Risks & uncertainties

Principal risks

The group operates through a wide range of activities across multiple geographies and therefore from a group-wide perspective the principal risks and uncertainties identified by the directors relate to the market conditions in which we operate and to management’s capability to deliver the large number of change programmes and recovery strategies currently underway across the businesses.

The principal risks are:

• A weakening of the economies in which we operate; and
• The number, scope, complexity and interdependencies of many initiatives – risk of management stretch and overlapping priorities.

These are discussed in more detail below as well as in the strategy review and in the review of operational performance. Financial and other risks are set out below.

Risk of economic weakening in the economies in which we operate

The group is exposed to the economic environments in over 50 countries across the world and whilst the UK represents a large proportion of the group’s businesses our international diversification means that our economic and geopolitical risks are spread widely. At the date of this report political and economic change in the North Africa and the Middle East will have some impact on the group’s operations in those territories. The pest control operations in Libya have been suspended and the small number of non-Libyan colleagues involved have left the country. Some current examples of the economic impact on our divisional operations are provided in the following paragraphs.

In 2010 the group’s Textiles & Hygiene division experienced difficult trading conditions in a number of territories. France, Belgium and the Netherlands were impacted particularly by competitive pricing pressure which resulted in a number of contract losses earlier in the year and which also affected the division’s ability to win new contracts. A further risk to this division is an inability to cover various cost increases such as wage inflation, which within some of our countries of operation, is determined by the governments of those countries and not under our own control. Actions to mitigate these risks include passing on price increases to customers to counter cost inflation and pricing contracts appropriately to remain competitive. In those circumstances where our competitors are engaging in aggressive price discounting and where we believe that to offer similar prices would compromise service levels, our only mitigating course of action is to ensure that contract losses do not directly result from poor customer care, service or relationships. Further mitigating actions include improving the competitiveness of the business through significant restructuring programmes in Belgium and France and through extensive cost-savings programmes across all businesses.

In the Asia Pacific region our Asia Pest Control and Hygiene markets experienced a slow down in 2009 with tightening economic conditions impacting a number of countries of operation. Growth in the Australia and Pacific Pest Control and Hygiene businesses has also been impacted by weaker markets caused by a nervous economic backdrop. The division also experienced a severe decline in the fumigation business as a result of slower international trade in 2009. Further, job revenue has been impacted by reduced demand for pre-construction termite barriers as a result of a downturn in building construction. Mitigating actions include efforts to improve customer retention through focusing on high levels of service and implementing a continuing series of cost reduction measures.

In the Ambius division revenue declined in 2009 and 2010 as demand for products and services softened in the major markets, especially in the US, UK, France and Belgium and principally the result of challenging economic conditions. Mitigating actions include adjusting service head count in line with portfolio movement and the ongoing pursuit of cost savings initiatives to mitigate revenue decline.

The UK parcels market has been extremely competitive over the past two years with severe price cutting by competitors in order to drive volumes through their networks. There have been some signs of recovery in pricing in 2010 but the market is expected to remain very competitive throughout the coming year as excess capacity in the industry still remains the predominant feature.

The group’s Facilities Services division has also been impacted by weakened market conditions in the UK and Spain, particularly in 2009, with severe price cutting from competitors, site closures and reductions in service frequency. Conditions eased however in 2010. Deteriorating market conditions may result in customers seeking cost reductions, fewer service lines and reductions in service frequency. In some instances, activities which are typically outsourced to FM businesses such as our own are brought in house and contracts terminated in their entirety.

While our Pest Control business is least impacted by weakening global conditions, the business is not immune to economic impact. Most countries within the Pest Control division experienced difficult market conditions in 2010.

The company has been going through a period of significant change since 2005 with new chief executives being appointed in 2005 and 2008. The company’s current management team is implementing a five-year recovery plan based on operational excellence which itself is built around five key strategic thrusts namely: to deliver outstanding customer service, to develop capability, to drive operational excellence, to operate at lowest cost and to generate profitable growth. Within each of these thrusts are a large number of improvement initiatives which individually are managed through a proper risk control process but the principal risk for the group is that management has the capacity and capability to deliver the strategic thrusts.

As an illustration of the scope of change, all but one of Rentokil Initial's Executive Committee has been changed over the past 28 months, major physical restructuring programmes are underway in our Textiles & Hygiene and City Link businesses, common systems (IT, finance etc.) are being introduced across our more than 50 countries of operation and major cost savings programmes are being undertaken across most of the group. These programmes are described in the strategy update and collectively their delivery is the principal risk to the execution of the company’s operational excellence strategy. Financial and other risks are set out below:

Financial and other risk

The group’s activities expose it to capital risk, liquidity risk, market risk and credit risk.

