Arafura Resources
Annual Report 2017

Plain-text annual report

CONSOLIDATED ANNUAL REPORT 2017 Driving innovation in dairy A r l a F o o d s C o n s o l i d a t e d A n n u a l R e p o r t 2 0 1 7 As people all over the world are focusing on obtaining the most out of life, a healthy lifestyle is becoming the new normal. How we fuel ourselves and our families starts by what we find in our fridge. At Arla, we create innovative products that delight consumers and help them live a balanced and healthier life. We push the boundaries of science and technology to build a bright future for dairy, and natural food for everyone. Project management: Corporate external reporting, Arla. Copy, design and production: We Love People. Translation: TextMinded. Photos: Jens Bangsbo, Hans-Henrik Hoeg and Arla. The annual report is published in English, Danish, Swedish, German and French. Only the original English text is legally binding. The translation has been prepared for practical purposes. Financial statements of the parent company Under section 149 of the Danish Financial Statements Act, these consolidated financial statements represent an extract of Arla’s complete annual report. In order to make this report more manageable and user-friendly, we publish Group consolidated financial statements without the financial statements of the parent company, Arla Foods amba. The annual report of the parent company is an integrated part of the full annual report and available on www. arlafoods.com. Profit sharing and supplementary payment from the parent company are set out in the equity section of the consolidated financial statements. The full annual report contains the statement from the Board of Directors and the Executive Board as well as the independent auditor’s report. Content MANAGEMENT REVIEW 04 Performance at a glance 06 Message from the Chairman of the Board of Directors 08 Message from the CEO 10 Highlights 12 Financial overview 13 Business priorities 2017 Our Strategy 16 Good Growth 2020 18 Trends in the world around us 20 Responding to change 22 Business priorities 2018 Our Brands and Commercial Segments 26 Arla® 28 Lurpak® 29 Castello® 29 Puck® 30 Europe 32 34 Arla Foods Ingredients 35 Trading International Arlagården® quality programme Our Cooperative 38 Our business model 40 42 Code of conduct 43 Compliance 44 Corporate responsibility 46 Risk management 48 Our risk landscape 50 Preparing for Brexit 51 Our tax affairs Our Governance 54 Governance framework 56 Executive Management Team 58 Board of Directors 60 Management remuneration 61 Diversity and inclusion Our Financial Review 64 Market overview 66 Financial review 72 Financial outlook CONSOLIDATED FINANCIAL STATEMENTS 74 Primary financial statements 84 Statement by the Board of Directors and the Executive Board 85 Notes Endorsement 132 Independent auditor’s report 134 Glossary 135 Corporate calendar 2017 Performance at a glance 4 Milk volume BILLION KG 14.2 2015 13.9 2016 13.9 2017 Performance price EUR-CENT/KG 38.12017 38.1 33.7 30.9 2015 2016 2017 All targets are based on full-year results. • Target fully achieved • Achievement on major components • Target not achieved * ** International share is based on retail and foodservice revenue, excluding revenue from third party manufacturing, Arla Foods Ingredients and Trading activities. Based on profit allocated to owners of Arla Foods amba. MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017Revenue 10.3 BILLION EUR Profit share** 2.8% OF REVENUE Strategic branded volume driven revenue growth 3.0% 3.4% 5.2% 3.0% 2015 2016 2017 • Target 2017 1 - 3% International share* 20.2% 5 2017 2016 2015 20,2% 19,7% 18,1% • Target 2020 >20% 2017 2016 2015 2017 2016 2015 2017 2016 2015 10.3 2017 9.6 2016 10.3 2015 2.8% 2.8% 3.6% • Target 2017 EUR 10 - 10.5 billion • Target 2017 2.8 - 3.2 % Brand share 44.6% 44.6% 44.5% 42.1% • Target 2020 >45% Conversion cost 103.9 Leverage 2.6 103.9 2017 99.2 98 2016 2015 2.6 2.4 3.3 • Target 2017 <100 • Target 2017 2.8 - 3.4 MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017MESSAGE FROM THE CHAIRMAN OF THE BOARD OF DIRECTORS A significant year on a positive journey 2017 was a good year for both Arla dairy farmers and dairy products, supported by a much-needed recovery in the milk price after the tough times farmers experienced last year. Our business remains focused on adding value to our products and responding to changing market dynamics. 6 Milk prices improved throughout 2017 and Arla succeeded in closing the year with the highest milk price in three years. Fat prices outperformed protein for the first time, with butter prices rising far beyond expectations, highlighting a significant change in market demands. Although butter prices declined modestly at the end of the year, they remain at a historically high level. Milk volumes were virtually unchanged for the year, with lower levels in the first half offset by increases in the second half as farmer owners responded to the recovering milk price. Declining prices on the world market have begun as we enter 2018, meaning that Arla will need to continue its efforts to value-up products in order to secure highest possible returns to farmer owners through the milk price. Nevertheless, even if price declines persist in the months to come, we continue to expect reasonable price levels. Operating in a consumer-driven market It is crucial for us to understand that we operate in an extremely consumer-driven market, where demands on transparency are high and there is a growing interest from both consumers and customers in the origin of dairy products. They seek answers regarding how we treat our cows, what we feed them and how we operate our farms in relation to environmental issues. In this market, being a farmer-owned cooperative is an immense strength, but only if we succeed in keeping a firm connection between consumers, customers, farmer owners and our cooperative. The value of our high standards This is the reason why Arlagården® Plus was launched in 2017 as an essential tool in securing our continued growth. This quality assurance programme delivers data that enables us to provide fact-based insights about the high standards on our farms. We closed the first round of data collection in December 2017, and the participation from our farmer owners in all owner countries was promising. 75 per cent of all farmer owners delivering milk in November and December 2017 participated in the programme, thereby qualifying to receive an additional 1 EUR-cent/kg of milk. This is a result to be proud of as it demonstrates that our farmer owners understand the signs from the market and meet demands from customers and consumers. Our expectations are high for 2018, where Arlagården® Plus will continue and grow into being an important instrument in securing Arla’s position as a unique and industry-leading cooperative, adding even more value to our brands and products. Evolving our cooperative Throughout 2017, we have seen our owner strategy evolve. The Board of Representatives adopted a new governance structure, an eligibility and election procedure and an annual meeting cycle. The first elections in our new governance structure were also conducted. Two Area Forum rounds, consisting of all elected representatives in each area, increased cross-border interaction and were very positively received for all involved. In the coming year, our goal is extend this strategy even further, amending the Articles of Association and offering direct membership for all owners, respecting that as we strive for equality across borders, all should be working under the same Articles. Direct membership for all farmer owners will further strengthen our democracy as we step up our efforts to act as a truly global company. As part of this process, our elected farmer owners are taking on increasing responsibility and will continue to develop the relevant education programmes needed to further strengthen their roles going forward. Embracing the future Given the significant market volatility of recent years, it has become increasingly difficult to predict milk volume developments as well as how the market will evolve. We expect milk prices to decline during the first half of 2018. However, Arla is well equipped to react, in line with the Good Growth 2020 strategy. The market is changing and becoming ever more consumer-driven, and we must work continu- ously to ensure that our brands and products remain strong and competitive. We are doing it together, as farmer owners in cooperatives have done for centuries. ÅKE HANTOFT Chairman of the Board of Directors Performance price EUR-CENT/KG 38.1 38.1 33.7 30.9 2015 2016 2017 MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017ARLA’S MISSION To secure the highest value for our farmers’ milk while creating opportunities for their growth. 7 MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017ARLA’S VISION Creating the future of dairy to bring health and inspiration to the world, naturally. 8 MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017MESSAGE FROM THE CHIEF EXECUTIVE OFFICER Growing our brands to transform the business In 2017, the shape of our business continued to improve as we grew our brands and delivered EUR 1 billion worth of sales price increases, an achievement that could not have been possible without focused effort and commitment across Arla. However, there remain challenges to overcome. 9 It was quite a turbulent year for the European dairy industry which started with a significant raw milk shortage, a reaction to the low market prices in 2016. With milk intake remaining at a low level, there was an unprecedented fat price rally in the second quarter, creating an extremely volatile market. From an Arla perspective, 2017 showcased strong increases in market and farmer milk prices, although volatility continued across the dairy industry. For Arla, it was a year in which we focused on driving our long-term strategy, strong branded growth and a significant investment in innovation. From a business point of view, not all targets were met, especially due to the effects of Brexit on the milk price relative to competitors and increased production complexity to meet consumer demands for new and more differentiated dairy products. This approach, however, resonated with consumers who rewarded us with market share gains in nearly all our major brands and markets. Strengthening our brands An increased consumer demand for dairy products richer in fat drove fat prices to a historical high level in 2017. Combined with a growing demand for a diversified choice of dairy products, over the last year we saw a growing interest for organic and lactose-free dairy products, and those based on non-GMO feed. We held true to our heritage of producing natural products, and developed new innovations, encouraged by our strategy, Good Growth 2020. Thereby, we continue to send a clear signal to our consumers, customers, and business partners, that we are committed to creating the future of dairy by focusing our strong brands and having the confidence to innovate and adapt. Innovation and bold moves Another important milestone was the opening of our global Innovation Centre in Aarhus, Denmark, employing 150 experts from around the world. This is now the central hub for innovation in Arla and will be for many years to come. Not only developing new products, innovation is also about creating packaging and technologies to ease transport of fresh milk and dairy products across continents, and exploring new sales channels. E-commerce is growing rapidly, and we increased our focus on this area in 2017 and will continue to do so in 2018 in close cooperation with some of the biggest players in the field. Another crucial success factor is our Ingredients business, which showed significant top and bottom line growth in its specialty protein range. We made some important milk moves for the future this year, expanding our world-leading position for high-margin mozzarella with our cooperations with DMK in Germany and Mengniu in China, who will deliver approximately 35,000 tonnes and 13,000 tonnes respectively starting in 2019. These bold moves pave the way for our future, ensuring important margin gains for farmer owner milk in the future. Developments in our markets Our International business continued to develop strongly in 2017, with impressive growth seen in Sub-Saharan Africa, China and South East Asia. Europe continued to deliver solid sales growth despite volume declines and adverse currency effects. Arla is in a strong position to create joint ventures and strategic partnerships all over the world, being a truly global company with operations in 38 countries. In 2017, a great example of this was in Nigeria, where product innovation, brand and retail knowledge, local consumer understanding and execution power resulted in a reach to ten thousands of shops. This represents a role model for partnerships in Arla. Expectations for 2018 In 2018, we will continue to strengthen Arla’s business even further in line with our strategy, Good Growth 2020, having identified eight essential business priorities on which we will focus in the coming year. One of these is to further strengthen our cornerstone Arla® brand. Another is to transform our business with a group-wide focus on value creation and efficiencies, through our new transformation programme, Calcium. Calcium will allow us to reinvest back into our business, creating a stronger company that is able to invest even more in growth. There is no doubt that we will meet an even more consumer-driven market, where inclusiveness with the whole value chain and holistic responsibility will be more important for us than ever. As a farmer-owned dairy company, we must meet these demands by being even more transparent and using the tools we have in our quality assurance programme, Arlagården®, to bring consumers and customers closer to Arla. We have seen market milk prices begin to decline, but we are well-positioned to deliver in 2018. We intend to keep our strategic promise of brand growth, knowing that the forecast for 2018 is for another volatile year. We have come out of 2017 as a stronger company, and financially we have never had more room to operate and invest in the future. PEDER TUBORGH CEO MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017 Highlights By growing our brands, pursuing innovative ideas and making key investments for the future, Arla continued to improve the shape of our business in 2017. With commitment and inspiration, all segments of our business contributed new product launches and exciting initiatives as we continue to fulfil our Good Growth 2020 strategy. StarbucksTM finishes the year on a high StarbucksTM continued its double-digit growth streak, fuelled by a lot of activities in 2017. Finishing the year on a high note, distinctive Christmas packaging was released and consumers were invited to share a moment of connection over social media, reaching over 12 million people across five markets. 