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Leonardo and risk management

Below are detailed the key risks applicable to Leonardo’s business areas, together with the specific mitigation actions which have been put in place. It should be noted that starting from 2014 Leonardo’s organisation has required a close cooperation of the Risk Management operating unit with the competent functions in order set up a coordinated control over all risk areas, while ensuring that suitable methods to manage risks are designed and spread and supporting the top management with the control of risks associated with programmes.

RISKSACTIONS
The Group is strongly dependent on the level of expenditure of national governments and public institutionsThe major customers of the Group are national governments or public institutions. Moreover, the Group takes part in numerous international programmes funded by the European Union or other intergovernmental organisations. Therefore, the Group is affected by the reduction in the expense policies of the public institutions. The expenditure programmes adopted by governments may be subject to delays, changes under way, annual reviews or cancellations, in particular in periods with high instability like those that mark the global economy now, due to, for example, oil price trends, which can lead to a growing complexity of the prospective scenario. The Group’s industrial plans, as well as the financial resources necessary for their implementation, might be affected by significant changes, with impacts not only on volumes and results, but also on the Group debt, due to lower amounts received as advances on new orders.The Group continues pursuing an international diversification policy, which leads the same to compete not only in its main markets (Italy, the UK and the US) but also in emerging markets marked by high growth rates, especially in the Aeronautics and Defence markets, in order to be less dependent on cuts that may be made by individual countries. Moreover, under the Group strategy, performance in the major countries is constantly monitored in order to ensure a timely alignment of activities planned with customer needs and a strict selection of its investments, through assessment procedures of the potential returns and their strategic capacity. In addition, the organisation plan in which the Group is involved, should guarantee, against the reduction in the customers’ budgets, an increased ability to compete in national and international markets.

RISKSACTIONS
Cuts in public budgets could affect grants from the Government for the research and development activities of the Group and, as a consequence, also the Group ability to successfully compete in global marketsThe tensions on public budgets could further reducepublic grants for R&D activities, for which the Groupinvested €bil. 1.4 in 2016, considering the unavoidable need to constantly improve its products portfolio. Inparticular, in Italy, grants for R&D expenses for theAeronautics and Defence sectors, which are regulatedby Law 808/1985, represent the indispensablefunding for the research activities in the sector. A noncomplianceof the granting levels with those of theother European competitors could negatively influencethe Group capacity of being successfully competitive,due to a lower self-financing ability caused by thecomplex economic scenario; this would increase therisk of inadequate time-to-market of the products beingdeveloped.The Group pursues a strict policy as regards the assessment and selection of the investments through which it focuses the resources available on the most efficient programmes with the highest potential of return. Moreover, the Group is focused on steadily strengthening synergies among the corporate functions involved in the development of new products, especially with reference to products marked by high levels of technology innovation.

RISKSACTIONS
The Group also operates in civil sectors exposed to crisisThe Group is also potentially exposed to slowdowns in certain non-public markets, which could affect the spending capacity of certain customers. Delays or reductions in the acquisitions of new orders, or the acquisition of new orders on less favourable terms than in the past, including financially, contribute to a growing complexity of the prospective scenario and could reduce the profitability and increase the financial requirements of the Group during the performance of such orders.The Group’s goal is to improve its industrial efficiency and its ability to perform contracts, while reducing overhead costs with a view to enhance its competitive capacity and pursue appropriate actions to diversify the client base.

RISKSACTIONS
In the past certain Group companies were involved in judicial investigationsAs more fully explained in paragraph “Provisions for risks and charges and contingent liabilities” of the notes to the consolidated financial statements, certain Group companies and the Parent Company itself have been involved in judicial investigations, some of which are still underway. In this regard, the directors made provisions where necessary, on the basis of the stage of the legal proceedings and of the information obtained and the analyses performed to date. However, further developments presently unforeseeable and indefinable, together with the possible consequential impact on Leonardo’s reputation, could significantly affect the Group’s performance and financial position, as well as its relationships with customers.The Group has taken all steps necessary to more thoroughly examine any irregularities and to prevent employees, directors and suppliers from repeating inappropriate practices. All this has been done through specific actions, which consist in spreading a company culture founded on a set of values, rules of conduct and intangible principles hinged upon the “zero-tolerance” policy. Leonardo’s management is constantly committed to spreading these messages at each and every level based on the “Tone from the Top” concept. Specific measures have been adopted also with reference to suppliers, by centralising the process of qualification and management of supplier registers and the prompt identification of the indicators to be monitored for possible inhibition.

