Risk Managment

Risk report 2019

Disclosures on the internal control and risk management system for financial reporting, pursuant to Section 289 (4) of German Commercial Code and Section 315 (4) of German Commercial Code

The internal control and risk management system for financial reporting by the CENTROTEC Group aims to identify potential internal sources of error and to limit or eliminate the risks arising from them. In addition to optimising internal processes and procedures, it above all encompasses financial reporting by the CENTROTEC Group. One core function of financial reporting is to steer the Group as a whole. Target and deviation analyses are conducted on the basis of the budget and mid-range planning approved by the supervisory bodies of the Group and subsidiaries. Regular forecasts are made to monitor the changing framework for ongoing business operations.

CENTROTEC’s financial statements are based on a Group-wide reporting system. This constitutes the basis for a standardised data reporting process throughout the Group. The operating companies’ accounting functions are organised non-centrally but are harmonised by means of a Group-wide accounting manual that regulates how IFRS accounting standards as adopted in the EU are to be applied in Group-wide financial reporting, and on the basis of a Group-wide, uniform, digital reporting system.

The information obtained within a narrow time frame from this comprehensive reporting system provides the basis for active, prompt Group steering. The holding of regular Management Board and Supervisory Board meetings and the close support provided for managing directors by the Management Board guarantee that the information obtained in reporting is suitably evaluated and leads to appropriate remedial measures, as necessary. Together with the provisions in the Articles of Association and the individual rules of internal procedure for the Supervisory Board, Management Board and managing directors, this portfolio of reporting and analytical measures creates a coherently functioning overall system. The system’s efficiency and effectiveness are examined by the Management Board and Supervisory Board at regular intervals, and the system is then revised or widened as necessary.

The Group’s Legal department helps to draft or cross-checks all materially significant contracts of Group companies. The auditors of the individual companies, sub-groups and Consolidated Financial Statements examine the internal system of control for financial reporting and the risk early warning system to the extent that is necessary based on the audit standards and chosen audit strategy, and they report on their findings to the Supervisory Board. Suggested improvements are taken up by the Management Board and executive management in order to continually develop and improve the system.

To monitor and control the various risk areas, CENTROTEC implements a Group-wide risk management system. To increase efficiency and comply with the changing regulations, the uniform, recognised, professional risk management tool created in 2016 by an external provider in accordance with the requirements of Section 317 (4) of the German Commercial Code along with auditing standard IDW PS 340 and implemented Group-wide was correspondingly updated continuously in line with the requirements of the CENTROTEC Group. The aim of the risk management system and the central task of risk reporting is to identify and evaluate material, existential risks within and outside the Group companies, and to define or initiate appropriate risk management measures so that the executive management of each company has a sound basis for its management decisions. Risk management is run by a risk committee. It manages the Group-wide non-central network in which each individual company is represented by at least one risk manager. Taking account of the existing guidelines, a quarterly report was issued presenting the risk type, likelihood and potential impact of identified risks, along with risk management measures. The reporting cycle was changed to half-yearly reporting from the second half of 2019.

The risks are evaluated primarily in quantitative terms, taking account of their respective probability of occurrence and loss level according to a gross and net assessment, based on the change in earnings (EBIT) compared with the budget figure. The net assessment already takes risk-reducing measures into account and is the basis for risk reporting. However provisions already formed are not considered as risk-reducing factors; they are instead specifically listed separately. Blanket risks such as natural disasters or risks normally encountered in the course of business, such as the fundamental possibility of bad debts, are not taken into account unless there is specific evidence of an increased probability of occurrence of these events. Furthermore, qualitative evaluation of non-quantifiable risks can be performed by determining the level of control and severity.

Within the context of this risk report, Group-level risks are classified as “very low” if their net risk expectation value is between EUR 100 and 300 thousand, as “low” if the effect is up to one million euros, as “moderate” if the effect is below two million euros, as “high” if it is up to five million euros, and as “very high” if it is over five million euros, Different threshold amounts are defined at individual company level, in line with the size of the respective companies.