1 0 Cocio® bridging retail and digital Cocio® delivered strong engagement with its young millennial consumers. A shopper campaign, Shake To Win, bridged retail with the digital space through a mobile campaign site and successful engagement via Facebook and YouTube. The campaign ran across several markets, including Norway, Greece, the Netherlands and Denmark. Getting going in Ghana Arla added another market to its Sub-Saharan Africa business region, by establishing a new sales and packaging facility in Ghana. The subsidiary began selling Arla® branded products in Ghana from September 2017 in response to a growing demand for nutritious dairy products. MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017Celebrating World Milk Day World Milk Day successfully took place in 81 countries on 1st June 2017, initiated by the Food and Agriculture Organisation of the United Nations. Milk and all dairy products were celebrated by farmers, chefs, nutritionists, academics and others raising their glasses to the benefits of milk in their lives, starting at sunrise in New Zealand and ending with the sunset in Hawaii. Arla® Organic Milk launches in MENA Arla® Organic Milk hit the shelves of leading retailers across the United Arab Emirates as Arla’s ambition to win as an innovative dairy brand in this region picked up pace. The launch presents a sizeable opportunity to share our organic products with consumers that seek a stronger availability, awareness, and affordability of more natural and organic products. Grand opening of the Arla Innovation Centre Arla’s new state-of-the-art Innovation Centre officially opened in May 2017, and continues to play a pivotal role in the pursuit of our strategy by adding more value-added products to the market. Chefs, scientists, consumers and customers collaborate at the centre to redefine trends and technologies that shape worldwide dairy. 1 1 Proudly farmer-owned Our farmer-owned campaign raises consumer awareness, differentiates us from competitors and instills higher consumer trust in our products. To date we have integrated the marque on 90 per cent of all Arla® branded packaging, displayed on more than 900 different products. Creating our own Lurpak® Christmas tree Key seasons are important times of the year for the Lurpak®. We increased our ambition on Ramadan and Easter and had a significant presence at Christmas this year, with a successful media campaign spanning across markets. We also created our own Lurpak® Christmas tree in the UK that we took to high footfall shopping locations and our retail partners. 12MILLION EUR Invested in an upgrade of AKAFA site. Investing in high-quality child nutrition Arla aims to be among the world’s leading dairy companies within the high-growth child nutrition category, investing EUR 12 million in an upgrade of our AKAFA production site in Denmark, which is essential in a category where quality is the key differentiator. RAISE A GLASSWORLD MILK DAYMANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017Financial overview Financial key figures (EURm) Performance price EUR-cent/kg owner milk Income statement Revenue EBITDA EBIT Net financials Profit for the year Profit appropriation for the year Individual capital Common capital Supplementary payment Balance sheet Total assets Non-current assets Current assets Equity Non-current liabilities Current liabilities Net interest-bearing debt including pension liabilities Net working capital 1 2 Cash flows Cash flow from operating activities Cash flow from investing activities Free cash flow Cash flow from financing activities Investments in property, plant and equipment Purchase of enterprises Financial ratios Profit share EBIT margin Leverage Interest cover Equity ratio Inflow of raw milk (mkg) Inflow from owners in Denmark Inflow from owners in the UK Inflow from owners in Sweden Inflow from owners in Germany Inflow from owners in Belgium Inflow from owners in Luxembourg Inflow from owners in the Netherlands Inflow from others Total inflow of raw milk Number of owners Owners in Sweden Owners in Denmark Owners in Germany Owners in the UK Owners in Belgium Owners in Luxembourg Owners in the Netherlands Total number of owners Please refer to glossary on page 134. 2017 2016 2015 2014 2013 38.1 30.9 33.7 41.7 41.0 10,338 738 385 -64 299 38 120 127 6,422 3,551 2,871 2,369 1,554 2,499 1,913 970 386 -286 100 -155 -248 -7 2.8% 3.7% 2.6 12.9 36% 4,827 3,203 1,855 1,759 524 151 54 1,564 13,937 2,780 2,675 2,327 2,395 815 215 55 11,262 9,567 839 505 -107 356 30 193 124 6,382 3,714 2,668 2,192 1,742 2,448 2,017 831 806 -167 639 -624 -263 - 3.6% 5.3% 2.4 13.3 34% 4,728 3,210 1,909 1,758 515 144 56 1,554 13,874 2,972 2,877 2,461 2,485 852 218 57 11,922 10,262 754 400 -63 295 10,614 681 368 -30 320 31 141 113 6,736 3,903 2,833 2,148 2,084 2,504 2,497 999 669 -402 267 -274 -348 -29 2.8% 3.9% 3.3 13.2 31% 4,705 3,320 1,995 1,741 531 130 41 1,729 14,192 3,174 3,027 2,636 2,654 882 221 56 12,650 39 171 104 6,613 3,774 2,839 1,874 2,137 2,602 2,547 928 511 -416 95 -93 -429 15 3.0% 3.5% 3.7 8.2 28% 4,550 3,088 2,035 1,526 403 119 17 1,832 13,570 3,366 3,144 2,769 2,854 997 228 55 13,413 9,870 737 425 -88 300 43 131 121 6,187 3,427 2,760 1,708 2,189 2,290 2,394 906 342 -470 -128 110 -505 - 3.0% 4.3% 3.2 11.1 28% 4,508 1,254 2,016 1,332 253 111 - 3,202 12,676 3,385 3,168 2,500 2,815 529 232 - 12,629 MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017Essential business priorities for 2017 In 2017, our essential business priorities focused on delivering price increases and driving margin focus as our strategic focus shifted to driving bold brand growth to create the future of dairy and deliver the highest value to our farmer owners. As volatility persisted in the global dairy industry, we knew that there would be challenges to overcome, but a firm focus on our essential business priorities and Good Growth 2020 strategy were, and continue to be, central to our success. Deliver price increases and drive margin focus Our strategic focus to proactively manage prices in 2017 across all European and International markets and categories delivered over EUR 1 billion of sales price increases, and was driven by improved price management analytics and processes. Solid commercial and financial discipline enabled us to succeed, and thereby provide a competitive milk price to our farmer owners. Make leadership matter in the milk, yogurt and powder category Successful launches of specialty product ranges, such as Arla® Organic, Lactose-free, skyr, and Protein, in combination with strong branded growth led to advances in driving market leadership in our biggest product category MYPC. We also continued to improve our position with non-genetically modified feed across the European markets. Drive bold brand growth and bold innovation Partner for growth with leading customers We maintained focus on growing our strategic brands Arla®, Lurpak®, Castello®, and Puck® to improve the profitability of our product mix, reflected in higher market shares. Brands accounted for 44.6 per cent of sales in 2017, close to our 2020 goal of a brand share greater than 45 per cent. Our new state of the art Innovation Centre will boost the innovation pipeline to support further branded growth. In 2017, we made significant progress on our ambition to strengthen the customer centricity of our business and win with leading customers. This required special attention to growth and profitability, joint category development, and delivery service, amongst others. In 2017, we successfully launched a new organisation within Foodservice in Europe. 1 3 • • • • Control costs, drive operational efficiencies and release cash Financial leverage outperformed our long-term target range of 2.8 to 3.4 at 2.6 in 2017, illustrating our strong financial position. An increasing mix complexity of our branded portfolio impacted conversion cost in supply chain. Higher price levels challenged our working capital on inventory and receivables, countered by improvements on overdue collection. Marketing spend efficiency increased materially. Build leading market positions in International Strengthen the important German market position Our International commercial segment achieved significant growth, fueled by numerous new product launches. Across the Middle East and North Africa, Sub-Saharan Africa, the Americas, China and South-East Asia, and other markets including Russia, this was driven by strengthened relevance with consumers, increased market investments, as well as local partnerships. In the challenging German market where margins are pressured, our increased focus on brands and innovation was crucial to improve quality and profitability of our business, and strategic choices towards a new value-focused direction were made. Our commercial bets in Germany focused on managing prices, strengthening our branded positions as well as improving our operational basics. Accelerating the value journey in Arla Foods Ingredients Our Ingredients business continued to deliver growth in 2017 with its high-value added products. New investments and strong research and development efforts paved the way to transform the business with a focus on higher-value specialties. Collaboration with partners continued to be a priority to increase the supply of raw materials, supporting our growth ambitions. • • • • • Target fully achieved • Achievement on major components • Target not achieved MANAGEMENT REVIEWARLA FOODS ANNUAL REPORT 2017 Y G E T A R T S R U O As the world’s largest producer of organic dairy products, we constantly develop and produce new, high quality organic products. Arla Baby&Me® Organic is our 100% organic product line for little ones. This product range is designed to give babies a great, organic start to life. Towards Good Growth 2020 Good Growth is a name with a dual purpose. It identifies both our corporate identity and the strategy that will help us create the future of dairy towards 2020. We want to develop Arla’s role as a global food company that adds value to people’s lives through natural nutrition and responsible operations. The Good Growth 2020 strategy is our foundation to do so, proactively acting to changing supply and demand for milk, competition, the occurrence of new demographic realities and fast developing consumer trends. By excelling in eight categories, focusing on six regions and winning as one Arla, we strive to achieve global growth and create value for our farmer owners towards 2020. 1 6 Our strategy With the Good Growth 2020 strategy, Arla has a fantastic foundation in place to fulfil people’s needs and our dairy products play an important role in doing so. We have matched or own strengths in the dairy categories to the consumer demands we see globally, identifying growth opportunities on a global and regional scale in eight categories. Determining the regions in which Arla has the greatest potential to grow a long-term profitable business for our farmer owners has focused us geographically as we strengthen our global category and brand building, our innovation across borders and our commercial excellence. OUR STRATEGYARLA FOODS ANNUAL REPORT 2017Our vision Create the future of dairy to bring health and inspiration to the world, naturally. Our identity Good Growth Good Growth describes who we are and how we are creating the future of dairy. It is what we stand for as a company, defined and shaped by our actions. It guides how we develop our cooperative, products, markets and ways of working. Responsible Growth Growing by ensuring safety, taking responsibility for our impact on society and the environment, and having a long-term perspective in everything we do. Cooperative Growth Growing by being farmer-owned and cooperating with all our stakeholders for mutual benefit. Healthy Growth Growing by promoting dairy nutrition and helping people live healthier lives. Natural Growth Growing by making natural products of the highest quality. Our mission To secure the highest value for our farmers’ milk while creating opportunities for their growth. 