OPPORTUNITIES AND RISKS REPORT

As an organisation that operates throughout the world, the KSB Group is exposed to both global and regional risks. Our risk policy is designed to enable us to grow sustainably and profitably. We aim to reduce the risks associated with our business and where possible avoid them completely. At the same time our global alignment and our extensive product range offer a wealth of opportunities. This includes in particular any opportunities that arise on the basis of our research and development activities, as well as any that are linked to the quality and cost effectiveness of our products. Our competitive position for the awarding of orders is also improved by the expansion of our worldwide sales and production network. We always review opportunities to expand our global presence and are able to achieve this through start-ups on the one hand and acquisition projects on the other.

In order to manage the varied opportunities and risks professionally and efficiently, we align our actions accordingly and focus upon the respective situation when selecting the persons responsible. In doing so, Controlling, Finance and Accounting as well as Internal Audits perform important monitoring tasks. Accounting also produces the annual and consolidated financial statements.

RISK MANAGEMENT SYSTEM

KSB has implemented a Group-wide risk management system for identifying and assessing relevant risks and reporting these to Group headquarters. This process and the responsibilities of Management are documented in our Risk Management Manual. Managers are encouraged to take timely action to prevent or limit damage that may result from the occurrence of risk events. All Business Units, central corporate departments and Group companies, including Group companies that are not consolidated, are included in this risk management system. The responsible managers are required to supply their relevant key business and financial indicators each month. As well as creating quarterly forecasts on business trends, they also report recognised risks to Group headquarters twice a year. A distinction is made between high (> 70%), medium (30% to 70%) and low (< 30%) probability of occurrence for the risk areas of markets / competition, projects / products, finance / liquidity, procurement, technology / research and development as well as environment, human resources and other risks. According to their potential economic impact, we categorise risks as high, medium and low. This approach gives us the necessary transparency to identify risks in their entirety and to manage them effectively, professionally and in an economically responsible manner. Furthermore, Finance and Accounting as well as Controlling review all reported risks in terms of their relevance for the preparation of the financial statements and as such ensure a systematic link with the Group accounting process. The Board of Management and the Supervisory Board’s Audit Committee receive at least two risk reports based upon this information per financial year. These reports include all the risks that are categorised as high or medium that exceed pre-defined threshold values individually or collectively, not considering any action that has been taken. Particularly critical topics are reported on an ad-hoc basis by the managers in charge. In contrast, opportunities are not taken into account in this system, but are examined separately in consultation with Business Unit Managers and Regional Managers.

RISK MANAGEMENT SYSTEM OF THE KSB GROUP

With regard to financial risks we also make use of additional risk identification, assessment, management and communication. The central Finance department is responsible for this task which is described in further detail later in this section.

Compliance risks are dealt with by the Chief Compliance Officer, who is assigned to the Legal and Compliance staff function. The Chief Compliance Officer is supported by the members of the Compliance Committee and the Compliance Managers of the individual companies.

The Internal Audits department is integrated into the risk management system as part of our internal control system. When planning audits, it prioritises areas according to potential risks and is provided with all the necessary information. The auditors ensure that all audited units adhere to the applicable guidelines, actively participate in the risk management system, and control or avoid their risks. Information obtained by Internal Audits on both the recognised risks and the countermeasures introduced in response forms an integral part of the reporting to the Board of Management and the Audit Committee of the Supervisory Board.

Our risk management system is regularly reviewed and promptly updated where necessary, for example, in the event of relevant legal or organisational changes. It is also reviewed by our auditor as part of the audit of the annual financial statements.

INTERNAL CONTROL SYSTEM AND RISK MANAGEMENT SYSTEM WITH REGARD TO
THE GROUP ACCOUNTING PROCESS

The accounting-related internal control system (ICS) contributes towards ensuring proper financial reporting. The aim is to ensure that the consolidated financial statements and group management report comply with all relevant regulations. Key elements of the ICS are – as well as the risk management system described above – guidelines and regulations which include standard accounting policies. They must be applied to the full extent by all our Group companies. Functional separation and the principle of dual control are observed; this is ensured by the audits carried out by our Internal Audits department.

