Principal Risks and Uncertainties
In the day-to-day operations of the Group we face many risks and uncertainties. Our job is to mitigate and manage these risks, and the Board has developed a formal risk management process to support this. Set out below are the principal risks and uncertainties which we believe could adversely affect us, potentially impacting our employees, operations, revenue, profits, cash flows or assets. This list is not exhaustive – there are many things that could go wrong in an operation as large and geographically diverse as ours – and the list might change as something that seems immaterial today assumes greater importance tomorrow.
The foundation upon which the Group's risk management process is built is the Group Risk Register. This is compiled based on input from the businesses across the world as well as a top-down review by members of the Executive Committee and Board. This forms the basis of the mitigation strategies put in place for all the key identified risks. In the section below, we have picked from the Risk Register those items we currently consider to be our most important risks. The order in which they are presented is not significant.
Economic conditions
There is a link in our business between demand for our services and levels of economic activity; this link is particularly evident in the Local business. If GDP growth goes negative, demand for rental equipment is likely to shrink even faster and this impact is likely to be multiplied by pricing weakness at times of low demand. As we have experienced in recent years, the operational gearing inherent in our business models means that variations in demand can lead to much larger variations in profitability. We also have some businesses which, by their nature, are exposed to particular sectors – for instance, our Australian business is highly dependent on mining activity, our Singapore business has a high proportion of shipping activity, and a material proportion of our North American business comes from upstream and downstream oil and gas.
We mitigate this risk in a number of ways. First, having a global footprint is a great advantage because we can move rental fleet from low-growth economies to higher-growth environments; for example, in 2011, we moved fleet out of Western Europe into Russia to support its rapid growth. Secondly, we try to ensure that, as they grow, our businesses build a customerbase which is as diverse as possible, to minimise exposure to any single sector. In Brazil, we are investing in temperature control to reduce our sectoral exposure to offshore oil and gas; while in South Africa we are expanding our geographic footprint to enable us to develop under-penetrated sectors such as shipping. Thirdly, in the event of a more generalised downturn in demand, as we experienced in 2009, we can quickly reduce capital expenditure which was demonstrated by our new fleet investment being £107 million lower in 2009 than 2008. Given the large depreciation element in the business' cost base (£186 million in 2011), reducing capital expenditure to a level close to depreciation makes the business very cash generative which, in turn, reduces debt and interest cost.
Another economic factor to consider is the price of fuel, which is usually the single biggest element in the cost of running a generator. Over the last 5 years, the price of fuel has been volatile, with the Brent Blend price1 ranging from $35 to $145, but this does not seem to have had any noticeable impact on people's willingness to rent; people rent generators because they need power, not because it is a cheap way of generating electricity. The major impact of the oilprice on our business is that, at times when it has been high it has produced huge wealth in oil-producing countries which has been re-cycled into infrastructure investment and this, in turn, stimulated demand for our services. If the oil-price is persistently low – by which we mean under $50 per barrel – we would expect to see an adverse impact on our business in a number of oil-producing countries.
Exchange rate fluctuations can have a material impact on our performance reflected in Sterling: the Group's asset values, earnings and cash flows are influenced by a wide variety of currencies owing to the geographic diversity of the Group's customers and areas of operation. Around 75% of the Group's revenue and costs are denominated in US Dollars; the next largest currency exposure is to the Euro which accounts for around 7% of our revenues and costs. The relative value of currencies can fluctuate widely and could have a material impact on the Group's asset values, costs, earnings, debt levels and cash flows, expressed in Sterling. We manage the transactional exchange impact through hedging and denomination of borrowings but we do not try and manage translational exchange impact. In terms of translational exchange, a 5 cent movement in 2011 Sterling/Dollar exchange rate had an impact of around £30 million on revenue and £9 million on trading profit.
Political risk
This section should be read in conjunction with the subsequent section on failure to collect payments. The Group operates in around 100 countries, many in Africa, Asia and Central and South America. In some jurisdictions there are significant risks of political instability which can result in civil unrest, equipment seizure, renegotiation or nullification of existing agreements, changes in laws, taxation policies or currency restrictions. Any of these could have a damaging effect on the profitability of our operations in a country.
Prior to undertaking a contract in a new country, we carry out a risk assessment process to consider risks to our people, to assets and to payments. By far the greatest exposure to political risk is in the International Power Projects business. In all cases, the safety of our employees is always our first concern, and if the level of risk is considered unacceptable we will decline to participate in any contract; where there are potential risks, we develop detailed security plans to ensure the safety of our employees. In terms of asset risks, the Group uses a wide range of tools and techniques to manage risk, including insurances, bonds, guarantees and cash advances. International Power Projects' financial exposures are monitored by the Board on a monthly basis and action plans to address assets, payments or tax exposures are reviewed.
Generally, we find that Governments are keen to behave in a fair way to suppliers of critical infrastructure such as Aggreko. In the last four years, we have had two incidents, both of which were subsequently resolved, where our equipment was seized by authorities as a result of tax or import duty disputes. Neither of these were material to a Group of our size, but either could have been fatal to a small company. Both are indicative of the fact that we operate in countries where the behaviour of the authorities can be unpredictable, and not always in line with contractual commitments.
