Report on Risks and Opportunities
Risks and opportunities are inherent to entrepreneurial activity. We have put systems and processes in place to identify risks at an early stage and to counteract them by taking appropriate action. Within the company, opportunity management is an integral component of internal decision-making processes such as short- and medium-term planning and intra-year business plans.
Risk and opportunity management
Merck KGaA, Darmstadt, Germany, is part of a complex, global business world and is therefore exposed to a multitude of external and internal influences. Every business decision is therefore based on the associated risks and opportunities.
In our internal risk reporting, risks are defined as potential future events or developments that could lead to a negative deviation from our (financial) targets. In parallel, opportunities are defined as potential events or developments that imply a positive deviation from our planned (financial) targets. Identified future events and expected developments are taken into account in internal planning provided that it can be assumed that their occurrence is likely in the planning period. The risks and opportunities presented in the following risk and opportunities report are those potential future events that could respectively lead to a negative or positive deviation from the topics covered by planning.
Risk management process
The objective of our risk management activities is to recognize, assess and manage risks early on and to implement appropriate measures to minimize them. The responsibilities, objectives and processes of risk management are described in our internal risk management guidelines. The business heads, managing directors of our subsidiaries, and the heads of Group functions are specified as employees with responsibility for risks. The group of consolidated companies for risk reporting purposes is the same as the group of consolidated companies for the consolidated financial statements. Every six months, the risk owners assess their risk status and report their risk portfolio to Risk Management. We use special risk management software in the context of these activities.
Likewise, risk-mitigating measures are reported and assessed. The effectiveness of these measures and the planned implementation time frame are monitored by Group Risk Management.
The residual risk after the implementation of these measures is presented in the internal risk report as net risk.
Group Controlling & Risk Management forms the organizational framework for risk management and reports directly to the Group Chief Financial Officer. Group Risk Management uses the information reported to determine the current risk portfolio for the Group, presenting this in a report to the Executive Board, the Supervisory Board and the Finance Committee with detailed explanations twice per year. This also encompasses a probability-weighted aggregation of risks at Group level using a Monte Carlo simulation. Furthermore, significant changes in the assessment of the risks already known and new significant risks can be reported at any time and are communicated to the corporate bodies on an ad hoc basis.
For reporting risks with a potential negative impact on our EBIT, a threshold is set at a value of € 5 million in the standard process and at a value of € 25 million in the ad hoc process. Risks below these thresholds are steered independently within the business sectors. The relevant timeframe for internal risk reporting is five years. The effects of risks described in this report on risks and opportunities are presented as annual values. The assessment of the risks presented relates to December 31, 2017. There were no relevant changes after the balance sheet date that would have necessitated an amended presentation of the risk situation of the Group.
Within the scope of audits, Group Internal Auditing regularly reviews the performance of risk management processes within the units and, at the same time, the communication of relevant risks from the operating businesses to Group Risk Management.
Opportunity management process
The risk management system described concentrates on business risks, and not on opportunities at the same time. The opportunity management process is integrated into our internal controlling processes and carried out in the operating units on the basis of the Group strategy. The businesses analyze and assess potential market opportunities as part of strategy and planning processes. In this context, investment opportunities are examined and prioritized primarily in terms of their potential value proposition in order to ensure an effective allocation of resources. We selectively invest in growth markets to leverage the opportunities of dynamic development and customer proximity at a local level.
If the occurrence of the identified opportunities is rated as likely, they are incorporated into the business plans and the short-term forecasts. Trends going beyond this or events that could lead to a positive development in the net assets, financial position and results of operations are presented in the following report as opportunities. These could have a positive effect on our medium-term prospects.
Risk and opportunity assessment
The significance of risks is calculated on the basis of their potential negative impact on the forecast financial targets in conjunction with the probability of occurrence of the respective risk. In line with these two factors, risks are classified as ‟high”, ‟medium” or ‟low”.
The underlying scales for measuring these factors are shown below:21 KB EXCEL
PROBABILITY OF OCCURRENCE
|Probability of occurrence||Explanation|
|20 – 50%||Possible|
|51 – 80%||Likely|
DEGREE OF IMPACT
|Degree of impact||Explanation|
|€ 50 million||Substantial negative impact on the net assets, financial position and results of operations|
|€ 20 – 50 million||Moderate negative impact on the net assets, financial position and results of operations|
|€ 5 – 20 million||Immaterial negative impact on the net assets, financial position and results of operations|
|€ 5 million||Critical negative impact on the net assets, financial position and results of operations|
The combination of the two factors results in the risk matrix below, which shows the individual risks and their significance to the Group.22 KB EXCEL
|> € 50 million||Medium||Medium||High||High|
|€ 20 – 50 million||Medium||Medium||Medium||High|
|€ 5 – 20 million||Low||Medium||Medium||Medium|
|< € 5 million||Low||Low||Low||Low|
|Impact / Probability of occurrence||20%||20 – 50%||51 – 80%||80%|
Opportunities are assessed in their respective specific business environment. General measures of the business functions are quantified during operational planning in relation to sales, EBITDA pre and business free cash flow. Net present value, internal rate of return, the return on capital employed (ROCE), and the amortization period of the investment are primarily used to assess and prioritize investment opportunities. Similarly, scenarios are frequently set up to simulate the influence of possible fluctuations and changes in the respective factors on results. There is no overarching, systematic classification of the probability of occurrence and impact of opportunities.
