerobustec businesses because their risks are very similar. Their collective performance is tied directly to the economic conditions of the commercial aerospace and defence industries.
17.4.5.1 Airline Industry Performance
Corporate profits for the aerospace industries are linked to airline profits and global aircraft demand. Historical data on the airline industry suggests that the demand for flights is generally increasing.
17.4.5.2 Global Defence Spending
Many of the aircraft and systems manufactured by these industries are dependent on the level of global defence spending.
17.4.5.3 Defence Contract Risk
The largest market for helicopters is from the US Department of Defence. Although the demand for US defence spending, particularly for aviation acquisitions, has risen steadily, Copters can be constrained to demand by government contracts.
Table 17.2 Strategic business unit risk register
17.4.5.4 Political Risk
There is the risk that changing regimes will place a lower priority on military imports.
Table 17.2 and Figure 17.3 provide a summary of the risks UUU faces at the strategic business unit level.
17.5 PROJECT LEVEL RISK REGISTER
Although there is a great diversity in projects that UUU undertakes with its seven strategic business units, there are common risks across the majority of its projects. Because there is no detailed information for these projects there will be fewer risks for this register as only the most common ones will be covered.
17.5.1 Cultural/Language Risk
As a global company that conducts business worldwide, projects must overcome cultural and language barriers. For instance, projects in the Middle East will require prayer tents and some countries have limited working hours per week. It may also be difficult to recruit highly skilled foreign labour who can also speak the necessary project languages.
Figure 17.3 Probability impact grid for the strategic business unit level
17.5.2 Purchasing Risk
For the aerospace projects, purchasing new commercial engines carries risk due to the size of investment required and some of the issues surrounding engine development. This can put a large strain on liquidity and cash flows. One means to transfer this risk to sell partner shares for some projects. By allowing other companies to finance portions of the commercial projects, UUU can reduce its initial costs by sacrificing a percentage of revenues from future revenues which are redistributed to partner companies.
17.5.3 Design Risk
Design risk, particularly for the aerospace projects, is very high due to the costs associated with the design process. Design is especially stringent when trying to meet government specifications and most contracts require submitting multiple design proposals. Some Federal Aviation Administration certifications take 3-5 years to attain making design an expensive investment. Also, mistakes in the early stages of the design process can lead to costly mistakes throughout the project’s life cycle.
17.5.4 Cash Flow/Liquidity Risk
Many of UUU’s commercial projects have cash flows which may not be positive for 7-10 years and profitability may not occur until 15-20 years. Additional warranty and engineering costs in the initial stages of product purchase also contribute to negative cash flows. Already narrow profit margins can be reduced by economic fluctuations, changing manufacturing costs, and demand for spare parts. For UUU’s government contracts this risk is naturally reduced but remains high in private sector purchases.
17.5.5 Regulatory/Environmental Risk
UUU has numerous regulatory and environmental constraints which can be even more stringent for government contracts. Strong management and regulatory enforcement are needed to minimise these risks.
17.5.6 Maintenance Risk
Many of the products sold by UUU are covered by warranty and therefore UUU holds the majority of the maintenance risk. High upfront maintenance costs will add to a project’s negative cash flows. However, maintenance risk can be positive if not covered under warranty as spare parts are one of the most profitable aspects of any UUU project.
17.5.7 Counter-party Risk
Many of the contracts UUU enters depend on the strength of its counter-party. For instance, contracts in countries that are politically weak or suffer high budget deficits may pose a counter-party risk. In addition, cancellation of a particular programme or product by the government is a large threat to project profitability.
Table 17.3 Project level risk register
17.5.8 Delay Risk
Some of UUU’s contracts have penalties associated with project delay. Delay risk can also have costs in the design phase of a product when there are competitors who can offer a better bid earlier than UUU.
17.5.9 Technology/System’s Integration Risk
For projects lasting decades there is the risk of dealing with technological and engineering innovations which make earlier designs outdated. Integrating newer technology systems may be costly or impossible.
Table 17.3 and Figure 17.4 provides a summary of the risks UUU faces at the strategic business unit level.
17.6 RISK STATEMENT TO SHAREHOLDERS
After identifying the risks at all three levels of a corporation, it is necessary to summarise and transmit this information to shareholders and lenders. When purchasing stock, most shareholders look at the most recent annual report of a corporation as well as historical annual reports. This provides the best information on what risks a company faces and by looking at former reports it also acts as a condensed historical risk register. Thus, a short risk statement included in the annual report is acceptable for shareholders and the majority of lenders. However, lenders may be involved in lending for a specific risky project. In the event that UUU was borrowing for such a project it would need to provide a separate risk statement for that project which would include far more detailed information than shown here.
