Exposure to Foreign Currencies
A significant portion of EADS’ revenues is denominated in U.S. dollars, while a substantial portion of its costs is incurred in Euro, and to a lesser extent, in Pounds Sterling. Consequently, to the extent that EADS does not use financial instruments to cover its exposure resulting from this foreign currency mismatch, its profits will be affected by market changes in the exchange rate of the U.S. dollar against these currencies. EADS has therefore implemented an exchange rate strategy in order to manage and minimise such exposure. In order to secure the rates at which U.S. dollar revenues (arising primarily at Airbus and in the commercial satellite business) are converted into euro or pounds sterling, EADS manages a long-term hedging portfolio. There are complexities inherent in determining whether and when foreign exchange rate exposure of EADS will materialise, in particular given the possibility of unpredictable revenue variations arising from order cancellations and postponements. Furthermore, as a significant portion of EADS’ foreign currency exposure is hedged through contractual arrangements with third parties, EADS is exposed to the risk of non-performance by its hedging counterparties. No assurances may be given that EADS’ exchange rate hedging strategy will protect it fully from significant changes in the exchange rate of the U.S. dollar to the euro and the pound sterling and that such changes will not affect its results of operation and financial condition.
EADS’ consolidated revenues, costs, assets and liabilities denominated in currencies other than the euro are translated into the euro for the purposes of compiling its financial statements. EADS’ exchange rate hedging strategy aims to cover its cash flows, and, to a large extent, earnings before interest and taxes, pre-goodwill impairment and exceptionals (“EBIT*”). Changes in the value of these currencies relative to the euro will have an effect on the euro value of EADS’ reported revenues, costs, assets and liabilities and, to a lesser extent, EBIT*.
Currency exchange rate fluctuations in those currencies other than the U.S. dollar in which EADS incurs its principal manufacturing expenses (mainly the euro) may have the effect of distorting competition between EADS and competitors whose costs are incurred in other currencies. This is particularly true with respect to fluctuations relative to the U.S. dollar, as many of EADS’ products and those of its competitors (e.g., in the defence export market) are priced in U.S. dollars. EADS’ ability to compete with competitors may be eroded to the extent that any of EADS’ principal currencies appreciates in value against the principal currencies of such competitors.
See “EBIT* Performance by Division — Hedging Impact on EBIT*” for a discussion of EADS’ foreign currency hedging policy. See “Accounting for Hedged Foreign Exchange Transactions in the Financial Statements” for a summary of EADS’ accounting treatment of foreign currency hedging transactions.
Exposure to Sales Financing Risk
In support of sales, EADS (primarily through Airbus and ATR with respect to commercial aircraft) may agree to participate in the financing of customers. As a result, EADS has a significant portfolio of leases and other financing arrangements with airlines. The risks arising from EADS’ sales financing activities may be classified into two categories: (i) credit risk, which concerns the customer’s ability to perform its obligations under a financing arrangement, and (ii) aircraft value risk, which primarily relates to unexpected decreases in the future value of aircraft. Measures taken by EADS to mitigate these risks include optimised financing and legal structures, diversification over a number of aircraft and customers, credit analysis of financing counterparties, provisioning for the credit and asset value exposure, and transfers of exposure to third parties. No assurances may be given that these measures will protect EADS fully from defaults by its customers or significant decreases in the value of the financed aircraft in the resale market.
EADS’ sales financing arrangements expose it to aircraft value risk, because it retains collateral interests in aircraft for the purpose of securing customers’ performance of their financial obligations to EADS, and because it guarantees part of the market value of certain aircraft during limited periods after their delivery to customers. Under adverse market conditions, the market for used aircraft could become illiquid and the market value of used aircraft could significantly decrease below projected amounts. In the event of a financing customer default at a time when the market value for a used aircraft has unexpectedly decreased, EADS would be exposed to the difference between the outstanding loan amount and the market value of the aircraft, net of ancillary costs (such as maintenance and remarketing costs, etc.). Similarly, if an unexpected decrease in the market value of a given aircraft coincided with the exercise window of an asset value guarantee (“AVG”) with respect to that aircraft, EADS would be exposed to losing as much as the difference between the market value of such aircraft and the AVG amount. No assurances may be given that the provisions taken by EADS will be sufficient to cover these potential shortfalls. Through the Airbus Asset Management Department or as a result of past financing transactions, EADS is the owner of used aircraft, exposing it directly to fluctuations in the market value of these used aircraft.
Finally, EADS also has several outstanding backstop commitments to provide financing related to orders on Airbus’ and ATR’s backlog. While past experience suggests it is unlikely that all such proposed financing actually will be implemented, a deterioration in the credit markets may reduce the amount of outside financing available to customers to fund their aircraft purchases, causing them to seek to increase their utilisation of backstop commitments provided by EADS. In particular, ongoing market disruptions triggered by the U.S. “subprime” debt crisis may worsen, resulting in the elimination of several potential sources of credit for aircraft financing. To the extent that EADS’ customers look to it to fill the gap, EADS’ sales financing exposure could increase significantly depending on the agreement reached with customers. Despite the measures taken by EADS to mitigate the risks arising from sales financing activities described above, EADS will be further exposed to the risk of defaults by its customers or significant decreases in the value of the financed aircraft in the resale market, which may have a negative effect on its future results of operation and financial condition.
Counterparty Credit Risk
EADS is exposed to credit risk to the extent of non-performance by its counterparties for financial instruments, such as hedging instruments and cash investments. However, the Group has policies in place to avoid concentrations of credit risk and to ensure that credit risk is limited.
Cash transactions and derivative counterparties are contracted with a large number of financial institutions worldwide, but only if they meet certain high credit quality criteria. EADS has set up a credit limit system to actively manage and limit its credit risk exposure. This limit system assigns maximum exposure lines to counterparties of financial transactions, based at a minimum on their credit ratings as published by Standard & Poor’s, Moody’s and Fitch Ratings. The respective limits are regularly monitored and updated, but there can be no assurances that despite these limits and the diversification of counterparties, EADS will not lose the benefit of certain derivatives, or cash investments, in case of a systemic extension of market disruptions triggered by the U.S. “subprime” debt crisis.
As counterparty credit risk also arises in the context of sales financing transactions, EADS’ general policy is to provide financing to customers and through structures with an appropriate credit standing. See “Sales Financing”.
Exposure on Equity Investment Portfolio
EADS holds several equity investments for industrial or strategic reasons, the business rationale for which may vary over the life of the investment. Equity investments are either accounted for using the equity method (associated companies), if EADS has the ability to exercise significant influence, or at fair value. If fair value is not readily determinable, the investment is measured at cost.
EADS’ principal investment in associates is Dassault Aviation. The net asset value of this investment was €2.1 billion at 31st December 2007. EADS believes that its exposure to the risk of unexpected material adverse changes in the fair value of Dassault Aviation (other than business jet market cyclicality) and that of other associated companies is limited. For equity investments other than associates, which make up only a fraction of EADS’ total assets, EADS regards the risk of negative changes in fair value or impairments on these investments as non-significant.
Treasury shares held by EADS are not considered to be equity investments. Additionally, treasury shares are not regarded as being exposed to risk, as any change in value of treasury shares is recognised directly in equity only when sold to the market and never affects net income. Treasury shares are primarily held to hedge the dilution risk arising from employee stock ownership plans and the exercise by employees of stock options.
