Pirelli & C.

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Risks and uncertainties

The current macroeconomic situation is characterised by a series of factors of uncertainty associated mainly with the volatility of the financial markets, the trend in interest rates, the cost of raw materials, the unemployment rate, and the growing difficulties in obtaining credit. This context requires the adoption of rigorous business management models, which should make it possible to mitigate the uncertainties deriving from the limited forseeability of future events, influenced by often uncontrollable exogenous factors.

The market context, in which the Group works, entailed a profound review of the strategy and the preparation of an incisive action plan with the aim of ensuring the maximization of efficiency and competitiveness. The main strategic guidelines, the actions taken and the related financial resources available to implement them were announced on the occasion of presentation to the financial community of the 2009-2011 business plan.

Risks associated with the business in which the Group operates

As regards the Tyre sector, the results obtained in 2009 fully achieved the targets set for the first year in the 2009-2011 business plan, in a context of ongoing widespread macroeconomic difficulties.

The risks for continuation of the plan on the one hand concern the expected recovery of economic and productive activities in macroeconomic terms, especially in the Western markets, which, if it happens more slowly, could reduce the growth of turnovers in the industry: on this point however it must be stressed that the company’s strategy, oriented in the Consumer segment to the production of "high range" goods and in the Industrial segment to focusing on emerging markets, attenuates this risk.

On the other hand the significant growth in the cost of raw materials, especially natural rubber, seen in the last few months, may cause in the first stage a partial reduction of absolute and percentage profitability, to the extent to which the disadvantage cannot be recovered immediately through the commercial lever of the price/mix and the internal lever of cost efficiencies.

As regards the Real Estate Sector, the main cases involved in the situations of uncertainty caused by the current macroeconomic context, are, in particular, the measurement of equity investments both in associated companies and joint ventures and in other companies, and of intangible assets (including goodwill).

In particular, the profitability envisaged in the new 2009-2011 business plan takes into account the macroeconomic scenario of reference for the property market.

With particular reference to the Italian real estate market, also during 2009, there was a gradual decline in the main indicators: number of transactions, average time to completion of rentals, sales and lending transactions. Property market operators expect 2010 to be difficult but characterized by a slow recovery of transactions in the residential market and substantial stability in other markets, confiding also in the economic policy decisions that had been taken by governments and central banks.

Offsetting all of the above there are however both structural and economic/financial aspects characterising the Italian real estate sector which, unlike in other European countries, could help to revive the market:

  1. the low rate of growth of the available stock of new spaces, that has characterized the last few years, means that in Italy there is no excess supply as is the case in other countries such as Spain and the United Kingdom;
  2. the low rate of indebtedness of Italian families compared with those of other countries, which makes the Italian banking system more solid, should help to sustain the propensity to consume and, therefore, the sustainability of rents for commercial businesses;
  3. the substantial reduction in the cost of money, with the return of the Euribor to the levels of 2002, will contribute to the sustainability of borrowing costs for real estate investment operations;
  4. investment in real estate is perceived as inherently defensive and less risky, in particular during periods of economic uncertainty.

In this scenario it is therefore possible for prices and values to encounter a period of particular volatility until the market recovers conditions of stability.

This scenario led the Company to consider the potential of every single initiative and to continue in the process of revision of the structure of operating costs and of internal reorganization, which has already begun in 2008.

Although in a difficult economic and financial context which determined a slowdown in the global economy, with particularly accentuated effects in the real estate sector, and which consequently also affected the consolidated net income for the financial year 2009, the Company believes that, as matters stand, there are no factors that might jeopardise the company’s ability to continue as an ongoing concern in consideration of the success of the share capital increase completed in July 2009, of the obtainment from eight leading financial institutions of a “committed” credit facility more adequate to the new business needs of the Company, and of the actions in progress and planned.

The market context in which the Real Estate Group works entailed, however, a profound review of the strategy with a strong objective focused on the “core” businesses and in particular on fund management, and the preparation of an incisive action plan with the aim of ensuring the maximization of efficiency and competitiveness.

As far as the Particulate Filter business is concerned, the main risk lies in the speed of growth in demand in the markets where the group operates, which depends on the definition of specific regulations, and on the ability to obtain the approvals needed for its products.

Financial risks

As reported also in the notes to the consolidated financial statements, the Group is exposed to risks of financial nature, associated mainly with trends in exchange rates, the procurement of financial resources on the market, the fluctuation of interest rates, and the ability of its customers to fulfil their obligations towards the Group.