Internal control system for the Group accounting process
The objective of the internal control system for the accounting process is to implement controls that provide assurance that the financial statements are prepared in compliance with the relevant accounting laws and standards. This system covers measures designed to ensure the complete, correct and timely conveyance and presentation of information that is relevant for the preparation of the consolidated financial statements and the combined management report.
The internal control system aims to ensure the accuracy of the consolidated accounting process through functioning internal controls with reasonable assurance. The Group Accounting function centrally steers the preparation of the consolidated financial statements of Merck KGaA, Darmstadt, Germany, as the parent company of the Group. This Group function defines the reporting requirements that all our subsidiaries must meet. At the same time, this function steers and monitors the scheduling and process-related requirements of the consolidated financial statements. Group Accounting centrally manages all changes to the equity holding structure and correspondingly adapts the Group’s scope of consolidation. The proper elimination of intragroup transactions within the scope of the consolidation process is ensured. Group-wide accounting guidelines form the basis for the preparation of the statutory financial statements of the parent company and of the subsidiaries, which are reported to Group Accounting; the guidelines are adapted in a timely manner to reflect changes in the financial regulatory environment and are updated in accordance with internal reporting requirements. For special issues, such as the accounting treatment of intangible assets within the scope of company acquisitions or pension obligations, external experts are additionally involved where necessary.
The individual companies have a local internal control system. Where financial processes are handled by a Shared Service Center, the internal control system of the Shared Service Center is additionally applied. Both ensure that accounting complies with IFRS (International Financial Reporting Standards) and with the Group accounting guidelines.
Group Accounting provides support to the local contacts and ensures a consistently high quality of reporting throughout the entire reporting process.
For Group financial reporting purposes, most of our subsidiaries use standard SAP software. Consolidation software from SAP is also used for the elimination of intragroup transactions. A detailed authorization concept ensures the separation of duties with respect to both single-entity reporting and the consolidated financial statements. In principle, the accounting process is designed to ensure that all units involved adhere to the principle of dual control.
The effectiveness of our internal control system with regard to accounting and the compliance of financial reporting by the individual companies is confirmed by both the local managing director and the local chief financial officer when they sign the single-entity reporting. For the accounting treatment of balance sheet items, Group Accounting closely cooperates with Group Risk Management in order to correctly present potential balance sheet risks. All the structures and processes described are subject to regular review by Group Internal Auditing based on an annual audit plan set out by the Executive Board. The results of these audits are dealt with by the Executive Board, the Supervisory Board and the Finance Committee. The internal control system at our company makes it possible to lower the risk of material misstatements in accounting to a minimum. However, no internal control system – regardless of its design – can entirely rule out a residual risk.
Business-related risks and opportunities
Political and regulatory risks and opportunities
As a global company, we face political and regulatory changes in a large number of countries and markets.
Risk of more restrictive regulatory requirements regarding drug pricing, reimbursement and approval
In our Healthcare business sector, the known trend towards increasingly restrictive requirements in terms of drug pricing, reimbursement and approval is continuing. These requirements can negatively influence the profitability of our products, also through market referencing between countries, and jeopardize the success of market launches and new approvals. Foreseeable effects are taken into account as far as possible in the business sector’s plans. Close communication with health and regulatory authorities serves as a preventive measure to avert risks. Remaining risks beyond the current plans resulting from restrictive regulatory requirements are classified as a medium risk owing to the possible critical negative impact.
Risk of stricter regulations for the manufacturing, testing and marketing of products
Likewise, in our Life Science and Performance Materials business sectors, we must adhere to a multitude of regulatory specifications regarding the manufacturing, testing and marketing of many of our products. Specifically in the European Union, we are subject to the European chemicals regulation REACH. It demands comprehensive tests for chemical products. Moreover, the use of chemicals in production could be restricted, which would make it impossible to continue manufacturing certain products. We are constantly pursuing research and development in substance characterization and the possible substitution of critical substances so as to reduce the occurrence of this risk, and therefore view it as unlikely. Nevertheless, it is classified as a medium risk given its critical negative impact on the net assets, financial position and results of operations.
Risk of negative political and macroeconomic developments
The destabilization of political systems (as for example in Turkey or the Middle East), the possible establishment of trade barriers as well as foreign exchange policy changes can lead to declines in sales in certain countries and regions. These risks are taken into account as far as possible in the business plans of the affected countries and regions and mitigated through product, industry and regional diversification.
Potential negative macroeconomic developments, for example in Argentina and Brazil, can also impact our business. To minimize these impacts, corresponding measures pertaining to the sales strategy have been initiated in these countries.
The United Kingdom’s imminent exit from the European Union (‟Brexit”) gives rise to risks for our existing business in that country (2017: sales of € 429 million, 1,514 employees and five production sites) such as the decline in the value of the British pound, a weakening of economic activity in the United Kingdom, regulatory changes, and the creation of trade barriers such as import duties, which could have an impact on our profitability. To analyze these risks and to counteract them in a timely and targeted manner, internal working groups have been set up.
