Growth in the sporting goods industry is highly dependent on consumer spending and consumer confidence....

Growth in the sporting goods industry is highly dependent on consumer spending and consumer confidence. Abrupt economic downturns, socio--political factors such as civil unrest, nationalisation or expropriation, in particular in regions where the Group is highly represented, therefore pose a significant short-term risk to sales development. To mitigate this risk, the Group strives to balance sales across key global regions and also between developed and emerging markets. In addition, a core element of our positioning in performance sports is the utilisation of an extensive global event and partnership portfolio where demand is more predictable and less sensitive to macroeconomic influences. In 2011, we expect the global economy to grow, albeit with varying degrees of performance geographically. As a result, we assess the likelihood that adverse macroeconomic events could impact our business as likely, which is a reduction compared to the prior year. Nevertheless, we continue to regard the potential financial impact of such events as significant.

Failure to anticipate and respond to changes in consumer demand for sporting goods products is one of the most serious threats to our industry. ...

Failure to anticipate and respond to changes in consumer demand for sporting goods products is one of the most serious threats to our industry. Consumer demand changes can be sudden and unexpected, particularly in our fashion-related businesses. Because industry product procurement cycles average 12 to 18 months, the Group faces a risk of short-term revenue loss in cases where it is unable to respond quickly to such changes. Even more critical, however, is the risk of continuously overlooking a new consumer trend or failing to acknowledge its potential magnitude over a sustained period of time.
 
To mitigate this risk, identifying and responding to shifts in consumer demand as early as possible is a key responsibility of our brands and in particular of the respective Risk Owners. Therefore, we utilise extensive primary and secondary research tools as outlined in our risk and opportunity identification process.
 
As a leader in our industry, our brand strategies are focused on influencing rather than reacting to the changing consumer environment. We invest significant resources in research and development to innovate and bring fresh new technologies and designs to market.  
 
We also seek to enhance consumer demand for our brands through extensive marketing, product and brand communication programmes. And we focus on supply chain improvements to speed up creation-to-shelf timelines.
 
Given the broad spectrum of our Group’s product offering, retailer feedback and other early indicators, we view the risk from consumer demand shifts as unchanged versus the prior year. We therefore rate the likelihood of changes in consumer demand as likely, and the potential financial impact as moderate.

The adidas Group is exposed to risks from market consolidation and strategic alliances amongst competitors and/or retailers. ...

The adidas Group is exposed to risks from market consolidation and strategic alliances amongst competitors and/or retailers. This can result in a reduction of our bargaining power, or harmful competitive behaviour such as price wars. Abnormal product discounting and reduced shelf space allocation from retailers are the most common potential outcomes of these risks. Sustained promotional pressure in one of the Group’s key markets could threaten the Group’s sales and profitability development.
 
To moderate this risk, we are committed to maintaining a regionally balanced sales mix and continually adapting the Group’s distribution strategy with a particular focus on controlled space initiatives. Although the market capitalisation of many companies within the sporting goods industry increased substantially in 2010, merger and acquisition activity is forecasted to intensify in the light of good credit market conditions as well as improving corporate balance sheets and business projections. As a result, we continue to regard risks from market consolidation as having a probable likelihood of occurrence. The potential financial impact is assessed as significant.

The adidas Group is exposed to external risks such as natural disasters, epidemics, fire and accidents. ...

The adidas Group is exposed to external risks such as natural disasters, epidemics, fire and accidents. Physical damage to our own or our suppliers’ premises, production units, warehouses and stock in transit can lead to property damage and business interruption. These risks are mitigated by loss prevention measures such as working with reliable suppliers and logistics providers who guarantee high safety standards. In addition to the insurance coverage we have secured, the Group has also implemented contingency plans to minimise potential negative effects.
 
We assess the potential occurrence of hazard risks as unlikely. In connection with the adjustment of our risk methodology in 2010, however, we have changed our assessment of the potential financial impact. Should those risks materialise, we now expect hazard risks to have a major financial impact, reflecting the fundamental and devastating consequences natural disasters or terrorist acts might have on our business on a theoretical basis.

The adidas Group faces considerable risk if we are unable to uphold high levels of consumer awareness, affiliation and purchase intent for our brands. ...

