14 OCTOBER 2013
SMITHS GROUP PLC
ANNUAL FINANCIAL REPORT 2013
LISTING RULE LR 9.6.3 R
The Company is submitting today copies of the documents listed below to the UK Listing Authority, in compliance with Listing Rule LR 9.6.1 R.
1. Annual Report 2013;
2. Notice of Annual General Meeting;
3. Notice of the availability of company documents in electronic format; and
4. Proxy Form.
The above-mentioned documents will be uploaded to the National Storage Mechanism website, in pdf file format, and will shortly be available for viewing by visiting http://www.morningstar.co.uk/uk/NSM.
Copies of the documents referred to above have been posted to some shareholders and made available online to the other shareholders today, in accordance with their respective elections for company communications.
The Annual Report 2013 and the Notice of Annual General Meeting are now available online at the Company's website, www.smiths.com. Printed copies may be obtained by writing to The Company Secretary, Smiths Group plc, 2nd Floor, Cardinal Place, 80 Victoria Street, London SW1E 5JL or sending an e-mail request to [email protected].
DISCLOSURE & TRANSPARENCY RULE DTR 6.3.5(2)
A condensed set of the Company's consolidated financial statements and information on important events that occurred during the financial year ended 31 July 2013 and their impact on the financial statements were contained in the Final Results announcement issued by the Company, through the Regulated News Service of the London Stock Exchange, at 07:00 on 18 September 2013. That information, together with the information set out below, which is extracted from the Annual Report 2013, constitute the material required by Disclosure & Transparency Rule 6.3.5 to be communicated to the media in full unedited text through a Regulatory Information Service. This announcement is not a substitute for reading the full Annual Report 2013. Page and note references in the text below refer to page numbers in the Annual Report 2013 and notes to the financial statements (available online from www.smiths.com and www.morningstar.co.uk/uk/NSM).
RISK MANAGEMENT
(Extract comprising pages 56 to 61 in the Annual Report 2013)
Managing risk in delivering our strategy
Smiths Group is exposed to a wide range of risks in running its businesses. We regularly review these risks and ensure we have the appropriate processes and policies for managing them.
Our approach to risk governance
Smiths Group 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.
The Board has overall responsibility for our risk management policies and ensuring we have an effective system of internal control. 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. An outline of this year's review process by the Board and Audit Committee is set out on pages 81 to 82. A description of the Company's internal controls and risk management processes is given in the Corporate Governance statement on pages 79 to 80.
Our approach to risk management
In delivering our strategy, it is important that we understand and manage the risks that face us. We achieve this through our embedded risk management approach, combining a top-down strategic view of risks with a bottom-up divisional process.
Our top-down approach involves a review of the external and internal environment, and an assessment by the Executive Committee regarding the key risks that face Smiths Group. This review is formalised twice a year. A 'risk owner' is assigned to each risk with the responsibility to monitor the risk and ensure the agreed mitigation actions are completed.
These 'Group-wide' risks are categorised as either:
• Major business challenges
• Risks caused by uncontrollable external factors
• Other risks
A summary of these 'Group-wide' risks is presented for discussion at the July Board meeting. In reviewing the major risks, the Board determines the level of risk which we are prepared to accept in the pursuit of our business goals - this is our risk appetite. Where the risk impact is greater than that which we are prepared to accept, further mitigation actions are agreed to reduce the potential impact. Where further mitigation actions are not possible or are considered to be cost prohibitive, the risk is closely monitored.
Our bottom-up divisional approach involves the identification, management and monitoring of the material risks in each of our divisions. Each division is required to maintain risk registers and monitor their significant risks on an on-going basis. Each division attends one Audit Committee a year, to explain and discuss the inherent risks and challenges faced by the division. Additionally, the strategic risks are further debated at the divisional strategy presentations which are made annually to the Group Board. The divisions are also required to provide an update regarding their risk mitigation actions at the Quarterly Business Reviews held with the Chief Executive and Finance Director.
This dual process provides a framework such that the Group's strategic, financial and operational risks are adequately considered and discussed by the Executive Committee and the Board.
There can be no assurance that our approach to risk management will be effective in any particular case. If any of the risks which we identify, 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.
Our Group-wide risks as assessed by the Board
RISKS CAUSED BY UNCONTROLLABLE EXTERNAL FACTORS
Economic outlook
Potential impact - High
Trend - No change
Risk and potential impact
The Group operates in more than 50 countries and is affected by global economic conditions, particularly in the US and Europe. Our business is also affected by government spending priorities 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 Group's operational performance and financial condition. A recession may also materially affect our customers, suppliers and other parties with which we do business. Adverse economic and financial market conditions may cause our customers to terminate existing orders, to reduce their purchases from the Group, or to be unable to meet their obligations to pay outstanding debts to the Group. These market conditions may also cause our suppliers to be unable to meet their commitments to the Group or to change the credit terms they extend to us.
Mitigation
• The Group has a diversified portfolio of businesses that mitigates 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 deteriorating trading conditions.
• In the event of a significant economic downturn, there may be opportunities to identify and implement cost-reduction measures to offset the impact on margins from deteriorating sales.