The Accounting department carries out regular analytical plausibility checks of time series analyses and actual / budget variance analyses. This enables us to identify significant changes early on, which we then examine for accounting and measurement discrepancies. The resulting findings are discussed at management level.

The responsibility for Group accounting lies with the employees in the central Accounting KSB Group department. We employ the services of qualified external reviewers for certain calculations as part of financial reporting (such as the calculation of complex pension obligations using actuarial assumptions).

Binding schedules and guidelines apply to accounting within the KSB Group and to accounting at each individual subsidiary. The accounting methods that must be applied to compile the consolidated financial statements are defined in writing in a manual that we update and revise on a continual basis. This also includes the guidelines for posting intragroup transactions. We continually analyse new accounting principles and other official announcements with regard to their relevance and impact on the consolidated financial statements. To this end we maintain regular contact with our auditors. We adapt our guidelines and manual where necessary and communicate any changes immediately to our companies. Accounting KSB Group monitors compliance with these regulations. This enables us to reduce the risk of compiling inappropriate financial statements or failing to publish them by the defined deadlines.

We automatically process the financial statement information for all Group companies using certified and tested standard consolidation software. Systematic checks are implemented to help us validate the data. Employees in Accounting KSB Group verify any warning signals that arise before using the data. The sequence of the processing steps is strictly specified through the use of the consolidation monitor within our IT system. This ensures that data we process is always accurate.

To enable a seamless and accurate accounting process, we only assign employees to this task who have the appropriate specialist know-how. These employees are trained on a regular basis to make sure that their expert knowledge remains up to date.

We have defined access authorisations for the accounting-related IT system. This protects the data against unauthorised access as well as improper usage and modification. The data is checked at many stages, helping to ensure the processing quality. Alongside regular system reviews by the auditors, these checks contribute to limiting operational risks.

OPPORTUNITIES AND RISKS CATEGORIES

The categories outlined below indicate risk areas that can have a major negative impact on our results of operations, financial position and net assets, as well as our reputation. The risks and the important opportunities for business development are listed within these categories. Economic development has the greatest level of influence, whereas all other opportunities and risks are rated as subordinate.

Markets / Competition

Our business is affected by changes in the economic and political environment. This includes uncertainties within the global economy and current economic developments such as the high level of public sector debt in the USA and certain European countries. They harbour the risk of a recession which would have a negative impact upon the demand for our products.

In the project business, we are dependent on sectors with long investment cycles. This can cause customers to delay placing orders. Because of the ongoing overcapacity on the supply side, the pressure on our products’ selling prices also continues. Asian competitors in particular are entering the global market with their products. We manage the risk of fluctuations in the economy and in demand by remaining active in several market sectors and industries with different economic cycles. Furthermore we are monitoring the development of the economic environment for our market sectors. If necessary, we adapt our capacities and implement cost-cutting measures.

If the investment climate were to improve faster than expected, boosting the economy accordingly, this would encourage demand for our products in the project business.

The success of our pumps, valves and service business in power plant engineering depends on global energy demand as well as the regulations introduced as part of energy and environmental policies in our customers’ countries. In Germany in particular the power plant market is still undergoing a transformation due to the change in energy policy initiated by the Federal Government. As we offered our products and service range on a large scale to the owners / operators of large power stations including nuclear plants, we have lost business volumes. We must compensate this through a growth in sales revenue in other countries and areas of application for pumps and valves. To the extent that this substitution involves an unexpectedly high expenditure, this can result in a considerably higher burden upon the results of operations than initially planned. Greater focus by our clients on operating reliability and low life cycle costs, as offered by our products, can open up additional business opportunities.

If energy suppliers outside of Europe decide to build new power plants earlier than anticipated, this will increase our opportunities in the project business.

Realisation of many major projects is pending in the markets of the Middle East as well as North Africa. The background to this is the continuing instability in several countries. The current lower number of new orders entails high price and delivery time pressure, to which we are adapting. We see opportunities in some countries such as Saudi Arabia, Kuwait and Oman as well as in the sub-Saharan region, where we offer our pumps and valves for infrastructure projects for water and energy supply as well as for improved waste water treatment. We are also ramping up our activities in the mining business in certain resource-rich countries. The imposition of export restrictions relating to some countries in the region can in principle put both our orders in hand and order opportunities at risk.