The adidas Group faces considerable risk if we are unable to uphold high levels of consumer awareness, affiliation and purchase intent for our brands. In addition, if the Group’s brands are not allocating sufficient marketing resources to activate our sports assets and brand campaigns in a sustainable manner, we face the risk of fading consumer awareness and attractiveness. To mitigate these risks, we have defined clear mission statements, values and goals for all our brands. These form the foundation of our product and brand communication strategies. We also continually refine our product offering to meet shifts in consumer demand and to contemporise our offering to respond to current trends.
 
Central to all our brand initiatives is ensuring clear and consistent messaging to our targeted consumer audience. Market share gains at TaylorMade as well as adidas’ achievements at the 2010 FIFA World Cup give us confidence that brand image risks for these brands are unlikely. In addition, the successful introduction of new Reebok product initiatives such as in the toning category and ZigTech has helped to stimulate consumer interest and improve Reebok’s brand image.
 
Aggregating these factors, we believe that the risk from loss of brand image for the Group has only a possible likelihood of occurrence. Nevertheless, a considerable deterioration in brand image could have a significant financial impact on our Group.

New adidas, Reebok and Rockport own-retail stores require considerable up-front investment in furniture and fittings as well as ongoing maintenance. ...

New adidas, Reebok and Rockport own-retail stores require considerable up-front investment in furniture and fittings as well as ongoing maintenance. In addition, own-retail activities often require longer-term lease or rent commitments. Retail also employs significantly more personnel in relation to net sales than our wholesale business. The higher portion of fixed costs compared to our wholesale business implies a larger profitability impact in cases of significant sales declines.
 
The Group reduces this risk by only entering into lease contracts with durations of less than ten years. Store performance is measured by a retail scorecard consisting of nine quantitative key performance indicators. Underperforming stores are reorganised, remodelled or closed as appropriate.
 
Our increased focus on improving our sophistication as a retailer by investing in management expertise as well as in IT systems remains a key priority for 2011. Despite the projected improvement in the global macroeconomic environment in 2011, risks to consumer spending due to rising inflation are high. Therefore, we view the risk of underperformance of some of our own-retail stores as likely. The potential financial impact from own-retail underperformance, which may also involve impairment charges and store closures, is moderate.

Raw material and labour costs account for approximately 70% of the Group’s cost of sales. ...

Raw material and labour costs account for approximately 70% of the Group’s cost of sales. Prices of materials such as rubber, cotton, polyester and those which closely correlate with the oil price are especially subject to the risk of price changes. As our ordering process and price negotiations usually take place around six months in advance of production, our sourcing function has visibility and reaction time to plan for sharp increases in input costs.
 
To reduce the financial impact on our product margins from higher sourcing costs, we are implementing further lean manufacturing techniques at our partner factories, reducing time and cost in the procurement process, re-engineering our products and selectively increasing prices where possible. In addition, within our end-to-end profitability initiatives, we have implemented a dedicated team which is responsible for elaborating mitigation measures against rising input costs throughout the supply chain. In the medium term, we also have the ability to adapt our sourcing structure to take advantage of more competitive pricing in other locations.
 
As a result of the considerable turnaround in global economic activity, raw material prices have increased significantly compared to the prior year. This development is forecasted to negatively impact our sourcing costs in 2011. As we begin planning for 2012, further increases cannot be ruled out. Therefore, the risks from rising input costs have increased significantly compared to the end of 2009 and are now assessed as having a highly probable likelihood of occurrence and a major potential financial impact.

Over 95% of our product offering is sourced through independent suppliers, mainly located in Asia....

Over 95% of our product offering is sourced through independent suppliers, mainly located in Asia. To reduce the risk of business interruptions following a potential supplier default, we work with vendors who demonstrate reliability, quality, innovation and continuous improvement.
 
In addition, we have bought insurance coverage for the risk of business interruptions caused by physical damage to supplier premises.
 
Therefore, we assess supplier default risks as having a possible likelihood of occurrence and a moderate potential financial impact.

As we place initial production orders around six months in advance of delivery, the adidas Group is exposed to inventory risks relating to misjudging consumer demand at the time of production planning. ...