1 7 Excel in eight categories Focus on six regions Win as ONE Arla The global dairy industry is developing at high speed and is characterised by a constant evolution of consumer habits and preferences. Analysing consumer needs and trends and matching these to our own strengths, we identified eight product categories that are the core focus for our efforts to shape the dairy market. By offering innovative products with natural ingredients, great taste and good nutrition, we are making it easier for consumers to live healthy lives. Our key categories are milk and powder; milk-based beverages; spreadable cheese; yogurt; butter and spreads; specialty cheeses; mozzarella and ingredients. The six regions represent the markets in which we believe Arla has the biggest potential to grow a long-term profitable business. Arla has a strong position in Northern Europe as the preferred dairy company for consumers, and in Middle East and North Africa where our brands are among the strongest in the food industry. Arla is continually expanding market positions in growth markets such as China, South East Asia and Sub-Saharan Africa, whilst further engaging in opportunities in the US and Nigeria. The six regions are Europe, Middle East and North Africa, Sub-Saharan Africa, China and South East Asia, USA, and Russia. Arla has grown significantly in Europe with mergers and acquisitions in Central Europe, the UK and Sweden. The past few years have been spent aligning the different companies into ONE, thereby harvesting the synergies that the mergers created. With Good Growth 2020, we will take this unity to the next level. Arla’s ambition is that all our 18,973 employees work from ONE strong common platform. We want to create ONE global Arla where we actively use each other’s different competencies and, in so doing, contribute to our success. OUR STRATEGYARLA FOODS ANNUAL REPORT 2017Trends in the world around us Arla is an international business. Key market dynamics impact the global dairy market as we move towards 2020. Analysing these is critical to our success. Shifting economic power, rapidly developing technology, population growth, environmental shifts and changing values are all drivers for an exponentially changing world. Megatrends shape the world around us, presenting both new opportunities and challenges. We have identified the trends most influential to Arla. 2 Authenticity Authenticity is a standout consumer value declared by everyone from changemakers and celebrities to supermarkets and chefs. In a world where millions share their lives on social media, there is a consumer eagerness to be ‘real’ and authentically different. Consumers are making more considered purchasing decisions, buying from ‘responsible’ brands that sell quality products with real value, and following alternative eating trends like flexitarian, vegan and vegetarian. With excellent products and strong brands, a business can be close to consumers as a key differentiator. Arla is in a unique position in this sense, being the largest organic dairy producer in the world and a leading producer of lactose-free alternative dairy products. These characteristics, along with being a farmer-owned cooperative, make our brands and products authentic. Organic and lactose-free dairy alternatives 1 Healthy living Whilst being healthy is not a new trend, aspirations for healthy living are more comprehensive today, including aspects of health, wellness and conscious living. This development has led to the creation of new dairy products as well as dairy-free alternatives. Consumers are increasingly looking for transparency in products and packaging. Rapidly changing macro trends lead to diverse consumer requirements for products, formats and packaging. Retailers increasingly seek differentiation and focus on non-genetically modified feed and animal welfare product claims, continually pushing for ways to differentiate milk in order to gain customer loyalty. Our product portfolio caters to a broad range of health needs and we continuously innovate to meet consumers’ demands and to aid a balanced lifestyle. Innovative dairy products to aid a balanced lifestyle A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 1 8 O U R S T R A T E G Y 3 Simplicity Almost 70 per cent of people are looking for ways to simplify their lives, according to Euromonitor’s Global Consumer Trends Survey. As technology is becoming so engrained in all aspects of life, consumers have a growing desire for simplicity, an antidote to consumerism, endless choice and constantly updated products and services. Freedom to choose, to see, to listen, to do and to say is crucial for today’s consumer. The trend for increased simplicity also applies to food products. As consumers look for items with limited or no artificial ingredients, Arla’s product benefits, a clean label and short ingredient lists, meet consumer demands of today. Compelling attributes of Arla products are no synthetic hormones and no preservatives features - natural products from cow to consumer. Natural products from cow to consumer 4 Connected consumers Consumers are becoming increasingly connected. Connected consumers use smartphones, computers, tablets and other devices to connect to the internet, in order to experience and interact with digital content. These digital connections disrupt and challenge the traditional structures of shopping, entertainment and socialising, amongst others, and underpin shifts in how consumers live, work and consume. The experience is becoming almost more important than the product itself. While connectivity first spread through developed markets, the growth of affordable mobile technology has enabled consumers in the developing world to come online. This is underpinning generational shifts in how they live, work, shop and play. Digitalisation is essential in all industries but also in creating the future of dairy. Connecting with farmers and consumers via virtual reality Market presence in developing markets 5 Shifting market frontiers As some areas of the globe become over-populated or otherwise reach their maximum potential, others gain prominence for their unexploited potential. By 2030, emerging and developing countries will account for almost half of global GDP and 86 per cent of the population. Rising business investment, increasing disposable incomes, better infrastructure and growing access to internet have contributed to exponential growth in areas of the world such as China, Nigeria, Ghana and Bangladesh. To ensure future growth, businesses need to adapt to changing demographic, economic and technological developments bringing new markets from frontier into the spotlight. Understanding and reacting to these critical shifts is a global differentiator. Arla’s European origin has an international appeal and our International business segment is continuing to delivering solid double digit growth rates. The trends on this and the previous page were identified by Euromonitor International, 2017. A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 1 9 O U R S T R A T E G Y Responding to change In December 2015, Arla presented a new five-year strategy, Good Growth 2020. Two years into the strategic period, we are tracking well against our initial ambitions for growth with key brands, markets and customers. However, we also believe that our strategy must constantly evolve to incorporate changing market conditions, consumer trends and base assumptions. It is our job to analyse, understand and respond to these trends and their potential impact on our strategy and financial results. Here we highlight the major trends and changed assumptions over the last two years and our corresponding responses to maximise our strategy. Consumers Customers 2 0 Change Our Response Consumers are becoming more and more conscious and selective of what they consume, which has led to, amongst others, a very strong drive for a healthy lifestyle and buzz around naturalness of products. Growing urbanisation is driving a liking for on-the-go food consumption. These developments have accelerated versus our original evaluation, and we acknowledge that flexitarian consumption with less meat and more lifestyle protein alternatives, and the demand for more milk types in the EU has grown faster than we expected. Digitalisation of the industry is progressing at an even faster than anticipated pace and on multiple levels with, for example, digital platforms and digital marketplaces. In China, our e-commerce sales grew by 11.5 per cent in 2017. Other customer developments are continuing as expected in 2017 and beyond, for example the ongoing private label pressure in the EU. It is important to adapt, together with our customers, to the growing developments in order to stay relevant to the consumers. For Arla, naturalness is at the core of our identity and heritage. We continuously innovate to fulfill consumers’ demands and to aid a balanced lifestyle. In response to changing consumer demands, we have expanded our product portfolio to cater to a broad range of health needs and consumption preferences, from high-protein to low sugar and on-the-go. Arla is also the largest organic dairy producer in the world and a leading producer of lactose-free alternative dairy products. We are also a farmer owned cooperative and uphold high animal welfare standards. These niche traits contribute to our products’ and brands’ unique characteristics and give consumers the possibility of purchasing products to either meet their dietary preferences, contribute to animal welfare or support a community of farmers. Digitalisation is essential to creating the future of dairy. Arla sells through e-commerce channels in many countries, introduced the concept of virtual reality farming on social media and engaged in an array of digital marketing initiatives, for example, live streaming how everyday people experience our products, as well as virtual reality cheese tastings. We drive the dairy category together with our customers through joint category development to ensure growth in value above volume. Our largest focus is on our brands- brand growth is key for stronger profitability and to drive less volatile earnings. At the same time, our aim is to optimise our private label positions and to be a strategic own-label partner to our customers and forge long-lasting relationships. OUR STRATEGYARLA FOODS ANNUAL REPORT 2017“We believe that the best strategies are those that are dynamic and adaptable to change. At Arla, we continuously evaluate developments and trends as they unfold in order to ensure that we are directed by the best strategy for our business.” Peder Tuborgh, CEO Owners Emerging macro EU macro The dairy industry is global, but the supply and demand for milk are increasingly geographically detached. Since the abolition of the EU quota system in 2015, farmers are able to produce unlimited quantities of milk for the first time ever, which led to an underlying assumption of increased production in the EU. As a result, we expect approximately 1.5 billion kg more milk in Arla by 2020, however, this is approximately 1 billion kg less than originally anticipated. Emerging markets other than the EU and US continue to drive firm growth and generate approximately 95 per cent of dairy growth. Meanwhile, the economic outlook in the Middle East and North Africa was affected by oil price declines. Whilst this development was considered when setting our strategy, the impact in the region has been more severe than originally anticipated. Other macro developments such as the embargo in Russia which is still present, are in line with original expectations. 2 1 The majority of our revenue is generated in Europe which makes it a very important market to us. We continue to expect a stable development in this region, however, Brexit is a destabilising factor in the EU and the severity of it remains unknown. That said, as negotiations progress and we fully take charge of the opportunity to ensure our views are heard at the highest level in the UK, the great unknown of Brexit becomes less destabilising. Ensuring that we create the most value possible for the existing milk pool is critical. In order to do so, we continue to channel our milk through the means and to the markets where the highest value can be added. The premium of the branded business is generating higher margins than other alternatives. Prices remain volatile across the dairy industry, which emphasises the need to continually improve the underlying business composition. In the long run, the branded business will win over the commodity market through stability and prices. Our branded business has grown dramatically in recent years and now represents approximately 44.6 per cent of total revenue. With a wide presence in emerging markets, International continues to drive solid double digit growth rates in 2017 and exhibits a positive growth outlook for the foreseeable future. The Middle East is a special focus area for us, being our biggest strategic growth market outside Europe and the aim is for Arla’s business in the region to double by 2020. We recently launched organic milk here under the Arla® brand, a first for consumers in this region. To sustain double-digit International growth and balance risks, we continue to broaden our distribution networks and strengthen our production footprint. To respond to the embargo in Russia for example, we managed to set up local production and limited imports of speciality cheese. As a company, we are in favour of the free movement of goods and people. We want the final trade deal between the UK and EU to be free from tariff and non-tariff barriers in milk and dairy. As the negotiations progress, we continue to deliver strong, evidence-based arguments to politicians and policy makers hand in hand with our farmer owners and peers in the dairy industry. We are also collaborating with partners in the dairy industry and the wider food and farming community to build support for our position across Europe. For Arla, this is a mission to work to protect the competitiveness of the UK dairy industry within the wider EU, as well as the global dairy market. Refer to page 50 for more on Brexit. OUR STRATEGYARLA FOODS ANNUAL REPORT 2017Essential business priorities for 2018 To achieve our long-term strategy, we need a short-term action plan. The essential business priorities are an enabler for our strategy, Good Growth 2020, as they consist of critical areas that we should prioritise in the short-term on our journey to success. In order to continuously deliver strong results for our owners, the Executive Management Team determines our Essentials each year, subject to approval by the Board of Directors. The Essentials are a set of clear and aligned business priorities, aiming to support the growth agenda and direction for the business set out in our strategy. Improve gross margins Create the future of dairy with more innovation Take efficiencies to a new level Drive strategic brand growth Drive growth in high-profit areas Win with customers Transform Germany and the UK in light of new realities Arla Foods Ingredients next A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 2 2 O U R S T R A T E G Y As volatility in the underlying commodity market continues, we will maintain a strategic focus on proactive price management. Managing a continually diversifying milk pool, we aim to implement gross margin-enhancing initiatives to optimise the balance between complexity and customer requirements, short-term price volatility, and long-term market positions. With commercial and financial discipline, we are confident that we can ensure a competitive milk price for our farmer owners. Innovation is a core lever to realise our vision to create the future of dairy, and we will take the next steps towards this by further enhancing our pipeline. Our focus is on the Arla® brand as we cater to the growing demand for lifestyle dairy products, including Arla® Lactofree and Organic. We will empower innovative digital solutions as we expand our presence across digital platforms, and plan to combine our social