Operating business is moreover closely monitored by the Management Board. With this as the basis, an early response within the risk management system is initiated and various escalation hierarchies are involved, right up to the Management Board and Supervisory Board, depending on the value of the risk, in order to avoid or hedge risks. The risk management system serves as the basis for the following description of the risk areas and exposure of the Group.

Risk areas

Risks from the economic environment and the industry

The business performance of CENTROTEC is fundamentally dependent on the wider economic environment and on general cyclical developments, especially in Europe. Germany remains by far the most significant individual market from the Group perspective. This high dependence continues to represent a high risk in the event of a deterioration in the economic situation in Germany. This risk is addressed by concerted efforts to internationalise.

CENTROTEC fundamentally operates in the industry environment of building investment. Falling building investment can fundamentally adversely affect the sales performance of the Group. CENTROTEC addresses the sales risk that is fundamentally assessed as high for example by focusing on particularly energy-efficient solutions for heating and climate control of buildings: such solutions are becoming ever more relevant in light of the increasingly tough national regulatory requirements regarding the energy efficiency of buildings, as well as the high probability of medium and long-term rises in energy prices. Although the probability of falling building investment has risen because of the record level of European and specifically German construction activity reached in recent years, building investment would still be at a very high level even after a moderate downturn.

Statutory framework conditions and public funding programmes nevertheless continue to have a clear influence. For instance a scaling-back of subsidies if the general conditions remain otherwise unchanged could lead to falling revenue or slower revenue growth. In the past there have been a large number of changes made at various points throughout the year, often causing considerable uncertainty among end customers. Specifically in the area of subsidies, certain countries could moreover be prompted to freeze subsidies or suspend state measures designed to promote construction activity and protect the climate if they encounter financial constraints. This risk is currently classified as high despite the relatively stable economic development throughout Europe. Protracted negotiations about possible improvements to the terms of such subsidies could temporarily prompt an investment backlog.

Finally, the development in the prices of fossil fuels has a major influence on readiness to invest in efficient heating, ventilation and climate technology and the use of renewable energies. The fact that gas and oil prices remain low reduces the pressure to invest in modernising existing heating systems, many of which specifically in Germany are obsolete and inefficient. Notwithstanding such short-term economic benefits, the increased use of fossil fuels will seriously aggravate the problem of climate change. Nevertheless, the comparatively low current price level still offers more potential for a rise, e.g. in the form of carbon taxes, than for a decline in energy prices, and therefore in the long term more opportunities than risks from the company’s perspective. All in all, the risk presented by the development in energy prices is assessed as moderate.

In addition, in the long term there is the possibility that still-dominant fossil fuels such as gas and oil could be banished from the heating market by regulatory means. CENTROTEC addresses this risk, which still lies well into the future and will initially probably be limited to the new-build market, by practising active strategic planning and suitably adjusting the product portfolio.

Corporate strategy risks

Alongside organic growth, another fundamental dimension of CENTROTEC’s strategy is growth through acquisitions. One key challenge here is to adapt the internal organisation and processes swiftly to the new, larger entity each time and to integrate the acquired or newly established, frequently foreign businesses into the corporate structure. If ties between new entities and the existing Group are too weak, a loss of transparency and control can ensue. Forcing the corporate culture onto new entities can cause employees to cease identifying with products and companies, ultimately leading to a weakening of the market position and thus of market value. CENTROTEC therefore strives for a balance between control and entrepreneurial freedom at its Group companies. The dovetailing of acquired or newly established entities with the Group is promoted by an overarching integration management approach and continually monitored until the entity is finally fully integrated into the Group-wide mechanisms of control and steering. The structure of the Group as a whole is continually scrutinised for potential for improvements that are implemented by reorganisation projects in the individual segments, in order to establish a workable basis for the continuing sustained development of the Group. The overall corporate strategy risks arising from acquisitions continue to be rated as low.

