10. Risk report

The Schaeffler Group intentionally takes manageable business risks in order to implement its [--break--]  corporate strategy and realize the related earnings opportunities. However, the Schaeffler Group is exposed to a large number of risks that can adversely affect its business and, in extreme cases, jeopardize the company’s existence. We are currently not aware of any such risks that are probable to occur.

Schaeffler defines risks as possible future developments or events that can result in negative deviations from budgeted results.

Responsibilities for identifying and controlling significant risks are clearly divided within the Schaeffler Group at various levels and organizational units. Risks are monitored by local management at the subsidiaries as well as group-wide by the statutory board of directors. Local management is responsible for managing risks without significant adverse effects at the level of the Schaeffler Group. Risk evaluation is based on an estimate of the monetary impact on net income and the related probability of occurrence.

The risk management system is constantly improved and updated. As the risk management system was rolled-out to additional group companies in stages in 2011, the system has now been implemented in all regions. The risk management guideline has been integrated into the Schaeffler [--break--]  Group Management Handbook, making it available to all employees. In addition to the process description, the allocation of responsibilities and the structure of the risk management system, it includes, in particular, a description of the content of the risk categories and suggested risk assessments.

Identified risks and related measures are combined at group level by risk management, monitored and regularly reported to the appropriate members of management. Within its area of responsibility, management decides what measures are required and ensures that their implementation is managed on an ongoing basis. The executive board monitors the development of all identified risks and the status of measures taken. Reports on these measures and the status of their implementation were provided to the audit committee of the supervisory board during the year.

In order to be able to operate successfully in its business environment, the Schaeffler Group has established an effective internal control system which is an integral part of its risk management system. The objective of the internal control system relating to accounting and financial reporting is to ensure the accuracy of the accounting system and the related reporting.

Schaeffler’s system of internal controls over financial reporting includes the following measures:

  • extensive system-based plausibility checks integrated in the day-to-day reporting system;
  • regular consultations with operating units on accounting matters;
  • controls using reviews (by a second member of staff) carried out regularly at individual company level as well as at group reporting level;
  • accounting policies applied uniformly throughout the group; and
  • processes for recognizing and eliminating intragroup transactions.

The proper functioning of the internal control system was confirmed at the individual company level in 2011 with the help of a control self-assessment process. Identified control weaknesses were evaluated and analyzed at company and group level. Measures for continual improvement and for eliminating risks are being implemented with the help of the internal audit function.

Despite the steps taken to monitor its proper functioning and continuous improvement, the internal control and risk management system relating to the financial reporting process cannot with absolute certainty prevent accounting misstatements from occurring.

Management divides the risks to which the Schaeffler Group is exposed into strategic, operating, legal and financial risks.

10.1 Strategic risks

Decisions made in connection with the strategic approach of our group and our product portfolio always bear the risk that market trends and technological changes are not recognized on a timely basis, or are incorrectly evaluated.

Extensive market analyses are carried out in order to be able to limit such risks. Trends are analyzed and evaluated early on and alternative development decisions are considered with respect to their effects on the product portfolio and strategic approach of the group.

Planning our geographic presence is driven by the need to be close to our customers. This leads to the risk that, due to the lack of a local presence, new customer orders cannot be obtained or existing customer orders cannot be processed entirely locally.

We counter this risk by strategically planning our geographic presence, with the aim, amongst other matters, of establishing or expanding production capacities timely at the relevant locations. This is demonstrated by our international reach.

Changes affecting the social, political, legal, or economic stability in certain markets may lead to a restriction of our planned expansion.

10.2 Operating risks

Demand for our products both in the Automotive and in the Industrial sector is significantly affected worldwide by economic conditions. In addition, cyclical fluctuations in individual sectors represent another risk to the utilization of production capacity and, consequently, earnings.

The development and bringing to market of new products bears the risk that timing, quality or planned costs can not be met.