responsibility, brand and corporate communication programmes to enhance our identity. Continually realising efficiencies in our business allows us to reinvest significantly into areas that fuel growth, which is what our holistic transformation programme, Calcium, will help us achieve. Calcium will cover activities throughout Arla, from further improving marketing efficiency to supply chain productivity initiatives, and will be a key driver in increasing our performance price. Our ambition is to achieve a bottom line impact of EUR 30 million in 2018. In 2018, we will continue to develop and sharpen the profile of our strategic brands Arla®, Castello®, Lurpak® and Puck®, specifically, by introducing new sub-brands to our broad product portfolio. We believe that continuing to invest in our brands to increase the share of branded sales will ensure our future growth and profitability. We plan to invest in areas where we see the most growth potential, supported by exciting new marketing initiatives as we secure the identity of our global brands. In 2018, we will strategically focus on delivering branded growth in high-profit market segments, such as Bangladesh, Nigeria, China, the US and MENA. We will continue to strengthen our partnerships, for example with StarbucksTM, and continue to focus innovation on these key markets to ensure future growth. As the European food services market continues to grow, we aim to further develop this line of business in key markets. Maintaining and building on our strong customer partnerships is at the core of Arla, and in 2018 we plan to continue to do so by driving category growth through our strategic brands, as well as through own-label innovation. Customer service is also a top priority for 2018, as we aim to improve and build long-term customer relationships. Another important and rapidly growing focus area is e-commerce, where we aim to closely cooperate with some of the biggest players. The UK is an important market for us and as Brexit negotiations progress, we will continue to make our position clear and ensure that we can serve our great customer and consumer base in the UK post Brexit. Germany continues to be a challenging market, but we are committed to transforming the German business. Within supply chain, we will focus on continued development of our production footprint. An increased focus on brands and innovation will be crucial to improve product mix and profitability. For Arla Foods Ingredients, we will focus on the continued transformation of existing products to higher-value specialties through new investments and focused research and development efforts. As the demand for our specialised ingredients keeps accelerating, we will strive to grow our raw material pool to secure more whey, enabling us to serve our global customer base. We will also strengthen our customer focus and sales capabilities as the business continues to grow in 2018. A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 2 3 O U R S T R A T E G Y I L A C R E M M O C D N A S D N A R B R U O S T N E M G E S We strive to redesign the future with renewable packaging. By removing a material layer of our Arla® organic milk carton in Sweden, the carton's climate impact has been reduced by 24 per cent.  Arla's overall ambition is to reduce the climate impact of packaging by 25 per cent by 2020, compared to 2005. We are already a good way along this journey, with new innovations like these paving the way for further climate footprint reductions. The journey of our Arla® brand The Arla® brand is our most widespread global brand with over 50 sub-brands in its broad portfolio. Arla® branded products are sold in more than 80 countries, including Northern Europe, China and more recently the US and the Middle East - it ranks as the fastest growing FMCG brand in many countries. The identity of the Arla® brand is very close to our heritage, staying true to our core values of healthy, natural, responsible and being farmer-owned. We bring these values and the goodness of dairy through our products to consumers across the globe. In 2017, we identified an opportunity to sharpen and shift the Arla® brand, driven by a clear position of what our trusted brand represents, namely a close connection to our Scandinavian heritage and dairy filled with natural goodness. We will continue the journey in 2018 with more consumer facing activities and communication, building a stronger, trusted and loved brand. To enable this journey, we will move focus from many small local products to creating the future of dairy with big innovative global concepts that can travel to more markets and consumers. 2 6 The Arla® brand showed strong growth due to increased investment in innovative product ranges, such as Arla® Lactofree, skyr and other natural and high-protein products, as well as infant nutritional formula such as Arla Baby & Me®. The Arla® brand delivered a strategic volume driven revenue growth of 3.4 per cent and revenue for the brand grew by 10.1 per cent to EUR 3,026 million compared to last year, through stronger activation and roll-out of new product developments. The brand also won 21 awards in 2017 and the celebrated prize for being on the list of 'Brands Top-100 Fastest Growing brands in retail' in the Netherlands, achievements we are proud of. In 2017, we focused particularly on growing the Arla® brand position among consumers. Through winning awards from large retailers globally this year for our Arla® products, we are gaining the acknowledgement from retailers in general which is integral for our continued success. Fat free, reduced sugar, high protein. Protein contributes to growth in muscle mass They say he starts his day with Arla® skyr, 2017 OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Staying strong with Arla® Protein Supporting consumers to live an active and healthy lifestyle, in 2017, Arla® Protein extended its range through new package innovation with its on-the-go protein pouch, launched in Finland and the UK. Arla® Protein is now available in 14 markets worldwide and continues to deliver strong growth. Bringing health and naturalness through good food habits We believe that creating good food habits can make a positive impact on our lives. The choices we make when purchasing and preparing our meals have an effect on ourselves and the world around us. With the Arla® brand, we want to make eating well, simple and joyful for everyone. Our raw material milk is the best foundation on our journey, being both nutritious and natural. We continue to stay true to our natural principles and in 2017, we strengthened our health focus with the use of the Arla® brand nutrition criteria, ensuring that all Arla branded products carrying a health claim always deliver on dairy goodness, such as calcium and protein. This builds a trusted and strong position in the long-run. In addition, we joined the the EU Pledge initiative on responsible food marketing to children in 2017. Together with 21 other major international food brand owners, Arla is committed to responsible marketing to children across Europe. Building on our farmer-owned platform We are trustworthy because we are farmer-owned and we will continue to build on this platform. It gives us the right to speak about healthy and natural food, sustainability and good food habits. It is clearly understood by consumers 'that when you grow it, you know it', making it trustworthy for Arla as a farmer-owned brand to have a voice when it comes to origin, naturalness and sustainability. This goes hand in hand with increased responsi- bility and commitment linking to the importance of our quality assurance programme, Arlagården®. Our farmer owners play an important role in spreading the fact that we are farmer-owned and what this entails. For Open Farm Days, Organic Days and school visits, farmers in Denmark, Sweden, Germany and the UK invite the public to explore farm life. In 2017, we had a total of over 463,000 visitors in these core markets and educated as many as 33,000 Danish and 24,000 Swedish school children at our farms this year. Our farmer owners also welcomed hundreds of Arla employees to their farms, sharing their passion and knowledge for them to utilise and commercialise in their everyday work. Focusing on growth areas as we continue our journey Driven by our resharpened position of the Arla® brand, we will continue our journey in 2018. We identified a number of focus areas that have shown successful growth. We will be targeting our brand to these growth areas, such as Arla® Lactofree and Organic, for consumers seeking a more diverse choice of lifestyle dairy products, and fill-and-fuel for those that seek a balanced diet whilst consuming on-the-go. Arla® skyr excels in Germany With revenue growth of more than 94 per cent compared to last year, Arla® skyr is the success story in the German brand business. Arla® skyr will continue to make an important contribution in achieving Good Growth towards 2020. 2 7 Revenue 3,026 MILLION EUR Revenue development 10.1% Strategic branded volume driven revenue growth 3.4% 2016: 4.5% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Good food deserves Lurpak® Lurpak® has long been a symbol of Denmark’s dairy heritage, since 1901. Last year, Lurpak® celebrated its 115th birthday, and the high-quality standards of our butter still remain and are the foundation for the brand. Our brand mission is to make good food central to the lives of people by being the champion of good food. Lurpak® is sold in more than 75 countries, from Denmark to the UK and beyond, boasting a global fan base that spans the world. Impact of rising fat prices Market fat prices were at a historical high in 2017, being valued more than protein for the first time ever. The increase in the market price eventually translated into increases in sales prices across all core markets for high-fat dairy products such as butter. This development challenged the strategic branded revenue growth for the Lurpak® brand, which was -2.7 per cent for 2017, most notable for Arla in the UK and Denmark. 2 8 Reaching consumers with digital Everything Lurpak® says and does is designed to emotionally engage the public with the full wonder of good food. Be that its creation, enjoyment or discovery. 2017 was the year of step change for digital engagement of our Lurpak® brand. With increased media investment into prioritised channels, data-led targeting and high-quality content, the brand over-delivered compared to our 2020 engagement target, engaging 42 million consumers worldwide. Digital will continue to be a priority channel for Lurpak® going forward, as media landscapes change and we have the opportunity to reach more consumers in new ways. Exciting initiatives in 2017 In 2017, we continued to roll out our global ‘Game on Cooks’ campaign into new markets such as Greece, Australia and Sweden to create a truly global campaign. Communicating the naturalness of our products was also a success this year, with a solid increase in the naturalness perception of our brand with a strong digital, shopper and public relations activation plan in key markets. Revenue 528 MILLION EUR Revenue development 8.3% Strategic branded volume driven revenue growth -2.7% 2016: 7.7% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Indulgent sensations with Castello® not be a one-dimensional experience, so we use our experience and creativity to create cheeses to surprise your senses with every bite. Castello® achieving growth The Castello® brand achieved a solid strategic branded growth of 2.7 per cent in 2017. The brand showed especially strong growth in Australia and Greece. Castello® is a heritage and tradition of creative cheese making since 1893. Innovative new cheeses, dozens of varieties and intriguing flavours, all that tell their own unique story. Castello® cheeses are developed with a real understanding of how we perceive flavour as well as taste, so you can experience something special with every bite. Our speciality cheeses are sold all around the world under the Castello® brand. Our latest campaign “Sensations by Castello®” Castello® cheeses each bring to the consumer a unique and indulgent sensation. Be it the intensity of Castello® yellow cheese, the creaminess of the whites or the sharpness of the blues, each cheese delivers an everyday indulgent sensation. Castello® cheeses are developed with a real understanding of how we perceive flavour as well as taste, so our consumers can experience something special with every bite. We believe that eating should Revenue 181 MILLION EUR Revenue development 3.1% Strategic branded volume driven revenue growth 2.7% 2016: 3.0% 2 9 Celebrating the everyday chef with Puck® Puck® is MENA’s leading brand and is reaping the benefits of its transformation, a journey that started two and a half years ago. A new brand positioning based on strong consumer insights, upgraded packaging graphics for the entire portfolio and a fresh new look and feel across all communication platforms are just some of the things that Puck® underwent. Its trusted and natural product range includes mozzarella, labneh, and several cream cheeses. Continuing Puck's® growth streak The Puck® brand achieved solid results in 2017. As MENA’s leading brand, Puck® continued to perform strongly with a strategic branded growth of 4.4 per cent in 2017. Puck® also reached the number one market share this year in Saudi Arabia, an especially solid achievement given the turbulent macroeconomic environment in MENA in 2017. MENA Effies 2017 award winners Ending 2017 strongly, Puck® celebrated the success of its Ramadan Lend #AHelpingHand campaign. The effectiveness of this campaign was recognised at the prestigious MENA Effies of 2017, where it won two silver awards and a bronze. Revenue 339 MILLION EUR Revenue development 6.8% Strategic branded volume driven revenue growth 4.4% 2016: 10.6% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Europe The Europe zone, representing 63 per cent of total revenue, continued its Good Growth journey in 2017. It grew its branded milk and yogurt business against a backdrop of volume declines and adverse currency effects. The zone delivered significant sales price increases, which contributed to an increase in revenue of 3.9 per cent, also reflecting the rising fat price market. Despite these volatile and challenging conditions, we maintained our brand position