The net risk of negative political and macroeconomic developments is seen as possible and has critical negative effects on the net assets, financial position and results of operations. We thus rate this as a medium risk.
Market risks and opportunities
We compete with numerous companies in the pharmaceutical, chemical and life science sectors. Rising competitive pressure can have a significant impact on the quantities sold and prices attainable for our products.
Opportunities due to new technologies in the manufacturing of displays
We see opportunities in the medium-to long-term possibilities of significant market growth of OLED applications in high-quality display applications. We are building on more than ten years of experience in manufacturing organic light-emitting diode (OLED) materials as well as a strong portfolio of worldwide patents in order to develop ultrapure and extremely stable materials that are precisely tailored to customer requirements. The development in the OLED market is being driven by the diversification of applications for OLED displays. OLED technology is an established alternative to LCDs in small-area displays, for instance smartphones. However, owing to technological advances, OLED technology is being used in more and more large-area displays, such as televisions. High-quality lighting applications, for example for automobiles, offer further growth potential for OLEDs. In order to make the mass production of large-area OLED displays more efficient, we have been cooperating since the end of 2012 with Seiko Epson Corporation to enable printing processes for OLED displays. At the beginning of the second quarter of 2017, the HyperOLED project started within the scope of the Horizon 2020 initiative, an EU-based program. As part of this project, together with four other partners, we will be developing high-performance, hyperfluorescence OLEDs for display and lighting applications over the next three years.
To expand our expertise in the field of high-quality display applications, we entered into a development agreement with CLEARink Displays. Together, we plan to launch an innovative, patented and reflecting display technology for mobile devices. Our objective is to commercialize the first video-enabled reflecting color displays in 2018.
Opportunities due to new application possibilities for liquid crystals
We are pursuing a strategy of leveraging our expertise as the global market leader in liquid crystals in order to develop new fields of application for innovative liquid crystal technologies. For instance, we are pressing ahead to capture the future markets for liquid crystal windows (LCWs) and mobile antennas. Thanks to licrivision™ technology, LCWs create new architectural possibilities.
Through continuously variable brightness control, they can for example increase a building’s energy efficiency. To drive forward the market penetration of liquid crystal windows, we are investing around € 19 million in the construction of a production facility for window modules. Initial sales, albeit at a low level, are expected in 2018 with greater medium-term potential. Antennas that can receive signals transmitted in the high frequency range can also be realized with the aid of corresponding liquid crystal mixtures. As a result, mobile data exchange could improve significantly in a wide variety of fields of application. Since novel liquid crystal materials for antennas are currently being developed, the market launch of liquid crystal antennas could still take a few years. New application opportunities for liquid crystals could have medium- to long-term positive effects on the financial indicators of our Performance Materials business sector.
Opportunities offered by the increased importance of the automotive platform
In the future, topics such as data transmission, individual design, smart lighting and autonomous driving will play an important role in the automotive industry, thus expanding our opportunities in smart technologies.
In 2017, we presented our automotive innovations at our own exhibition stand at the International Motor Show (IAA) in Frankfurt am Main, Germany, for the first time. With our products and displays in the New Mobility World, we offered visitors the opportunity to familiarize themselves with the broad range of future applications and with our company.
Opportunities from leveraging the e-commerce and distribution platform
With the acquisition of Sigma-Aldrich in 2015 we have gained access to the leading life science e-commerce platform. Our customers are already benefiting from an offering of more than 300,000 products including highly respected brands distributed via this e-commerce platform. We are further expanding this platform in order to continuously increase the number of products available on it. Making ordering processes faster and more convenient for our customers and offering support through individualized product recommendations could lead to higher sales volumes and enable us to win new customers. Consequently, this distribution channel could lead to an above-average development of sales in the medium term.
This is being expanded through the collaboration with Elsevier. Our products are now listed in Reaxys, a chemicals database. Users can now conveniently find and purchase the products we develop and supply.
The acquisition of Grzybowski Scientific Inventions complements our e-commerce platform. The retro-synthesis software from this acquisition offers the possibility to identify and select synthesis methods.
Risk due to increased competition and customer technology changes
In our Healthcare business sector, both our biopharmaceutical products and classic pharmaceutical business are exposed to increased competition from rival products (in the form of biosimilars and generics). In the Life Science and Performance Materials business sectors, risks are posed by not only cyclical business fluctuations but also changes in the technologies used or customer sourcing strategies, particularly with respect to liquid crystals. We use close customer relationships and in-house further developments as well as market proximity, including precise market analyses as mitigating measures. Overall, owing to its possible occurrence with a critical negative impact, the market risk is classified as a medium risk.
