The Company is exposed to several risks. They can be categorized as 1) operational risks, 2) strategic risks, 3) intangible risks and 4) financial risks. Some of the major risks in each category are described below.
There are also other risks that could have a material adverse effect on the Company’s results and financial position. Consequently, the description does not claim to be complete.
As described below, the Company has taken several mitigating actions, applied many strategies, adopted policies, and introduced control and reporting systems to reduce and mitigate these risks.
Since roughly one-third of the Company’s costs is relatively fixed, short-term earnings are highly dependent on the capacity utilization in Autoliv’s plants and therefore sales dependent.
Global light vehicle production is an indicator of the Company’s sales development, but it is the production levels for individual vehicle models that Autoliv supplies which are critical. The Company’s sales are split over several hundred contracts covering at least as many vehicle platforms or models which usually moderates the effect of changes in the vehicle demand in individual countries and regions.
It is also the Company’s strategy to reduce this risk by using a high number of temporary employees instead of permanent employees, especially in high-labor-cost countries. (Of total headcount, 13% are temporary workers). If, however, there would be a dramatic reduction in the level of production of the vehicles supplied by the Company in any of its major markets, it would take considerable time to reduce the level of permanent employees and to reduce fixed production capacity.
Pricing pressure from customers is an inherent part of the automotive components business. The extent of reductions varies from year to year, and is taking the form of reductions both reimbursements for engineering work and direct sales prices.
In response, the Company is continuously engaged in efforts to reduce cost and works to give customers added value by developing new products through its world-class engineering organization and test facilities.
The cost-reduction programs include, for instance, product redesigns, product standardization, efficiencies from global purchasing activities, improvements in productivity and shifting manufacturing to low-production-cost countries.
The Company’s various cost-reduction programs are, to a considerable extent, interrelated. This interrelationship makes it difficult to isolate the impact of any single program on costs, and management does not generally attempt to do so. Instead, management monitors key measures such as costs in relation to margins and geographical employee mix. But generally speaking, the speed by which these cost-reduction programs generate results will, to a large extent, determine the future profitability of the Company.
Since the cost of direct materials is nearly 50% of sales, changes in these component costs could have a major impact on margins. Of the direct materials costs, approximately 33% are comprised of raw materials and the remaining 67% value added by the supply chain. Given our current material use and material prices, approximately 38% of this raw materials cost is based on steel prices, 35% on oil prices (i.e. nylon, polyester and engineering plastics) and 15% on circuit boards and other electronic components. Changes in raw material prices typically feed through in six to twelve months.
The Company’s strategy is to offset price increases on cost of materials by taking an increasingly global approach and by taking actions such as consolidating volumes to fewer suppliers and moving components sources from high- to low-cost countries.
However, significant price increases of raw materials – particularly steel and petroleum- based products – began to have an effect in the second half of 2004 and are expected to have an increased impact on the Company’s cost of materials during 2005.
In addition to vehicle production, the Company’s market is driven by the safety content per vehicle, which is affected by new regulations and new crash test programs, in addition to consumer demand for new safety technologies. This has enabled the Company to increase its sales above the 2% long-term growth rate of global light vehicle production.
The most important regulation is the federal law that requires frontal airbags for both the driver and the front-seat passenger in all new vehicles sold in the U.S. Seat belt installation laws exist in all vehicle- producing countries. Many countries also have strict enforcement laws on the wearing of seat belts. The U.S., Europe and Japan all have plans to introduce new regulations for such needs as side-impact protection, rollover protection and pedestrian protection that could affect the Company’s market.
There can be no assurance, however, that changes in regulations could not adversely affect the demand for the Company’s products or, at least, result in a slower increase in the demand for them.
The five largest vehicle manufacturers account for 58% of global light vehicle production and the ten largest manufacturers for 84%. As a result of this market concentration, the Company is dependent on a relatively small number of customers with strong purchasing power. The Company’s five largest customers account for 67% of revenues and the ten largest customers account for 93% of revenues. For a list of the largest customers, see Note 19 to the Consolidated Financial Statements included herein.
Although business with every major customer is split into several contracts (usually one contract per vehicle platform), the loss of all business of a major customer could have a material adverse effect on the Company. The largest contract accounted for 6% of sales in 2004. This contract is due to expire in 2009.
In addition, a significant disruption in the industry, a significant decline in demand or pricing or a dramatic change in technology could have a material adverse effect.
The Company, at each stage of production, relies on internal or external suppliers in order to meet its delivery commitments. In some cases, the Company’s customers require that the Company’s suppliers are qualified and approved by them. In addition, the Company may be dependent, in certain instances, on a single supplier for a specific component. Consequently, there is a risk that disruptions in the supply chain could lead to the Company not being able to meet its delivery commitments and, in addition, to extra costs.