Eurozone break-up
Potential impact - Medium
Trend - Reduced
Risk and potential impact
Political and economic structural weaknesses in the single currency framework lead to heightened risk that the Eurozone may not survive in its present form. If the Eurozone breaks up, one or more countries will leave the Euro, and opt for new currencies. This may result in a substantial default on existing Euro sovereign debt and economic dislocation. It could also result in capital exchange controls being imposed, some domestic banking failures and expropriation of assets.
Smiths Group has approximately 5-6% of its business (measured by sales, profit or net assets) in Spain, Ireland, Portugal, Italy and Greece, which could be adversely affected by currency devaluations.
A Eurozone break-up might affect the profitability of existing contracts and customers might be unable to repay debts according to agreed terms. A break-up is likely to affect the wider economic environment, particularly in Europe, which could affect trading on a global basis.
The risk has reduced slightly over the last 12 months as we have collected some long overdue debts in Spain and repatriated the capital.
Mitigation
• The diversified portfolio mitigates exposure to any single country or currency. We also have robust processes to monitor overdue debts.
• We have net investment hedging of c. 50% of our overseas currency exposure and assets.
• We have identified further divisional risk mitigation actions should the risk occur.
Compliance with legislation and regulations
Potential impact - Low to Medium
Trend - No change
Risk and potential impact
There is a risk that the Group may not always be in complete compliance with laws, regulations or permits, for example concerning environmental or safety requirements. The Group could be held responsible for liabilities and consequences arising from past or future environmental damage, including potentially significant remedial costs. There can also be no assurance that any provisions for expected environmental liabilities and remediation costs will adequately cover these liabilities or costs.
The Group 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.
Smiths Detection and Smiths Interconnect manufacture security products and components, which 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.
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. Corruption on the part of a single employee can entail severe consequences for the Group.
Failure to comply with certain regulations may result in significant financial penalties, debarment from government contracts and/or reputational damage.
Mitigation
• 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.
Pension funding
Potential impact - High
Trend - Reduced slightly
Risk and potential impact
At 31 July 2013, the Group has legacy defined benefit pension plans, with aggregate liabilities of around £4bn on an accounting basis.
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 plan's assets, such as investments in equity and debt securities, will not be sufficient to cover the value of those benefits.
The implications of a higher pension deficit include a direct impact on valuation, credit rating and potential additional funding requirements at subsequent triennial reviews. However, following the 2012 triennial review, cash payments to the principal UK pension schemes remained at the levels agreed in the 2009 review.
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.
Mitigation
• 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.
Read more in note 9 on pages 124-127
Financial risks (foreign exchange, funding, tax and insurance)
Potential impact - Medium
Trend - Slightly higher
Risk and potential impact
Foreign exchange: Exchange rate fluctuations have had, and could continue to have, a material impact on the reported results. The Group is exposed to two types of currency risk: transaction and translation. 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's ability to refinance its borrowings in the bank or capital markets is dependent on market conditions and the proper functioning of financial markets. The Group may be unable to refinance its debt when due.
Tax: The Group's future profitability, particularly 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. Taxation costs could rise and earnings per share could deteriorate, which could affect the Group's market valuation.
Insurance: The Group cannot be certain that it will be able to obtain insurance on acceptable terms or at all. Furthermore, the Group 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. If insurance cover is inadequate or does not pay out as expected, the Group could be exposed to an unexpected material cash outflow, which may impact on the Group's liquidity and/or share price.
The risk has increased slightly since last year, in particular, tax and exchange rate risk. However, funding risk is lower in the light of the bond issue in October 2012.
Mitigation
• 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 2013, 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.
Read more on page 52
BUSINESS CHALLENGES / THEMATIC RISKS
Product liability and litigation
Potential impact - Medium
Trend - No change
Risk and potential impact
In the ordinary course of its business, the Group 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.
Any liability claim against the Group, 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.
Mitigation
• Quality assurance processes are embedded in our manufacturing locations for critical equipment, supporting compliance with industry regulations.
• A global best practice programme is continuing to enhance product quality processes across the Group. This is sponsored by the Executive Committee and leverages the on-going work in Smiths Medical and John Crane.
• The divisions have procedures for dealing with product liability issues and potential product recalls. These procedures are informed by crisis management planning workshops and rehearsals.
• The Group has insurance cover for certain product liability risks. 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 legal function. We have detailed action plans to manage actual or threatened litigation.
Read more on page 53 and in note 21 on pages 140-141
Global supply chain/concentration of manufacturing
Potential impact - Medium
Trend - No change
Risk and potential impact
The Group's 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. The Group 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.
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.
Mitigation
• 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.
• The Group has business interruption and property damage insurance.
Government customers
Potential impact - High
Trend - No change
Risk and potential impact
We derive a significant proportion of our revenues in mature Western economies and some 35% of the Group's revenues are directly related to government spend. Additionally, a high proportion of our products and services are in some way influenced by government regulation and certification.
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.
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.
Mitigation
• The Group has a diversified portfolio of businesses that mitigates 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 a government relations function so that it can inform policy and maintain close relationships with customers.