in Europe and even saw the Arla brand grow and take market share in the UK, Netherlands and Germany. Cross-Europe big bets contributed significantly to growth, with Arla® skyr and Protein continuing their successful growth across Europe and our Lactofree and organic product lines delivering sustained growth. We followed consumers into new channels like e-commerce, working with existing customers and online retailers like Amazon in the UK and Germany. The European food services market continued to grow. This year we stepped up our food services businesses and established Arla Pro which delivered strong growth, mainly driven in the Netherlands, Finland and the UK. 3 0 UK Arla® was the fastest growing brand among large manufacturers in the UK and our Arla® BoB (Best of Both) white milk was voted product of the year. Our farmer-owned model was key to winning a significant contract to supply liquid milk to Morrisons. The weak GBP, a consequence of Brexit, challenged the business’ profitability. However, we continue to develop robust plans to deal with the eventual outcome of the Brexit negotiations. Refer to page 50 for more detail. Revenue split by country Germany The German business continued to mature as we executed our strategy and lifted profitability. It was a challenging year, especially regarding price evolution, but we saw significant growth in the Arla® and StarbucksTM brands in retail. Arla® skyr won several awards and our strong position in organic fresh milk with the Arla® Bio brand was reinforced. Denmark Our Danish business continued to develop positively despite a challenging domestic dairy market. The business delivered innovations such as launching white milk based on non-GMO feed and new Arla Baby and Me® products. We also had record positive reputation scores that reflect the high level of consumer trust in Arla. 34% 21% 15% 2016: 35% 2016: 19% 2016: 15% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017“We ended the year stronger as a zone and leveraged our scale, allowing us to roll out innovations quickly. We lifted revenue across the board through significant sales price increases, whilst maintaining our brand positions and growing our market share with the Arla® brand. A weakened GBP put pressure on our business and rising market prices for fat slowed growth in branded fat products.” Peter Giørtz-Carlsen, Executive Vice President Revenue, MILLION EUR 6,568 2016: 6,321 Strategic branded volume driven revenue growth -0.1% 2016: 3.2% Brand share 48.3% 2016: 47.6% Revenue development 3.9% 2016: -6.9% Sweden Arla’s reputation continued to improve throughout the year, which contributed to the long-term health of our brands. Sweden was a key market for our Arla® Lactrofree products, which tapped into a growing consumer trend for lifestyle dairy products. Netherlands and Belgium Our market share in fresh dairy reached the highest level ever and is now running above 10 per cent. Our growth was achieved with a leading position in organic, innovations such as Arla® skyr, Protein and Lactofree and close cooperation with our customers. Our focus in Belgium was to build the business to deliver at a similar pace as the Netherlands. Finland Despite a long-term trend of decreasing dairy consumption, the key focus brands, Arla® Luonto+ in yoghurt and Lempi in cooking, kept growing. In yellow cheeses, both Arla® family cheeses gained market share and the Castello® launch into the category exceeded expectations. 3 1 21% 4% 5% 2016: 22% 2016: 4% 2016: 5% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017International The International zone, which comprises 16 per cent of total revenue, continued its journey of delivering profitable growth in 2017. We achieved double digit growth with our strategic and local brands. We continued to seek new opportunities and in 2017 we expanded into new markets in the Sub Saharan Africa, North Africa and South East Asia regions. The zone was challenged by volatile global market conditions, but we successfully executed our growth strategy and delivered on our big bets. 3 2 Sub-Saharan Africa Our business in Sub-Saharan Africa continued to grow. We navigated a challenging currency environment in Nigeria, our main market, in the first half of the year and the business almost doubled its revenue in 2017. The increase in revenue was driven by the growth of the Arla® Dano Milk Powder brand. We also strengthened our footprint across the region, opening operations in Ghana and increasing our capacity in Lagos. And we invested in our next generation product portfolio for the West Africa region. Middle East and North Africa Our strategic agenda in the Middle East and North Africa progressed well in 2017, despite low economic growth and political uncertainty affecting the region. Revenue grew and we continued to develop new opportunities, including launching the Arla® Organic Brand in the UAE and locally produced cheese in Egypt. We strengthened our branded positions on Puck® and Lurpak® in the region throughout 2017. Our focus on growth, particularly in high-margin product ranges through innovation, gave us a great foundation to build on going forward. Americas 2017 was a big year for Arla in the US. We entered the market by positioning Arla as a challenger in the cheese category, leveraging our brand proposition and high-quality natural products. Our products are performing strongly and we created great brand awareness with our marketing investment. Alongside this, Canada drove strong profit growth. We also divested our shares in Vigor in Brazil, and continued to develop our cooperation with Dairy Farmers of America as part of our strategy to grow in the US. Revenue split by region 9% 34% 20% 2016: 6% 2016: 36% 2016: 24% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017“We had strong performance this year, building on the gains we made last year. We achieved a solid strategic volume driven revenue growth, grew our branded market share in key markets and delivered strong price management which drove profitability in a year of volatile market conditions. Investments in markets such as Africa and China are paying off and give us a strong foundation to deliver in 2018 and beyond.” Tim Ørting Jørgensen, Executive Vice President Revenue, MILLION EUR 1,616 2016: 1,428 Strategic branded volume-driven revenue growth 10.5% 2016: 10.7% Brand share 83.9% 2016: 81.4% Revenue development 13.2% 2016: 5.9% Russia and others There was a strong turnaround in our Russian business which delivered profitable growth despite the ongoing embargo. We continued to drive branded positions and saw very strong growth of Lurpak® in distributor sales markets, Australia and Greece. Castello® showed good growth in Australia and Norway. Our milk-based beverages business, under the brands of Arla® Protein and Starbucks, grew significantly in Spain and Greece in retail and convenience channels. Our foodservice business continued to develop and we will continue this journey next year under the Arla® Pro brand. China We almost doubled our revenue in China during 2017 and the business improved its profitability. Our partnership with Mengniu is progressing well. We continued to strengthen our branded position, particularly with Infant Milk Formula and organic products, but saw imported UHT move towards European price levels. Our reorganisation of the Asia business into two separate regions, China and South East Asia, will go live in January 2018. 3 3 South East Asia Bangladesh continued to grow through the Arla® Dano brand and our businesses in Singapore, Japan and Korea delivered profitable growth. We continued to expand our footprint in the region, including signing a partnership agreement with Indofood, one of the leading FMCG companies and dairy players in Indonesia. This gives us a significant platform to grow in this market. 23% 6% 8% 2016: 22% 2016: 4% 2016: 7% OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Arla Foods Ingredients Arla Foods Ingredients (AFI) is a 100 per cent owned subsidiary of Arla and a global leader in whey-based ingredients used in a wide range of categories from bakery, beverages, dairy and ice cream to clinical, infant and sports nutrition. AFI contributes 6 per cent of total revenue. The products, which are produced in Denmark or by one of AFI’s three joint ventures in Argentina and Germany, are sold in more than 90 countries. “Through a strong innovation agenda, we continuously push the boundaries of what technology can bring to whey. In 2017, we addressed future demands for quality and food safety in collaboration with our customers, and invested heavily in our child nutrition business.” Henrik Andersen, Group Vice President 2017 was another successful year for AFI, delivering 19.6 per cent revenue growth compared to last year, largely driven by a strategic focus on value-added ingredients and a strong Third Party Manufacturing (TPM) business. In 2017, Arla's child nutrition plant was transferred to AFI. For more than 20 years, AFI has delivered double digit annual growth rates by pushing the boundaries of technology and innovation, growing our volume and revenue. 3 4 Volume of standard products and value-add products Index 140 Index 100 Standard products The whey industry is entering a new phase Significant changes are impacting the industry in which AFI operates. In the past, whey was regarded as a simple by-product from cheese production. Today whey is treated as an ingredient in its own right, and in the future, AFI’s core markets will need even more product differentiation. Whey is no longer a commodity product where one size fits all. Our customers and consumers are the most demanding in the dairy industry, and they want specialised products of the highest quality. AFI aims to take full advantage of the developing industry In order to succeed in becoming the global supplier of value added whey, AFI seeks to grow its raw material pool in the coming years through sourcing, partnerships and joint ventures. AFI will deliver an ambitious innovation agenda, by continuing to grow and refine the existing products and implement new innovative concepts. AFI’s growth will be based on value-added sales, refining our products for our strategic business segments: Infant Nutrition, Clinical Nutrition, Sports Nutrition, and Food. We will increase our value-add ratio compared to standard products, delivering more value to our customers and creating more value for our farmer owners. Over the past five years, we invested approximately EUR 220 million in our value-add business, by amongst others, increasing our capacities. 68% 74% Value products 2012 2017 In our TPM business, we conducted large investments to increase our supply of infant formula. Arla’s Child Nutrition plant, ARINCO, was transferred to AFI, realising synergies between sales and supply chain and enabling us to continue to grow the infant formula business even stronger in the coming years. We worked hard in 2017 to address the future demands to quality and food safety performance in collaboration with our customers. AFI intend to be recognised as a market leader in food safety and quality, and we will invest heavily in both people and infrastructure to implement it. OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017Revenue split by regions, MILLION EUR 651* 2016: 545 Europe, the Middle East and Africa Asia Americas 2017 2016 49% 47% 41% 40% 10% 13% Revenue development 19.6% 2016: 5.0% *A large part of Arla Foods Ingredients activities are carried out in joint ventures, which are not included in the consolidated financial statements. Revenue including joint ventures amounts to EUR 766 million. AFI’S MISSION To discover and deliver all the wonders whey can bring to people’s lives. 3 5 Trading In addition to our main sales channels, Arla conducts business-to-business sales to other companies for use in their production, as well as industry sales of cheese, milk powder and butter. Trading activities contribute 15 per cent of total revenue, and although this is not a core business segment for Arla, it is critical to our success. The market for dairy has become increasingly volatile, especially since the abolition of the EU quota system in 2015 in Europe, making it difficult to predict milk volumes. Trading allows us to manage seasonal and geographical availability in milk intake. Trading and other sales increased 18.0 per cent in 2017 to EUR 1,503 million, versus EUR 1,273 million last year. The average value of commodities was higher in 2017 compared to last year and for the first time in history, fat was more valuable than protein. The adjacent graph illustrates the extreme volatility cycle in the dairy industry. Combined fat and protein prices, three year cycle showing volatility in the dairy industry G K R E P T N E C - R U E 50 40 30 20 10 0 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Dec 2017 OUR BRANDS AND COMMERCIAL SEGMENTSARLA FOODS ANNUAL REPORT 2017 I E V T A R E P O O C R U O Through continuous innovation and uncompromising standards for the highest quality, our milk powder products provide the reassurance of a strong heritage and proudly display our Farmer Owned marque. Arla Dano® milk powder provides the essential energy and nutrition families need for growth and strong health, especially in developing countries. Our business model Arla is the fourth largest dairy company in the world based on milk intake and the world’s largest and leading organic dairy producer. Our farmer owners are at the core of our business model, true to our cooperative structure. Rooted in our mission, it is our objective to secure the highest value for our farmer owners’ milk while creating opportunities for growth and fulfilling the needs of our consumers and customers with our natural and innovative products and brands. 