9. Risk report
9.1. Risk and opportunity management system
Opportunity/risk management
Software AG's primary goal is long-term, profitable growth. Based on that, we intend to increase our enterprise value on a consistent basis. To that end, we combine established, stable business activities with an involvement in promising new market segments and regions. We strive for balance between opportunities and risks and take on risks only if the business activities associated with them have a high probability of enhancing the value of Software AG. It is always a prerequisite that the risks remain manageable and controllable.
Risk and opportunity management system throughout the Group
Through a Group-wide risk and opportunity management system, we identify possible risks at an early stage so as to correctly evaluate them and limit them to the extent possible. By continuously monitoring risks, we can constantly evaluate the presumed overall status systematically and in a timely manner and better assess the effectiveness of appropriate countermeasures. In doing so, we include operational risks as well as financial, economic and market risks. Opportunities are generally congruent to the operational and functional risk structure in all risk areas.
One of our tools for ongoing monitoring of the risk areas identified is a balanced scorecard system. The Executive Board is continously informed of current and future risks and opportunities as well as the overall risk and opportunity situation via established channels. Software AG updates and monitors the applicable specifications for preventing and reducing threats on an ongoing basis throughout the Group.
Central responsibility for Group-wide processes
Risks and opportunities throughout the world are managed and controlled at corporate headquarters for both Software AG and the individual Group companies. Corporate headquarters compiles risk and opportunity reports, initiates further development of our risk management system and elaborages risk-mitigating guidelines for the entire Group. We constantly review the functioning and reliability of the system as well as the reporting.
Software AG’s internal control system has operationalized business risks by way of internal guidelines on business policies and practices. Software AG classifies these policies by field: general, Professional Services, financial powers and financial markets. The defined policies regulate internal procedures at the global and local levels. They are designed to provide information for management and to monitor the operating business risks of the Software AG Group. In order to enhance transparency, these policies are administered and published centrally.
Another component of risk and opportunity management is the transfer of operating risks to insurance carriers. The General Services department at corporate headquarters coordinates this function globally.
Internal audit
Software AG’s internal audit is an active component of the Company's risk management system. Through a systematic and targeted approach, it ensures the effectiveness of risk management along with the evaluation and continual improvement of the internal control systems and the management and supervision processes. It is also geared to the creation of added value for Software AG by optimizing business processes.
9.2. Presentation of key individual risks
We explore key risk areas and individual risks discerned from the totality of risks identified through the risk and opportunity management system. The related opportunities are detailed in the Forecast and in the segment sections in the Management Report.
9.2.1. Environment and sector risks
Market risks
Among other things, market risks are related to the different economic developments in individual countries or regions. The technological evolution of the individual sectors of the IT industry can adversely impact the business potential of the mainframe market. Due to our increasing global expansion, Software AG is not particularly dependent on individual regional markets. Both business divisions market a technology that is used in a large number of industries, ruling out a concentration on individual industries or single customers. We have also decreased our reliance on developments in the mainframe market thanks to the strong integration business we have built. We take advantage of our technical innovations and growing range of integration products, including the integration of mainframe-based applications, to promote the satisfaction of our ETS customers and to secure our broad customer base over the long term.
The financial crisis that began in 2008 presents a particular risk for the sale of our products. Our customers’ IT budgets have been cut in conjunction with this crisis, and the effects on Software AG are not yet clear. By deploying integration and modernization products from both our product lines, our customers achieve considerable cost reductions for their IT infrastructure. The return-on-investment times are very short for our customers. Hence, these products offer a way to cope with crisis-induced cost pressures. The overwhelming majority of our customers use our software for business-critical applications that cannot be shut down in times of economic crisis. Therefore, our revenue flow is very stable, especially from maintenance services. In addition, we are continuing our geographical expansion, in particular in Brazil and Japan. Because of the opportunities found there, the Company is expecting continued moderate growth in the future as well.
9.2.2. Corporate strategy risks
Product risks
Close collaboration between our Sales force and the Research and Development team (R&D) makes it possible for the development of new products to be market-driven and also market-relevant. As is customary in the software industry, one of our greatest challenges is to optimally allocate our R&D resources. Development of the webMethods business division is particularly susceptible to being negatively affected by new competitor products. We reduce this risk by implementing our functional triangle (Sales - Marketing - R&D) and by close contact with customers in all industries and countries. Moreover, we maintain close contact with technology analysts so as to be continuously informed of new market and product developments.
As confirmed by independent analysts, we are a technology leader. In the webMethods product areas in particular, this means that we often assume a pioneer role in unknown technological territory. This carries the risk of marketing products that are not completely technologically mature, which can damage customer relationships. In order to manage this risk, during the year under review, we started our Entire Readiness of Software AG for New Technology / Release initiative to prepare the whole Software AG Group optimally for launching new products.
The Company’s Research and Development group uses open-source code in its product development to a lesser extent. In doing so, the self-developed source code absolutely must function separately from the open-source code components. In order to guarantee this, Software AG implemented R&D internal approval processes in 1998. There is a risk that these processes could fail in isolated cases and the company would not be able to impose any licensing fees for products contaminated with open-source code rights.
Risks in Professional Services
Price is often a key factor in winning projects in the area of Professional Services. This results in the risk of accepting orders at prices below cost. Furthermore the actual costs can exceed budgeted costs. A standard, automated approval process across the Group (Global Deal Desk) mitigates this risk and places emphasis on adequate risk-adjusted profit margins, and it is continuously monitored.