Growing internationalisation furthermore entails wide-ranging risks which are cumulatively of increased significance for CENTROTEC, arising e.g. from changing political and legal frameworks, exchange rate fluctuations, the development of special products for international markets, transport and processing risks, and cultural differences. For its further expansion, in the future CENTROTEC will fundamentally also rely on strong local partners with extensive market-end and logistics expertise and knowledge of their local context. Markets that are the focus of the internationalisation strategy are accessed with the help of Group-owned subsidiaries, and increasingly also through local manufacturing units. By monitoring and examining the risk positions on an ongoing basis in the course of risk management and business operations, the market opportunities and risks that arise are kept under control, and this risk that is classified as growing but moderate is clearly limited.

 

Risks from operating business

Procurement risks

The production and delivery capability of the CENTROTEC companies depends to a great extent on reliable supplies of raw materials and consumables. As well as all the opportunities they present, increasingly international procurement channels can also represent a risk, as can currently be observed from the as-yet unforeseeable impact of the coronavirus that has spread from China. The risk resulting from the area of procurement is rated as high and is contained through close technical cooperation with important suppliers and, as far as possible, by maintaining at least two sources of supplies in each case. However the hitherto healthy level of business activity across the industry has resulted in longer lead times and also in isolated supply bottlenecks, for example for electronic components, which could fundamentally likewise affect the CENTROTEC companies.

A possible further rise in procurement prices constitutes another potential risk at the procurement end that could become relevant from a Group perspective. Depending on the segment and product area, the recurrence of this problem as a result of market developments is controlled by methods such as protecting long-term supplier relations and corresponding price agreements, and by continuously observing the market and optimising procurement sources. Price developments in the commodity and supply markets are actively monitored. At the same time potential for compensating for price increases is being identified through the Group-wide profitability improvement programmes and suitable improvements are being implemented. Because impending further procurement price increases for raw materials are already factored into the budget, CENTROTEC currently rates the additional risk of rising procurement prices as moderate. In addition, there is fundamentally the risk that service companies especially in the IT or staffing areas could fail to meet their contractual obligations or could terminate existing contracts. This specific risk is assessed as low overall; the effects would be limited to the individual company concerned and are therefore slight for the Group as a whole. Nevertheless, we see a rising tendency in these potential risks, not least as a result of the spread of the “software as a service” approach. Mid to long-term, the risks resulting from the entire procurement process are a significant risk group for the CENTROTEC Group.

Technical and quality risks

Risks may arise from product defects and quality problems. These are addressed for example through internal guidelines at the individual companies and certification to international quality standards such as ISO 9001, ISO 14001 and ISO TS 16949. The individual Group companies always take the most rigorous quality standards in their specific sectors as the benchmark. To safeguard product quality and minimise the associated risks, quality-critical components of CENTROTEC products are subjected to comprehensive quality checks both during the entire production process and in the end products. The methods and systems used to this end are examined and regularly updated in line with current standards. The effect is to significantly reduce the overall impact of this continuing risk, which is fundamentally present in all corporate divisions. Furthermore, appropriate provisions in the amount of the anticipated warranty risks are created. There nevertheless remains a moderate risk because the companies of the Group extensively use modern, high-efficiency technologies in their products so product defects and quality risks cannot be excluded altogether.

The risk of accidents and plant breakdowns is countered by providing suitable training for customers and employees, and implementing accident prevention regulations and task instructions.

The biggest single risk to this area is the possible failure of production plant. This risk is addressed by preventive maintenance and ongoing monitoring of the operating parameters. Plant itself, along with the possibility of a business interruption, is insured for potential forms of loss in line with its value. Together, the technical and quality risks in the 2019 financial year are assessed as moderate.

Innovation risks

The development of innovative products fundamentally involves the risk that the desired outcome may not be achieved despite the expending of considerable resources. For example, regulatory or subsidy-related changes can adversely affect the prospects of development projects succeeding. To minimise this fundamental development risk, there is an intensive dialogue and peer review of product development activities between the individual Group companies, along with intensive market analysis. The internationally growing sales and service organisations are also increasingly called upon to contribute their market knowledge. This helps to identify off-target developments swiftly and limit their potential effects by making adjustments to decisions promptly. All capital investments and development projects are in addition evaluated intensively and promptly in the context of Group-wide development activities, looking at the overall portfolio and the individual opportunities and risks involved. Against a backdrop of a steadily accelerating pace of development, increased product complexity and the specific requirements of international sales markets, there nevertheless remains a moderate innovation risk.