In order to mitigate this risk, the Schaeffler Group has implemented a group-wide system to manage its research and development processes. This system allows decision makers to monitor the relevant projects efficiently and influence further progress timely. Particularly in the [--break--]  Automotive division we can further reduce the above-mentioned risks by closely cooperating [--break--] with our key customers in the areas of customer-specific development and continuous improvement.

Maintaining our technological leadership and developing new and improved products requires significant capital expenditures. Such capital expenditures may be restricted not only by a deterioration of earnings, but also by financial covenants (see 10.4 Financial risks), jeopardizing the development they are intended to facilitate.

Procurement risks arise both from market price fluctuations and from lack of availability of raw materials of the appropriate quality and quantity. Manufacturing our products requires large amounts of raw materials and components, mainly a wide variety of steel alloys, as well as energy.

These risks are mitigated by systematically selecting and evaluating suppliers. Existing knowledge of local markets is integrated in the development of the purchasing strategy. For this reason, regional purchasing organizations are involved in the process, from developing a strategy to country-specific implementation. The Schaeffler Group also mitigates the volatility of raw material prices by entering into tranche transactions (such as for energy) and by passing on price fluctuations to customers using price adjustment clauses. Derivative financial instruments are not used to hedge raw material prices.

The continuing success and forecasted growth of the Schaeffler Group depend above all upon recruiting, integrating and retaining appropriate personnel. Competition for highly-qualified employees, particularly for engineers and managers, remains considerable, which firstly makes attracting new staff difficult and secondly can result in the loss of key personnel. The deliberate expansion of personnel marketing is intended to increase the awareness and attractiveness of the Schaeffler Group. Measures to develop and train personnel are designed to improve staff qualification and motivation.

Poor quality of delivered products can represent a product liability risk. The use of defective products leads to damage, unplanned repairs or recalls which can result in liability claims or reputational damage. Furthermore, deteriorating product quality can result in increased guarantee and warranty claims by our customers. We respond to this risk by adopting strict quality control measures and continually improving our production processes.

Sales risks arise from price risks and the risk of delays in making products available to customers. This can lead to a loss of orders and a loss of market share. We mitigate this risk by systematically improving our production and delivery logistics.

Many of our customers are OEMs or Tier 1 suppliers. Close product development cooperation with these customers and strict product quality control measures prevent substitution of our products and, at the same time, help maintain price levels.

Regular credit checks of our customers reduce the risk of customers defaulting.

The Schaeffler Group brands INA, LuK and FAG are inseparably connected with a high standard [--break--]  of quality, making them increasingly subject to product piracy. Combating product piracy is a high priority for Schaeffler. We protect intellectual property not only by global patents and industrial property rights but also by taking action against the increase in counterfeit products, which damage our image and our revenue.

Natural disasters, accidents, or pollution caused may give rise to potential risks to assets. Resulting possible disruptions to the supply chain or to production processes could adversely affect supply to our customers. This risk is mitigated by the ability to produce products at various locations which provides production alternatives, at short notice if necessary. We also have appropriate insurance coverage.

Our operations are based on complex IT systems, network infrastructure, as well as internal and external communication media. The resulting dependencies give rise to risks with respect to ongoing data availability and confidential treatment of data. Any disruption of information security as a result of intentional attacks or manipulation of the IT infrastructure could significantly affect our operations.

10.3 Legal risks

There are various legal claims against the Schaeffler Group that have been asserted or that could be asserted in the future. We consider these to be mainly normal, routine legal disputes arising in connection with our business.

In late 2011, several antitrust authorities have commenced investigations of several manufacturers of rolling and plain bearings for the automotive and other industrial sectors. The authorities are investigating possible agreements violating antitrust laws. Schaeffler AG and some of its subsidiaries are subject to these investigations. Schaeffler is cooperating with the investigating authorities and supports their work. To date, the investigations have not yet been specified in more detail. There is a risk that the antitrust authorities will impose penalties, and that third parties may claim damages. The amount of potential penalties or subsequent claims is uncertain, but could be significant.