Technology and innovation
Potential impact - Medium
Trend - No change
Risk and potential impact
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.
The failure of the Group to develop its products and services, or more effective innovation by a competitor, could have a materially adverse effect on sales growth.
Mitigation
• 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
Potential impact - Medium
Trend - No change
Risk and potential impact
The loss of key personnel, or the failure to plan adequately for succession or develop new talent may impact the reputation of the Group, or lead to a disruption in the leadership of the business.
Competition for personnel is intense and the Group 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, the Group's inability to attract new or adequately trained employees, or a delay in hiring key personnel, could seriously harm the Group's 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.
Mitigation
• 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.
• The Chief Executive has assessed and continues to assess the Top 25 people in the organisation for performance, skills and competencies and presents development and succession plans to the Board.
Read more on pages 20-26 and 66-67
Contractual liabilities
Potential impact - Medium to high
Trend - Higher
Risk and potential impact
Failure to deliver, in a timely fashion or at all, the products and services Smiths is obliged to deliver, or any fault in contract execution due to delays or breaches by its suppliers or other counterparties, may lead to higher costs, liquidated damages or other penalties.
Differences between the estimated costs in Smiths medium and long-term contracts and actual costs may arise from a number of factors including production delays, cost overruns and other items.
Certain of Smiths contracts, particularly those with governments, may include terms that provide for unlimited liabilities on Smiths part or allow the government body or counterparty to terminate unilaterally, reduce or modify the relevant contracts or seek alternative sources of supply at Smiths expense.
Mitigation
• Contracts are managed and delivered by programme management teams that regularly review contract risks and take appropriate action.
• Divisional boards review significant contracts.
• The diversified nature of the Group mitigates the exposure to any single contract.
Acquisitions and disposals
Potential impact - Low to Medium
Trend - No change
Risk and potential impact
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.
The Group 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, the Group has disposed of a number of businesses, including its Aerospace operations, where it has given indemnities, warranties and guarantees to counterparties. The Group 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.
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.
Mitigation
• 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 Group seeks to minimise its exposure to indemnities and warranties and any that are provided are reviewed on a regular basis.
Information technology and cyber-security
Potential impact - Medium to high
Trend Higher
Risk and potential impact
The Group's information systems, personnel and facilities are subject to security risk. The Group is dependent on information technology systems for both internal and external communications and for the day-to-day management of its operations. The incidence of cyber-security crime is on the rise and some Smiths Group companies operate in sectors where cyber-criminals are active.
Any disruption to the information systems could have significant adverse consequences for the Group's operations or its ability to trade. It could result in the loss of confidential information and intellectual property, which could affect the Group's competitive position and cause reputational damage.
Mitigation
• 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.
• A Group-wide information security awareness programme has been launched.
STATEMENT OF DIRECTORS' RESPONSIBILITIES
(This statement is repeated here solely for the purposes of complying with Disclosure & Transparency Rule 6.3.5. This statement relates to and is extracted from page 102 of the Annual Report 2013. It is not connected to the extracted information presented in this announcement or to the Final Results announcement released on 18 September 2013.)
Company law requires the directors to prepare accounts for each financial year. Under company law the directors must not approve the accounts unless they are satisfied that they give a true and fair view of the state of affairs of the Group and the Company and of the profit or loss of the Group for that period. In preparing these accounts, the directors are required to:
• select suitable accounting policies and then apply them consistently;
• make judgements and accounting estimates that are reasonable and prudent;
• state whether the consolidated accounts comply with International Financial Reporting Standards ("IFRS"), and the Parent Company accounts comply with applicable UK Accounting Standards, subject to any material departures disclosed and explained in the accounts;
• prepare the accounts on the going concern basis unless it is inappropriate to presume that the Group and the Company will continue in business.
The directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Group's and the Company's transactions and disclose with reasonable accuracy at any time the financial position of the Group and the Company and enable them to ensure that the accounts and the Directors' remuneration report comply with the Companies Act 2006 and, as regards the Group financial statements, Article 4 of the IAS Regulation. They are also responsible for safeguarding the assets of the Group and the Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
In accordance with the Disclosure and Transparency Rules of the UK Listing Authority, each of the directors (who are listed in the Group directors' report) confirms that to the best of his or her knowledge:
• the Group's financial statements have been prepared in accordance with IFRS as adopted by the European Union and give a true and fair view of the Group's assets, liabilities and financial position as at 31 July 2013 and of its profit for the financial year then ended; and
• the Group directors' report includes a fair review of the development and performance of the business and the position of the Group, together with a description of the principal risks and uncertainties that the Group faces.
(This Statement was signed on behalf of the Board on 17 September 2013.)
This announcement contains certain statements that are forward-looking statements. They include statements regarding the Company's intentions, beliefs or current expectations and those of its officers, directors and employees concerning, amongst other things, our results of operations, financial condition, liquidity, prospects, growth, strategies and the business we operate. By their nature, these statements involve uncertainty since future events and circumstances can cause results and developments to differ materially from those anticipated. The forward-looking statements reflect the knowledge and information available at the date of this announcement and unless otherwise required by applicable law the Company undertakes no obligation to update or revise these forward-looking statements.
