FINANCIAL RISK MANAGEMENT
In the normal course of business Kingspan Group has exposures to foreign currency, interest rate and credit risks. The Group’s focus is to understand these risks and to put in place policies that minimise the economic impact of an adverse event on the Group’s performance. Meetings are held on a regular basis to review the results of the risk assessment, approve recommended risk management strategies and monitor the effectiveness of such polices.
Funding and liquidity risks
The Group operates a prudent approach to liquidity management using a mixture of long-term debt together with short-term debt, cash and cash equivalents, to meet its liabilities when due. This is in addition to the Group’s high level of free-cashflow generation.
The Group’s core funding is provided by a private placing of $200mn converted into €151mn at the time of the placing. Of this debt, €119mn (79%) matures in March 2015 and the balance in March 2017. The Group also has a five year committed banking facility of €330mn which was put in place in September 2008. At year end the Private Placement debt was drawn down in full and €56.8mn of the banking facility was drawn. The Group also has in place a number of uncommitted bilateral working capital/overdraft facilities amounting to circa €65mn at year end.
The Group’s committed facilities are subject to covenants which are based on Net Debt/EBITDA no higher than 3.5 times, EBITDA/net interest cover of not lower than 4 times. In addition the Group’s €330mn banking facility has a Net Asset covenant of not less than €400mn. These covenants are less restrictive than the Group’s internal targets. At 31 December 2009 the Group was comfortably within these covenants with interest cover of 9.4, Net Debt/EBITDA of 1.6 and Net Assets of €585.5mn.
Foreign exchange risk
There are three types of foreign exchange risks to which the Group is exposed:
1. Transactional - where a business unit has input costs or sales in currency other than its local currency; 2. Translational - where profits are earned in a currency other than Euro, which is the reporting currency for the Group; and 3. Balance Sheet - where the Group has net assets in non-Euro currencies. The first two affect the Earnings of the Group and the latter goes directly to Reserves and affects the Net Assets position.
Transactional - transaction exposures are internally hedged as far as possible and to the extent that they are not, such material residual exposures are hedged on a rolling 12 month basis. Based on current cash flow projections for the existing businesses to 31 December 2010, it is estimated that the Group will have surplus sterling of approximately £44mn which will be required to be converted to Euro during the year.
At the current date £26mn, or 60% of the surplus, has been sold forward at an average rate of 0.8840 compared to the average rate in 2009 of 0.892. The Group will also need to sell the equivalent of US$12mn in Sterling for US Dollar and at the current date this amount was substantially hedged at an average rate of 1.58 compared to the average rate in 2009 of 1.395.
Translational - it is Group policy not to hedge translational exposure, which is effectively a non cash transaction in the accounts. There was a negative impact on non-Euro profits of circa €4mn due to adverse movements in average rates used for translation in 2009 versus 2008.
Balance Sheet – as the bulk of the Group’s non-Euro investments are Sterling denominated, the translation of these investments into Euro has given rise to an exchange gain of €22mn which has been taken directly to reserves, thereby increasing the Group net assets. This annual translation adjustment can be positive or negative depending on the movement between the opening and closing currency exchange rates. The sharp fall in Sterling was the single biggest contributory factor to this translation adjustment in 2008. Balance sheet exchange exposure is mitigated where possible by denominating debt in those currencies where such exposure lies, pro rata to the assets in those currencies.
Foreign exchange rates have recently undergone a period of exceptional volatility due to economic situations of individual countries, the current global economic downturn, and political considerations. While the Group hedging policy attempts to mitigate this risk, a net exposure will remain to currencies which may depreciate against the Euro in the future.
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Interest rate risk
The Group adopts a policy of ensuring that an appropriate proportion of its exposure to changes in interest rates on borrowings is covered by effective conversion to a fixed rate. Interest rate swaps are entered into to achieve an appropriate mix of fixed and floating exposure that is consistent with the Group’s policy.