Sales risks

At the sales end, there is the potential risk of losing important customer relationships, in particular with key accounts. Dependence on individual customers is fundamentally reduced by focusing predominantly on products for end users, despite sales via wholesalers. For example CENTROTEC’s biggest customer accounted for less than four percent of consolidated revenue, with all other customers well below that figure. At the level of the individual Group companies, this threshold is nevertheless exceeded to some extent. The loss of contact with a wholesale or key account fundamentally always has a palpable impact on revenue and earnings for both the Group itself and the Group companies. This risk of dependence, which is rated as low from a Group perspective, is countered by active management of customer relations and by diversifying the sales channels in the various markets. To that end the sales channels in the individual segments and countries have recently undergone steady expansion and will continue to be examined for scope for expansion in line with the strategy. Revenue dependence on individual customers has furthermore fallen along with the growth already realised, and will continue to decline hand in hand with the future international growth that is being targeted.

There is a further moderate risk in the sales sphere from the growing pressure on the prices of CENTROTEC products, in particular from existing or, in individual instances, new competitors. CENTROTEC believes it enjoys a strong position in its various segments thanks to its rigorous focus on customer requirements and the market position it has already achieved. The product portfolio is moreover regularly scrutinised for potential to innovate and for scope to improve customer centricity, as a means of safeguarding and extending its competitive position. Furthermore, the growth being targeted internationally is designed to gradually reduce the diseconomies of scale compared with large competitors. None the less, as a whole the disparate sales risks outlined represent a significant risk group with a comparatively high risk expectation value from a Group perspective.

Human resource risks

There is fundamentally the potential risk of losing managers and employees in key positions. CENTROTEC addresses this risk that is real, but where its impact has so far been considered low from a Group perspective, by broadening the human resources base as part of developing the Group organisation as a whole. The further development and regular training of employees in their individual specialist areas are supported, and employees are encouraged to show independent initiative in developing and implementing new approaches and methods. In addition, the topic of human resources development is increasingly coming into focus within the business strategy of a growing number of Group companies. This will also be supported by the planned introduction of Group-wide human resources management software in the first half of 2020. CENTROTEC will then be better placed to address an area that will continue to grow in importance, and offer its employees enhanced long-term development prospects. The aim in all this is to further reduce fluctuation in key positions and upskill employees more effectively. These are important measures for guarding against a generally observed risk of shortages of specialists; this risk is already being specifically addressed in practice through training measures for young people that are tailored to the needs of the individual Group companies.

In addition, specifically at times of high capacity utilisation in the general economy there is the risk of excessive cost increases in the human resources area as a result of high wage and salary rises. This regularly recurring risk is countered by active personnel costs management and trust-based partnership between the workforce and the management in a spirit of mutuality. The consequences of potentially high pay settlements are also cushioned by planned revenue increases and the ongoing optimisation of processes throughout the Group, but may fundamentally put pressure on earnings.

Information technology risks

In the domain of information technology, it is fundamentally impossible to exclude the possibility that problems will arise with existing systems or future extensions to existing systems, such as introductions of new software releases, or that system failures will hamper business operations. The customary precautions and security measures in the IT sector are adopted to limit these risks. The appropriateness of the security measures in information technology is regularly checked. The systems and processes in use are adapted to changing requirements if necessary. In addition, a cautious migration approach is taken for the integration of new business units to avoid major risks to business operations, for instance as a result of incompatibility between systems or inadequate reflection of specific business features. Furthermore, the number of ERP systems used throughout the Group is progressively being reduced to avoid possible errors or incompatibility and further optimise systems maintenance. The operating units are increasingly integrated at systems level in line with their business requirements.