The quantum of political risk faced by the business has grown in recent years with the rapid expansion of our International Power Projects business, but the benefit of scale is that the risk becomes more diversified.
Failure to collect payments or to recover assets
In practice, the biggest risk is non-payment. The vast majority of the contracts into which the Group enters are small relative to the size of the Group and, if a customer fails to pay a debt, this is dealt with in the normal course. However, the Group has some large contracts in developing countries where payment practices can be unpredictable. The truth is that, with contracts in around 100 countries there are always two or three large customers who are misbehaving as far as payment is concerned, and we constantly monitor the risk profile and debtor position of such contracts, and deploying a variety of techniques to mitigate the risks of delayed or non-payment. This mitigation will vary from customer to customer, but our armoury includes obtaining advance payments, letters of credit, bank guarantees, and, in some cases, insurance against losses. As a result of the rigorous approach to risk management, the Group has never had a significant loss, although we have had some very near misses. While the rapid growth in our International Power Projects business makes it less likely that any bad debt would be material to the Group's balance sheet, the increased number of contracts and countries in which we operate increases the likelihood of a loss and makes it highly likely that, at some stage, a major customer will default or prevent us from repatriating assets.
The risk of non-payment of a receivable presents a particular risk for a public company such as Aggreko, because our customers are rarely attuned to our obligations to update regularly the market on our performance. While we seek to ensure that no single country could cause the company material medium or long-term damage, failure to collect a major debt could result in an unexpected, and possibly significant, reduction in our profits in any given reporting period. The impact of failure to collect a debt is twofold; first we have a write-off of the debt, and secondly, we lose future revenue and profit. We continually make judgements as to whether we need to book a provision against particular debts, and, if the debts are material, they could cause us to miss a forecast and lead to a negative share price reaction. Unless a customer actually seizes equipment, deciding whether a receivable will be collected or not is more art than science and there have been several occasions when we have had to make difficult judgements as to when to provide for a debt. The potential for volatility was illustrated during 2011. During the first half, the bad debt provision in International Power Projects was increased by £14 million reflecting the heightened risk of non-payment in 3 countries. During the second half, significant payments were received in respect of these countries and circa £11 million of this bad debt provision was released to the Income Statement.
Even though we have an ever broader portfolio of contracts, and therefore a more diversified portfolio of risk, we caution investors that the current very high returns on capital that we earn, particularly in our International Power Projects business, are in effect 'risk-unadjusted'. So far, no customer has behaved badly enough to adjust them, but, as we repeatedly tell people, it is probably only a matter of time before they do.
Events
The business is, by nature, driven by events. People hire generators because some event or need makes it essential. Aggreko's revenues, cashflows and profits can be influenced significantly by external events as evidenced in the past by hurricanes in North America or by the contracts to supply power to the military camps in the Middle East. These events are, by their nature, difficult to predict and, combined with the high operational gearing inherent in our business, can lead to volatility in trading outcomes. By developing the business globally, as well as by increasing and broadening the Group's revenue base, the impact of a single event on the overall Group will reduce. Additionally, the ability to move equipment around the world allows the Group to adjust to changes in utilisation caused by any changes in demand.
Failure to conduct business dealings with integrity and honesty
Some of the countries in which the Group operates have a reputation for corruption and, given that many of our contracts involve large sums of money, we are at risk of being accused of bribery and other unethical behaviour. The first and most important way of avoiding this risk is to ensure that people, both inside and outside the Group, know that Aggreko does not engage in, and will not tolerate, bribery, corruption or unethical behaviour. We have a strict Ethics Policy, a copy of which is available on our website www.aggreko.com. Rather than just publishing it, we get every employee to sign it when they join the business; every consultant acting on our behalf agrees in writing to abide by it, and every consultancy or agency agreement has an explicit term stating that the agreement will be terminated immediately if the consultant or agent does not abide by our policy. During the year we also rolled out a confidential, multi-lingual hotline, available world-wide, which allows any employee who has any ethical concerns to report them to an independent third party on an anonymous basis.
While the risk of unethical behaviour can take many forms, the most significant risk we run in this area is the behaviour of third party sales agents and consultants in our International Power Projects business. Given the ephemeral nature of this business – there might be no business for us in a country for 5 years and then suddenly a power crisis might present an opportunity to supply 100MW for 6 months – it is not practical to maintain full-time salespeople in each of the 100 countries where we do, or could conceivably do, business. Instead, we make agreements with organisations which know a country well, can keep our services on the radar of decision makers, and keep us briefed on opportunities. When an opportunity arises, we send in our own salespeople to work with them. These consultants do not get paid a retainer and may receive no compensation other than a 'thank you' and a pat on the back for years; the reason why they are prepared to do this is because when we do win a contract, they are well rewarded. And they work hard for the money, often taking responsibility for the supply of critical elements of the project such as finding power-plant sites, providing administration and technical services, labour and security. The fact that they are only paid on results might be seen to raise the risk that they are tempted to indulge in bribery to secure their income. How do we protect against this? In our view, it is all down to the choice of the sales consultant and, to this end, we carry out comprehensive due diligence on all potential candidates. Before we appoint an agent or consultant, we use specialist third-party investigators to conduct comprehensive background checks on them; these checks include obtaining bank references and searches for previous records of inappropriate behaviour or of any family or other links with the customer or government. Once a sales consultant has been appointed, we keep a close eye on them. Payments made to agents and sales consultants are subject to audit by internal auditors to ensure they are in accordance with the agreements, and we have a fulltime Compliance Officer who continuously monitors our dealings with sales consultants and agents. In addition, we carry out regular training by outside lawyers of managers and salespeople who deal in at-risk jurisdictions and, from time to time, we conduct independent reviews of contract files. We also structure our sales consultancy agreements to allow us to terminate any agreement immediately and without compensation in the event that we suspect any inappropriate behaviour. Given that these sales consultants have much to gain by working for us, this is a powerful incentive to behave.
