Transition of the reporting from the former METRO GROUP to the new METRO

Due to the thematic proximity and conceptual association, we have included the following risks reported in the previous year for the former METRO GROUP in risk no. 3 “challenges in the business model”: “insufficient implementation of the strategy and strategic projects”, “non-profitable use of selling space”, “insufficient or ineffective internal controls with regard to investment and costs related to expansion and construction as well as in operational processes” and “impairment of goodwill and assets”.

The risk “geopolitical situation in Russia / Ukraine” reported in the previous year has now been included in risk no. 1 “macro-economic and political risks”.

The risks bearing relevance in their own right are the following risks reported in the previous year: “interruption of business activities” (see risk no. 2), “budget and forecast reliability” (see risk no. 6 “reliability of planning”), “insufficient development and maintenance of talent pool” (see risk no. 8 “development of employee numbers and attractiveness as an employer”) and “more stringent regulation pertaining to deferred compensation” (see risk no. 10).

Judging by the current market environment, we believe that there is only a low probability of Standard & Poor’s lowering their current METRO credit ranking (BBB–) by 2 levels to BB. We have therefore assessed the associated risks as bearing little relevance. A separate representation as in the previous year (risk “rating downgrade METRO AG”) is therefore obsolete. The relevance of the risk “infringements against antitrust law” represented in the previous year has diminished and has therefore also been omitted.

The following sections outline the risks bearing particular relevance and the essential risk control measures. In principle, all group segments are affected.

Risks related to the business environment

Macroeconomic and political risks (risk 1)

As a company with global operations, METRO depends on the political and economic situation in the countries in which it operates. The fundamental business environment can change rapidly. Changes in political leadership, civil unrest, terrorist attacks or natural disasters can jeopardise METRO’s business. For the reporting year 2016/17, the political and economic situations in Russia, Ukraine, China and Turkey were of particular relevance. The potential risks include the loss of property and real estate assets, changes in the exchange rate, trade restrictions, capital controls and regulatory restrictions. The stand-off between North Korea and the United States as well as the UK’s withdrawal from the European Union (Brexit) are further threatening the entire global economy. A continuous monitoring of the economic and political developments and a review of our strategic objectives allow us to respond to these challenges in a timely and appropriate fashion. Our international presence comes with the advantage of being able to balance the economic, legal and political risks as well as fluctuations in demand between the countries.

Interruption of business activities (risk 2)

Our business operations could, for example, be interrupted by a failure of IT systems, natural disasters, pandemics or terrorist attacks. Important business processes such as purchasing/product ordering, marketing and sales have used IT systems for many years. Systems for online retailing must be continuously available, as these systems are a prerequisite for unlimited access outside normal store hours. As a result, the continuous availability of the infrastructure is a critical factor in the development and implementation of our IT solutions. Systems that are essential for business operations in the stores, especially checkouts, are largely self-contained and can continue to be used for some time even during events such as network failures or the failure of central systems. In case of partial network failures, they can automatically reroute data or switch to redundant routes. Modern technologies such as remote server management and cloud computing allow us to use our hardware efficiently. In addition, our centralised IT systems can be quickly restored in the event of one or several servers failing. We operate several central IT centres, which enables us to compensate for major business interruptions or limit their duration to the absolute minimum. We also have a contingency plan to restore IT centres in Germany after extended outages (that is outages caused by fire, natural disasters or criminal actions). We also prepare ourselves for the risk of an interruption of our business activities by employing a comprehensive business continuity management system. A professional crisis management allows for a rapid crisis response and thereby ensures the protection of our employees and customers. This includes evacuation plans, training measures and specific instructions. We insure ourselves against the loss of tangible assets and any impending loss of revenues or profits resultant from business interruptions wherever it is possible and serves the purpose.

Specific industry sector risks

Risks related to the retail business

Challenges in the business model (risk 3)

The retail and wholesale trade in the saturated markets of Western Europe is characterised by rapid changes and fierce competition. A fundamental risk is consumers’ fluctuating propensity to consume. Changes in consumer behaviour and customer expectations pose additional risks, among others, in the face of demographic change, rising competition and increasing digitisation. A failure to adequately address our customers’ needs and price developments, or if we miss trends with regard to our assortments or appropriate sales formats and new sales channels, could potentially impede the development of our sales and income and also jeopardise our objectives in terms of growth and profitability. We address these risks by developing country-specific customer-focused Value Creation Plans. The operating partners and international working groups (federations) monitor and support the implementation and achievement of objectives. We are, for example, expanding our range of regionally traded products in all sales lines and are progressively gearing our assortments to meet our customers’ increasing demands with regard to environmental, social and health considerations. We are also expanding our sales channels by employing a multi-channel strategy to grow our delivery business and online activities. Franchise concepts are used to develop new store locations. At the same time, we are monitoring our competitors even more closely. Our various strategic projects aim at further optimising our purchasing and sales processes and to create additional value for our customers. We aim at achieving sustainable growth in our revenues and income and to ensure the recoverability of assets and thereby master the challenges faced by our business model. As a wholesale and food specialist, we want to further increase our customer focus, accelerate our growth, simplify our structures and increase the implementation speed, thereby improving our overall operational performance. Decisions on new store locations are subject to an extensive assessment. As we continually monitor the profitability of our store network, we can identify adverse developments at individual stores or retail outlets at an early stage and respond quickly. In the event our measures fail to secure success and it appears to be unlikely that the situation will change in a sustainable way, we dispose of the respective outlet. This allows us to continually optimise our store network.