It is also to be noted that the risks from cybercrime are growing in significance. Within the context of its IT strategy, CENTROTEC strives to balance the use of modern IT solutions with retaining full control over the central business data needed for business operations in order to, for the CENTROTEC Group with its largely independent IT systems, limit this risk that it still considers to be low.

Finally, the demands of digitalisation are increasing at all value creation stages. The number of IT solutions used in the Group above and beyond classic ERP systems is steadily growing. In implementing these solutions, a balance must regularly be sought between the objectives of unrestricted system stability on the one hand and the swiftest possible implementation on the other.

In summary, the risks from the sphere of information technology are classified as moderate from a Group perspective despite the growing dependence on information technology systems.

In addition, specifically at times of high capacity utilisation in the general economy there is the risk of excessive cost increases in the human resources area as a result of high wage and salary rises. This regularly recurring risk is countered by active personnel costs management and trust-based partnership between the workforce and the management in a spirit of mutuality. The consequences of potentially high pay settlements are also cushioned by planned revenue increases and the ongoing optimisation of processes throughout the Group, but may fundamentally put pressure on earnings.

Financial risks

Financial risks for CENTROTEC result largely from the partial use of borrowed capital for financing its growth and potential acquisitions. The opportunities successfully taken in the past to generate high, steadily rising earnings in this way go hand in hand with the potential risk of earnings falling or even not being achieved, with the corresponding financial consequences. For financing its operating subsidiaries, CENTROTEC limits the risk it bears by generally restricting this to the entities or corporate divisions in question (ring-fenced financing) and conducts comprehensive profit and earnings controlling on the current and future profitability of all corporate entities as well as on compliance with the relevant financial ratios at both individual company and Group level. Deviations are thus rapidly identified. Any corrective action required is then implemented promptly and thoroughly. For financing, the interest rate risks for the partly variable-rate loans are hedged to some extent by means of interest rate derivatives with banks. The remaining risks in this area are to be rated as low.

In addition, a promissory note loan was placed to lock long-term into attractive interest rates. Furthermore, in the past CENTROTEC has always paid back borrowings according to schedule in order to minimise the resulting financial burdens and maintain sufficient financial leeway.

Adjustments to financing are made as required within the individual financing groups, in line with the needs arising from those financing groups’ business operations and the funding requirements. The share buyback programmes of the past two years have prompted the Group’s net gearing to rise again somewhat, with the result that the financial risks remain relevant from a Group perspective not least because of the promissory note loan. For more detailed information on the financial situation of the CENTROTEC Group, we refer to the Notes to the Consolidated Financial Statements.

Until now, the focus of business has been on core European countries, specifically in Western Europe. The overwhelming proportion of revenue is generated in the eurozone. This emphasis gives rise to merely limited exposure to risks from changes in foreign exchange rates. Business outside the eurozone and in other countries outside Europe will also become increasingly important. The aim here is to build on the pattern of recent years in further broadening the sales basis and thus to reduce dependence on the German market. However this development leads to increased risks from transactions in foreign currencies. In the past, the hitherto low risks to the Group from possible exchange rate movements were hedged selectively within the Group by means of appropriate instruments. As well as the risks of a devaluation of foreign currencies, there is also the risk of a devaluation of the euro. This nevertheless goes hand in hand with increased opportunities for exports to countries outside the eurozone. On the other hand an appreciation in the value of the euro could adversely affect the sales prospects of the Group’s products, which are made predominantly in the eurozone. In that respect the goal is to limit this risk further by spreading sales markets more widely through internationalisation.

Possible financial risks from debt defaults are minimised for example by means of payment in advance, credit insurance, flat-rate export guarantees (Hermes export credit guarantees), credit processing, ongoing receivables management, general creditworthiness checks as well as through existing del credere liability, so as to limit their possible consequences for the Group. However there remains a low risk from possible debt defaults. The current investments within other financial investments represent a balance sheet item that is fundamentally exposed to fluctuations in the financial market. This risk, rated as moderate, therefore goes hand in hand with a greater opportunity for the expectation value.

The risk from the fiscal area, which results substantially from the growing requirements to document transfer prices and occurs in several countries, is rated as low from a Group perspective. The risks arisen from the measurement of inventories are rated as low from a Group perspective.