Opportunities offered by digitalization and activities to boost innovative strength
Digital technologies are becoming increasingly important for our markets and our world of work. Therefore, in 2015, we launched strategic digital initiatives geared to improving the efficiency of our internal processes and to evaluating the opportunities of digitalization with regard to our products and customers. In addition to collaborations with external partners to expand e-health solutions for patients, e.g. our MSdialog platform, the Accelerator program, which is being driven by our Innovation Center, is one component of our innovation strategy. We achieved a record number of applicants, with the number of applications increasing by 82% over the previous round. The program comprises support for and access to start-up companies that offer innovative digital solutions in the fields of healthcare, life science and performance materials. With our corporate venture capital fund, we are also strengthening our collaboration with and access to highly innovative start-ups. The expansion of these activities could lead to new market opportunities for us. In the medium term, these could have a positive impact on the development of our sales.
Furthermore, we are expanding our expertise through a PMatX incubator for next-generation electronics in Israel. With a focus on start-up companies for state-of-the-art electronics, the topics being addressed are closely related to Performance Materials.
Risks and opportunities of research and development
For us, innovation is a major element of the Group strategy. Research and development projects can experience delays, expected budgets can be exceeded, or targets can remain unmet. Research and development activities are of special importance to our Healthcare business sector. In the course of portfolio management, we regularly evaluate and, if necessary, refocus research areas and all R&D pipeline projects.
Special mention should be made of the strategic alliance formed in 2014 between our company and Pfizer Inc. as a research and development opportunity in our Healthcare business sector. In 2017, the European Commission approved Bavencio®, an anti- PD-L1 antibody we are co-developing with Pfizer, in 28 countries of the European Union, Iceland, Liechtenstein and Norway as well as in Canada and Japan. This builds on the previous approvals in the United States and Switzerland. Bavencio® is thus the first immunotherapy for patients with metastatic Merkel cell carcinoma.
Additionally, Bavencio® was approved by the FDA for the treatment of patients with locally advanced or metastatic urothelial cancer.
In addition, Mavenclad® was approved in 2017 in the European Union by the European Commission. Approvals were also granted in Canada and Australia. It is the first short-course oral treatment approved in Europe for the treatment of relapsing multiple sclerosis in patients with high disease activity. The first market launch will take place in Germany, followed by the United Kingdom and the remaining EU member states.
We plan to submit Mavenclad® for regulatory review in the United States and both drugs in Asia.
Apart from these regulatory submissions, we are pushing ahead with research projects in further important indications and are actively pursuing new opportunities through in- and outlicensing.
The expenses currently being incurred, especially in our Healthcare research and development, are already reflected in the current plans. The same applies to net sales generated by the products Bavencio® and Mavenclad®. If approved in further countries, the estimated sales potential could increase.
Moreover, we in-licensed four oncology research and development programs from Vertex. With this strategic portfolio acquisition, we are strengthening our oncology pipeline in two attractive areas where we already possess substantial expertise: DNA damage response as well as immuno-oncology. These areas offer highly promising therapeutic synergies.
Risks of discontinuing development projects and regulatory approval of developed medicines
Sometimes development projects are discontinued after high levels of investment at a late phase of clinical development. Decisions – such as those relating to the transition to the next clinical phase – are taken with a view to minimizing risk. Furthermore, there is the risk that regulatory authorities either do not grant or delay approval, which can have an impact on earnings, for example by lower sales or missed milestone payments from collaboration agreements. Additionally, there is the danger that undesirable side effects of a pharmaceutical product could remain undetected until after approval or registration, which could result in a restriction of approval or withdrawal from the market. We are currently not aware of any risks beyond general development risks that could significantly affect the net assets, financial position and results of operations.
Product-related risks and opportunities
Risk of a temporary ban on products/production facilities or of non-registration of products due to non-compliance with quality standards
We are required to comply with the highest standards of quality in the manufacturing of pharmaceutical products (Good Manufacturing Practice). In this regard we are subject to the supervision of the regulatory authorities. Conditions imposed by national regulatory authorities could result in a temporary ban on products/production facilities, and possibly affect new registrations with the respective authority. We take the utmost effort to ensure compliance with regulations, regularly perform our own internal inspections and also carry out external audits. Thanks to these quality assurance processes, the occurrence of a risk is unlikely, however cannot be entirely ruled out. Depending on the product concerned and the severity of the objection, such a risk can have a critical negative impact on the net assets, financial position and results of operations. Therefore, we rate this as a medium risk.
Operational failure risks
Further risks include operational failures due to fire or force majeure, for example natural disasters such as floods or earthquakes, which could lead to a substantial interruption or restriction of business activities. Insofar as it is possible and economically viable, the Group limits its damage risks with insurance coverage, the nature and extent of which is constantly adapted to current requirements. Likewise, we are exposed to risks of production outages and the related supply bottlenecks that can be triggered by technical problems in production facilities with very high capacity utilization. We are working to continuously mitigate the risks by making regular investments, setting up alternative sourcing options and maintaining inventory levels.
Although the occurrence of these risks is considered unlikely, an individual event could have a critical negative effect on the net assets, financial position and results of operations and are therefore classified as a medium risk.
Risks of dependency on suppliers
Quality controls along the entire value chain reduce the risks related to product quality and availability. This starts with the qualification of our suppliers. Quality controls also include comprehensive quality requirements for raw materials, purchased semi-finished products and plants. We are dependent on individual suppliers for a number of precursor products, packaging materials and finished goods. In the event that one of these suppliers curtails or discontinues production, or supply is disrupted, this could potentially have a critical impact on the business concerned. With long-term strategic alliances for precursor products critical to supply and price as well as alternative sourcing strategies, we reduce the probability of occurrence of these risks and rate them as unlikely. Overall, these are classified as medium risks.