As we place initial production orders around six months in advance of delivery, the adidas Group is exposed to inventory risks relating to misjudging consumer demand at the time of production planning. A sudden decline in demand has the potential to cause excess inventories. This can have negative implications for our financial performance, including higher levels of clearance activity and inventory obsolescence as well as reduced liquidity due to higher operating working capital requirements.
 
On the other hand, a sudden increase in demand can lead to product shortfalls at the point of sale. In this situation, our Group faces the risk of missed sales opportunities and/or customer and consumer disappointment, which could lead to a reduction in brand loyalty and our reputation as an on-time, in-full supplier. In addition, the Group faces potential profitability impacts from costs such as air freight in efforts to speed up replenishment.
 
In order to mitigate these risks, we continuously strive to improve our forecasting and material planning processes. Our replenishment programmes are another example of how we are striving to shorten production lead times, ensuring availability of products while avoiding excess inventories. Although the expected over-proportionate growth of the Retail segment will increase the exposure towards swings in consumer demand, our demand and inventory planning accuracy for 2011 will benefit from the improved macroeconomic climate versus 2010. Therefore, the associated inventory risks have decreased slightly and are now assessed as having a possible likelihood of occurrence and a moderate potential financial impact on our Group.

Customer risks arise from our dependence on key customers who have the ability to exert bargaining power and can therefore cause considerable margin pressure or cancel orders. ...

Customer risks arise from our dependence on key customers who have the ability to exert bargaining power and can therefore cause considerable margin pressure or cancel orders. These risks exist not only due to the relative size of some of our major customers, but also as a result of our limited ability to influence how they conduct business. In addition, over recent years, several large customers have been expanding their own private brand and private label businesses, which can negatively impact our efforts to increase shelf space.
 
To limit these risks, we utilise a broad distribution strategy which includes expanding our controlled space activities. This enables us to reduce negative consequences resulting from sales shortfalls that can occur with key customers. Specifically, no single customer of our Group accounted for more than 10% of Group sales in 2010.
 
When necessary, we also restrict or limit the distribution of our products to protect brand image or product margins. By differentiating our product offer to customers, we limit the risk of increased price competition on specific products which can result in margin erosion.
 
Furthermore, with our substantial marketing efforts we are aiming at building desirable brands which resonate with the tastes of our consumers and ultimately drive high sell-through rates for our customers, thus providing less incentive for our customers to engage in private label initiatives.
 
In light of improving retailer trends, we believe the risk of a strong reduction of business with one of our biggest retailers is unlikely. Nevertheless, due to increasing customer activity with regard to private brand and private label business, we now believe that on an aggregate level customer risks have increased and have a highly probable likelihood of occurrence on a continuous basis. The potential financial impact on the Group is regarded as major.

Regulatory risks predominantly include potential losses from significant changes to trade policies. ...

Regulatory risks predominantly include potential losses from significant changes to trade policies. In particular, the adidas Group faces risks arising from sudden increases of import restrictions, as well as import tariffs and duties that could compromise the free flow of goods within the Group and from suppliers. For example, several Latin American countries have significant import duties on footwear imports from China in place, which negatively impacts our profitability in these markets.
 
To limit these risks, we proactively utilise a regionally diversified supplier base which provides some protection against unforeseen changes in regulations and also allows us to shift production to other countries at an early stage if necessary.
 
As a result of the likelihood of rising protectionist activity by governments, we continue to regard further political and regulatory actions as having a likely potential of occurrence. An unexpected significant change in the political and regulatory environment could have a significant financial impact on the Group.

Event and promotion partnerships play an important role in building brand image and product authenticity with our consumers, and this ultimately supports the generation of sales of licensed products. ...

Event and promotion partnerships play an important role in building brand image and product authenticity with our consumers, and this ultimately supports the generation of sales of licensed products. The adidas Group faces the risk of either losing key partnerships or having to accept unfavourable terms due to intensified competition for attractive contracts. To mitigate these inherent risks, we not only seek to extend our most important partnership agreements before contract expiry, but also to broaden the Group’s portfolio of premium partnerships to help our brands to expand their consumer reach and reduce our reliance on single affiliations. Two examples in 2010 were the extension of the partnership between adidas and the Mexican Football Federation and Reebok’s global alliance with Giorgio Armani to create special collections.
 
