UPM annual report 2014

Risk management

Financial targets

Earnings sensitivities

Changes in sales prices The biggest factor affecting UPM’s financial results is the sales price of paper. A change in the volume delivered has less than half of the effect of the same percentage change in sales prices.

UPM’s business operations are subject to various risks which may have an adverse effect on the company. The list below is not complete but it explains some of the risks with their potential impacts and how UPM manages those risks today. 1)

At the business area level, UPM targets top relative performance in their respective markets compared with key peers. UPM has also defined long-term EBITDA margin and ROCE targets for each of its business areas. In the case of UPM Paper ENA, these long-term targets are instead defined for cash flow margin and cash flow return on capital employed. In UPM Energy, where the asset base is valued at fair value, the ROCE target is 6%. In the less capital intensive converting industry, UPM Raflatac, the ROCE target is 18%. Final- ly, in the process industry businesses UPM Biorefining, UPM Paper Asia and UPM Ply- wood, the ROCE target is 10-12%, or cash return in the case of UPM Paper ENA. With the current business portfolio, achiev- ing the business area targets simultaneously would result in a UPM Group operating profit margin of approximately 10%, and ROCE of approximately 9%. At the Group level, UPM’s financial targets are based on return on equity and gearing. The return on equity target is at least five percentage points above the yield of a 10-year risk-free investment such as the Finnish government’s euro-denominated bonds. At the end of 2014, the minimum target for return on equity, as defined above, was 5.9%. The gearing ratio is to be kept below 90%. For 2014, UPM’s return on equity excluding special items was 8.3% and gearing was 32% at the end of the year.

Changing exchange rates can also have indirect effects, such as change in relative competitiveness between currency regions.

FOREIGN CURRENCY NET CASH FLOW

EURm

EFFECT OF A 10% CHANGE IN PRICES ON OPERATING PROFIT FOR THE YEAR

810 500 160 170

USD GBP

Risk description

Impact

Management

EURm

JPY

STRATEGIC RISKS

Structural changes in paper usage result in decline in paper demand which leads to overcapacity

Continuously operating rates and weak pricing power in the industry

Ensure cost efficiency of operations Proactive product portfolio management

509

Papers in UPM Paper ENA Fine and speciality papers in UPM Paper Asia

Others, total

90

Delay in OL3 nuclear plant start-up and consequent loss of profit and cost overruns

Material cost overrun

Ensure that contractual obligations are met by both parties Arbitration proceedings have been initiated by both parties Disciplined acquisition preparation to ensure the strategic fit, right valuation and effective integration Communicate the employment and value- added creation impacts of such policies clearly Invest in new, value-adding uses of biomass Cost competitive operations Improving materials efficiency Long-term sourcing contracts and relying on alternative suppliers Ownership of forest land and long-term forest management contracts

Cost structure The company’s biggest cost items are the cost of fibre raw material and personnel expenses.

125

Label materials

40 29 18

Plywood

Sawn timber

Chemical pulp (net effect)

Cost of an acquisition proves high and/ or targets for strategic fit and integration of operations are not met

Return on investment does not meet targets

COSTS, EXCLUDING DEPRECIATION

Exchange rate risk Changes in exchange rates over a prolonged period have a marked impact on financial results. It is the company’s policy to hedge an aver- age of 50% of its estimated net currency cash flow for 12 months ahead. At the end of 2014, UPM’s estimated net currency flow for the coming 12 months was EUR 1,640 million. The US dollar represented the biggest exposure, at EUR 810 million.

%

2014 2013 10 11 31 29 9 10 11 12 14 13 15 15 10 10 100 100

Subsidies for alternative uses of wood raw material increase costs Changes to relative competitiveness of energy forms

Regulatory changes such as EU climate policy and new requirements for CO 2 emissions

Delivery of own products

Wood and fibre

Energy

Fillers, coating and chemicals

Other variable costs Personnel expenses Other fixed costs

OPERATIONAL RISKS

Availability and price of major production inputs like chemicals, fillers or roundwood

Increased cost of raw materials and potential production interruptions would lower profitability

Total

Costs totalled EUR 8.7 billion in 2014 (2013: 9.1 billion)

Execution of investment projects

Material cost overrun, return on investment does not meet targets Business planning and execution impaired, affecting long-term profitability Interruptions in critical information services cause a major interruption of UPM business

Disciplined planning, project management and follow-up processes

Achievement of the long-term return targets in 2013–2014

Ability to retain and recruit skilled personnel

Competence development Incentive schemes

ROCE % * )

ROCE %

ROCE %

CF/CE % **)

ROCE %

ROCE %

20

Availability of information systems

Technical, physical and process improvements to mitigate availability risk

16

FINANCIAL RISKS

Major trading currencies like USD move significantly against euro

Changes in currencies change profitability of exports and relative competitiveness of currency areas

Hedging net currency exposure on a continuous basis Hedging the balance sheet

12

8

Payment default or customer bankruptcy

Loss of income

Active management of credit risks and use of credit insurance

4

0

2013 2014 UPM Energy

2013 2014 UPM Biorefining

2013 2014 UPM Paper Asia

2013 2014 UPM Paper ENA

2013 2014 UPM Plywood

2013 2014 UPM Raflatac

HAZARD RISKS

Environmental risks; A leak, spill or explosion

Damage to reputation, possible sanctions Direct cost to clean up and to repair potential damages to production unit, loss of production Harm to employees and damage to reputation Damage to assets or loss of production

Maintenance, internal controls and reports Certified environmental management systems (ISO 14001, EMAS) Occupational health and safety systems Loss prevention activities and systems Emergency and business continuity procedures

Target

*) shareholdings in UPM Energy valued at fair value

**) cash flow after investments, changes in working capital and restructuring payments

Physical damage to the employees or property

Net debt and gearing EURm

ROE compared with target %

Operating profit excluding special items % of sales

Gearing %

4,500

90

12

12

3,600

72

9

9

1) A more detailed description of risks and risk management is included in the Report of the Board of Directors on page 70.

2,700

54

6

6

1,800

36

3

800

18

3

0

0

0

10

11

12

13

14

10

11

12

13

14

0

10

11

12

13

14

■ Net debt Gearing ratio Gearing limit

■ ROE excluding special items, % Minimum target

■ Operating profit excluding special items, %

CONTENTS

13

14

UPM Annual Report 2014

UPM Annual Report 2014