Strategic Risks

These are closely tied to the Group’s objectives and consequent strategic choices. This category includes the exogenous risks stemming from evolution in the external context where the Group operates and the risks stemming from internal factors, such as financial risks, the risks connected with typical business processes and human resource/organisation risks.

General Economic Risks

In line with the forecasts made by leading analysts, Pirelli expects a general economic slowdown in 2012. In particular:

  • SLOWDOWN BUT NOT RECESSION IN THE UNITED STATES

The latest business cycle indicators point to slight growth from the recent past. This phenomenon seems to indicate that risks are decreasing, at least at the domestic level, and that the United States economy will probably avoid being drawn into a new recession over the next year.

  • RECESSION IN THE EUROZONE

Business cycle indicators, hard data and recent decisions taken by the ECB and national governments suggest that the eurozone is entering a new recession, which will be particularly acute in peripheral members of the monetary union.

  • CONTINUED GROWTH IN APAC

Even if a recession occurs in the Old Continent, economic growth in the Asian region should stay robust and confirm its global lead in terms of GDP growth. The recovery staged by the Japanese economy, stimulated by restocking after the tsunami, combined with growth in the Chinese economy that is at or in line with the target set in the twelfth five-year plan, should more than offset a contraction in demand for products by Europe.

  • GROWTH IN SOUTH AMERICA

Latam should maintain a reasonably vigorous growth rate – albeit slower than in 2011 – due to the lower exposure of emerging economies to a recession in the eurozone.

The tyre sector has expanded without interruption over the last several years. The downturn that occurred between 2008 and 2009, in consequence of the global economic crisis, has been more than offset by high growth in 2010 and 2011. The total number of cars on the road is growing steadily, driven by rapidly developing economies, and the demand for high-end vehicles, equipped with premium tyres (the segment in which Pirelli has a leading position), is growing at even higher rates.

Against the backdrop of a macroeconomic slowdown, it should be noted that the tyre market is historically more profitable and less cyclical than the car market. Sales are driven by the replacement channel (which accounts for 74.5% of sales at Pirelli) and are less vulnerable to possible contraction in the automotive sector and consequent demand in the original equipment channel. Even during the last recession, the global market for premium tyres (replacement channel) posted growth of +2.9% in 2008 and +6.8% in 2009 (source: Europool, RMA, Anip, CRIA). Furthermore, premium tyres are increasingly seen as products associated with sustainability and safety, areas dominated by Pirelli with its cutting-edge know-how and technology. Finally, Pirelli’s major presence – as measured in terms of revenue – in rapidly developing economies, especially Latin America and in Russia from 2012, reduces the possible impact stemming from any slowdown in European countries.

However, if global macroeconomic conditions should deteriorate significantly, Pirelli has prepared a contingency plan to deal with the change in context as flexibly as possible. If demand in the auto original equipment channel should fall more than 10%, if the truck business contracts more than 20%, and if distributors’ inventories increase more than 10%, the contingency plan would aim to keep cash flow and profitability under control by adjusting planned investments within the flexible range of about 20%, by carefully managing working capital, by taking measures to improve internal efficiency and implementing a programme to reduce fixed costs.

Country Risk

Pirelli implements a “local for local” strategy by setting up production sites in rapidly developing countries to serve local demand at competitive industrial and logistic costs. In the context of an economic slowdown, this strategy improves Group competitiveness in the face of resurgent trading blocs and growing protectionist measures (customs barriers or other measures such as technical prerequisites, product certification, and administrative costs connected with import procedures, etc.). The Pirelli Group adopts this strategy for its operations in countries such as Argentina, Brazil, Mexico, Russia, China, Egypt, Turkey and Venezuela, where the general political and economic context and tax systems might prove unstable in future. The political or economic instability of these countries might have a negative impact on the Group’s earnings and/or financial position. In particular, the revolution that took place in Egypt in 2011 partially interrupted production there for about 30 days. The local situation has gradually returned to normal, with full resumption of activity at the Alexandria factory and exports. In order to adopt prompt (or even preventive, when possible) measures to mitigate the possible impact stemming from changes in the local context, the Group constantly monitors the evolution of political, earnings, financial and safety risks associated with the countries where it operates.

Moreover, in situations where the production capacity of certain factories is underutilised, production can be reassigned to other Group plants.

Risks Associated with the Markets Where the Group Operates

Over the last several years, competition has increased on the markets where the Group operates, especially in Latin America, due to the entry of low-cost products from Asian countries in the lowest market segment. This phenomenon has been driven by the appreciation of local currencies.