3 8 Creating value, from cow to consumer Arla is a farmer-owned cooperative. Creating value for our farmer owners’ milk is embedded throughout the value chain, from cow to consumer. We continuously seek growth opportunities worldwide, strive for sustainable market leadership and improve value creation through investment in innovation and our brands. We operate our entire value chain with a continuous focus on quality, efficiency and optimisation of our raw materials, capital and human resources. This promotes growth among our current farmer owners and inspires new members to pursue their future with Arla. Proudly farmer-owned As the world’s oldest dairy cooperative, our philosophy of producing natural, healthy and high quality dairy products dates back to the 1880s when dairy farmers joined forces with one common goal: to produce and provide the best dairy products. Our heritage has laid the foundation for our cooperative today, empowering Arla to drive innovation for dairy. ONE milk pool As a dairy cooperative, our primary raw material is the raw milk delivered by our farmer owners. Having ONE milk pool irrespective of the origin of the milk, allows a holistic use of our raw milk across Arla. In the pursuit of securing the highest value for our farmer owners’ milk in accordance with our mission. Operating as ONE ensures that milk can flow to markets with the best opportunities. We want to create the maximum value for all collected raw milk: ONE milk pool, with the same quality requirements through our quality assurance programme, Arlagården®, together with an efficient supply chain, enables Arla to balance the raw milk volumes in the most profitable way in support of our ambition. ONE milk price Our farmer owners farm across seven countries and are all paid ONE milk price, i.e. the prepaid milk price for raw milk delivered during the year, with the exception of limited transition periods following the entry of new members. The prepaid milk price is set with the ambition to reach a targeted range of 2.8 to 3.2 per cent annual result net profit. As part of the annual profit appropriation subject to approval by the Board of Representatives, our farmer owners receive a supplementary payment based on their annual milk volumes. Milk flow across legal entities In our cooperative, all raw milk from our farmer owners is purchased by the parent company, Arla Foods amba. Subsequently, the parent company sells the raw milk to relevant Group entities at the same price paid to our farmer owners – a price based on the average earnings generated across all markets and product categories. Our dairy activities are global and earnings are different in individual markets and across product categories. Earnings in some markets and legal entities may be higher or lower than average. However, based on the cooperative principle, it is the average of all earnings that determines the milk price paid to farmer owners. The profitability of the Group entities may differ significantly between markets and year to year, but all entities contribute positively to our cooperative. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017 Consumers and customers With our unique brands and products we are able to provide our consumers and customers the opportunity to live a healthy and balanced lifestyle. Our extensive product portfolio caters to a broad range of consumer preferences and needs. Production and logistics With 18,973 employees across 120 countries, we work to achieve efficient and streamlined operations - from ensuring world-class food safety standards in our production line, to reaching worldwide markets in our supply chain. Innovation We aim to fulfil the growing demand for more and better natural dairy products by using all our knowledge in dairy farming, milk expertise, nutrition science, product and packaging design to bring new and exciting products to market. These innovations build our strong brands and create the future of dairy. 3 9 Value creation A competitive milk price creates sustainable growth improvements for our farmer owners. In order to achieve this, Arla creates value per kg of milk through proactive price management, innovation, brands, cost programmes, international growth and economies of scale. Farmer owner As both owners and suppliers, our farmers are at the centre of our business. As a cooperative, Arla is obliged to collect all of our farmer owners’ milk, at ONE milk price, with a commitment to add value to it. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017The value of Arlagården® Food safety and animal welfare enables Arla to operate and create growth for our products and brands and thereby growth for our farmer owners. As a cooperative in control of the entire value chain, our quality assurance programme, Arlagården®, ensures high quality milk produced responsibly. High quality is an important part of our strategy and key to creating the future of dairy. As high quality in our products starts on the farm, all of our 11,262 farmer owners are governed by our quality assurance programme, Arlagården®. Arlagården® covers all the good work our farmers are doing every day, to ensure superior raw milk quality and welfare for both animals and the environment. Our farmers are proud of how they farm and to Arla, it is a strength that as owners they are committed to shared principles and standards. Arlagården® enhances our ability to compete in both European and International markets and protects our reputation for supplying high quality milk produced according to the same high standards. 4 0 Food safety, traceability and raw milk quality assured by Arlagården® Arlagården® is built on four cornerstones: milk quality, food safety, environment and animal welfare. It includes regulations and guidelines that are audited and actively enforced to ensure excellent food safety, traceability and raw milk quality. Every single Arla farm is audited by third party agricultural advisors to ensure that farms comply with Arlagården®. As a farmer owned cooperative, Arla makes sure that farmers who need support and guidance in implementing further improvements receive sufficient support from farm advisors to develop further. Launch of Arlagården® Plus for the benefit of consumers and owners It is increasingly important to share the story about all the good we do on the farms every day as consumers and customers are more and more interested in the origin of our products, specifically what farmers feed their cows and how they look after them. This has presented a commercial opportunity for Arla. Principles, facts and figures are vital in strengthening the Arla® brand as well as our position with consumers and customers. As a result, Arla and 152 farmer representatives collaborated to develop a new online documen- tation centre, Arlagården® Plus. Arlagården® Plus was launched in November 2017 and presented to all farmer owners, with voluntary participation by means of farmers inputting their data. Farmer owners that participated in the programme in November and December 2017 collectively contributed 88 per cent of the total milk delivered by members. As the programme develops, farmer owners will have access to their own data which can be used as a farm management tool and thereby, for example, to develop animal welfare on farms. Furthermore, Arlagården® Plus will serve as a benchmarking tool, enabling the individual farmer to benchmark his or her own progress against groups of other Arla farmer owners. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Four cornerstones of Arlagården®: Milk composition We strive to achieve a milk composition that ensures that our products live up to the needs and wishes of the consumer, compensating our owners according to the quality of the milk. Food safety Starting at the farm, we strive to provide consumers with a safe milk-based product. Our owners treat the milk with care and respect to maintain its natural fresh taste and health benefits. Animal welfare We strive to meet the animals’ physiological and behavioral needs in order to improve their health and well-being, because healthy and happy cows produce more milk and milk of a higher quality. Environmental considerations We strive to encourage an environmentally sound production on the farm that is respectful of nature. For more details on our four cornerstones refer to www.arla.com/arlagaarden/ 4 1 OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Our Code of Conduct Responsibility is part of Arla’s DNA. This is why we continue to maintain high standards for our healthy, safe and natural products, the environment, and the people we employ and do business with. We are committed to constant improvement, combining tradition and world-class innovation, and incorporating nature into the entire value chain from cow to consumer. The Code of Conduct applies to all Arla employees and at all our sites worldwide and forms the foundation for how we act and operate. 4 2 Responsible company In Arla, it is a given that profitability and ethical business practices go hand in hand. This is achieved through commitment, know-how, willpower and hard work. Business principles We comply with our Code of Conduct and the local laws in all the countries in which we operate. Operational principles We manage our business in a responsible and cooperative way that promotes the financial interests of our farmer owners. We enable our farmer owners’ participation in important decisions. Market conduct We have a transparent and ongoing dialogue with consumers and customers, and we support competition on equal terms. Procurement and supplier relations We expect our suppliers to assume social and environmental responsibility as we do ourselves, so we can achieve our objective of purchasing goods and services in a sustainable manner. Confidence in products Supplying safe products is our top priority. And we strive to do even more- we aim to make it possible for consumers to make their own informed and healthy choices of products based on clear information and knowledge. Food safety Food safety cannot be compro- mised. This is why we have certified food safety systems, quality programmes and committed employees which ensure safe products of high quality throughout our global supply chain. We ensure our products are safe, no matter where they are manufactured. Nutrition and health We are committed to meeting our consumers’ demand for natural and healthy products and reliable labelling of nutritional information and ingredients, helping consumers make well-informed decisions. Care for the environment and animal welfare As a dairy company, we have a natural interest in good environmental and dairy farming practices. We work to continuously reduce our adverse environmental impact, and maintain high animal welfare standards. Environment and climate Our ambition is to reduce our environmental impact from cow to consumer through food production and transportation of goods. We continually improve our environmental performance by applying sound and sustainable principles throughout our entire value chain. Dairy farming We actively support the develop- ment of sustainable dairy farming. Healthy cows on well-kept farms give better milk. Together with our farmer owners, we formed the quality assurance programme Arlagården®, which covers aspects such as animal welfare, milk quality and the environment. Refer to page 40 for more detail. Responsible relations We have relationships with people, organisations and communities in many countries. No matter what the relationship is, we are committed to maintaining mutual respect and understanding. Workplace We provide safe and healthy working conditions, for our competent, committed and engaged employees, creating a workplace that is inclusive, stimulating and respectful. Human rights Arla not only provides food products but also a culture that upholds internationally recognised human rights, respecting the human rights of all people. Society and community relations We engage in open, respectful and constructive community relations and establish long-term relationships to contribute to both local and global development. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Our compliance activities Responsible business conduct comes from living our Code of Conduct and strong company values through a culture of honesty and integrity. We expect all employees to act ethically and in compliance with Arla’s Code of Conduct. Our corporate policies are built on this foundation and are business principles that address critical aspects of individual or business conduct. Our corporate policies guide us to act responsibly and with integrity, and help us govern our ways of working as ONE aligned and efficient Arla. Through our compliance framework we drive compliance with our Code of Conduct by ensuring that adequate policies, processes and guidelines are established, embedded and enforced throughout the business. All white-collar employees are trained in our Code of Conduct and asked to complete the mandatory policy awareness e-learning. Other high risk compliance training courses are also provided, such as global security and competition law. High risk compliance areas are monitored continuously through review and audit activities. Furthermore, all employees are encouraged to speak up and voice any concerns or violations to the Code of Conduct, including corporate policies, for example, through our whistleblower service. Code of Conduct Policies 4 3 Processes, procedures and standards Guidelines and instructions Examples of our compliance activities Safeguarding of assets Arla works continuously to develop a robust internal control environment, by strengthening and automating existing internal controls and establishing new controls to mitigate identified significant risks. Risk assessments are performed to identify and prioritise high risk areas for detailed compliance reviews and self-assessments. This provides Arla with a transparent overview of financial and operational risks and highlight areas of weakness or with significant control gaps, which are addressed with mitigating activities. IT security Arla continuously assesses the increasing threats from the online world to ensure that we have proper and adequate IT security and internal controls in place. Our employees are the first line of defence and we prioritise education in cyber-security whereby all Arla employees are educated in cyber security in a mandatory ‘Are you cyber-safe?’ e-learning. Our stronger focus on the increased IT security risks that we face means that we continuously assess our IT controls and governance around access to our systems, including our SAP platform, to secure that we are strengthening our resilience towards IT security risks and cyber threats. Data protection In 2018, the new General Data Protection Regulation (GDPR) will come into force imposing new and stricter obligations on Arla when processing personal data relating to employees, members, business partners and consumers. In 2017, Arla initiated a GDPR compliance project and put in place a project team that will ensure compliance going forward. Fraud and Bribery It is Arla’s policy to conduct business in an honest and ethical manner and we have a zero-tolerance to fraud and bribery. We are committed to acting professionally, fairly and with integrity in all our business dealings, transactions and relationships and we systematically implement and enforce effective systems to counter corruption and fraud. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Our responsibility We operate our business in a sustainable and responsible manner based on our Code of Conduct. We believe that in developing our operations in this way, we are able to respond to the increased demand for accessible and sustainable food options as the population of the world grows. Working in this manner safeguards and develops Arla’s reputation and profitability, while caring for people and delivering growth. In 2017, we divided our activities into four main strategic areas: health, inspiration, natural and human rights. 4 4 Health Inspiration As one of the world’s largest dairy companies, Arla has the opportunity to influence millions of consumers’ food habits. We make dairy available in a variety of tasty products, and enable consumers to live healthier lives. Inspiration is evident in all parts of Arla, and we aim to inspire through our farmer owners sharing experiences on new farming practices, and consumers feeling inspired to cook different recipes or try new products. Highlights 2017 Highlights 2017 93 per cent of Arla® branded products in the milk, yogurt and everyday cheese categories now comply with the Arla® Nutrition Criteria. Arla has joined 21 other major food companies in signing up to the voluntary EU Pledge initiative on responsible food marketing to children. Arla Foods Ingredients is engaged in a project with NGOs to increase the general health of Ethiopia’s children by making better use of the milk from the country’s 11 million cows. Many consumers were engaged in 2017 through our wide range of digital networks, for example through social media or recipes on our website. Our digital sites had 148 million interactions. With our ‘little farmer programmes’ we invited 70,000 school children to our farmer owners’ farms, educating more than a million children to date about life on the farm and the origin of their food. Arla Next, our farmer owner training programme , involved 60 participants in 2017 from Denmark, Sweden, the UK and Central Europe. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017“Authentic socially responsible brands and businesses are winning the world over as more people are using their purchasing power to create change and to support issues and causes they believe in. As a cooperative, Arla will create greater awareness of our Good Growth identity and strategy and show how we will create the future of dairy.” Peder Tuborgh, CEO Read more about our commitments and achievements for 2017 in Arla’s Corporate Responsibility Report on http://www.arla.com/csr-reports/ in accordance with section 99a in the Danish Financial Statements Act. Natural Human rights 4 5 Together with our farmer owners, we are in the unique position of being able to work with every step in the whole value chain, to make a positive contribution to a more sustainable future. We contribute to the UN sustainability goals through job creation, responsible sourcing, and competencies on quality, food safety and product innovation. We are committed to meeting international human rights principles. Highlights 2017 Highlights 2017 Increased use of biogas at our dairies with 5.7 per cent of Arla’s total use of energy derived from biogas, and 24 per cent from renewable sources in total in 2017. Focus on operations, packaging and transport with Arla’s total climate impact decreasing by 18 per cent since 2005, despite increased production. Launch of a digital documentation centre, Arlagården® Plus, which is a database that details information about the farm, animals and animal welfare. Refer to page 40 for more detail. During 2017, we published a Modern Slavery statement, outlining our commitment to tackling modern slavery and human trafficking, and adapted our procurement tendering process to secure that suppliers comply with the Modern Slavery Act. In our strengthened focus on human rights impacts, we conducted human rights due diligences in Indonesia and Ghana, both in terms of country assessments and partner assessments. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Promoting and supporting risk awareness The potential of our strategy, Good Growth 2020, is promising, but there are also a number of areas where Arla faces increased risks and uncertainty in pursuit of growth. In 2017, we significantly enhanced our risk management processes throughout the organisation and reorganised our set-up to elevate strategic risk management (SRM) in our business. Our goal is to promote and support risk awareness for braver decision-making, to seize key business opportunities and ensure more effective execution. 4 6 Risk and opportunity identification Risk and opportunity assessment 4 1 Risk owner 3 2 Risk and opportunity monitoring and reporting Risk and opportunity management OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017 1 Risk and opportunity identification To identify risks and opportunities at Arla, we continuously monitor the global market situation as well as internal processes, ensuring early and proactive decision making. Our SRM process is designed to identify major risks using the insights of leaders from all major areas across the Group. Furthermore, certain expert functions such as Global Tax, Treasury, Legal and Procurement also monitor their specific risk profiles on a regular basis during the year. In 2017, we revised our risk and opportunity categorisation into either events or trends. including new areas such as cyberattack and changing consumer demands etc. We also integrated it to our annual business planning process on all levels of organisation to ensure incorporation into daily decision-making . Risk and opportunity assessment Risk and opportunities are assessed both individually and systematically, allowing adequate prioritisation and allocation of resources. 2 Assessment is performed based on two dimensions: Potential financial impact on profit and likelihood of occurrence. The former includes quantitative and qualitative measurements such as reputation, impairment to brand value, impact on market position and media coverage. The likelihood aspect considers if a given risk or opportunity materialises within the next three to five years. During 2017, we enhanced our focus on building risk management capabilities and held a number of work and training sessions across the global Arla organisation. 4 7 Risk and opportunity management We continuously manage our risks and opportunities by developing and implementing appropriate mitigating actions and exploring opportunities within our business. Our SRM function is focused on integrating risk efforts into existing processes, as well as developing harmonised methodologies and tools. This process is supported by a common language and a clear methodology for assessing risks and defining opportunities. In 2017, we completed a one year collaboration with external consultants to ensure that we had implemented best practice SRM. We also established task forces to manage mitigation plans for key focus areas, for example, Brexit and General Data Protection Regulation. Risk and opportunity monitoring and reporting As both risks and opportunities are subject to constant change, we aim to increase their transparency. Risk owners monitor development in risk trends and identified or emerging opportunities in their respective business areas. They are also responsible for consistently ensuring the adequacy and effectiveness of our risk mitigation and resolution strategies. To enable a real value creation, in 2017 we aligned reporting timelines across all functions and integrated risk and opportunity management throughout our performance management reporting procedures and tools. The result is a summary of top risks and mitigating actions, which is revised formally to the Board of Directors twice a year. 3 4 OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017 Our risk landscape Arla’s risk landscape highlights our top emerging, strategic and operational risks, characterised as either event or trend risks. Our increased risk awareness through 2017 is reflected in the risk landscape. We assess risks based on the potential impact on Arla’s reputation and/or profit, as well as the likelihood of the risk to occur within the next three to five years. The assessment is based on the net effect after all current mitigating actions. € T I F O R P r o / d n a N O T A T U P E R I Event Trend B A H K J D E C F G I L MAJOR T C A P M I MODERATE MINOR POSSIBLE LIKELY VERY LIKELY LIKELIHOOD 4 8 Supply and production disruptions Milk price and volume volatility Continued milk volume and price volatility strongly influence our sales volumes and profit respectively. Arla’s Good Growth 2020 strategy focuses on value creation through our strong brands and products, which continually reduces exposure to commodity pricing. Nevertheless, to reduce these risks, we significantly enhanced our price and perfor- mance management in 2017. Market milk prices increased in 2017 in comparison to last year, leading to a more sustainable financial situation for our farmer owners. Being in control of the entire value chain gives Arla a major foundation to manage our risks well. Guaranteeing food safety is our key priority. Besides clear and professional crisis management processes, upgraded in 2017, and active application of analyses to improve product quality and prevent reoccurring failures, our focus is on adherence to the Arlagården® quality assurance programme and our comprehensive quality, health, environment and safety model to safeguard the highest quality for all our products. Furthermore, failure or breakdown of our vital production facilities, or any hazard risks like explosions or strikes could affect business operations. An emergency programme exists across all production sites and lessons from historical incidents are continuously incorporated. In 2017, an explosion and fire occurred in a section of a drying facility, which did not impact the business. Crisis plans were in place and damages were repaired within a month. Deliveries were covered by safety stock and processes have been adapted accordingly. Risk Risk scenario Risk Risk scenario . A B Major product recall damaging the Arla brand and image G Milk price and volume volatility Major breakdown at key production site OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017 Market risks and global instability Financial and IT risks Having sales and production across the world means that we are exposed to both specific country risk as well as most macroeconomic developments. Economic turmoil in emerging markets, volatility in commodity prices and political instability increase our risk exposure, leading to thorough monitoring of developments and trends, and continuous internal agility to changes. We review both external factors and internal levers as a part of our business review process, plan mitigation steps and monitor the developments. Brexit will have inevitable consequences for Arla and was determined as our most critical risk. Hence, we undertook extensive study and scenario planning to understand Brexit implications and secure a robust plan for Arla for the different possible Brexit outcomes. For more information on Brexit, refer to page 50. Arla’s main financial risks relate to exchange rates, tax disputes, interest rate changes and pension liability valuations. Due to exposure to international markets, our sales occur in a range of currencies. To manage this risk, the Group hedges expected future cash flows for selected key currencies. Furthermore, we constantly monitor and review worldwide tax matters to ensure our compliance in all locations. Based on external incidents in 2017, as well as the expansion of our operations to new markets, we assessed that risks relating to cyber security have increased. To minimise cyber security risks, we continuously review our activities. Furthermore, in 2017 we rearranged our task force to strengthen our work on IT control requirements and in monitoring compliance in this area across the global organisation. Risk Risk scenario Risk Risk scenario 4 9 C D Political instability and economic turmoil in emerging markets Consequences of Brexit and further EU exits and protectionism H I J Taxation and transfer pricing risks Currency, interest and pensions risks Major cyber attack Changing consumer demands and digital disruption Business ethics, legal and HR risks The increasing role of our branded business requires a higher risk awareness regarding reputational and social media impacts to protect the brand value of our company. In 2017, we distinguished changing consumer demands and digital disruption risks as trends. Hence, we dramatically increased our digital engagements with consumers, allowing us to improve our understanding of consumers and continu- ously monitoring behavioral trends and hereby supporting product innovations, exploring new technologies and digital business models. Negative impacts on human rights and a violation of business ethics could severely harm Arla’s and our brands’ reputation. These risks are part of our major risks due to our geographical exposure combined with increased societal expectations. To minimise business ethics and legal risks, a number of activities are performed by our Legal, IT and Corporate Responsibility departments. During 2017, we significantly increased our resources on data privacy to ensure compliance with upcoming EU General Data Protection Regulation. Furthermore in 2017, we experienced a rising popularity of alternative eating trends like flexitarian, vegan and vegetarian, and saw animal welfare concerns in social media. Based on our quality assurance programme, Arlagården®, our focus on natural and healthy products and being the world’s largest organic milk producer, we proactively position ourselves at the forefront of natural food options. The loss of key