If one or more of these risks become reality, our operations, our financial position, and our earnings would be adversely affected, making it more difficult to meet our obligations under [--break--]  our financial debt.

10.4 Financial risks

Overview

Due to the financing requirements of its global business activities, the Schaeffler Group is exposed to the following risks from its use of financial instruments:

(1) Credit risk

(2) Liquidity risk

(3) Market risk (currency, interest rate, and other price risk)

The Schaeffler Group’s executive board has overall responsibility for the group’s risk management system.

(1) Credit risk

The risk of a customer or business partner defaulting is called credit risk. Among Schaeffler’s major customers in the Automotive segment are OEM’s. There is a concentration of credit risk within trade receivables with regard to these business relationships.

Credit risk is managed by constant monitoring of customers’ financial status, creditworthiness and payment history. Additional measures include our collection procedures and the use of commercial credit insurance.

The carrying amounts of financial assets represent the maximum credit exposure at the end of each reporting period as follows:

Maximum credit risk on financial assets

No. 010
Carrying amount
in € millions 12/31/2011 12/31/2010
Trade receivables 1,607 1,443
Other investments 14 8
Other assets

Marketable securities

4 3

Other loans receivable

103 107

Derivatives designated as hedging instruments

0 43

Derivatives not designated as hedging instruments

13 77
Cash and cash equivalents 397 733
Total financial assets 2,138 2,414

Investments of funds as well as hedging instruments are only entered into with the significant banks commissioned by Schaeffler. These banks have low credit risk. Corporate Treasury continually manages individual exposures and monitors any change in credit risk of individual banks, including changes in their ratings.

(2) Liquidity risk

The risk that the Schaeffler Group will not be able to meet its financial obligations as they become due is referred to as liquidity risk.

The Schaeffler Group secures the financing of its operations and its financial obligations by using equity, cash pooling arrangements, intercompany loans and existing lines of credit.

The Schaeffler Group’s contractual payments of interest and principal on financial debt and derivative financial liabilities are summarized as follows:

Contractual payments of interest and principal on financial debt and derivative liabilities

No. 011
in € millions Carrying amount Contractual cash flows Up to
1 year
1–5 years More than 5 years
December 31, 2011
Non-derivative financial liabilities 8,553 9,126 1,810 7,309 7

Financial debt

7,485 8,058 751 7,307 0

Trade payables

873 873 873 0

Other liabilities

195 195 186 2 7
Derivative financial liabilities 316 320 176 144
Total 8,869 9,446 1,986 7,453 7
December 31, 2010
Non-derivative financial liabilities 7,289 8,820 1,269 7,547 4

Financial debt

6,477 7,993 456 7,537 0

Trade payables

729 744 737 3 4

Other liabilities

83 83 76 7
Derivative financial liabilities 444 433 218 215 0
Total 7,733 9,253 1,487 7,762 4

The Schaeffler Group’s medium and long-term financing requirements were met throughout the year by the Senior Facility Agreement ( see 4.15 Financial instruments ) dated November 20, 2009 as amended by [--break--]  the refinancing arrangement completed in March 2011. The Schaeffler Group has a revolving credit facility of EUR 793 m and other bilateral lines of credit available to meet its financing needs.

The Senior Facility Agreement (SFA) dated November 20, 2009 contained certain constraints including a requirement to meet certain financial covenants relating to:

  • ratio of net debt to EBITDA (senior debt leverage),
  • ratio of EBITDA to interest expense (senior interest cover),
  • ratio of cash flow to debt service (senior cash flow cover), and
  • capital expenditures.

The SFA gave the creditors the right to call the debt before maturity for certain reasons, including if the covenants are not met, which would result in the debt becoming due immediately.

Compliance with covenants is monitored at group level. The applicable inputs to the calculations [--break--]  are defined in detail in the loan agreements and cannot be derived directly from the consolidated financial statements.