In growth markets such as the BRIC countries there is a risk that competitors with new production capacities will make competition tougher and delay our planned growth. If currencies weaken in countries that are of importance to us, this can have a negative effect in particular on our exports from Europe. At the same time there is an opportunity for our production facilities in countries with weak currencies to benefit from such a development and increase exports in the medium term. They could contribute increasingly towards global growth within the Group.

We will get more involved in some South American and Asian countries where economic and political stability has improved and where the need for infrastructure is high. This development makes additional markets available to our products in the medium term.

Overall, our projects aim to increase the number of potential opportunities for sustained profitable growth. However, market and technical requirements might change during the period in which we are carrying out our projects, meaning that individual opportunities must be reassessed. Therefore we do not expect all of our projects to lead to success as planned. If necessary we will adapt our goals and measures to new circumstances. Changing market conditions usually also represent further success potential.

Additionally, an improved product range increases our market opportunities. We see good business opportunities in areas including building services where we have launched new circulator pumps. Improved products also enhance our opportunities in the oil and gas industry as well as the mining sector. We aim to increase customer value and improve our market penetration across all our businesses through more efficient electrical drives.

Projects / Products

Large-scale projects with longer-term agreements are also always associated with risks. There may be cost overruns, staff shortages, technical difficulties or quality problems – including possible penalties – that reduce our margins. We therefore train our employees in project management and enable them to identify risks associated with longer-term contracts at an early stage. Our project managers are provided with appropriate management tools. Decisions are made in conjunction with clearly structured authorisation processes. We set aside suitable provisions for warranty and penalty risks. These amounted to € 43 million in the annual financial statements for 2013 compared with € 49 million in the previous year; beyond which there is no other major residual risk (net risk).

Orders including newly designed products involve both technical and financial risks. We limit technical risks to the extent that we define intermediate steps for development work and subject partial solutions to assessments. This also applies to pumps that we provide within the framework of a major contract running over a number of years for the construction of a new type of power plant in China. We minimise financial risks by using appropriate contractual clauses, and ensure that advances cover the costs incurred.

Technical developments essentially support us in opening up new attractive areas of application and improving customer value.

Acquiring companies or establishing joint ventures enables us to strengthen our product portfolio. Such steps inevitably involve risks as we have to integrate new employees, harmonise processes and add products to an existing programme. We evaluate these projects by applying appropriate analysis methods to closely weigh up the opportunities and risks.

The political demands to develop energy-saving, environmentally friendly products and the resulting demand from customers open up further opportunities for growth through new and efficient products.

By stepping up our capacities at certain locations, we are increasing our opportunities to respond quickly to the increasing demand of our customers and to provide larger quantities. There are also investment risks such as exceeding time schedules and costs or insufficient order volumes at the time of completion. To minimise these risks and safeguard our opportunities in the best possible manner, all investments run through a step-by-step approval process.

Finances / Liquidity

Acquisitions generally result in an increase in intangible assets. Adverse changes in the market environment or delayed integration of our acquisitions may affect the commercial and financial development of a new unit. This may lead to reduction of goodwill. Therefore we monitor very closely the course that the businesses of our acquired companies take (post-merger phase).

In the project business we see risks for our margins and liquidity. As well as the continued pressure on our selling prices, which is reducing our profit margins, these include unfavourable contract conditions such as reduced advances and tougher contractual penalties. We counter this risk by paying careful attention to the approval processes in the tender phase, and constantly monitoring our net financial position. In this way we are able to recognise and avoid liquidity shortages. Where necessary, we secure sufficient liquidity by agreeing corresponding credit lines early on.

Persistent recessions can aggravate the financial situation of our customers. Delayed payments and credit losses as a result of this can place a burden upon our results of operations. The same effect might occur if the foreign exchange regulations become stricter for individual countries.

Litigation and regulatory proceedings can also affect our business.

We use foreign exchange hedges to reduce risks from transactions involving different currencies. These are generally currency forwards, which we use both for transactions that have already been recognised and for future cash flows from orders still to be processed. By strengthening our production sites worldwide, we can realise natural currency hedging in currency markets that continue to be volatile.