RISKSACTIONS
The Group operates significantly on long-term contracts at a given priceIn order to recognise revenues and margins resulting from medium- and long-term contracts in the income statement of each period, the Group adopts the percentage-of-completion method, which requires: (i) an estimate of the costs necessary to carry out the contract, including risks for delays and additional actions to be undertaken to mitigate the risk of non-performance and (ii) checking the state of progress of the activities. Given their nature, these are both subject to management’s estimates and, as a result, they depend on the ability to foresee the effects of future events. An unexpected increase in the costs incurred while performing the contracts might determine a significant reduction in profitability or a loss, if these costs exceed the revenues deriving from the contract.Leonardo’s goal is to regulate within the Group the process of preparing and authorising major contracts by issuing a special Directive. In fact, starting with the business proposal stage, Leonardo controls the main performance and financial parameters including the Economic Value Added (EVA), which is one of the aggregates used to evaluate the major contracts of directly controlled and strategic companies. Moreover, the Group reviews the estimated costs of contracts regularly, at least quarterly. In order to identify, monitor and assess risks and uncertainties linked to the performance of the contracts, the Group adopted Life Cycle Management and Risk Management procedures, aimed at reducing the probability of occurrence or the negative consequences identified and at timely implementing the mitigation actions identified. Under these procedures, all significant risks must be identified from the offering stage and monitored while the programme is being carried out, by constantly comparing the physical progress and the accounting status of the programme. Top management, programme managers and the risk management quality, production and finance departments are all involved in making these assessments. The results are weighted in determining the costs necessary to complete the programme on an at least quarterly basis. The Group is also committed to improving its industrial efficiency and its ability to precisely perform to customer specifications.

 

RISKSACTIONS
During the current activity, the Leonardo Group is exposed to liability risks to customers or associated third parties in connection with the proper performance of contracts, also because of activities pertaining to sub-suppliersAs part of its activities, the Group may be held liable in connection with (i) the delay in or non-supply of the products or the services indicated in the contract, (ii) the non-compliance of these products or services with the customer’s requests, due to design and manufacturing defects of products and services, for example, and (iii) defaults and/or delays in marketing, rendering of after-sale services and maintenance and revision of products. These liabilities might arise from causes that are directly ascribable to Group companies or due to maintaining the specialist expertise of the company resources or from causes that are ascribable to third parties outside the Group that act as suppliers or sub-suppliers for the Group.The Group continuously monitors the performance of programmes using the aforementioned Life Cycle Management techniques. In connection with these programmes the Group is committed to improving its industrial efficiency and its ability to precisely perform to customer specifications, also through managing the development and succession of the core competencies.

 

RISKSACTIONS
The Group’s debt shows high level and could have an impact on the Group’s operational and financial strategiesAt 31 December 2016, the Group net debt amounted to €bil. 2.8. This level of debt was previously affected by the acquisition of DRS and by the negative performance of the Transportation sector. Such debt level, beside impacting the Group’s profitability as an effect of the related borrowing costs, could affect the Group’s strategy, limiting its operational and strategic flexibility. Potential future liquidity crises could also restrict the Group’s ability to repay its debts.Following the acquisition of DRS Leonardo reduced its level of indebtedness through a successful capital increase and the selling off of assets, with particular reference to the Transportation and Energy businesses. Moreover, Leonardo seeks to continually reduce its debt by keeping a close eye on cash generation. In 2015 the Group also renegotiated the contractual terms of its Revolving Credit Facility setting the total amount at €bil. 2.0: this credit line is an important source of medium-term liquidity and, given its amount and that it is a revolving facility, it meets the Group’s working capital requirements, in which collections are highly seasonal in nature. The amount of this credit facility is adequate and meets the Group’s financial requirements.