The senior debt leverage ratio in particular is an important financial ratio; it was not permitted to exceed a value of 4.04 at the reporting date December 31, 2011. In addition, the senior interest cover ratio for the year had to be at least 2.52. Senior debt service was covered by cash flow throughout 2011 and the prior year (senior cash flow cover as defined in the loan agreement). The Schaeffler Group’s capital expenditures of EUR 783 m for 2011 also met the corresponding covenant.

Although the refinancing arrangement completed January 27, 2012 left the underlying calculations nearly unchanged, it redefined the financial covenants for the period to December 31, 2016 as follows:

  • the debt leverage ratio cannot exceed a value of 3.90 and 3.50 at December 31, 2012 and [--break--]  December 31, 2013, respectively,
  • the interest cover ratio has to be at least 3.50 for 2012 and 3.70 for 2013,
  • cash flow still has to be sufficient to cover debt service, and
  • capital expenditures can generally not exceed 8 % of consolidated revenue.

The Schaeffler Group has complied with the financial covenants throughout both 2011 and the prior year, and also expects to comply with them during the next two years, 2012 and 2013, and the years beyond.

In addition to liquidity risk related to financing, additional short-term liquidity risk can arise if, contrary to assumptions made in budgeting working capital, receivables are not collected on a timely basis. Corporate Treasury prepares a rolling four-week liquidity plan to monitor and control the group’s short-term liquidity risk. Short-term fluctuations in working capital requirements are monitored daily and can be offset by using lines of credit. Structural short-term and medium-term liquidity requirements can generally be met by drawing down the revolver.

A strict working capital management system whose methods and aims are regularly reviewed and adjusted as necessary also helps manage short-term liquidity risk.

Medium-term liquidity risk is monitored and managed using a rolling 12-month liquidity budget. Compliance with financial covenants is monitored and managed by the executive board using forecasted and actual data and is reported to the lending banks each month.

(3) Market risk

Market risk is defined as the risk that changes in market prices, such as interest rates, foreign exchange rates, and equity prices will affect the Schaeffler Group’s net income or the value of its financial instruments. Our objective is to limit market risk while managing and controlling the optimization of returns.

In order to manage market risk, the Schaeffler Group enters into derivatives (see 4.15 Financial instruments).

Interest rate risk

Schaeffler’s interest-bearing financial instruments can be summarized by type of interest as [--break--]  follows as of each December 31:

Variable and fixed interest financial debt

No. 012
Carrying amount
in € millions 12/31/2011 12/31/2010
Variable interest instruments 6,964 6,304

Financial debt

6,964 6,304
Fixed interest instruments 521 173

Financial debt

521 173

The floating rate senior term loan gives rise to interest rate risk relating to fluctuations in the 1-month EURIBOR. This interest rate risk is hedged by entering into interest rate swaps, caps and collars. Existing interest rate hedging transactions were entered into at a higher interest rate level than current rates and limit the risk of fluctuations in the 1-month EURIBOR over the entire term of the senior term loan. Interest rate risk and developments in the interest rate markets are continually monitored as part of market risk reporting.

With regard to a sensitivity analysis of variable interest instruments, a change in the yield curve by 100 basis points (bp) as at December 31, 2011 would have affected (increased/decreased) net income by the following amounts. The amounts are based on the assumption that all other variables, particularly foreign exchange rates, are held constant.

Sensitivity analysis: shift in yield curve

No. 013
Net income (loss) Shareholders’ equity
in € millions Plus 100 Bp Minus 100 Bp Plus 100 Bp Minus 100 Bp
As of December 31, 2011
Variable interest instruments -27 27
Interest rate derivatives designated as hedging instruments 16 -2 96 -94
Interest rate derivatives not designated as hedging instruments 5 -5
Total -6 20 96 -94
As of December 31, 2010
Variable interest instruments -65 36
Interest rate derivatives not designated as hedging instruments 260 -213
Total 195 -177 0 0

The impact of variable interest instruments is solely due to an increase or decrease in the interest charge. The change in net income and shareholders’ equity from interest rate derivatives is entirely due to changes in fair value. The effect of fair value changes of interest rate derivatives designated as hedging instruments on net income is EUR 16 m and EUR -2 m and the effect on [--break--]  the reserve in shareholders’ equity is EUR 96 m and EUR -94 m. The impact of interest rate derivatives not designated as hedging instruments on net income is EUR 5 m and EUR -5 m.