Capital risk

The group is committed to maintaining a debt/equity structure which allows continued access to a broad range of financing sources and sufficient flexibility to pursue commercial opportunities in a timely manner as they present themselves, without onerous financing terms and conditions. The group has in issue Medium Term Notes and a £500m Revolving Credit Facility (see note 21 for details). These contain a single covenant requiring that EBITDA:Interest should be at least 4.0:1.0 at each semi-annual reporting date. The group was compliant throughout the year.

The group targets an investment grade rating of BBB or above for debt issuance over the medium term. Currently the group is rated BBB- with a stable outlook.

The group’s Medium Term Notes may be recalled by its investors in the event of a change of control of the group and within 120 days if:

1. the group’s debt is down-graded below investment grade or the rating is withdrawn; and
2. the rating agency confirms in writing, either publicly or in writing to the issuer or the Trustee that the rating action occurred either wholly or in part due to the change of control.

Liquidity risk

The group is committed to ensuring it has sufficient liquidity to meet its payables as they fall due. To achieve this it aims to maintain minimum committed financing headroom of £200m, over the medium term, when measured against the latest forecast cash flows over a rolling 12-month horizon. At 31 December 2010 the group had headroom of £390m.

Market risk

The group is exposed to market risk primarily related to foreign exchange and interest rate risk. The group’s objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in interest rates, foreign currency rates and the exposure of certain net investments in foreign subsidiaries. To achieve this, management actively monitors these exposures and the group enters into currency and interest rate swaps, forward rate agreements and forward foreign exchange contracts to manage the volatility relating to these.

Foreign exchange rate risk

The group is exposed to the following foreign exchange risks: pre-transaction risk, transaction risk, translation risk and economic risk.

The group’s policy response is as follows:

• Pre-transaction risk – The majority of sales and purchases are local, limiting pre-transaction risk. The policy is therefore to accept the risk.
• Transaction risk – The majority of sales and purchases are local, limiting transaction risk. The policy is therefore to accept the risk, except where significant acquisitions or disposals (not internally funded) are to be undertaken, where the transaction may be hedged to give certainty of pricing.
• Translation risk – The group is exposed to translation risk as a result of its worldwide operations. The group aims to hold debt in currencies broadly matching its forecast cash flows, meaning that currency interest costs reduce the net profit retranslation exposure. This reduces the volatility of earnings affecting the group’s interest cover covenant. Foreign currency debt is designated for hedge accounting as a hedge of its currency net assets, so reducing its net currency assets. Retranslation gains and losses are recognised in reserves, rather than in the income statement.
• Economic risk – Economic risk is a core risk to the business, which the business therefore accepts.

The group calculates the impact on the income statement and equity of a 10% shift in foreign exchange rates. The group’s principal foreign currency exposure is to Euro, and a 10% shift in GBP/EUR would result in a £8.7m (2009: £8.7m) increase/decrease in operating profit, offset by a £1.9m (2009: £1.9m) increase/decrease in interest payable. Equity reserves would decrease/increase by £5.9m (2009: £17.1m).

Interest rate risk

The group is exposed to cash flow interest rate risk on borrowings and cash balances held at variable rates, resulting in variable interest cash flows.

The group seeks to manage interest rate risk to ensure reasonable certainty of its interest cash flows whilst allowing an element of risk exposure consistent with the variability of the group’s cash flows.

The group has a policy of fixing (or capping) a minimum of 50% of the group’s estimated future interest rate exposures (excluding pensions) for a minimum of 12 months forward.

At the end of December 2010 approximately 89% of the group’s debt was at a fixed rate of interest. The impact on profit and loss of a 1% shift would be a maximum increase/decrease of £0.6m (2009: £4.1m).

Credit risk

The group has no significant concentration of credit risk. Sales are typically low value, high volume, spreading the risk across a number of customers. Policies are in place to ensure that sales are only made to customers with an appropriate credit history. Derivative counterparties and cash transactions are limited to high-credit-quality financial institutions. The group operates in some territories where there is increased exposure to trade credit risks and in those cases the group seeks to put in place appropriate additional measures where possible to manage its credit exposure.

Treasury risk

The company utilises financial instruments to manage known financial exposures in line with policies agreed by the board and outlined above. The company does not enter into any speculative derivative contracts.

Other risks

The group has contingent and other exposures relating to liabilities over property, environmental and commercial matters and pension funding obligations which are properly reflected in the financial statements. The level of such exposures changes over time and is kept under review by management. Pension funding risk includes investment and counterparty risk within the pension scheme in relation to the assets held by the pension scheme. A contingent risk remains that unidentified historic risks relating to acquired entities emerge, which if material would need to be reflected in future financial statements.