 

RISKSACTIONS
The Group’s credit rating is also linked to the opinions of the rating agenciesAll Group bond issues are given a medium-term financial credit rating by the three international rating agencies: Moody’s Investors Service (Moody’s), Standard & Poor’s and Fitch. At the presentation date of this report Leonardo’s credit ratings were: Ba1 with a stable outlook from Moody’s, BB+ with a stable outlook from Standard & Poor’s and BB+ with a positive outlook from Fitch. The downgrading experienced from 2011 and 2014 was attributable to the deterioration in the Group’s financial and economic performance, to the delays in the execution of the expected disposal plan of the Transportation and Energy sectors and, in part, to the downgrade in the rating for the Italian Republic. Overall, all rating agencies assigned the sub-investment grade rating status to Leonardo. A further downgrade in the Group’s credit rating, even with no effect on the existing loans, could severely limit its access to funding sources, as well as increase its borrowing costs for existing and future loans, which would have a negative impact on the Group’s business prospects and its performance and financial results.As noted previously, the Group is actively engaged in implementing actions identified under the Industrial Plan for reducing its debt. Moreover, the Group’s financial policies and careful selection of investments and contracts involve being constantly alert to maintaining a balanced financial structure. In seeking out strategies to pursue, the Group always takes into account the potential impact such could have in the indicators used by the rating agencies.

 

RISKSACTIONS
The Group realises part of its revenues in currencies other than the currencies in which costs are incurred, exposing it to the risk of exchange-rate fluctuations. A part of consolidated assets are denominated in US dollars and pound sterlingThe Group reports a significant portion of revenues in US dollars and pounds, while costs can be denominated in other currencies (mainly euros). Accordingly, any negative changes in the reference exchange rate might have negative effects (transaction risk). Moreover, the Group made significant investments in the United Kingdom and in the United States. Since the reporting currency of the consolidated Group financial statements is the euro, negative changes in the exchange rates between the euro and the dollar and between the euro and the pound sterling might have a negative impact on the Group balance sheet and income statement due to the translation of the financial statements of foreign investees (translation risk).The Group continuously applies an organised hedge policy to combat transaction risk for all contracts using the financial instruments available on the market. Changes in the US dollar and pound sterling exchange rates also give rise to translation differences recognised in Group equity that are partially mitigated through the aforementioned pound and dollar issues. Moreover, in intercompany financing activities denominated in currencies other than the euro individual positions are hedged at the Group level.
 

RISKSACTIONS
The Group operates in some segments through Joint Ventures, in which the control is shared with other partnersThe major Joint Ventures in the Aerospace, Defence & Security area are MBDA, held at 25% (with partners BAE Systems and Airbus Group), Thales Alenia Space, held at 33%, and Telespazio, held at 67% (both with partner Thales) and GIE ATR, held at 50% (with Airbus Group). The operations of the Joint Ventures are subject to management risks and uncertainties, mainly due to the possible arising of differences between the partners on the identification and the achievement of operating and strategic objectives, and the difficulties in resolving any conflicts that may arise between them in the ordinary course of business of the Joint Venture. In particular, the Joint Ventures in which the Group has an interest may be subject to decision deadlocks which may ultimately lead to the liquidation of the Joint Venture. In the case of liquidation of the Joint Venture or sale of the interest by the Group, it may have to share or transfer technological skills or know-how that were originally contributed to the Joint Venture.The Group constantly follows, including through the involvement of its own top management, the performance of these activities, in order to timely identify and manage critical issues.
 