Due to the hedging relationship of the variable interest payments under the Senior Facility Agreement, both economic and for accounting purposes, sensitivities for the variable interest instruments have been determined based on the net interest rate risk exposure. In the prior [--break--]  year, the line item variable interest instruments reflected only interest expense on the Senior Facility Agreement. The impact of interest on interest rate derivatives was shown under interest rate derivatives not designated as hedging instruments.

Currency risk

The Schaeffler Group is exposed to diverse foreign exchange risks due to its international reach. The largest foreign currency risks result from exchange rate fluctuations of the U.S. Dollar and [--break--]  the Romanian Leu. Potential foreign currency fluctuations have an effect on sales as well as on [--break--] procurement costs. The various specific effects on earnings are monitored as part of the monthly reporting.

Foreign exchange risk is managed centrally by Schaeffler AG’s Corporate Treasury. It aggregates currency risk across the group and hedges it using hedging instruments. Hedging instruments used include forward exchange contracts and options. Currency risk, market values of foreign currency derivatives and developments in foreign exchange markets are continuously monitored as part of the risk management system.

The Schaeffler Group’s significant expected currency risk exposures by currency based on face values as of the end of each reporting period are as follows:

Expected currency risk from operations

No. 014
in € millions USD RON JPY HUF
December 31, 2011
Estimated currency risk from operations 1.062 -190 108 -93
Forward exchange contracts -639 152 -82 76
Currency options -156 0 0 0
Remaining currency risk from operations 267 -38 26 -17
December 31, 2010
Estimated currency risk from operations 852 -198 98 -84
Forward exchange contracts -599 157 -78 67
Currency options -225 0 0 0
Remaining currency risk from operations 28 -41 20 -17

Estimated currency risk from operations represents the currency risk from operating and investing activities within twelve months after the end of each reporting period. The remaining [--break--]  currency risk from operations reflects the combined exposure of all Schaeffler Group entities not subject to local restrictions on foreign exchange transactions with Schaeffler’s finance organization. Thus, this exposure represents the difference between recognized hedged items and hedged items in the form of expected future foreign currency cash flows that have not yet been recognized on the one hand and hedging instruments that have been recognized in the statement of financial position on the other hand. Currency risk in countries with foreign exchange restrictions (e.g. China, Brazil) is monitored by Schaeffler’s finance organization. The most significant currency risk in these countries arises on the USD and amounts to an estimated EUR -314 m (prior year: EUR -227 m).

The sensitivity analysis for currency risk is based on a hypothetical 10 % weakening of the Euro against each of the group’s significant foreign currencies as of December 31. The analysis covers foreign currency receivables and payables as well as derivative financial instruments used to hedge foreign currency risk and assumes that all other variables, particularly interest rates, remain constant.

The following table shows the potential effect on net income and shareholders’ equity of translating balances at the closing rate and of measurement at fair value:

Sensitivity analysis: change in foreign exchange rates

No. 015
12/31/2011 12/31/2010
in € millions Net income (loss) Shareholders’ equity Net income (loss) Shareholders’ equity
USD 15 -77 -23 -4
JPY -4 -6 -1 0
HUF -5 8 0 0
RON -18 16 1 0

Conversely, a 10 % rise in the Euro against the significant foreign currencies as at December 31 would have had the same but opposite effect, again holding all other variables constant.

Other price risk

Risks related to stock-market prices and stock price indices only arise from securities. The market price risk associated with this exposure is not considered significant.

Overall risk assessment

The Schaeffler Group’s situation with respect to risk has not changed significantly. Key risks are the financing risk related to the company’s high level of debt, revenue trends and a decrease in the quality of earnings.