Product liability risks
Companies in the chemical and pharmaceutical industries are exposed to product liability risks in particular. Product liability risks can lead to considerable claims for damages, loss of reputation and costs to avert damages. We have taken out the liability insurance that is standard in the industry for such risks. However, it could be that the insurance coverage available is insufficient for individual cases. Although the occurrence of product liability claims in excess of the existing insurance coverage is considered unlikely, individual cases could still have a critical negative effect on the net assets, financial position and results of operations. We therefore rate a potential product liability risk as a medium risk.
Risks due to product-related crime and espionage
Owing to our portfolio, we are exposed to a number of sector-specific crime risks. This relates primarily to products, including among other things, counterfeiting, illegal channeling, misuse as well as all types of property crime, including attempts at these crimes. Crime phenomena such as cybercrime and espionage could equally affect our innovations or innovation abilities as such.
To combat product-related crime, an internal coordination network covering all functions and businesses (‟Anti-Counterfeiting Operational Network”) was set up several years ago. In addition, security measures are in use to protect products against counterfeiting. Innovative technical security solutions and defined preventive approaches are used to ward off dangers relating to cybercrime and espionage. Measures to prevent risks and to prosecute identified offenses are conducted in all the relevant crime areas in close and trustworthy cooperation with the responsible authorities. The impact of these risks on business operations depends on the respective individual case, product-specific factors, the value chain, as well as on regional aspects in particular. Our Corporate Security department is responsible for the overall coordination of all measures in this area. Overall, the threat resulting from crime in general is seen as being possible and is classified as a medium risk.
Opportunities due to an expanding local presence in high-growth markets
For numerous markets in Asia, the Middle East, Latin America and Africa, we expect that in the coming years all business sectors will continue to make above-average contributions to growth. In order to further expand this potential for our businesses, we have moved forward with several investment projects in recent years. For instance, in 2017 we invested around € 25 million in China to further expand the capacity of a pharmaceutical manufacturing facility as well as a further € 26 million in a manufacturing plant for our Life Science business sector. Moreover, we are continuing our engagement in Africa. The greater local presence and customer proximity could give us a key competitive edge and, in the medium to long term, offers the opportunity for significant growth in sales and EBITDA pre.
Risks and opportunities from the use of social media
Our company and its employees are active on numerous social media channels. The consistent and legally compliant use of the channels and their content is important in terms of increasing awareness of our brand, among other things. We take precautions and implement processes to ensure awareness of the proper handling of social media, controlling publication and actively managing communication.
Nevertheless, reputational risks could result, for instance through public dialogues in social media. Overall, we rate this as a low risk.
Financial risks and opportunities
As a corporate group that operates internationally and due to our presence in the capital market, we are exposed to various financial risks and opportunities. Above all, these are liquidity and counterparty risks, financial market risks and opportunities, risks of fluctuations in the market values of operational tangible and intangible assets, as well as risks and opportunities from pension obligations.
Risk and opportunity management in relation to the use of financial instruments
In the area of financial risks and opportunities, we use an active management strategy to reduce the effects of fluctuations in exchange and interest rates. The management of financial risks and opportunities by using derivatives in particular is regulated by extensive guidelines. Speculation is prohibited. Derivative transactions are subject to constant risk controls. A strict separation of functions between trading, settlement and control functions is ensured.
In order to ensure its continued existence, a company must be able to fulfill its commitments from operating and financial activities at all times. To reduce potential liquidity risks, we have a central Group-wide liquidity management system in place and a balanced maturity profile. The maturities of our financial liabilities are aligned with our planned free cash flow. Furthermore, we have a multicurrency revolving credit facility of € 2 billion with a term until 2020, which ensures continuing solvency if any liquidity bottlenecks occur. As our loan agreements do not contain any financial covenants, these agreed lines of credit can be accessed even if our credit rating should deteriorate. Additionally, we have a commercial paper program with a maximum volume of € 2 billion.
Overall, the liquidity risk is unlikely and rated as low.
Counterparty risks arise from the potential default by a partner in connection with financial investments, loans and financing commitments on the one hand and receivables in operating business on the other.
As for counterparty risks from financial transactions, we review all positions relating to trading partners and their credit ratings on a daily basis. We manage financial risks of default by diversifying our financial positions and through the related active management of our trading partners. Significant financial transactions involving credit risk are entered into with banks and industrial companies that have a good credit rating. Moreover, our large banking syndicate – the multi-currency revolving credit facility of € 2 billion was syndicated by 19 banks – reduces possible losses in the event of default.
The solvency and operational development of trading partners is regularly reviewed as part of the management of operational counterparty risks. Sovereign risks are also analyzed. The volume of receivables of each customer is capped in line with their credit ratings. Risk-mitigating measures, such as credit insurance, are utilized as appropriate. Nevertheless, defaults by isolated trading partners, even those with outstanding credit ratings, cannot be entirely ruled out, although rated as unlikely (further information can be found in ‟Credit risks” under ‟Management of financial risks” in the Notes to the Consolidated Financial Statements).