Rights management
Our growth strategy for the ETS business division is based in part on the possibility of extending customers’ existing licensing rights to generate new sales revenues. This option cannot be repeated arbitrarily after completed contract optimization. Through this, the risk arises that revenue growth in individual core countries could fall, especially for the ETS product line. We are reducing this risk by steadily adding to our ETS product line.
Profitable growth for the webMethods division
There is a risk associated with new customer projects in the webMethods business division being postponed and revenue deviating from budget due to the current macroeconomic business environment.
Ensuring productive acquisitions
Through selective acquisitions, we are expanding our technological product range and continuing to build up our global presence. This entails the risk that the companies acquired cannot be successfully integrated. The challenges arising from this include the integration of the product portfolio, the processes, the organization, the human resources, and the different corporate cultures. In order to successfully integrate the companies involved, we have defined safeguarding processes for the time prior to and after acquisition:
- Pre-acquisition phase: prior to a takeover, an intensive review is conducted to ascertain whether the technologies of the company in question effectively expand Software AG's product portfolio, how market access and market penetration will change, and what synergy potentials can be realized. Every acquisition is preceded by a precise analysis of the financial condition of the target company. Moreover, the question of whether its corporate culture is compatible with ours is explored.
- Post-acquisition phase: We identify potential problem areas as quickly as possible using established control mechanisms. We look at all key areas of the acquired company, including finance, legal affairs, research and development, sales, marketing and internal communication.
9.2.3. Product distribution risks
Sales risks
The complexity of our products requires a high level of experience and expertise on the part of our sales force. In addition, the advanced technology of our products necessitates the provision of a considerable amount of information when selling them.
The establishment of user groups in connection with intensive training of our sales employees and of our customers significantly facilitates the sale of these products.
Distribution partner risks
Due to the complexity of our products, undertaking sales via partnerships is a challenge. To ensure these conditions with indirect sales via partners, we are offering targeted training sessions and are focusing on select partners.
9.2.4. Financial risks
Exchange rate risks
Due to our global business activities, Software AG is exposed to exchange rate risks. Our sales organizations operate in the countries in which the sales are transacted. The sales-related expenses are in the same currency as the sales themselves. This natural hedging relationship is further strengthened in the U.S. due to the fact that components of our Research and Development and global marketing are based in the U.S. We further utilize derivative financial instruments to mitigate the effects of exchange rate fluctuations. Our hedging instruments are used to cover existing foreign currency receivables and payables and anticipated cash flows. Income generated in foreign currencies from individual Group companies is also hedged against changes in value due to exchange rate fluctuations. All exchange rate risks are monitored centrally.
Risks from financial instruments
The financial instruments open on the balance sheet date mean that a hypothetical increase in the market interest rate level by 100 basis points would raise Group net income by €0.2 million and the remaining equity ratio reserves would increase by €1.2 million. Provided that the Company did not finalize any additional hedging strategies and no negative effects were present on the balance sheet, a 10 percent decrease in the euro’s value against the U.S. dollar would cause Group net income to decrease by €3.1 million and the remaining reserves by €2.5 million.
Constantly monitoring the creditworthiness of the affected banks helps us minimize the risk of losing our business partners with whom we conclude derivative financial instruments. Liquidity and cash-flow risks concerning derivative financial instruments are eliminated by the fact that we secure existing balance sheet items or highly likely cash flows.
Other financial risks
Other financial risks include predominantly the risk of bad debt losses. No cluster risks exist due to Software AG's diversified markets and customer structure. Due to the long-range average, default risks are quite marginal as a result of the generally high level of creditworthiness on the part of our customers.
The 2008 financial crisis has had a negative effect on our customers’ creditworthiness, so we took extra precautions in fiscal year 2008 through reserves for portfolio risks. To reduce the impacts of this risk, we have optimized the approval process for customer contracts by introducing a Global Deal Desk based on our BPM software and improved monitoring processes.
To protect our cash holdings, we constantly monitor our partner banks’ creditworthiness and adjust our investment decisions accordingly.
9.2.5. Legal risks
Patent infringements
Especially in the U.S., the large number of software patents granted as well as the peculiarities of U.S. procedural law favor the bringing of patent lawsuits. This also affects Software AG. A small software company from Canada sued Software AG USA Inc., Software AG Inc., and Software AG along with seventeen other defendants, including Microsoft and IBM, in August 2007 for infringing on one of its software patents. Particulars about this case can be found in the Notes on the consolidated financial statements.
The Company has established an intellectual property rights team to counter patent law suits. This team handles our own patent applications and coordinates our defense against patent suits. Our own patents are the most effective protection against lawsuits. Software AG owns 47 patents from 22 patent families. In addition, a total of 152 registrations from 64 patent families are pending. In 2008, patents were filed for 20 (2007: 22) new inventions. These patents could contribute in the future to generating additional licensing revenues.
Other litigation
Sporadically, we are faced with legal proceedings that are distribution oriented or relate to the extent of usage rights. Generally, however, the number of legal disputes is very low.
Risks arising from U.S. export regulations
Software AG's U.S. locations are subject to U.S. export regulations. Restrictions exist against exports of the developments achieved in the U.S. to countries under U.S. embargo or to companies on the U.S. black list. United States export regulations also apply to products in which the provenance of component parts greater than a certain minimum can be traced back to development undertaken in the United States. Failure to respect these export regulations may result in sanctions from the U.S. government. Software AG, which has a customer base in 70 countries around the globe, has eliminated this risk by implementing an internal monitoring system that precludes deliveries to customers in U.S. embargo countries.
9.3. General statement on the Group's risk situation
An overall view indicates that risks in the Software AG Group are limited and manageable. No risks can be identified that are likely to jeopardize the going concern of the Company now or in the future.