We also regularly include change-of-control clauses as well as non-cash compensation components in contracts to avoid the risk that negotiations are reduced solely to price. We expect a high level of competition for top promotion partnerships to continue in the near to medium term as smaller competitors are expected to intensify their spending in this area.
 
Given the maturity of our most important contracts, we believe the risk of losing important individual promotion contracts is only likely. We assess the potential financial impact of this risk to be moderate in the medium term.

Innovative and attractive products generate strong sales and – more importantly – create a halo effect for other products. ...

Innovative and attractive products generate strong sales and – more importantly – create a halo effect for other products. Furthermore, fulfilling highest standards in terms of product quality and safety is critical to sustainable commercial success and forms an integral part of the product design and development phase. The speed with which new product technologies and fresh designs are brought to market is decisive for maintaining competitive advantage. In 2010, all brands generated the majority of their sales with products which had been brought to market over the previous 12 to 18 months. If the adidas Group failed to maintain a pipeline of new innovative products over a sustained period of time, we would risk a significant sales decline. We focus on pursuing our innovation and design strength. To ensure we can quickly adapt to changing consumer preferences, we focus on streamlining research and development processes to speed up the time to market.
 
We continue to assess the likelihood of occurrence of risks from product design and development as possible. However, given the broad spectrum of the adidas Group’s product offering, on an aggregate level, the potential financial impact has decreased and is now regarded as minor.

Achieving the adidas Group’s goal of becoming the global leader in the sporting goods industry is highly dependent on our employees and their talents. ...

Achieving the adidas Group’s goal of becoming the global leader in the sporting goods industry is highly dependent on our employees and their talents. The loss of key personnel in strategic positions is therefore an obvious risk we face. We also face the risk of being unable to identify, recruit and retain the most talented people who best meet the specific needs of our Group. In addition, a lack of sufficient training measures might cause the dilution of critical knowledge, in particular within the product design and development area.
 
To reduce this risk, we strongly engage in developing a motivating working environment. Our goal is to make the adidas Group the “Employer of Choice” within our industry. Attractive reward and incentive schemes are designed to supplement long-term career opportunities and planning.
 
With the expansion of our own-retail activities and the increase of our employee base in emerging markets, we believe that employee turnover will slightly increase in the future. Moreover, labour markets are becoming increasingly more competitive, with the battle for the most talented employees constantly intensifying.
 
Therefore, the likelihood of occurrence of personnel risks has increased and is now assessed as likely. If they materialise, these risks could have a moderate financial impact on our Group.

Key business processes including product marketing, order management, warehouse management, invoice processing, customer support and financial reporting are all dependent on IT systems. ...

Key business processes including product marketing, order management, warehouse management, invoice processing, customer support and financial reporting are all dependent on IT systems. A significant systems outage or loss of data could result in considerable disruptions to our business. Insufficient project management could delay the execution of projects critical to the Group or make them more expensive than planned.
 
To mitigate these risks, our IT organisation proactively engages in system preventive maintenance, service continuity planning and adherence to applicable IT policies. Data security is managed by restricting user access based on job description and adhering to data protection regulations.
 
We perform multiple backups at alternating data centre locations for the Group’s core enterprise resource planning system (ERP) on a daily basis. In addition, for the ERP system, our contingency solution allows us to quickly switch to a remote site if necessary – without any loss of data. System security, controls and reliability are reviewed and tested by the Internal Audit function.
 
IT project risks are further mitigated by utilising a proven project methodology for all IT projects that includes tight cost control and regular risk reviews for all major projects. In addition to these fundamental controls, the adidas Group continued to focus on additional IT control initiatives in 2010. The IT organisation’s strategic direction and five-year plan is aligned with the adidas Group’s overall Route 2015 strategic business plan. New quality reviews for major projects have been implemented to ensure that the progress, quality and costs of those projects are regularly evaluated by members of senior management. Finally, IT-related processes and systems were key components of the Group risk and opportunity management review in 2010.
 
Based on these factors, we believe the risk of a major IT default continues to be unlikely. Such a default, however, would result in a significant potential financial impact.