Our global production network also offers us the opportunity to benefit from currency effects and to use this where appropriate in competition with other manufacturers.

The most important currency for the KSB Group after the euro is the US dollar. If the exchange rate deviates from our assumptions, this would have positive or negative effects upon our business volumes and our earnings.

To prevent the loss of receivables, we have established a strict credit management system and use trade credit insurance.

Procurement

Commodity prices and procurement times are subject to increasingly stronger fluctuations due to market volatility. Where we are unable to offset cost increases or pass them on to our customers, this can have a negative impact on our earnings. Shortages or delays in our supply chain for raw materials and components can also lead to the impairment of our business activities. If we do not benefit promptly from declining procurement prices, the persistent pressure on the selling price of our products can have a negative effect on our earnings.

Therefore, we are actively seeking to identify alternative and better value supply sources, especially in Asia. In this context, we want to integrate our purchasing activities more closely and continue pooling our requirements. Depending on the subsequent procurement volumes, the price benefits could be greater then initially planned. However, we also pay attention to preventing dependencies caused by focusing upon just a few suppliers, as this could constitute significantly higher risk potential.

Technology / Research and Development

It is essential to our future success that we have a product and service range that is suited to the market in terms of technology, price and delivery time. The changing needs of our customers and new standards and regulations require that we continuously develop and improve our products and services. Research and development for innovations consumes significant financial and human resources, and the resulting products cannot always be successful.

To avoid any negative impact on earnings, it is important to recognise the market-related or technical risks early on. To this end, we are constantly updating our development process, which incorporates various control levels. As sales employees are regularly included in this process, risks arising from changes in markets or applications can be taken into account in good time in the evaluation. This close integration also enables us to respond to new market trends more quickly than our competitors.

Changing technical processes offer scope for new products. This includes, for example, ways in which energy can be used more efficiently, water can be treated more effectively and natural resources can be obtained at a lower cost. Our network with technology partners, customers and suppliers as well as representatives from science and politics enables us to identify such developments at an early stage and to adapt our product range accordingly.

Environment

Our production activities in particular are subject to numerous environmental protection laws and regulations. There is a risk that losses will result from environmental damage not covered by insurance. Therefore, at all company sites officers monitor compliance with laws and regulations as well as with internal KSB rules, which in some cases exceed the prescribed environmental standards.

As part of acquisition projects, we examine existing properties for possible contamination before purchase. If we discover any contamination, we set aside provisions to pay for the necessary clean-up work.

In markets where environmental regulations are becoming more stringent, there is a risk that our products and own or purchased services may cause infringements that lead to us losing our market authorisation and which damage our reputation. A change in rules on liability in environmental protection can also increase the risks for our business success. As a member of national and international professional associations we become aware of imminent changes in environmental law early on. We also continually update the legal frameworks that are in place in our Operational Units, enabling us to ensure that our employees always abide by the applicable law. This is also monitored by external auditors as part of the management certifications.

Through our environmental management system that conforms with international standards as well as our membership in the UN Global Compact, we meet the requirements of many customers who expect their suppliers to operate in an ecological manner. Therefore our environmental protection initiatives and sustainable business practices help us to maintain and enhance our order opportunities.

Human Resources

To achieve our growth and profitability targets, we need qualified employees at all our locations, including technical specialists. Due to the demographic change in some countries, the competition for these and other highly skilled professionals is increasing, and will intensify if economic recovery sets in.

We counter this risk with demand-oriented measures, systematic human resources planning and international recruitment processes.

Changing market conditions can have a negative impact on the funded status of our pension obligations. We are currently looking at alternative models.

Other Opportunities and Risks

The manipulation and loss of electronic data can lead to serious commercial disadvantages. We minimise this risk through suitable access procedures and backup systems. By centralising the IT systems of our various operating units, we implement high security standards and thus reduce the risk of data loss or corruption.

Other potential risks that might be associated with the activities of our employees include dishonest conduct or violations of laws, which could damage the image of KSB. We counter these risks and safeguard our reputation among our customers by organising regular compliance training and through individual initiatives in critical regions.