In summary, the risks from the financial sphere are estimated as moderate.

Miscellaneous risks

The supply and sale of products, plant and services may expose the CENTROTEC Group and its individual companies to legal risks which stem, for example, from the possibility of deliveries not being as per agreement, from product liability claims, product defects, quality problems, breaches of intellectual property or from the failure to comply with fiscal regulations. Despite comprehensive quality management activities and the corresponding regularly optimised organisational structures, such risks cannot be ruled out altogether but their level is normal for an industrial enterprise. To guard against this exposure, lump-sum warranty provisions are created to the customary extent for our business operations and corresponding product liability insurance cover is taken out, based on figures from experience of failures and corresponding warranties for potential customer claims, as well as to reflect potential accountability. All customer complaints are moreover systematically checked and processed, then investigated with a view to identifying scope for internal optimisation. To the extent that specific warranty risks are identified, additional one-off provisions in the amount of the expected risk are created.

In addition, further insurance policies were taken out to minimise the general risks from business operations in order to reduce the possible impact of such risks that are a fundamental part of business operations to a low level. Such insurance policies mainly comprise business interruption, business liability, legal protection, business and property, credit sale, loss of earnings and serial losses insurance, as well as D&O cover for Management Board members, managing directors and non-executive directors. There is in addition special property insurance cover (damage by the elements) for warehouses.

There are currently no cases of litigation pending that lead the Group to expect high financial obligations beyond the levels already reflected in the provisions created.

Special risk: coronavirus pandemic

In the weeks prior to this report’s completion the global spread of the coronavirus as well as efforts by individual countries to limit its spread prompted an unprecedented level of uncertainty on financial, commodity and goods markets worldwide. This crisis creates individual risks for CENTROTEC that are to be rated overall as very high, and essentially apply to the business environment, procurement, sales and human resources areas:

  • The travel and contact bans imposed in many countries, as well as business shutdowns, will have a lastingly negative impact on economic development. This could also lead to a marked fall in the propensity to invest in modernising building services, and across the construction industry in general.
  • The sealing-off of borders between individual countries could cause lasting disruption to the goods supply and the flow of essential materials. While supplier relationships with Asia often envisage ample buffer stocks in view of the longer transport route and manufacturing activity in China is extensively resuming, breaks in supply chains between European countries can lead to production stoppages within a matter of days.
  • This development could equally severely limit access to sales markets outside the domestic market.
  • Currently all individuals who have been in contact with persons infected with the SARS-CoV-2 virus are ordered to self-quarantine at home for 14 days. If employees of the company were to be affected, this could lead to substantial downtimes in entire departments and production areas, which could temporarily limit operating activity.

At the time of preparing this report it is not possible to estimate reliably to what extent any one or all of these risks will materialize. Although the risks generated by the coronavirus rate as very high overall for CENTROTEC, from the company’s perspective they do not pose an existential threat thanks to the stable financial and liquidity position.

Directors’ assessment of the risk situation

While the sales market situation should show a positive development in the long term, subject to stable underlying conditions, the increased number of uncertainties that stem from mainly political but also economic crises represent a risk to overall economic development for the industry, and therefore also for CENTROTEC, that is difficult to quantify. For as long as energy prices remain low, they too weigh on the sales market, though a slight upward movement was observed recently. The healthy net financial position has however given the Group adequate room for manoeuvre: on the one hand for international expansion through organic growth but possibly also through acquisitions, and by boosting its competitiveness further by investing in innovations as well as the sales and service organisation. On the other hand it is well equipped to respond to potential risks that may arise, or to deteriorating market conditions. Operationally, too, the Group has achieved a comparatively flexible costs structure at its main production establishments by engaging temporary workers, buying in other staffing services and adopting working hours models, giving it scope to adjust its production capacities to temporary cyclical and seasonal fluctuations. Considered in this light, the management regards the opportunities and risks profile as balanced, with no individual risks to the company as a going concern in the 2019 financial year.


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