The Company’s strategy is to reduce these risks by maintaining multiple suppliers in all significant component areas, by driving standardization and by developing alternative suppliers across the world.
The Company is exposed to product liability and warranty claims in the event that our products fail to perform as expected and such failure results, or is alleged to result, in bodily injury and/or property damage. There can be no assurance that the Company will not experience any material warranty or product liability losses in the future or that the Company will not incur significant costs to defend such claims.
In addition, if any of the Company’s products are or are alleged to be defective, the Company may be required to participate in a recall involving such products. Each vehicle manufacturer has its own practices regarding product recalls and other product liability actions relating to its suppliers.
As suppliers become more integrally involved in the vehicle design process and assume more of the vehicle assembly functions, vehicle manufacturers are increasingly looking to their suppliers for contribution when faced with recalls and product liability claims.
A recall claim or a product liability claim brought against the Company in excess of the Company’s available insurance may have a material adverse effect on the Company’s business. Vehicle manufacturers are also increasingly requiring their external suppliers to guarantee or warrant their products and bear the costs of repair and replacement of such products under new vehicle warranties. A vehicle manufacturer may attempt to hold the Company responsible for some or all of the repair or replacement costs of defective products under new vehicle warranties when the product supplied did not perform as represented.
Accordingly, the future costs of warranty claims by the Company’s customers may be material. However, we believe our established reserves are adequate to cover potential warranty settlements.
The Company’s warranty reserves are based upon management’s best estimates of amounts necessary to settle future and existing claims. Management regularly evaluates the appropriateness of these reserves, and adjusts them when appropriate. However, the final amounts determined to be due related to these matters could differ materially from the Company’s recorded estimates.
The Company’s strategy is to follow a stringent procedure when developing new products and technologies (see Autoliv’s Product Development System ) and to apply a proactive "zero-defect" quality policy (see Quality Management). The Company also carries product liability and product recall insurance with limits that management believes are sufficient to cover the risks. Such insurance may not always be available, however, in appropriate amounts. A substantial recall or liability in excess of coverage levels could therefore have a material adverse effect on the Company.
The Company’s strategy is to protect its innovations with patents, and to vigorously protect and defend its patents, trademarks and know-how against infringement and unauthorized use. At present, the Company holds more than 3,200 patents covering a large number of innovations and product ideas. These patents expire on various dates during the period 2005 to 2024. The expiration of any single patent is not expected to have a material adverse effect on the Company’s financial position.
Although the Company believes that its products and technology do not infringe upon the proprietary rights of others, there can be no assurance that third parties will not assert infringement claims against the Company in the future. There can be no assurance that any patent now owned by the Company will afford protection against competitors that develop similar technology.
The Company has no pending material environmentally-related issues, and it does not incur (or expect to incur) any material costs or capital expenditures associated with maintaining facilities compliant with U.S. or non-U.S. environmental requirements. Since most of the Company’s manufacturing processes consist of assembly of components, the environmental impact from the Company’s plants is generally modest.
To reduce the environmental risk the Company has implemented an environmental management system (see Environment) and has adopted an environmental policy (see corporate website www.autoliv.com) that requires, for instance, that all plants should be ISO-14001 certified.
However, environmental requirements are complex, change and have tended to become more stringent over time. Accordingly, there can be no assurance that these requirements will not change or become more stringent in the future or that the Company at all times will be in compliance with all such requirements and regulations, despite its intention to be.
The Company is exposed to financial risks through its international operations and debt-financed activities. These financial risks are caused by variations in the Company’s cash flows resulting from changes in exchange rates and interest rate levels, as well as from refinancing and credit risks.
Below follows a description of the Company’s financial risks and its overall policy to manage them. The Board of Directors monitors compliance under the financial policy on an ongoing basis. The Company was compliant with its financial policy at December 31, 2004.
The Company defines the financial risks as currency risk, interest-rate risk, refinancing risk and credit risk. In order to reduce these risks and to take advantage of economies of scale, the Company has a central treasury function supporting operations and management. The Treasury Department handles external financial transactions and functions as the Company’s in-house bank for its subsidiaries.
Transaction exposure arises because the cost of a product originates in one currency and the product is sold in another.
The Company’s gross transaction exposure is $1,130 million annually. Part of the flow has counter-flows in the same currency pair, which reduces the net exposure to $990 million per annum.
In the three largest net exposures, Autoliv sells USD against MXN for the equivalent of $133 million, EUR against GBP for $130 million and USD against CAD for $115 million. Together these account for more than 35% of the Company’s net exposure.
Hedging these flows postpones the impact of fluctuations but it does not reduce the impact. In addition, the net exposure only relates to 16% of sales and is made up of 40 different currency pairs with exposures in excess of $1 million. Autoliv therefore does not hedge these flows.