Figure 17.4 Probability impact grid for the project level
Thus, a typical risk statement to shareholders and most lenders could be presented as follows:
To UUU Shareholders,
UUU is a diversified company whose products include Verspack, Liftgro, Fisal, Jaypower and Aerobustec. As one of the world’s largest privately held manufacturers, we seek to provide shareholders with the best information about their investment. The following is an assessment of the risks and opportunities in the global market we manage on a daily basis.
a. Corporate risks
• Global economic conditions UUUs operates on a worldwide basis. Thus, we are subject to general world economic conditions and demand for our projects. However, our global footprint acts as natural diversification among the different geographical regions. UUU also seeks to capture growth from emerging market economies like China, India, Russia, and Argentina. As a precautionary measure, UUU’s investment in any particular country does not ‘exceed 2.5% of consolidated shareowners’ equity’.
• Commodities risk As one of the United States’ largest manufacturers, we use large volumes of certain commodities which have volatile prices. The impact is significant; in 2005 the increase in commodity and energy costs decreased operating results by $120 million. However, we seek to manage some of the fluctuations in oil, copper, and titanium prices through the use of forward contracts. These will not be used in every instance as we strive for opportunities to capture commodity prices when they decline.
• Human capital risk UUUs product line calls for a highly skilled labour force, both domestic and abroad. As one of the largest employers in the world, we strive to maintain a hedge on recruiting the most talented employees. Our Employee Scholar Programme offers unmatched educational incentives, including full tuition, expenses, and paid study time for accredited degree programmes. We also reward graduates with stock compensation. In return we know our employees will respond with new abilities, knowledge, and motivation to continue to make UUU a leading global company.
• Leadership risk At UUU we pride ourselves on our executive and management leadership. We believe leadership is the most important factor in remaining a global competitor. However, decisions made by our leadership and management carry risk due to imperfect information and a continuously changing marketplace.
• Government contract risk At UUU a significant portion of our revenues, particularly in the aerospace businesses, are derived from government contracts. The contract process itself carries risk through the tendering and design phases, as well as uncertainty about the cancellation of certain programmes. However, our corporation is diversified in international governments as well as between public and private sector sales. In addition, rising global defence expenditures have raised revenues.
• Foreign currency risk Operating in a global market carries the risk of foreign currency translation. Fortunately, the last few years saw appreciation in particular currencies which added to UUU revenues. For example, in 2003 and 2004 there was a favourable impact from foreign currency of $0.11 and $0.14 per share. One of UUU’s strengths in managing this risk is our natural geographic diversification. In the event there is a high level of foreign currency exposure we will use limited amounts of derivatives to mitigate the risk.
b. Strategic business units
• Information technology risk Fisal relies on cutting-edge technology to develop products which meet the demand for security needs. In addition, other business units, particularly those with government contracts, face network infiltration from computer hackers. UUU makes every effort to ensure security of its information, particularly employee personal information like social security numbers and bank account information.
• International urbanisation levels Liftgro elevators and escalators rely on increasing urbanisation as the main demand for its products. Urbanisation is also a key source of revenues for Jaypower which develops alternative fuel options for public transportation systems.
• Regional construction markets Verspack heating and air conditioning systems are reliant on regional housing markets. For instance, slowing demand in the US housing market has been replaced by growth in European nobreak markets.
• Airline industry performance Many of UUU’s products are sold to aerospace businesses. The recent rise in air transport demand has been favourable to UUU’s performance.
As a global leader, we see all these risks as opportunities for success. Confident in our leadership and employees, we expect continued growth for UUU throughout uncertain economic forecasts.
17.7 SUMMARY
Typical risks affecting each level can be addressed through a risk register. The detail of information provided in the above risk registers is relatively low compared with the case study in Chapter 16. The risk register shown in this case study reflects only the category or risk, response and the probability/impact of identified risks.
An amalgam of the information derived from these risk registers can be used to create a risk statement for shareholders on which they can determine their willingness to invest in the business based on the risks associated with each SBU and the characteristics of the project they may enter into.
The authors wish to thank Dr Anthony Merna and Mr Jacob Sheehan for allowing them to use this amended version of their paper.
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