Principal risks and uncertainties
There are a number of risks and uncertainties that could have an effect on the Group’s performance. As at the date of this report, the Board considers the risks described below to be the principal risks facing the Group. The Group has a risk management structure in place that is designed to identify, manage and mitigate business risks. This forms part of the Group’s system of internal control that is described in detail here (Corporate governance). The key risks identified through this risk management process and how they are managed are detailed below.
RoHS legislation
The legislation implementing the EU Directive on the Restriction of the use of certain Hazardous Substances in electronic and electrical equipment (the RoHS Directive) has been an area of focus for the Group during prior years as the legislation took effect on 1 July 2006. Moving to compliance involved the replacement of a significant proportion of stocked products with compliant alternatives. This brings with it the potential risk of stock write-offs greater than those for which provision has been made if the transition is not well managed. The Group has had a senior management team in place for over three years to address this risk and has been working closely with its suppliers and customers. The approach taken to achieve compliance with the legislation is very clear and well defined and has been communicated to suppliers and customers. The position regarding levels of stock and potential write-offs is managed closely and the Group’s internal targets to reduce any stock write-off in Europe have been met. The position in North America is more complicated due to the lack of a hard, legislatively mandated date for compliance, but good progress has also been made here and the Group considers that it is well placed to minimise its exposure.
As described in other sections of this report, dealing successfully with the implementation of the RoHS legislation has also provided a considerable opportunity for the Group to outperform its competitors.
The Chinese equivalent of the EU RoHS legislation came into force on 1 March 2007, although the most substantive elements are yet to be enforced. The Group has approached this legislation in the same proactive manner as its EU equivalent. The combination of the Group’s experience in dealing with the effects of the legislation in Europe and North America and the smaller scale of its business in China means that the Chinese legislation presents much less of a risk to the Group. The Chinese legislation does, however, also present a considerable business opportunity and work has been underway for some time to capitalise on this.
Market migration
Premier Farnell’s available market has remained relatively stable compared with the migration of manufacturing to lower cost economies in recent years. While lower wage rates have attracted high volume manufacturing to Eastern Europe and Asia, the migration of research and development and small scale manufacturing, two of Premier Farnell’s primary customer groups, is less pronounced. Work carried out as part of the Group’s review of strategy, announced in October 2006, confirmed that much of the electronic design engineering work that forms a large part of the Group’s customer base has remained in regions in which the Group has a strong presence. In addition, there is a large installed base of electronic equipment in Premier Farnell’s traditional geographic markets that needs maintaining, providing an ongoing market for the Group’s maintenance and repair products. Nevertheless, there is likely to be an ongoing decline in the Group’s manufacturing customer base in these geographic markets. This risk is being addressed in two ways: first, by emphasising growth in the electronic design engineering segment of the Group’s customer base and, second, by increasing the Group’s presence in Asia and Eastern Europe. Further progress was made in this area during the year with completion of the acquisition of the Hynetic business in India as a distributor of Farnell products and the launch of local transactional websites in a number of Eastern European countries and a Mandarin language website in China. The Group will continue to increase its presence in developing markets to mitigate dependence on territories where the market for its products and services is more mature.
Systems and infrastructure
The operations of the Group’s main businesses are heavily dependent on its principal distribution facilities in Gaffney (US), Leeds (UK) and Liège (Belgium), from which a significant proportion of customer orders are despatched, and on the Group’s IT hardware and software. The Group takes steps to protect these distribution facilities with measures such as sprinkler protection and the separate storage of highly flammable products and works closely with its insurers in assessing the risks of damage to these facilities. In addition, business continuity plans exist and are under review with the aim of minimising the adverse impact on the business should significant damage occur. For the UK and European business, this planning is assisted by the Group’s ability to switch order fulfilment between distribution facilities in Leeds and Liège, as these facilities hold a proportion of common products. In the US a review of warehouse management systems has led to improvements in performance and more robust contingency plans.
The resilience of the Group’s IT infrastructure is regularly reviewed by management and plans are developed to address areas of potential weakness. Where practicable, these plans are fully tested.
Competitive pressures
The Group’s Marketing and Distribution Division, which accounts for 90.1% of the Group’s sales, operates in a fragmented market with a number of international and many regional competitors. This environment creates pressure on the prices that the Division is able to charge for its products and on the levels of service it provides. It is therefore fundamental that the Division’s proposition to its customers remains attractive and at the forefront of its chosen markets. The Group maintains awareness of developments in the market, including actions by competitors, and anticipates and responds to such developments. The results of the review of strategy announced in October 2006 clearly defined the Group’s emphasis on areas of profitable growth via differentiation from its main competitors. An important factor in recent years has been customer demand for the ability to transact with the Group electronically. Electronic channels are increasingly preferred by customers and also bring efficiencies to the Group. There is, therefore, a significant focus on the Group’s progress in continually upgrading its eCommerce capabilities, such as the ease of use of its transactional web sites. During the year the Group has continued to roll out new web sites based on its global eCommerce platform, including a dual Mandarin/English language site for China. New analytical tools have helped to identify opportunities to improve both functional and user experience. The increased speed and stability of the websites has led to significant increases in eCommerce revenues. Improving electronic channels is part of delivering a multi-channel approach that provides flexibility for customers and reduces the cost to serve.
Foreign currency
As a relatively high proportion of the Group’s sales and operating profits arise in North America, the Group’s reported results are adversely affected by weakening of the US dollar against sterling. This profit translation risk is approximately £0.25 million per annum of operating profit for each one cent movement in the US dollar exchange rate. The Group has denominated most of its external borrowings in US dollars in order to mitigate this risk and provide a hedge against dollar denominated operating cash flows and the Group’s US investments.
In addition to the US dollar, the other major currency for which the Group has a translation risk is the Euro. Whilst there was a benefit from the strengthening of the Euro towards the end of 2008, a significant weakening of the Euro would adversely affect the Group’s results. This profit translation risk is approximately £0.2 million per annum of operating profit for each one cent movement in the Euro exchange rate.
The Group’s policy is not to hedge profit translation risk unless there is a real cash exposure since such hedges provide only a temporary deferral of the effect of movements in exchange rates.
Human resources
As a service business, Premier Farnell relies heavily on its employees. It would be damaging to the Group if it were unable to attract and retain personnel at key management levels. The ways in which this risk is addressed are described in detail in the Resources and relationships section of this report.
Legal risks
The Group operates internationally and is subject to laws and regulations in a large number of countries. Combined with this, the large numbers of customers and suppliers to the Group result in a complex set of contractual obligations and a risk of non-compliance.
The Group addresses this risk in a number of ways:
- Through reviews and training provided by the in-house legal department
- Advice provided by suitable external counsel
- Monitoring and reporting of issues by the Internal Audit function
- Internal control processes requiring local management to report on areas of potential non-compliance
- Controls on the levels of management required to approve proposed contractual arrangements