Pirelli generates more than 30% of its sales in Central and South America. In line with its strategy, it aims to seize the opportunities to create value resulting from the growth rates expected in the premium segment of the automotive market. Pirelli’s strengths are represented by its leadership on both the replacement and original equipment market, the broad and consolidated network of single-brand retail outlets, both in Brazil and Argentina, and its established brand, which is supported in part through its association with Formula 1.

Risks Associated with Price Trends and Availability of Raw Materials

In 2012 natural rubber, synthetic rubber and petroleum based raw materials (especially chemicals and carbon black) will remain an uncertain factor in the Group’s cost structure, due to the sharp volatility witnessed over the past several months and their impact on the cost of finished products (about 43% of cost on sales).

The growth enjoyed in 2011 and a consistent price policy applied to all markets made it possible fully to recover commodity cost increases.

Considering the slowdown in advanced economies and the simultaneous robust growth of emerging economies, in 2012 Pirelli expects that commodity prices will remain substantially stable at their 2011 prices. Two factors might alter these forecasts: on the one hand, a sharp slowdown in the Chinese economy might cause oil and natural rubber prices to fall, while on the other hand, possible conflicts or tensions in the Middle East might cause a marked increase in oil prices. Possible price scenarios are simulated for the principal raw materials acquired by the Group, in relation to historic volatility and/or the best information available on the market (e.g. forward prices). On the basis of various scenarios, increases in sale prices and/ or various internal cost efficiency actions (use of alternative raw materials, reduction in product weight, process quality improvement and reduction of discard volumes) have been identified as necessary to guarantee forecast profit margins.

On the other hand, in the case of strategic raw materials – which are subject to possible scarcity – Pirelli uses several suppliers for the individual type of raw material and makes long-term agreements in order to guarantee the volumes necessary for production and stabilise purchase prices.

Financial Risk

The Group is exposed to financial risks. These are principally associated with foreign exchange rates, raising funds on the market, fluctuations in interest rates, the ability of customers to honour their obligations to the Group, and the price of financial assets held as investments. Financial risk management is an integral part of Group business management and is handled directly by headquarters in accordance with guidelines issued by the Finance Department on the basis of general risk management strategies defined by the Managerial Risk Committee.

Exchange rate risk

The varied geographical distribution of Pirelli production and commercial activities entails exposure to transaction and translation exchange rate risk.

Transaction exchange rate risk is generated by the commercial and financial transactions executed in currencies other than the functional currency due to exchange rate fluctuations between the time when the commercial or financial relationship is established and when the transaction is completed (collection or payment). The Group aims to minimise the impact of transaction exchange rate risk on the income statement. To do so, Group procedures make the operating units responsible for collecting complete information about the assets and liabilities that are subject to transaction exchange rate risk. This risk is hedged with forward contracts made with the Group Treasury.

The items subject to exchange rate risk are mainly represented by receivables and payables denominated in foreign currency.

The Group Treasury is responsible for hedging the net position for each currency. In accordance with established guidelines and restrictions, it closes all risk positions by trading derivative hedging contracts on the market, which typically take the form of forward contracts.Furthermore, as part of the annual and three-year planning process, the Group makes exchange rate forecasts by using the best information available on the market. The fluctuation in exchange rates between the time when the forecast is made and the time when the commercial or financial transaction is established represents the transaction exchange rate risk on future transactions with respect to the targets announced to the market. Group central management periodically monitors the opportunity to enter into and authorise hedges on future transactions.

Currency translation risk Pirelli owns controlling interests in companies that prepare their financial statements in currencies other than the euro, which is used to prepare the consolidated financial statements. This exposes the Group to currency translation risk, which is generated by the conversion into euro of the assets and liabilities of subsidiaries whose functional currency is not the euro. The principal exposures to currency translation risk are constantly monitored, but it is not currently deemed necessary to adopt specific policies to hedge this exposure.

Liquidity risk

The principal instruments used by the Group to manage the risk of having insufficient resources to meet its financial and commercial obligations according to agreed terms and due dates are comprised by its annual and three-year financial and cash-pooling plans. These allow complete and fair detection and measurement of incoming and outgoing cash flows. The differences between plans and actual data are constantly analysed.

The Group has implemented a centralised cash pooling system for the management of collection and payment flows in compliance with 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 and longterm resources on the capital market is also streamlined through centralised management.

Prudent management of the risk described above requires maintaining an adequate level of cash equivalents and/or highly liquid short-term financial instruments, and the availability of funds through an adequate amount of committed credit facilities and/or recourse to the capital market.