RISKSACTIONS
The Group is a sponsor of defined-benefit pension plans in the United Kingdom and the United States and of other minor plans in EuropeUnder the defined-benefit plans, the Group is required to ensure a specific future retirement benefit level for employees participating in the plan; in the United Kingdom and the United States the pension funds in which the Group participates invest resources in the plan assets (stocks, bonds, etc.) that might not be sufficient to cover the agreedupon benefits. If the value of plan assets is less than the agreed-upon benefit level, the Group duly recognises the amount of the deficit among liabilities; at 31 December 2016, pension liabilities amounted to €mil. 338 and were more than offset by the plan assets amounting to €mil. 367. If the value of plan assets falls significantly, for example due to high volatility in the stock and bond markets, the Group must make good this loss to plan participants, which therefore has a negative effect on its own performance and financial position.The Group keeps a close eye on plan deficits and investment strategies and takes immediate corrective action when necessary.
 

RISKSACTIONS
The Group operates in particularly complex markets, where disputes are settled after a considerable period of time and following extremely convoluted proceduresThe Group is party to judicial, civil and administrative proceedings; for some of these, the Group has established a specific provision for risks and charges in the consolidated financial statements to cover any potential liabilities. Some of these proceedings in which the Leonardo Group is involved – for which a negative outcome is unlikely or thThe Group regularly monitors potential and existing disputes, taking the necessary corrective actions and adjusting its provisions for risks on a quarterly basis.
 

RISKSACTIONS
The Group also operates numerous industrial facilities and is therefore exposed to environmental risks or risks arising from the effects of the climate change, in addition to occupational health and safety risksThe Group’s business activities are subject to laws and regulations protecting the environment and human health that impose limits on air emissions and the release of waste into the water and the soil and that regulate the handling of hazardous waste and the restoration of contaminated sites. Under current regulations, owners and operators of contaminated sites are responsible for pollution found on such sites and, therefore, may be required to bear the costs of environmental assessment and remediation, regardless of the source of the contamination. While carrying out its production activities, the Group is exposed to the risk of accidental contamination of the environment and may be required to bear the costs of restoring any sites that may be contaminated. Moreover, the Group is exposed to risks regarding the workers’ health and safety, also with reference to third party work sites where workers operate.As to environmental risks or risks linked to unforeseeable climate events, the Group has established an environmental monitoring and assessment programme and has insurance coverage to limit the impact of any event. Occupational health and safety risks are managed through specific training and other work plans focused on a zero-tolerance policy, supported by an accurate system of delegated and other powers, with the aim of ensuring that action is aligned with corporate policies.
 

RISKSACTIONS
The Group operates in particularly complex markets which require compliance with specific regulationsThe Group designs, develops and manufactures products in the Defence sector. These products are particularly important to the protection of national security interests and, therefore, their exportation is subject to the receipt of special authorisations from the relevant authorities. The prohibition, limitation or withdrawal, if any (in the case, for example, of embargoes or geopolitical conflicts), of the authorisation to export the products might have significant negative impacts on the Group’s operations and financial situation. Moreover, non-compliance with these regulations could result in withdrawal of authorisations.The Group monitors, through specific structures, the constant updating of the relevant regulations. Commercial actions are subject to regulatory restrictions and receipt of the necessary authorisations.
 

RISKSACTIONS
A significant portion of the consolidated assets relates to intangible assets, specifically goodwillAt 31 December 2016 the Group reported intangible assets of €bil. 6.7, of which €bil. 3.8 relate to goodwill (15% of total assets) and €bil. 2.0 to development costs. The recoverability of these amounts is linked to the realisation of future plans of the reference businesses/products.The Group constantly monitors performance against the expected plans, implementing the necessary corrective measures in the case of unfavourable trends. These updates are reflected, when the adequacy of the amounts posted is assessed, in the expected flows used for the impairment tests. In the last three years, compared to previous periods, Leonardo reduced the amounts capitalised for intangible assets, especially with reference to development costs.
 

RISKSACTIONS
The Group operates in contexts requiring a proactive cyber security managementThe increased digitalisation and use of innovative technologies compel the company to cope with the risks linked to the IT security which may bring to leakage of sensitive data and information, endangering, inter alia, the company’s image.The Group manages cyber security through dedicated controls, training across all corporate staff, processes, procedures and specific detection technologies designed to detect and manage potential threats.