Management of financial risks is an integral part of management of the Group’s businesses and is carried out centrally on the basis of guidelines defined by the General Management. These guidelines define the risk categories and for each type of transaction and/or instrument, they specify the procedures and operational limits.

Exchange rate risk

The different geographical distribution of the manufacturing and commercial businesses of the Group entails an exposure to exchange rate risk. This risk is managed by the Group Treasury which, coordinating its work with the corresponding functions of the Segments, collects information on the positions subject to the exchange rate risk, assesses and manages the net position for each currency. It does this in accordance with the guidelines and the constraints laid down, by the trading on the market of derivative hedging contracts, typically futures contracts, with the aim of minimizing the effects of this type of risk.

Liquidity Risk

The main instruments used by the Group to manage the risk of insufficiency of financial resources available to fulfil its financial and commercial obligations within the set terms and deadlines are annual and three-year financial plans and treasury plans, which enable complete and correct detection and assessment of cash in-flows and out-flows. The differences between the plans and the final balances are constantly analysed.

Prudent management of the risk described above requires the maintenance of an adequate level of cash equivalents and/or easily-cashable short-term securities, the availability of funds obtainable through an adequate amount of committed credit facilities and/or the ability to close open positions on the market. Owing to the dynamic nature of the business in which it operates, the Group prefers flexibility in sourcing funds, resorting to committed credit facilities.

The Group has implemented a centralized system for the management of collection and payment flows in accordance with the various local currency and tax laws. Banking relationships are negotiated and managed centrally, in order to ensure coverage of short- and medium-term financial needs at the lowest possible cost. The procurement of medium/long-term resources on the capital market is also optimized through centralized management.

Interest rate risk

The Group’s policy is to attempt to maintain a correct proportion between indebtedness at fixed and variable interest rates.

The Group manages the risk of an increase in interest rates associated with indebtedness at a floating rate through indirect offsetting with financial receivables at a floating rate and, for the net amount, through recourse to derivative contracts, normally interest rate swaps and interest rate collars with the aim, as part of the correct mix mentioned above, to protect itself against an excessive rise in interest rates.

Price risk associated with financial assets

The Group is exposed to price risk only as regards the volatility of financial assets such as listed and unlisted shares and bonds, listed real estate funds and unlisted closed-end real estate funds.

Credit risk

Credit risk relates to the Group's exposure to potential losses deriving from the non-performance of obligations assumed by both trade and financial counterparties.

In order to limit this risk where trade counterparties are concerned, the Group has put in place procedures for evaluating its customers' potential and their financial solidity, for monitoring expected incoming cash flows, and for recovering credit.

The aim of this procedure is to establish customer credit limits, which if exceeded result in a suspension of further sales.

In some cases customers are asked to provide guarantees. These are mostly bank guarantees, issued by subjects with excellent credit or personal standing. Less frequently mortgage guarantees may be requested.

Another instrument used for the management of commercial credit risk is the purchase of insurance policies with the aim of preventing the risk of non-payment through a careful selection of the customer portfolio carried out together with the insurance company, which undertakes to guarantee compensation in the event of insolvency.

As regards the financial counterparties used for managing temporary surplus cash or for trading in derivatives, the Group uses only operators with high credit standing.

The Group does not show significant concentrations of credit risk.

Risks associated with human resources

The Group is exposed to the risk of loss of key resources which might therefore determine a negative impact on future results. To guard against this risk, the Group has adopted bonus policies which are regularly reviewed on the basis also of the general macroeconomic context.

Moreover, the effectiveness of any restructuring measures that entail staff cuts could be limited by the legislative constraints and trade union agreements existing in the various countries in which the Group operates.

Country risk

The Group operates in countries such as Venezuela, Argentina, Brazil, Turkey, China and Egypt, in which the general political and economic context and the tax regime applied may in future prove unstable.

Risks associated with environmental aspects

The activities and products of the Pirelli Group, a multinational which does business all over the world, are subject to many different environmental laws depending on the specific features of the various countries.

These laws share in any case a tendency to evolve in an increasingly restrictive manner, also because of the growing commitment of the international community to environmental sustainability.

We can therefore expect a gradual introduction of stricter laws in relation to the various environmental aspects on which businesses may have an impact (use of water, emissions into the atmosphere, generation of waste, effects on the soil, effects of products on the living environment, etc.), owing to which the Pirelli Group expects to have to continue to make investments and/or to incur costs that may be significant.