Another effect of exchange rate fluctuations arises when the income statements of non-U.S. subsidiaries are translated into U.S. dollars. Outside the U.S., the Company’s most significant currency is the Euro. Close to 60% of the Company’s sales is denominated in Euros or other European currencies, while approximately one-fourth of net sales is denominated in U.S. dollars.
The Company estimates that a one-percent increase in the value of the U.S. dollar versus the European currencies would have decreased reported U.S. dollar net sales in 2004 by approximately $40 million or by roughly 0.6%. The reported operating income for 2004 would also have declined by 0.6% or by approximately $3 million. The fact that both sales and operating income is impacted at the same rate (i.e. 0.6%) is due to the fact that most of the Company’s production is local and most revenues and costs are matched in the same currencies.
The Company’s policy is not to hedge this type of translation exposure, since the negative effects on the Company’s financial position of this risk are small.
A translation exposure also arises when the balance sheets of non-U.S. subsidiaries are translated into U.S. dollars. The policy of the Company is to finance major subsidiaries in the country’s local currency. Consequently, changes in currency rates relating to funding have a small impact on the Company’s income.
Interest rate risk is the risk that interest rate changes will affect the Company’s borrowing costs.
Autoliv’s policy is that an increase in floating interest rates of one percent should not increase the annual net interest expense by more than $5 million in the following year and not by more than $10 million in the second year.
The Company estimates, given its debt structure at the end of 2004, that a one-percent interest rate increase would increase net interest expense in 2005 and 2006 by $1 million and $3 million, respectively.
The fixed rate debt is achieved both by issuing fixed rate notes and through interest rate swaps. The table shows the maturity and composition of the Company’s gross borrowings at the end of 2004.
| December 31, 2004 | % of total | % of fixed interest | % of floating interest | Maturity of fixed rate part |
| USD | 79 | 48 | 52 | 2 years |
| JPY | 10 | 82 | 18 | 4 years |
| EUR | 11 | 91 | 9 | 1 year |
| 100 | 65 | 35 |
Given this interest rate profile, a 1% change in interest rates on the Company’s floating rate debt would change net interest cost by approximately $1 million during the first year and by $3 million during the second year.
Refinancing risk or borrowing risk refers to the risk that it could become difficult to refinance outstanding debt.
In order to protect against this risk, the Company has a syndicated revolving credit facility with a group of banks which backs its short-term commercial paper programs. The committed facility of $850 million has a $570 million long-term portion, which matures in March 2009, and a $280 million 364-day facility, which may – but is not guaranteed – to be renewed each March.
The Company’s policy is that total net debt shall be issued as or covered by long-term facilities with an average maturity of at least three years and with a target maturity of four years.
At December 31, 2004, net debt was $599 million and total available long-term facilities were $979 million with an average life of 3.4 years.
Credit risk is the risk of a counterparty being unable to fulfill an agreed obligation. In the Company’s financial operations, this risk arises in connection with the investment of liquid assets and when entering into forward exchange agreements, swap contracts or other financial instruments.
In order to reduce credit risk, deposits and financial instruments can only be entered into with a limited number of banks up to a risk amount of $75 million per bank. In addition, deposit can be made in Swedish government short-term notes as approved by the Company’s Board.
The policy of the Company is to work with banks that have a high credit rating and that participate in the Company’s financing.
In order to manage the inherent risks and cyclicality in the Company’s business, the Company maintains a relatively conservative gearing. At the same time, it is important to have a capital structure, which is optimal for shareholders.
The Company’s policy is to always maintain net debt significantly below three times EBITDA, (Earnings before Interest, Taxes, Depreciation and Amortization) and an interest coverage ratio significantly above 2.75. At the end of 2004, these ratios were 0.8 and 14.8, respectively. The tables below reconcile these two non-GAAP measures to GAAP measures.
In addition, it is the objective of Autoliv to maintain its current long-term credit rating of BBB+ from Standard and Poor’s.
| Interest Coverage Ratio | Full Year 2004 |
| Operating income | $513.1 |
| Amortization of intangibles (incl. impairment write offs) | 21.1 |
| Operating profit per the Policy | $534.2 |
| Interest expense net 1) | $36.2 |
| Interest coverage ratio | 14.8 |
Net Debt to EBITDA Ratio |
December 31, 2004 |
| Net debt 2) | $599.2 |
| Pension liabilities | 73.6 |
| Net debt per the Policy | $672.8 |
| Income before income taxes | 484.5 |
| Plus: Interest expense net 1) | 36.2 |
| Depreciation | 277.2 |
| Amortization of intangibles (incl. impairment write offs) | 21.1 |
| EBITDA per the Policy | $819.0 |
| Net debt to EBITDA ratio | 0.8 |