Risk and Opportunities Report

Download

The Value of Risk Management

As an internationally active trade and tourism group, we are exposed to a wide variety of risks, some with short reaction times, as part of our business operations.

Risks are uncertain company-external and internal influential factors that impair the potential profit areas (assets, profit and liquidity) and thus hinder or threaten to hinder the realisation of planned goals or may negatively impact further business development. On the other hand, opportunities are company-external and internal influential factors that create the potential profit areas (assets, profit and liquidity) and thus positively impact the planned goals or further business development.

We employ a uniform risk management system throughout the Group to counter this risk potential successfully and ensure our opportunities potential in the long term. In doing so, we understand risk management as a continual process that is firmly integrated as a regular step in our operating practices.

At the REWE Group, all risks are subject to mandatory management and are mitigated in their effect and probability through operational initiatives. The scope of the related need for action and the initiation of appropriate actions are based on the urgency (probability of materializing) as well as the threat potential (potential damage determined from the monetary, reputational, and legal impact) of the risk. We document and manage existing needs for action in our risk areas using action plans and schedules.

Risk Management Organisation

The general conditions, guidelines and processes for uniform corporate risk management are created centrally by Corporate Controlling and the corporate Compliance Department.

Under the groups' prescribed guidelines concerning the defined risk areas, it is the responsibility of the groups to locally organise the establishment and procedural flow of the operational risk management process.

Risk managers identify reportable risks early in our risk areas using a bottom-up approach and these risks are then classified and measured uniformly throughout the Group.

Risk checklists in the form of Group recommendations are developed by our corporate departments and provided to the risk areas regularly to support their risk identification and analysis. This ensures the Group-wide consideration of possible risk events as seen by headquarters.

The risk analysis covers a three-year planning horizon, analogous to the period of our mid-term plan.

Risks with relevant significance for the groups are managed and monitored by selected corporate departments based on their technical competence. In addition to operational business risks with significant threat potential, the focus is also on significant risks from finance, compliance, taxes and financial reporting. The corporate departments discuss and reconcile the varying risk assessments with the risk areas.

Risk Management System of the REWE Group

Our management and supervisory boards are informed of the groups' current risk situation in standardised form on an annual basis. To that end, the risk managers send risk reports to the groups. These reports contain inventories of relevant individual risks from the risk areas as of a given closing date. Risks with similar content and causes are subsequently aggregated at the level of the groups into risk categories and classified as high, medium or low with regard to their relevance to the groups based on the threat potential to our business activities, financial position, results of operations, cash flows and our reputation (high: monetary impact in specific cases > 100 million euros or considerable significance with regard to business activities, cash flows, financial position, and results of operations and reputation; medium and low: at most moderate significance with regard to business activities, cash flows, financial business activities, and results of operations and reputation).

We measure and manage opportunities as part of our regularly scheduled operational and strategic planning. Opportunities and risks are not offset at the level of the groups.

In addition, binding provisions were made under which newly identified, significant risks or existing risks with material effects, changes in their development and high probability of occurrence in the risk areas must be reported directly to our management bodies.

As independent bodies, external auditors and the Auditing department assess the quality and functionality of our risk management system at regular intervals. Nevertheless, we cannot guarantee with complete certainty that all relevant risks are recognised early and the controls and processes function in the desired scope. Human error can never be ruled out completely. 

Risk portfolio 2017

Presentation of Risks

The risk assessment is made based on given or realistically assumable circumstances. Changes in the risk environment, the initiation of actions and changes to planning approaches result in changes to the risk portfolio. Therefore, the catastrophes and political developments risk types are no longer included in the top risks. The environment risk type was added.

a) Top Risks

Valuation Risks
Assets

Unexpected budget or forecast deviations as well as changes in general economic conditions may result in having to remeasure assets such as real estate and goodwill. This can materially impact the earnings development of the groups. Changes in input factors can result in either charges to earnings through impairment write-downs and/or to increases in earnings through reversals of impairment losses. Regular reviews of the recoverability of assets, the examination and plausibility check of the mid-term plan as well as monitoring of the current development of earnings and values give us a current picture of our valuation portfolio and future valuation risks at all times. Necessary strategic measures for reducing the impairment risk can be taken in a timely manner.

Rental Agreements

Budget deviations may influence the measurement of rental agreements (onerous contracts). For example, a degradation of retail earnings can result in a higher risk provision that weighs down earnings. The monitoring of current earnings and a regular earnings forecast allow for the early countering of possible risks from existing rental agreements.