The Private Placement loan notes, which represent 73% of the drawn down facilities, are fixed out to maturity at a weighted average interest rate of 4.15%. €14mn of further USD borrowings have been fixed at 1.675% bringing the total fixed debt to 79%. The remainder of the drawn down facilities are subject to floating rates.
Kingspan Insulated Panels Majura Park, Canberra, Australia
OTHER RISKS AND UNCERTAINTIES
There are a number of other risks and uncertainties that can impact the performance of the Group, many of which are beyond the control of Kingspan and its Board. The Group’s businesses closely monitor market trends and risks on an ongoing basis and such trends and risks are the focus of monthly management meetings where the business unit’s performance is assessed versus budget, forecast and prior year. Such meetings are rotated around the different locations of the business unit and at least one executive board director is present. An annual assessment of trends and risks is also an integral part of the business unit’s annual review of its strategic plan and budget, which are submitted to the Group Board for consideration and approval.
Market conditions
Kingspan’s products are targeted to both the residential and non-residential (including retail, commercial, public sector and high-rise offices) construction sectors. As a result demand is dependent on activity levels in these respective segments, which vary by geographic market and are subject to the usual drivers of construction activity (i.e. general economic conditions, interest rates, business/consumer confidence levels, unemployment, population growth etc). While construction markets are inherently cyclical, changing building and environmental regulations continue to act as an underlying positive structural trend for demand for many of the Group’s products. The exposure to the cyclicality of any one construction market is partially mitigated by the Group’s diversification, both geographically and by product, and by the Group’s portfolio of products, which are heavily oriented towards sustainable and energy efficient construction.
Over the past 18 months the Group has experienced weakening of demand in several markets, notably in Ireland and the UK. This weakening has been particularly acute in the residential and commercial sectors, and this has had an impact on the results of the Group for the current year. Further weakening of the key markets for the Group is likely in the current year, and consequently this weakness is likely to have an adverse impact on the results of the Group in the near future.
Input prices and availability
The Group’s operating performance is impacted by the pricing and availability of its key inputs, which include steel and chemicals (the key chemicals are MDI and polyols). Pricing of such goods can be quite volatile at times due to the respective industries’ limited ability to adjust supply to changes in demand, capacity and input costs. The Group looks to minimise the adverse effect of such movements through strong long-term relationships with suppliers, economies of purchasing, multiple suppliers and inventory management.
In 2009, input prices have varied significantly due to volatility in response to global supply and demand imbalances. However to the extent that the Group has or assumes exposure to fixed price contracts, surplus inventory, or experiences demand levels which differ from forecasts, the Group may assume risk that replacement cost of raw materials may be higher or lower than the costs of the raw materials purchased.
There is a further risk to the Group given recent consolidation in many supplier markets, particularly steel, whereby the number of supply options has shrunk, and the Group is continually exploring ways of mitigating this risk.
Competitive pressures
Kingspan continually faces competition in each of the markets in which it has a presence. The competitive environment in any one market is a function of a number of factors including the number of competitors, production capacity, the demand characteristics of that market, the ease of imports from third countries and the availability of substitute products. While such competitive forces can impact profitability in the short-term, each of Kingspan’s operations looks to offset such adverse effects by: (i) ensuring a low cost manufacturing base through economies of scale, investment in modern and efficient plant and a programme of continuous process improvement; (ii) a permanent emphasis on product development which allows the Group’s companies to be leading edge providers of innovative building solutions and, therefore, helps to differentiate itself from competitors; and (iii) providing a best in class service to customers by offering expert technical support, short delivery times and products that come with a guaranteed performance. In recent months, competitive pressure has intensified due to contraction in the overall market size. This has lead in some cases to lower margins, although the Group’s focus is to improve and differentiate the product further. Should such pressures continue, it may have a further adverse impact on margins. Furthermore, due to capacity restrictions in some raw material markets, input prices are subject to upward pressures. Should input costs rise, competitive pressures in the market place may make it difficult to pass on some or all of these increases, thereby adversely affecting margins.