Counterparty risk is classified as a medium risk overall owing to the unlikely probability of occurrence with a potential critical negative effect.
Financial market opportunities and risks
As a result of our international business activities and global corporate structure, we are exposed to risks and opportunities from fluctuations in exchange rates. These result from financial transactions, operating receivables and liabilities, as well as forecast future cash flows from sales and costs in foreign currency. We use derivatives to manage and reduce the aforementioned risks and opportunities (further information can be found in ‟Derivative financial instruments” in the Notes to the Consolidated Financial Statements). Due to their possible occurrence with a potentially critical negative effect on the net assets, financial position and results of operations, foreign exchange rate risks are rated as medium risk.
Variable interest and current financial liabilities are exposed to the risks and opportunities of interest rate fluctuations. These are also managed and reduced using derivatives. Interest rate risks have a potentially moderate negative impact, are considered unlikely and pose low risks overall.
Risks of impairment of balance sheet items
The carrying amounts of individual balance sheet items are subject to the risk of changing market and business conditions and thus to changes in fair values as well. Necessary impairments could have a significant negative non-cash impact on earnings and affect the accounting ratios.
This applies in particular to the high level of intangible assets including goodwill, which mainly derive from the purchase price allocations made in connection with past acquisitions (further information can be found under ‟Goodwill” and ‟Other intangible assets” in the Notes to the Consolidated Financial Statements). All relevant risks were assessed during the preparation of the consolidated financial statements and taken into account accordingly. We rate risks beyond this as unlikely with a critical negative impact. Therefore, this is seen as a medium risk.
Risks and opportunities from pension obligations
We have commitments in connection with pension obligations. The present value of defined benefit obligations can be significantly increased or reduced by changes in the relevant valuation parameters, for example the interest rate or future salary increases. Pension obligations are regularly assessed as part of annual actuarial reports. The obligations are covered by the pension provisions reported in the balance sheet based on the assumptions as of the balance sheet date. Some of these obligations are funded by plan assets (further information can be found under ‟Provisions for pensions and other post-employment benefits” in the Notes to the Consolidated Financial Statements). To the extent that pension obligations are covered by plan assets consisting of interest-bearing securities, shares, real estate, and other financial assets, decreasing or negative returns on these assets can adversely affect the fair value of plan assets and thus result in further additions to pension provisions. By contrast, rising returns increase the value of plan assets, thereby resulting in excess cover of plan liabilities. We increase the opportunities of fluctuations in the market value of plan assets on the one hand and reduce the risks on the other by using a diversified investment strategy. The unlikely risk due to pension obligations could have moderate negative effects on the net assets, financial position and results of operations, and is to be classified as low.
Assessments by independent rating agencies
The capital market uses the assessments published by rating agencies to help lenders assess the risks of a financial instrument used by our company. We are currently rated by Standard & Poor’s, Moody’s and Scope. Standard & Poor’s has issued a long-term credit rating of A with a stable outlook, Moody’s a rating of Baa1 with a stable outlook, and Scope a rating of A-, likewise with a stable outlook. In line with market procedures, our financing conditions are closely tied to our rating. The better a rating, the more favorably we can generally raise funds on the capital market or from banks.
REPORT ON RISKS AND OPPORTUNITIES
Overview of rating development
Generally, we strive to minimize and control our legal risks. To this end, we have taken the necessary precautions to identify threats and defend our rights where necessary.
Nevertheless, we are still exposed to litigation risks or legal proceedings. In particular, these include risks in the areas of product liability, competition and antitrust law, pharmaceutical law, patent law, trademark law, tax law, and environmental protection. As a research-based company, we have a valuable portfolio of industrial property rights, patents and brands that could become the target of attacks and infringements. The outcome of future proceedings or those currently pending is difficult to foresee.
For instance, we are currently involved in litigation with Merck & Co. Inc., Kenilworth, NJ, USA (outside the United States and Canada: Merck Sharp & Dohme Corp. (MSD)), against whom we have filed lawsuits in various countries. This company has also sued us in the United States for trademark infringement, among other things.
Due to long statutes of limitations or in some cases the absence thereof, it is not possible to rule out that we will face third-party claims arising from the same issue despite the conclusion of legal proceedings. Court or official rulings or settlements can lead to expenses with a significant impact on our business and earnings.
Despite extensive precautionary measures, non-compliance with laws and regulations leading to related consequences can never be completely excluded.
Tax risks are reviewed regularly and systematically by Group Tax. Corresponding standards and guidelines are used in order to identify tax risks at an early stage as well as to review, evaluate and correspondingly minimize them. Risk reduction measures are coordinated by Group Tax together with the subsidiaries abroad.
In our opinion, the lawsuits described below constitute the most significant legal risks. This should not be seen as an exhaustive list of all legal disputes currently ongoing.