Personnel risks

Due to the dominance of personnel expenses in the retail business, risks relating to personnel expenses are also a primary focus of risk reporting. The development of pay scales and non-wage labour costs as well as the availability of labour are therefore of major importance. Risks in connection with third-party services and work agreements are also growing in significance. An optimum recruiting process is essential to ensure that vacancies are filled quickly and with suitable candidates. Should cost developments be over those previously known or expected, this results in a greater burden on retail earnings and can therefore weigh down the long-term earnings development of the REWE Group. Cost increases can be partially compensated for by continually reviewing our processes and optimising our procedures. This requires strict and consistent cost management.

IT and Data Security

Due to the high dependence of trading and tourism processes on IT systems, including of stored data, the security of these systems represents an important foundation for the Company's success. Risk gaps will be closed by a high level of expenditures and investments in the security and performance capability of systems as well as ongoing monitoring of key processes. Data security is ensured by the introduction of new, state-of-the art technologies, thus reducing possible abuse to a minimum. Documenting processes, setting rules and instructions as well as contractual safeguards form the basis for securing the Company's IT processes and systems.

A residual risk cannot be excluded entirely despite the necessary security measures.

Environment

Climate change and atypical weather developments result in greater sales volatility for seasonal items. Longer periods of persistent bad weather in the summer can have a negative impact on the relevant merchandise groups and a significant influence on the Group's earnings situation. Lower sales can increase the number of days in inventory, thus increasing the risk of an additional need for price mark-downs.

However, positive weather patterns can also offer the opportunity to markedly improve the revenue trend for the relevant groups of merchandise and can thus also improve the earnings situation. 

Price Trend Risks

An intensification of the competitive environment can negatively impact price trends and be contained by initiatives only with difficulty. Negative price developments slow sustainable growth in revenue and gross profit and lead to profit erosion. The situation is aggravated by discounters adding brand-name products to their shelves. Since these are essentially high revenue items, long-term price reductions on these items have a significant impact on the development of gross profit. 

Changes in the general conditions, such as an increase in excise duties or value added taxes, could materially impact the price trend and thus directly or indirectly affect the results of operations. Changes in prices on the procurement markets can also have a material influence on the gross profit situation. 

We are able to react quickly to price adjustments and adapt to the new price situation by monitoring the competition and prices. Innovative products and brands as well as competitive cost structures assist us in containing or reducing erosions of gross margins.

Image

Flawed communication with customers and stakeholders, first and foremost on the topic of sustainability, can lead to image risks for the Company. Because the REWE Group takes a leading position in the field of sustainability, correct and transparent communication, e.g. on issues relating to products and employees, plays an important role. Due to the high sustainability requirements and continual observation by stakeholders, flawed communication can have material adverse effects on customers and stakeholders. 

Sustainability communications are therefore subject to a careful examination and are reviewed by the necessary specialist departments. Campaigns are centrally supported by market research. A clearing office has been established to review communications media and statements.

Contracts

The uncertain and unclear legal situation in some countries, particularly in Eastern Europe, may lead to risks, particularly with respect to rental and licensing agreements. This could limit or render impossible the operation of stores or the sale of products, which in turn would reduce earnings. We conduct detailed and comprehensive contract assessments to keep this risk as low as possible.

Competitors

Overall, competition in the food retail sector continues to put pressure on prices and thus on gross margins.

Discounters are increasingly carrying brand-name products, which is increasing the pressure on market price trends. The resulting pressure on gross profit could have a material impact on the results of operations.

It is important for a retail company to recognise market trends early and to develop characteristics distinguishing it from the competition using new store concepts. Changes in customers' lifestyles affect their purchasing behaviour and thus the market requirements. Therefore, it is important to recognise market trends and changes in behaviour early in order to offer the store concepts to customers that meet their needs. If trends or market changes are identified too late, especially in the saturated markets, this results in a long-term competitive disadvantage and thus in revenue and earnings declines.

The growing online business poses new challenges for both over-the-counter retailing and travel and tourism. The increasing activities in the online retail trade will lead to changes in the trade landscape. It is therefore particularly important to closely observe and actively follow this trend. As an example, the REWE Group established an internal corporate department for coordinating online activities and further strengthened its online activities, above all in the German food retail sector. We plan to expand the segment further and take a leading role in online business in the German food retail sector. Strengthening activities and bundling the coordination of online activities in a central office will allow trends to be recognised early and online activities to be pushed and managed in a targeted manner.