Real estate risks

Deficient rental cover (risk 4)

Loss of rental income caused by insolvencies of third-party tenants and the risk of vacant and unused sales floor entail the risk of a deficient rental cover or an impairment of the underlying asset. We counter these risks with our strategic and operational real estate management and anticipatory investment planning. Our active real estate management is primarily designed to increase the value of our entire real estate portfolio and is based on continuous market monitoring, transparent profitability audits and strategic decisions. We counteract the risk of rent losses by continuously monitoring rent payments and renegotiating leases at an early stage. In addition, we drive the search for new tenants with good credit histories and the development of new usage concepts for our real estate.

Economic performance risks

Supplier and product risks

Quality risks (risk 5)

As a wholesale and retail company, METRO depends on external producers and service providers. We select our suppliers very carefully, especially for our own-brand products. We place a particularly high priority on the reliability of our own-brand suppliers with regard to product quality and compliance with safety and social standards as well as suppliers’ own compliance efforts. Defective or unsafe products, exploitation of the natural environment, inhumane working conditions or infringements against our compliance standards could potentially cause major damage to the reputation of METRO and pose a lasting threat to the company’s success. We therefore continuously audit our own-brand suppliers to assess their adherence to METRO’s stringent procurement and compliance standards. These include the food safety and quality standards recognised by the Global Food Safety Initiative (GFSI), such as the International Food Safety Standard and the GLOBALGAP certification for agricultural products. The standards help to ensure the safety of foods on all cultivation, production and sales levels. Own-brand suppliers without a recognised and valid audit certificate may qualify for preliminary inclusion in METRO’s supplier base by undergoing and passing a special assessment (METRO Assessment Solution) conducted by an accredited certification body. Violations of conditions can lead to exclusion from our supplier network or, in the case of unacceptable production methods, to a product being blacklisted. Should a quality incident occur despite these measures, the process steps for resolving interruptions and incidents described in our manual will set out the procedure to resolve the incident in the interest of our customers. We additionally evaluate potential improvements to our quality assurance systems.

We are not the only ones who have these concerns. Our customers place priority on quality and safety and are becoming increasingly interested in the environmental and social sustainability of the products sold in our stores and of the processes used to produce these products. For this purpose, METRO adopted a group-wide purchasing policy for a sustainable supply chain and procurement management that applies to all products. One of our focal points is promoting humane working conditions at our suppliers, for which we have implemented numerous measures. For example, our own-brand suppliers are required to uphold fundamental human rights and to guarantee fair working conditions. Our supplier contracts stipulate for compliance to be established in the form of an audit based on the BSCI (Business Social Compliance Initiative) standards or equivalent standards. This requirement applies to all suppliers of own-brand non-food products who manufacture end products in high-risk countries defined by the BSCI. We assist our suppliers in creating fair and humane working conditions by offering them targeted training programmes. As a signatory to the Bangladesh Accord on Fire and Building Safety, we are working to increase safety in the factories of all our suppliers producing in Bangladesh. Our effort to minimise our ecological footprint is exemplified in METRO’s membership in the Roundtable on Sustainable Palm Oil (RSPO). We have committed ourselves to only using certified sustainable palm oil in our own-brand products from 2020 onward. For products made from timber or paper, we use supplier certifications to ensure that the timber was sourced from sustainable forestry rather than illegal logging.

Financial risks

Planning reliability (risk 6)

Unexpected deviations from the budget or the forecast could potentially result in METRO missing its budget targets and making wrong business decisions.

We therefore place a high priority on measures designed to mitigate these risks. We do so by consistently implementing strategic measures that are directed at improving our income position. We support the operational units in their pro-active implementation of the strategy by providing them with value creation plans. We also mitigate risks by conducting effective internal controls, a closer interlocking of strategic planning and the budgeting process as well as a greater involvement of the supervisory bodies. The fact that our financial year differs from the calendar year allows us a high degree of planning certainty at an early stage, with the highly profitable Christmas quarter being the first quarter of our financial year. The forecast report offers insights into our expectations for the development of our business in the coming financial year.