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Customer credit risk
As part of the overall service package Kingspan provides credit to customers and as a result there is an associated risk that the customer may not be able to pay outstanding balances. Each of the business units has established procedures and credit control policies around managing its receivables and takes action where necessary. Trade receivables are also managed by having credit insurance policies, to the extent that these are available, and credit limits. All major outstanding and overdue balances together with significant potential exposures are reviewed regularly and concerns are discussed at monthly meetings at which group executive directors are present. Control systems are in place to ensure that authorisation requests are supported with appropriate and sufficient documentation and are approved at appropriate levels in the organisation.
At the year end, the Group was carrying a receivables book of €181mn expressed net of provisions for default in payment. Of these receivables approximately 55% were covered by credit insurance or other forms of collateral such as letters of credit and bank guarantees.
Regulation
Following the expansion of Kingspan over the last decade the Group has manufacturing and distribution operations in over 32 countries, each having its own statutes, taxes, regulations and laws. Each business unit closely monitors regulations across its markets to ensure any adverse impacts are minimised. However, certain changes are positive for the Group, in particular those pertaining to building and environment regulations which are becoming ever more stringent and harmonised across countries, especially in Europe, and as a result are increasing the demand for the Group’s products. More recently, authorities in several countries have introduced grant aid for many of the Group’s sustainable and energy efficient products such as insulation and evacuated solar tubes. As the introduction of such assistance has been positive for some Kingspan businesses, any future withdrawal of such assistance may have a negative effect.
Research & development and quality control
A key risk to Kingspan’s business and its reputation is the potential for functional failure of products when put to use, thereby leading to warranty costs and potential reputational damage. Quality control procedures in relation to both raw material inputs and Kingspan’s own manufacturing processes are, therefore, an essential part of the quality control before a Kingspan product is delivered to the customer. With the support of external audits, quality control systems are reviewed and improved on an ongoing basis to ensure each business unit is addressing the whole control environment around product and process development and the formal signing off from development to manufacturing. The majority of new products have also to go through a certification process which is undertaken by a recognised and reputable authority (for example, in the UK it is the Building Research Establishment, BRE) before it is brought to the market. To ensure that Kingspan meets the highest standards ISO accreditation is a tool that is used across the Group. At any one time 100% accreditation is unlikely as several of the sites are small operations which may be rationalised, restructured or amalgamated in the short to medium term. In addition Kingspan will generally have sites that have recently been acquired and therefore are still in the process of being integrated into the Kingspan model.
Expansion and acquisition
A key element of the Group’s strategy is to grow the business through both broadening its product offering and geographic expansion. This requires management to identify suitable investment opportunities both in the form of capital investment projects and acquisitions. Such expansion has its associated risks in terms of valuation, timing, integration / set-up and management resources. All investment proposals undergo a rigorous internal evaluation process incorporating a detailed market / competitive analysis, strategic rationale, external due diligence and pay-back valuation which targets double-digit pre-tax returns by year two, in accordance with set criteria for approving investments.
Information technology / business continuity
Kingspan uses a range of computer systems across its business units for efficient processing of orders, control procedures and financial management. These systems are constantly reviewed and updated accordingly to meet the growing needs of the Group. Business continuity planning is regularly being assessed and tested across the Group and addresses issues like personnel, manufacturing and disaster management. The Group is currently moving some of its similar business units to the same core operating platform in order to develop an in-house expertise in this system, and to generate scalability and mobility.
Taxation
Kingspan carries on significant levels of international trade and finance between members of the Group. The basis of this inter-group trade/finance is at arm’s length, and documented by agreement. Such agreements are open to challenge by the tax authorities in each member company’s jurisdiction, and the Group maintains an open dialogue with revenue authorities in various jurisdictions. An adverse view on these arrangements could give rise to increased taxation payments.
Dermot Mulvihill
Finance Director