A five-year revolving credit facility for euro 1.2 billion was obtained in November 2010. Euro 360 million of that facility had been used at December 2011. In February 2011, the placement of an unrated bond issue worth a nominal euro 500 million was successfully concluded with international institutional investors on the Eurobond market (5.125% coupon and maturity February 2016). Promptly seizing the best financing opportunities to provide continuous support for business growth in the face of volatile financial markets and restricted access to credit, the Board of Directors approved the issuance of non-convertible bonds up to a maximum nominal total of euro 800 million (or the same countervalue in other currencies), which could also be placed in several tranches on international markets. These bonds may also be issued by other Group companies and secured by Pirelli & C. S.p.A. The bonds may be placed exclusively with professional investors.

Interest rate risk

Fluctuations in interest rates impact the market value of Group financial assets and liabilities and net financial expenses.

Group policy is to attempt to maintain the following ratio between fixed rate and variable rate exposures: 65% fixed and 35% variable.

The Group makes derivative contracts, typically interest rate swaps, in order to maintain this target ratio.

Price risk associated with financial assets

Group exposure to price risk is limited to the volatility of financial assets, such as listed and unlisted stocks and bonds, which represent 4.1% of total Group assets. Derivatives contracts that would limit the volatility of these assets are not normally made.

Credit risk

Credit risk represents Group exposure to contingent losses resulting from default by commercial and financial counterparties. To limit commercial counterparty default risk, the Group has implemented procedures to evaluate its customers’ potential and financial solidity, monitor expected incoming cash flows and take credit recovery action if necessary. The aim of these procedures is to define customer credit limits. Further sales are suspended when those limits are exceeded. In certain cases customers are asked to provide guarantees. These mainly consist of standby letters of credit issued by parties with excellent credit or personal standing. Less frequently, mortgage guarantees may be requested. Another tool used to manage commercial credit risk is represented by insurance policies. The Group deals only with highly rated financial counterparties for the management of temporary surplus cash or for trading in derivatives.

Pirelli does not hold public debt instruments of any European country and constantly monitors its net credit exposure to the banking system. The Group does not have significant concentrations of credit risk.

In relation to financial receivables, Pirelli renewed the loan to Prelios S.p.A. (formerly Pirelli RE) for euro 160 million in December 2011, with full repayment due in July 2017.

Risks Associated with Ordinary Processes

Environmental risks

The activities and products of the Pirelli Group are subject to numerous environmental laws that vary from country to country. In any case, these laws share a common tendency to become increasingly restrictive over time, partly in response to the growing commitment by the international community to environmental sustainability. Pirelli expects that stricter laws will be gradually introduced, regulating the various types of environmental impact that businesses might have (air pollution, waste output, soil contamination, water use, etc.). Consequently, the Pirelli Group expects that it will have to continue to invest and/or to incur costs for what might become significant amounts. Reference is made to the Sustainability Report chapter “Environmental Dimension” for details on the process of managing and controlling environmental risks described above.

Employee health and safety risks

IAs part of operating its business, the Pirelli Group bears liabilities and costs for the measures necessary to guarantee full compliance with its obligations under workplace health and safety protection laws. Specifically in Italy, the workplace health and safety law (Legislative Decree 81/08), as amended (Legislative Decree 106/09), has introduced new obligations impacting the management of activities at Pirelli sites and the systems for allocating responsibility. Failure to comply with applicable laws and regulations results in the imposition of criminal and/or civil penalties on the persons responsible and, in certain cases where health and safety laws are violated, on the firms themselves, in accordance with a European standard of objective business liability that has also been received in Italian law (Legislative Decree 231/01). Reference is made to the Sustainability Report for details on the process of managing and controlling these risks.

Product defect risk

Like all other producers of goods for sale to the public, Pirelli might be affected by product liability suits or by product recalls due to presumed defects in sold materials. Although no major events of this sort have occurred in recent years and notwithstanding insurance coverage against these risks, the Pirelli brand might be negatively impacted should they ever occur. For this reason, the tyres made by Pirelli are subjected to intensive quality tests before being released for sale, and the entire production process is subject to specific quality assurance procedures with constantly rising thresholds for safety and performance.

Litigation risks

In the course of operating its business, Pirelli might be involved in legal actions, tax litigation, commercial lawsuits or labour lawsuits. The Group takes all measures necessary to prevent and attenuate any penalties that might result from these proceedings, including the accrual of provisions for liabilities detailed in the Explanatory Notes to the Consolidated Financial Statements (note 23).

Risks associated with human resources

The Group is exposed to the loss of human resources holding key positions or possessing critical know-how. To face this risk, Pirelli has adopted compensation policies that are periodically revised according to changes in general macroeconomic conditions as well as on the basis of pay benchmarks. Moreover, long-term incentive plans and specific not-to-compete clauses (also aimed at retention) are also envisaged. Finally, specific management policies are adopted to motivate and keep talented employees.