Other risks

Strategic risks

Risks associated with the demerger (risk 7)

The demerger of METRO GROUP was concluded on 13 July 2017 with the initial listing of METRO AG shares on the stock exchange. The former METRO GROUP has split into a wholesale and food specialist (new METRO AG) and a company focused on consumer electronics and services (CECONOMY AG, formerly METRO AG). The demerger may incur additional legal risks adding to the tax risks inherent in the implementation. in particular, these risks are: Prospectus liability, meaning shareholder claims stemming from share trading with insufficient information, continuing liability for all liabilities of CECONOMY AG existing as of the effective date of the demerger/split for a period of 5 years, and liability risks stemming from legal claims by shareholders of the former METRO AG in relation to the demerger. METRO AG has given an undertaking to absorb these costs under the demerger agreement. We are preparing for any potential complaints by way of legal defence strategies. Potential claims resulting from prospectus liability are covered by a prospectus insurance policy. We are continuously monitoring the financial position of CECONOMY AG.

Human resources risks

Development of employee numbers and attractiveness as an employer (risk 8)

The expertise, dedication and motivation of our employees are crucial success factors for METRO’s success in a competitive market. One prerequisite for achieving our strategic goals are highly qualified experts and managers. It is an ongoing challenge to recruit and retain these valuable employees for the group, in particular in the face of demographic change and fierce competition for the best talent. Intracompany programmes for the continued qualification of employees and the strengthening of corporate culture are also indispensable. Variable, performance-based remuneration components based on company targets and personal goals are designed to stimulate our employees’ performance. We also conduct annual performance reviews with our employees to assess the past year and agree on future measures for professional development. Targeted training programmes, which we implement in cooperation with various partners, allow us to attract young people to start their career at METRO and to foster their development with an eye on their individual personal strengths. In Germany in particular, METRO companies place great value on in-house training and apprenticeship programmes. We ensure the success of our succession planning by offering tailor-made career and professional development plans, in particular on senior management level.

Failed collective bargaining negotiations at Real (risk 9)

The potential failure of the collective bargaining negotiations would incur a risk for our Real sales line. In the event no new collective arrangement has been agreed by March 2018, the parties to the future collective agreement have a right to terminate the negotiations. If this happens and the parties walk away from the negotiating table, the current arrangement of a temporary reduction of the holiday and Christmas allowances would cease. At the same time, the adjustment to match the regional collective agreement for the retail industry will be different than in the case of a future collective agreement. This situation and the circumstance that no new and competitive salary structure is available to newly hired employees would result in a significant increase of personnel expenses and would also manifest the existing competitive disadvantage that Real currently suffers, contrary to retailers who are not bound by a collective agreement. A group of experts, chaired by the general management of Real, developed measures and alternatives to mitigate the risk of excessive personnel expenses in the case the future collective agreement is terminated.

Legal and tax risks

More stringent regulation on subsequent benefits (risk 10)

In addition to purchase price agreements, we also enter into agreements on so-called subsequent benefits with the suppliers of merchandise for our wholesale and retail operations. These agreements are concerned with purchasing terms and conditions, such as product-specific deferred discounts, reimbursement of expenses or remuneration for services, such as advertising or other marketing-related services.

We have observed tendencies to subject agreements on subsequent benefits between buyers and suppliers to increased regulatory restrictions. This is mainly the case in the Eastern European countries, but has also been observed in other METRO countries, including in the EU. Some of these restrictions go as far as prohibiting certain contractual terms. Antitrust law is at the same time utilised to counter a presumed relative market power by introducing regulation that interferes with terms in a way that entails unilateral impediments for retailers and wholesalers.

We continuously and systematically monitor the risks stemming from increasing regulation. We address these tendencies to excessive regulation in a preventative approach by continually adjusting our contractual relationships with suppliers in the concerned jurisdictions, with the aim of ensuring any subsequent benefit arrangement complies with the applicable laws at all times. We also take care to appropriately provide for the respective limitation periods under civil law. We analyse the historical structures of supplier terms and conditions in the context of a transformation programme spanning over a number of years and modernise the terms as required. Without active management, there would be a risk that added value in the form of subsequent benefits in selected product groups and/or countries could no longer or only partially be collected as a result of changes to the regulatory framework. This would have corresponding results on the total comprehensive income.

Tax risks (risk 11)

Tax risks can primarily arise in relation to the evaluation of financial matters by the financial administration (including transfer price issues). Additional risks may result from differing interpretations of sales tax (VAT) regulations. The Corporate Group Tax department of METRO AG has established appropriate guidelines to ensure early detection and minimisation of tax risks. These risks are regularly and systematically examined. The resultant risk mitigation measures are then coordinated between all persons involved.