Risks from product-related and patent law disputes
We are involved in a patent dispute in the United States with Biogen Inc. (Massachusetts, USA) (‟Biogen”). Biogen claims that the sale of Rebif® in the United States infringes on a Biogen patent. The disputed patent was granted to Biogen in 2009 in the United States. Subsequently, Biogen sued our company and other pharmaceutical companies for infringement of this patent. Our company defended itself against all allegations and brought a countersuit claiming that the patent is invalid and not infringed on by our actions. A Markman hearing took place in January 2012, leading to a decision in the first quarter of 2016. A first-instance ruling is now expected for 2018. A court-ordered mediation proceeding did not lead to an agreement between the parties. We have taken appropriate accounting measures.
Nevertheless, potentially critical negative impacts of the litigation on the financial position cannot be ruled out.
In our Performance Materials business sector, we are involved in a legal dispute with JNC Corporation, Japan, (JNC). JNC claims that by manufacturing and marketing certain liquid crystals mixtures, our company has infringed JNC patents. We maintain that JNC’s patent infringement assertion is invalid owing to relevant prior art and has filed the corresponding nullity actions, which in three cases were already successful in first-instance proceedings. JNC has filed complaints in each case. In a correction trial, a decision in favor of JNC was issued in the second instance. Both our company and the Korean Patent Office have filed complaints with the Korean Supreme Court. In parallel, JNC filed two patent infringement suits. In 2017, a first-instance decision was issued in favor of our company, which JNC then appealed. Our company has taken appropriate accounting measures. Nevertheless, a potentially critical negative impact of the litigation on the financial position cannot be ruled out.
In July, Bristol-Myers Squibb Co., USA, E.R. Squibb & Sons L.L.C., USA, Ono Pharmaceutical Co., Ltd., Japan, and a private individual filed suit in the United States District Court of Delaware against our company and Pfizer Inc., USA, (Pfizer) based on the allegation that Bavencio® infringes a U.S. patent. The plaintiffs accuse multiple companies of infringing a U.S. patent relating to methods of treating tumors with anti-PD-L1 antibodies. Both our company and Pfizer have initiated legal steps to defend themselves. A potentially critical negative impact of the litigation on the financial position cannot be ruled out.
Risks due to antitrust and other government proceedings
Raptiva®: In December 2011, the federal state of São Paulo, Brazil, sued us for damages because of alleged collusion between various pharmaceutical companies and an association of patients suffering from psoriasis and vitiligo. This collusion is alleged to have been intended to increase sales of the medicines from the companies involved to the detriment of patients and state coffers. Moreover, patients are also suing for damages in connection with the product Raptiva®.
We have taken appropriate accounting measures for these issues. Risks in excess of this with a substantial negative effect on the net assets, financial position and results of operations cannot be ruled out, but are considered unlikely. This is rated as a medium risk.
On July 6, 2017, we received notice from the European Commission (EU Commission), in which the EU Commission informed our company of its preliminary conclusion that our company and Sigma-Aldrich allegedly transmitted incorrect and/or misleading information within the scope of the acquisition of Sigma-Aldrich. The EU Commission received registration of the merger on April 21, 2015 and granted clearance on June 15, 2015 subject to the condition that our company and Sigma-Aldrich divest parts of the European solvents and inorganic chemicals businesses of Sigma-Aldrich in order to resolve antitrust concerns. According to the preliminary viewpoint of the EU Commission communicated in the letter dated July 6, 2017, our company and Sigma-Aldrich withheld in this connection important information about an innovation project allegedly relevant for certain laboratory chemicals of significance to the analysis by the EU Commission. According to the EU Commission, the innovation project should have been included in the remedies package. A meeting of the cooperation procedure between the EU Commission and our company took place on February 5, 2018. The ongoing investigations are limited to the examination of violations of EU merger control procedures and do not affect the validity of the EU Commission’s decision to approve the merger. The risk is considered likely with a critical negative impact on the net assets, financial position and results of operations and is thus classified as high. Appropriate accounting measures have been taken.
Risks owing to a settlement agreement of the divested Generics group
Paroxetine: In connection with the divested generics business, we are subject to antitrust investigations by the British Competition and Market Authority (CMA) in the United Kingdom. In March 2013, the authorities informed us of the assumption that a settlement agreement entered into in 2002 between Generics (UK) Ltd. and several subsidiaries of GlaxoSmithKline plc, (UK) in connection with the antidepressant drug paroxetine violates British and European competition law. Our company, the then owner of Generics (UK) Ltd., was allegedly involved in the negotiations for the settlement agreement and is therefore liable. The investigations into Generics (UK) Ltd. started in 2011, without this being known to us. On February 11, 2016, the CMA imposed a fine in this matter. We have taken legal action against this fine. Appropriate accounting measures have been taken. This is currently classified as a medium risk with a moderate negative impact on the financial position.
Human resources risks
Our future growth is highly dependent on our innovative strength. Therefore, the expertise and engagement of employees in all sectors in which we operate are crucial to the success of the company. The markets relevant to the company are characterized by intensive competition for qualified specialists and by the challenge of being perceived by the public as an attractive employer. Fluctuation risks specific to countries and industries have to be identified ahead of time and specifically addressed in order to keep the skills and expertise critical to success and business within the company.