Store concepts and ranges are continually refined, meaning that innovations must be identified and implemented at an early stage. We constantly observe our competitors and the markets so as not to miss trends or new developments. This enables us to identify and implement trends and changes at an early stage.

b) Other Risks

Financial Risks

The groups are exposed to various financial risks by their business activities, in particular to liquidity risk, interest rate risk, foreign currency risk and commodity risk (jet fuel). The liquidity, interest rate and foreign currency risks are managed systematically pursuant to the financial guidelines. Financial risks are identified, assessed and hedged in close co-operation with the operating units. A central Treasury Committee consults and decides on the risk policy and risk strategy. Treasury committees also exist at the level of the business segments. The permissible range of actions, responsibilities, financial reporting and control mechanisms for financial instruments are defined in detail in the corporate guidelines. These guidelines call in particular for a clear functional separation between trading and settlement activities.

Comprehensive management of financial risks focuses on the unpredictability of developments on the financial markets and aims to minimise the potential for negative impact on the financial position of the groups. Mitigating risk generally takes precedence over considerations of profitability.

A treasury management system is used to limit interest rate and foreign currency risks so that they are always within the scope stipulated by financial guidelines. Derivative financial instruments are used to hedge risks; their use is coordinated by the Treasury Committee.

Loans, fixed-term deposits and overnight money are used as financial instruments.

The aim of liquidity management is to ensure that, through REWE International Finance B.V., Venlo, Netherlands ("RIF"), the consolidated companies always have access to sufficient liquidity on the basis of adequate undrawn lines of credit so that no liquidity risk exists should unexpected events have a negative financial impact on liquidity.

The budgeted demand for jet fuel by Nova Airlines AB, which was acquired in 2015, is secured in coordination with the responsible managers within DER Touristik using derivative financial instruments with terms up to 18 months.

Legal Risks

As an international company, the REWE Group is confronted with changes in the legal framework of its business activities as well as legal disputes and official proceedings, some of which could significantly impact on the Group's business. A team of legal experts observes such changes continually and coordinates the Group's key legal steps.

A Compliance Management System (CMS) was implemented in the REWE Group in 2010 to ensure adherence with statutory and internal Company directives. Since then, the CMS has been continuously enhanced and includes in particular preventive measures to avoid compliance risks, with a focus on antitrust and corruption risks. The decentrally-structured compliance organisation has a direct link to the chairman of the Management Board.

The compliance programme was further expanded in 2017 as well. Phase I of the REWE Group's project to certify the Compliance Management System in accordance with the IDW Audit Standard AuS 980 – "Audit of the design of the REWE Group's CMS" – was successfully completed in 2017. The design of the Group-wide Compliance Management System was set out in writing and was subsequently examined by the external auditing firm KPMG, which issued an unqualified audit opinion. Phase II of the project, a review of the "Appropriateness of the CMS" in accordance with IDW Audit Standard AuS 980, was launched in mid-2017. Processing procedures related to compliance were and will continue to be optimised and revised substantively and for technical reasons. In addition, numerous on-site training sessions and workshops were again conducted in which employees were also taught subject-specific behaviour conforming to compliance requirements. The training programme was also expanded. In 2017, in addition to the existing interactive online courses, comprehensive in-person training sessions on anti-trust law were carried out. In addition, the compliance organisation was adapted and expanded in line with the current Group structures in order to ensure that the compliance system is appropriately organised and functions properly. Executives and employees also took advantage of the individual compliance consultations offered. The REWE Group's policies and guidelines management office, which has also been within the Compliance department's scope of responsibilities since the beginning of 2016, successfully concluded its Group-wide project to reorganise the Group's policies and guidelines management system in 2017. Policies and guidelines of relevance to the Group will successively be migrated to the new system and the national and international IT systems which have been created specifically for this purpose.

Employees have access to material and current compliance information on our intranet. The REWE Group's compliance reporting system is also available on the intranet and the contact data for whistleblower notifications is published there. Material information about the CMS as well as the REWE Group's code of conduct are also available on the REWE Group's website.

In its decision dated 2 February 2017, the European Commission initiated formal proceedings against the largest European tour operators – including companies of the groups – due to suspected source market restrictions. The outcome of these investigations is difficult to predict at the present time.

Tax Risks

Tax risks result primarily from ongoing and upcoming tax audits. These risks and possible legal risks are always taken into account by recognising provisions or allowances for claims in the statement of financial position. Tax risks are minimised by engaging qualified tax experts to closely monitor and collect information on the operating areas, by involving such experts in change projects and contractual matters and by the internal control system.