IMPORTANT OPPORTUNITIES AND RISKS BY SEGMENT

The opportunities and risks for the Business Units Pumps, Valves and Service are most influenced by economic development. Furthermore, the uncertainty surrounding the future development of the power plant business is of great importance to the Business Unit Pumps and to a lesser degree to the Business Units Service and Valves. In many countries the question as to how the energy sector will cover the upcoming demand for power remains unanswered. Future political decisions may have a greater impact than currently assumed on the development of sales of our products for systems used in conventional or renewable energy supply. An unexpectedly high commitment of some countries to expand nuclear power plant capacities would potentially have a positive impact on our business.

We expect the risk assessment to remain more or less unchanged for economic development, which is the greatest influential factor for us. In this respect we expect initial impulses and therefore better opportunities for our project business. Furthermore the European and American national debt crises also offer opportunities and risks for all Business Units. Where there is increasing pressure from competitors, this influences the profit quality for new orders, especially in the USA and countries in Southern Europe. Our customers are also often affected by recessions and more intense competition, which can have a negative impact upon their ability to pay in individual cases.

Weaker currencies in growth countries can threaten our exports, in particular those from our European plants. At the same time, there is an opportunity for our production facilities in the countries affected to benefit from such developments and to increase their export volumes.

RISK REPORT ON THE UTILISATION OF FINANCIAL INSTRUMENTS

Central financial management in the KSB Group performs its duties within the framework of the guidelines laid down by the Board of Management. We base the nature and scope of all financial transactions exclusively on the requirements of our business. The aim is to ensure liquidity at all times and to finance our activities under optimal conditions. With respect to our export business, we hedge foreign exchange and credit risks to the greatest extent possible. We continuously improve our receivables management methods with the goal of settling our outstanding amounts by their due dates.

Cavitation testing and other test series in our research and development facilities enhance the reliability of our products and their market opportunities.

We are exposed to the following financial risks as a consequence of our business activities:

On the one hand, we are exposed to credit risk. We define credit risk as potential default or delays in the receipt of contractually agreed payments. We are also exposed to liquidity risk, which is the risk that an entity will be unable to meet its financial obligations, or will be unable to meet them in full. In addition, we are exposed to market price risk. Exchange rate or interest rate changes may adversely affect the economic position of the Group. Risks from fluctuations in the prices of financial instruments are not material for us.

We use foreign exchange hedges to reduce the risks from transactions involving different currencies. These are generally currency forwards, which we use both for transactions that have already been recognised and for future cash flows from orders still to be processed. At year end, the notional volume of currency forwards used to hedge exchange rate risks was € 211.9 million (previous year: € 196.5 million). Foreign currency items denominated in USD account for the major volume hedged by forwards. By strengthening our production sites worldwide, we can realise natural currency hedging in currency markets that continue to be volatile.

To minimise interest rate risks, we concluded interest rate swaps to hedge cash flows from underlyings amounting to € 70.7 million (previous year: € 75.1 million). Underlyings and hedge transactions share the same floating interest rates and maturities (2 to 4 years).

We limit all these risks through an appropriate risk management system, defining how these risks are addressed through guidelines and work instructions. In addition, we monitor the current risk characteristics and continuously provide the information obtained in this way to the Board of Management and the Supervisory Board in the form of standardised reports and individual analyses.

For more information on the three risk areas and the impact on the balance sheet, see the Notes, section VI. Additional Disclosures on Financial Instruments.

SUMMARY OF THE OPPORTUNITY AND RISK SITUATION

The opportunities and risks for the KSB Group are mainly derived from macroeconomic influencing factors and their effects on the global mechanical engineering markets and the competition.

Overall, we assume there will be moderate economic recovery over the next year. However, an economic slowdown in the growth markets as well as negative developments that could result from the national debt crises in Europe and America present risks. New politico-economic consolidations and uncertainties with regard to the future realignment in energy policy can be a greater burden on the project business than expected. This would have a negative effect on our business volumes as well as the planned earnings.

In this environment, the KSB Group continues to rely on its ability to match capacities and resources to the changing market conditions.

Considering all known issues and circumstances, no developments have as yet been identified that would threaten the progress of the Group and the individual companies.