Recruiting and retaining specialists and talent is therefore one of the key priorities for the company and is managed through the targeted use of, for instance, employer branding initiatives, global talent and succession management processes as well as competitive compensation packages. Nevertheless, employee-related risks that affect business activities are possible, even though their impact is difficult to assess. We rate this as a medium risk.
Information technology risks
We use a variety of IT systems and processes in order to optimally support our globalization. Trends in information technology offer various opportunities but also harbor risks.
Risks due to cybercrime and the failure of business-critical IT applications
Increasing international networking and the related possibility of IT system abuse are resulting in cybercrime risks for our company, such as the failure of central IT systems, the disclosure or loss of the data integrity of confidential data from research and business activities, the manipulation of IT systems in chemical process control, or an increased burden or adverse impact on IT systems as a result of virus attacks.
The Group operates an information protection management system based on ISO 27001 comprising security guidelines as well as organizational and technical measures to prevent and address IT security incidents. Globally used IT applications form the basis for the contractual delivery of products and solutions. The failure of business-critical IT applications could therefore have a direct influence on our ability to deliver and the quality of our products. This also applies to the failure of a data center. To achieve the required service quality, we use a quality management system certified to ISO 9001 that also applies to the provision of IT.
In addition, to reduce the risk of failure, we operate several redundantly designed data centers. Likewise, complications with the changeover of IT systems could negatively impact the earnings situation. Close monitoring of critical IT projects serves to mitigate this risk.
Despite the mitigating measures taken and functional continuity plans, the effects of cybercrime or the failure of business-critical IT applications and their influence on the net assets, financial position and results of operations are considered high risks owing to likely and potentially critical negative impacts.
Environmental and safety risks
As a company with global production operations, we are exposed to risks of possible damage to people, goods and our reputation. Audits, consulting and training on environmental protection and occupational health and safety minimize these risks to people and the environment. In order to ensure the continuity of plant and equipment, we monitor these risks both at our own sites as well as at suppliers and contract manufacturers. By adhering to high technical standards, our rules of conduct and all legal requirements in environmental protection and occupational health and safety, we ensure the preservation of goods and assets. We have taken sufficient appropriate accounting measures for the environmental risks known to us. Nevertheless, we classify these as a high risk since a critical negative impact on the financial position cannot be ruled out.
Risks of the divestment, acquisition and integration of companies and businesses
Irrespective of the fact that acquisitions made in the past have been successfully completed, the risk of conducting the acquisition and integration exists for future transactions. This includes, among other things, the inability to meet sales volume targets and higher integration costs than expected, as well as the failure to meet synergy goals. The divestment of companies and businesses can lead to liability vis-à-vis the buyer, for instance through indemnity clauses and guarantee commitments. Through strong due diligence processes and closely managed integration processes, we seek to reduce the probability of occurrence of this risk. Therefore, we classify this as a low risk with an unlikely probability of occurrence and potentially moderate negative effects on the net assets, financial position and results of operations.
Overall view of the risk and opportunity situation and management assessment
Although the number of risks reported is higher than the specific opportunities identified, we consider the distribution of risks and opportunities to be balanced. A balanced overall view is also supported by the fact that net sales and business success are built on a diverse range of pharmaceutical and chemical products for a variety of industries. As the markets differ in their structure and economic cycles, this diversification helps to lower risk.
The most significant individual risks in the businesses have been named in the report above, with business-related risks being the most significant alongside legal risks.
With respect to high and medium risks, certain changes have resulted as the assessment of the individual risks has of course altered over the fiscal year due to changing external and internal conditions, while the overall risk profile remained stable. Thanks to the risk reduction measures taken – such as the consistent implementation of management action (organizational responsibility and process improvements), existing insurance coverage and accounting precautions – we take counteraction, in particular against significant risks.
The overall risk of the Group, which is derived from the probability-weighted aggregation of the identified risks, leads to the assessment that we are not exposed to risk scenarios of a nature to threaten the existence of the Group as a going concern or for which coverage and financing of the losses is questionable. We are confident that we will continue to successfully master the challenges arising from the above risks in the future as well.
In our view, business-related opportunities offer the greatest potential. An important element here is the continuous expansion of our businesses in Asia, Latin America, Africa, and the Middle East. With the successful focusing and continued intensification of our research and development activities, we want to be able to continue to offer our customers innovative products and help shape markets. Moreover, we also consolidate our expertise in numerous alliances with industrial partners as well as various universities and international organizations. We are making targeted investments in future-oriented companies and start-ups via our corporate venture capital Fund and our Accelerator programs. The topic of innovation is at the forefront of all our activities. Externally, this is becoming particularly apparent through our new Innovation Center at Group headquarters in Darmstadt, which is to develop into a nucleus of creativity at our company. The activities listed hold significant opportunities for us in the medium to long term, beyond the underlying forecast period.
We pursue the opportunities that arise and specify their expected effects in the forecast development of our key performance indicators – net sales, EBITDA pre and business free cash flow. Furthermore, we will actively seek new opportunities, examine their implementation and drive them forward where appropriate. If opportunities arise in addition to the forecast developments, or these occur more quickly than anticipated, this could have correspondingly positive effects on our net assets, financial position and results of operations.