Due to a 2017 ruling by Germany's Federal Finance Court (Bundesfinanzhof), which overruled an administrative opinion by the tax authorities, there is a risk for 2017 that the income tax group formed with a subsidiary will not be recognised. This could result in additional tax payments. This risk is considered extremely low.

Socio-political Risks

As an international corporate group, the REWE Group is dependent on the political and economic situation in the countries in which it operates. The general conditions in the individual countries can change rapidly. Changes or instability in the political leadership, strikes, civil unrest, attacks, embargos or changes in regulations, laws or levies can lead to risks.

We continuously monitor the development of socio-political risks in the countries relevant to us. In particular, we are closely monitoring current political developments in Turkey and in the Arabic world as well as the resulting uncertainty for our markets in these destinations as well as for the European economy, and developments in Ukraine.

We are also following very closely the current tense situation in Europe, the intensive discussions on immigration and asylum policies and the varying opinions of the individual member states regarding European policies. We closely analyse risks or opportunities that arise from the social and political situation and, if necessary, initiate measures.

Presentation of Opportunities

Markets and Customers

The REWE Group is represented in the Western and Eastern Europe countries with successful brands and distribution strategies. The REWE Group can utilise its opportunities on the market by further developing innovative sales concepts and consistently aligning its actions to the customers' needs.

As such, the customer is the focal point of the Group's actions. By expanding the product lines of regional and sustainable products, the REWE Group is taking a leading role in the food retail sector, which is distinguishing it significantly from the competition.

In international business, the REWE Group signifies strong brands such as BILLA, MERKUR, BIPA and PENNY that have a high degree of name recognition. Our strength is an innovative product line which is tailored to specific countries and is continually improved and expanded. Improvements in quality and freshness lead to a positive customer perception and strengthen our competitive position.

We are in a position to improve our market share through investments in a modern and extensive branch network and by focusing on strong brands and sales concepts.

The intensified expansion of our tourism business could enable us to solidify and expand our position in the European market. Extending the value chain and expanding into additional source markets create further added value and increase the potential of harnessing market opportunities.

We want to continue to exploit the opportunities to profit from the growth of online sales and online business by further expanding our online activities. At the same time, we can further expand our market position by sensibly linking our strong brick-and-mortar retail activities and travel service activities.

Economic Environment

The economic developments of recent years have significantly weighed on results, above all in Eastern Europe. The currently positive economic developments in Western Europe are also benefiting the economic climate in Eastern Europe. If the positive development in Western Europe persists, the knock-on effects could also lay a positive foundation for development in Eastern Europe.

Prices

The prevailing strong competition in the food retail sector, the continuing price wars and the increasing share of brand articles being sold in the discount sector are sharply reducing margins in the food retail sector. Should the price wars and competitive pressure abate or ease, this could lead to increasing revenue and margins and therefore positive growth of gross margins.

The success of our retail companies is dependent to a considerable extent on the purchase prices. In the past we formed a purchasing company in Brussels with E. Leclerc in order to meet the growing challenges of the competition in retailing and the increasing internationalisation of the food retail sector. 

We are also part of the COOPERNIC strategic alliance with other European retail companies. We can counter the risk of purchasing price volatility and leverage international purchasing potentials through joint purchasing and by negotiating terms and conditions.

Costs

Continuous optimisations of processes and costs lead to improvements in productivity which positively impacts costs, and in turn, earnings.

Management's Overall Assessment of the Risk Situation

Due to our activity in the retail and tourism sectors, we are particularly dependent on demand for consumer goods and the competitive situation. Recent years have shown that economic development in the countries of Western, Southern and Eastern Europe sharply impacts purchasing power and therefore demand. Even if the food retail sector is not as strongly affected by the economic crisis as other retail sectors, a degradation of general conditions still has a negative influence on the Company's success.

A substantial degradation of general economic conditions and an intensification of the political and economic situation in the leading nations in the Americas, Asia and Europe will greatly increase potential risks. Developments within the European Union and the discussion surrounding its future could also lead to higher potential risks. In the Travel and Tourism business segment, the booking behaviour of customers is significantly influenced by general economic conditions and external factors. Political events, natural disasters, epidemics or terrorist attacks influence the demand for travel in certain destination areas. The market risks are increasing through the entry of additional market participants and new business models.

Overall, however, there are currently no identifiable risks whose materialisation could threaten the continued existence of the groups.