Despite the fact that none of the business that we would consider to be at elevated risk of ethical issues comes under its jurisdiction, in the past we modelled our compliance regime around the requirements of the US Foreign Corrupt Practices Act (FCPA), on the basis that it probably set the highest standards in the world. The passing into law of the UK Bribery Act in 2011, which is generally regarded as being significantly stronger than the FCPA, led us to further review and tighten our procedures. Amongst the changes we made was the establishment of a Board Ethics Committee, composed entirely of Non-executive Directors, to approve our ethics-related policies and procedures, and to monitor compliance. A report from the Committee is set out the Ethics Committee Report of the Annual Report and Accounts.
Safety
The business of the Group involves transporting, installing and operating large amounts of heavy equipment, which produces lethal voltages or very high pressure air, and involves the use of millions of litres of fuel which could cause serious damage to the environment. Every day, we manage the risks associated with this business, and we have carefully designed procedures to minimise the risk of an accident. If these procedures are not followed however, accidents can happen and might result in injury to people, claims against the Group, damage to its reputation and its chances of winning and retaining contracts.
The Group has a proactive operational culture that puts health and safety at the top of its agenda in order to reduce the likelihood of an accident. We work very closely with our customers, employees and Health & Safety authorities, to evaluate and assess major risks to ensure that health and safety procedures are rigorously followed. The Group has developed health and safety KPIs which are reviewed by the Board on a regular basis.
Competition
Aggreko operates in a highly competitive business. The barriers to entry are low, particularly in the Local business and, in every major market in which we operate, competitors are constantly entering or leaving the market. We welcome this competition as it keeps us sharp and also helps to grow the overall rental market which, in many countries, is under-developed.
We monitor competitor activity carefully but, ultimately, our only protection from suffering material damage to our business by competitors is to work relentlessly to provide our customers with a high quality and differentiated service proposition at a price that they believe provides good value.
Product technology and emissions regulation
The majority of Aggreko's fleet is diesel-powered, and some of our equipment is over 10 years old. As part of the increasing focus on environmental issues, countries continue to introduce legislation related to permissible levels of emissions and this has the potential to affect our business. Our engines are sourced from major manufacturers who, in turn, have to develop products which conform to legislation, so we are dependent on them being able to respond to legislation. We also have to be aware that when we buy a generator, we want to be able to rent it for its useful life and to be able to move it between countries.
To mitigate these risks, we adopt a number of strategies. First, we retain considerable in-house expertise on engine technology and emissions – so we have a good understanding of these issues. Secondly, we have very close relationships with engine manufacturers, so we get good forward visibility of their product development pipeline. When new products appear – particularly those with improved emissions performance – we try to introduce them into the fleet as quickly as possible to ensure that, over time, our fleet evolves to ever-better levels of emissions performance. An example of this is the significant investment we have made in the development of our gas-fuelled technology: these engines have significantly reduced emissions compared with other fuel types. Thirdly, if emissions-compliance becomes such an issue that it begins to impact our business in a material way in some territories, our global footprint will be a major advantage as it gives us numerous options for the re-deployment of our fleet. An example of this in our North American business, where by the end of 2012 we will have replaced our whole power fleet with the latest level of emissions compliant equipment, with the previous fleet being re-deployed to other parts of the Group.
People
Aggreko knows that it is people who make the difference between great performance and mediocre performance. This is true at all levels within the business. We are keenly aware of the need to attract the right people, establish them in their roles and manage their development. As a framework for people development, we have in place a talent management programme which covers most of the management population. Under this programme, we try to identify the development needs of each individual from the outset, as well as identifying successor candidates for senior roles. We also have an ongoing relationship with one of the world's leading business schools, IMD, to deliver a tailor-made Group-wide management education programme.
Another risk is that competitors seek to recruit our key personnel. For many years, Aggreko has been a target for recruitment and we manage this on a daily basis. We actually regard it as a compliment that so many companies want to recruit our people. The main mitigation for this is to make sure that people enjoy working for Aggreko, that they feel that they are recognised, cared for, and have challenging and interesting jobs. Reward is also an important part of the equation, and there can be little doubt that our policy of rewarding people well for good performance, and of having a successful Long-term Incentive Plan, has acted as a powerful retention tool.