personnel in strategic positions and the inability to recruit and retain sufficiently qualified people also pose risks to our business performance. To mitigate this risk, we create the right corporate culture and work environment, as well as provide employees development and global career opportunities. In 2017, we set a new record achieving an engagement score of 84 per cent in our annual employee survey. Risk Risk scenario Risk Risk scenario E F Digital disruption and new competitors or retailers Growing anti-dairy and vegan movements K L Negative impact on human rights and/or non-compliance Loss of key personnel in strategic positions and recruiting and retaining the best talent OUR COOPERATIVEARLA FOODS ANNUAL REPORT 20175 0 Preparing for Brexit The effects of Brexit are our biggest risk. As negotiations progress, Arla continues to make our position clear, as a company in favour of the free movement of goods and people. The future trading relationship between the EU and the UK remains uncertain and we are preparing to handle a variety of Brexit scenarios. It is important for Arla’s customers and consumers that our products can move freely across the markets in which we operate to optimise the utilisation of our ONE milk pool and global supply chain. With 3,203 farmer owners based in the UK, the country is Arla’s biggest commercial market, accounting for approximately 25 per cent of the total revenue. A recent CEBR Economic Impact Assessment valued Arla’s total economic footprint in the UK at more than GBP 6 billion in Gross Value Added terms once direct and indirect impacts are factored in. Successful and loved brands in the UK market, including Lurpak®, Arla® Lactofree and skyr, are imported to the UK, with some others such as Castello® yellow cheeses being exported from the UK, and changes to the EU-UK trade relationship may signifi- cantly challenge this business. The Arla Brexit Task Force has been appointed to assess the impact of Brexit from a total value chain perspective, focusing on three possible outcomes: Free Trade Agreement (FTA), our preferred outcome, without tariffs for dairy products; World Trade Organisation (WTO) relationship, under which certain quotas would be apportioned without any tariff impacts; and 'No-deal scenario', under which dairy would be traded under WTO most-favoured-nation tariffs with a significant impact on our business as well as the UK dairy industry. We want the final trade deal between the UK and EU to be free from tariff and non-tariff barriers in milk and dairy and are collaborating with partners in the dairy industry and the wider food and farming community. Arla has contributed to dairy being the first industry to reach a public united position on the best future EU-UK relationship for our industry. We have advocated a positive solution for the future trading relationship in high level engagements with the UK government and the EU. As the negotiations progress, we will continue to deliver strong, evidence-based arguments to politicians and policy makers hand in hand with our farmer owners and peers in the dairy industry. And as the UK govern- ment begins developing its post Brexit agricultural policy, we will work closely with them to protect the competitiveness of the UK dairy industry within the EU and the global dairy market. Brexit negotiations: key dates Jan 2018 Negotiations directive for the transitional agreement Mar 2018 Guidelines for the framework of the future relations negotiations Oct 2018 Agreement on withdrawal agreement and transitional agreement, plus a political declaration on defining the scope of the future relationship Nov 2018 - Mar 2019 Ratification of the agreement (European Council, European Commission and European Parliament plus UK) Mar 2019 - end 2020 Detailed negotiations of the FTA, and transition period OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017Our tax affairs In recent years, multinationals have experienced a growing interest from media, non-governmental organisations and the public in general in how their tax matters are organised. As a globally operating company, Arla acknowledges the key role of taxes in the budgets of the countries in which we operate. Our approach to taxes conforms with Arla’s global Code of Conduct and is founded on a set of key tax principles approved by the Board of Directors. The BEPS project of the OECD led to the development of new tax principles and increased reporting and documentation requirements for multinationals. We are fully committed to meeting the new requirements for reporting and transparency. As we have always done, we will continue to strive for an open dialogue with tax authorities around the world, regarding our business and our tax reporting. Accountability and governance The complexity of our business requires a significant focus on tax management. Our global tax function is organised and driven to ensure that, as a business, we have the right policies, people and procedures in place to adhere to the key tax principles and ensure a transparent and strong tax management setup. We continuously work on establishing the internal standards and control mechanisms required to adhere to our key tax principles. Accountability for tax processes, with a few exceptions, resides within the global tax function. Operating under a cooperative tax scheme As a cooperative based in Denmark, our activities are governed by the Danish tax rules for cooperatives. Arla’s members are also our suppliers, and earnings do not accrue in the company but go back to the members in the form of the highest possible payment for their milk. The cooperative’s earnings can therefore be viewed as the farmer owners’ personal income. The members of Arla will generally pay income tax on the amount received for their milk. Danish cooperative tax rules reflect the fact that the cooperative acts as its members’ extended arm, and as such, Arla pays income tax in Denmark based on our assets, namely equity. Arla holds a number of subsidiaries globally. Our subsidiaries are typically limited liability and private limited companies subject to regular corporate taxation just like all other similar companies. Limited liability company Cooperative Profits Minimum payment for commodity Shareholder Supplier Maximum payment for commodity Owner/supplier 5 1 Our key tax principles Arla’s strategic ambition is to act as a responsible citizen in all tax matters, achieving a balance between managing tax costs, driving efficiencies and ensuring optimisation in a responsible way. Our key tax principles are aligned with this ambition and are the cornerstones for all tax-related matters in Arla. Our key tax principles are: Arla aims to report the right and proper amount of tax according to where value is created Arla is committed to pay taxes legally due and to ensure compliance with legislative requirements in all jurisdictions in which the business operates Arla does not use tax havens to reduce the Group’s tax liabilities Arla will not set up tax structures intended for tax avoidance which have no commercial substance and do not meet the spirit of the law Arla is transparent about our approach to tax and our tax position. Disclosures are made in accordance with relevant regulations and applicable reporting standards such as International Financial Reporting Standards Arla builds on good relations with tax authorities and trusts that transparency, collaboration and proactiveness minimises the extent of disputes. OUR COOPERATIVEARLA FOODS ANNUAL REPORT 2017E C N A N R E V O G R U O Puck® offers a wide range of dairy products right across the Middle East and is a perennial favourite in the region for its cream cheese. As consumers are seeking better choices with health being of growing importance in the region, we are expanding our range to include low fat and low salt variants to help consumers make better choices. A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 5 4 O U R G O V E R N A N C E Governance framework Arla appreciates the value of sound governance as a fundamental base in achieving trusting relations with our farmer owners, employees and other key stakeholders. Good governance represents responsible and transparent management and corporate control. As a cooperative owned by dairy farmers in seven countries, good governance is essential for achieving success and enhances the confidence placed in our cooperative. Arla’s governance model Cooperative governance District councils and Area councils Different democratic structures in DK, SE, UK, DE, BE, NL and LUX Board of Directors 18** Functional experts and commercial leaders 5 Employees 18,973 Owners 11,262 Board of Representatives 187* Executive Board 2 Executive Management Team 7 Corporate governance * Including 12 employee representatives. ** Including three employee representatives. Cooperative governance Arla’s democratic structure gives decision-making authority to the Board of Directors and to the Board of Representatives. Their primary tasks are the development of the ownership base, safeguarding the cooperative democracy, embedding decisions and developing competencies. Owners In 2017, 11,262 milk producers in Denmark, Sweden, the UK, Germany, Belgium, Luxembourg and the Netherlands were joint owners of Arla. Last year, the cooperative had 11,922 joint owners. Refer to page 12 for more detail. As a cooperative, all cooperative owners have the opportunity to influence significant decisions. District councils Each year, the cooperative owners convene for a local annual assembly in Denmark, Sweden, the UK and Central Europe (Germany, the Netherlands, Belgium and Luxembourg) to ensure democratic influence of the cooperative owners in the seven owner countries. The members in the district council elect members to represent their district on the Board of Representatives. Board of Representatives The Board of Representatives is the supreme body comprising 187 members of whom 175 are cooperative owners, while 12 are Arla employees. Cooperative owners are elected every other year in odd years. Following the 2017 election, over 20 per cent of the members are new and the diversity of the Board has improved. The Board of Representatives makes decisions including appropriation of profit for the year and elects the Board of Directors. The Board of Representatives meets at least twice a year. Board of Directors Appointed by the Board of Representatives, the Board of Directors is responsible for decisions relating to long-term strategies, major investments, as well as mergers and acquisitions. The Board of Directors consists of 15 elected Arla farmer owners and three employee representatives. Two new members joined the Board for the period 2017 to 2019, replacing two members not seeking re-election. Following the election this year, the Board reappointed Åke Hantoft as Chairman and Jan Toft Nørgaard as Vice Chairman. The composition of the Board of Directors reflects Arla’s ownership. The Board of Directors is responsible for monitoring the company’s activities and asset management, maintaining the accounts satisfactorily and appointing the Executive Board. The Board of Directors is also responsible for ensuring that Arla is managed in the best interest of the farmer owners and making decisions concerning the ownership structure. Area councils Arla has four area councils that are sub- committees of the Board of Directors and consists of members of the Board of Directors, as well as members of the Board of Representatives. The area councils are established in the four democratic areas: Sweden, Denmark, Central Europe and the UK; to take care of the matters that are of special interest to the farmer owners in each geographic area. Owner strategy As a thriving cooperative democracy, we are developing an owner strategy to further evolve and prepare Arla as a cooperative for the future. The strategy will ensure the organisational structure and processes are more uniform and transparent across all seven owner countries. In March 2017, the Board of Representatives decided to adopt a new governance structure, eligibility and election procedures, as well as an annual meeting cycle. The first elections in the new governance structure took place during spring and the new aligned meeting structure across all areas, for example two rounds of Area Forum meetings, was implemented successfully. The owner strategy will continue to progress into 2018. The next step will be considering amendments to the Articles of Association to support the new structure, which the Board of Representatives will decide on in February. Furthermore, the UK and Central European cooperative members will make a decision in May regarding potential direct membership. These decisions are part of the owner strategy and aim to achieve harmonisation following the mergers in 2011-2015. 5 5 Corporate governance Corporate governance in Arla is shared between the Executive Management Team and the Board of Directors. Together they define the company’s strategic direction and ensure adherence thereof, organise and manage the company, supervise management and ensure compliance. Executive Board The Executive Board, appointed by the Board of Directors, is responsible for managing the company, ensuring the proper long-term growth of the company from a global perspective, driving the strategic direction, following up on targets for the year and defining company policies, while striving for a sustainable increase in company value. Furthermore, the Executive Board ensures appropriate risk management and risk controlling, as well as compliance with statutory regulations and internal guidelines. This is where the Group’s ambitions are defined for cross-disciplinary efforts. In the first quarter of 2018, Povl Krogsgaard, Vice CEO and Executive Vice President Supply Chain, is retiring after a longstanding career with Arla. Executive Management Team The Executive Management Team is responsible for Arla’s day-to-day business operations, preparing strategies and planning the future operating structure. The Executive Management Team consists of the Executive Board plus three functional experts and two commercial leaders: Europe and International. In addition to their overall responsibility, the members of the Executive Management Team are individually responsible for managing their respective business areas. The members of the Executive Management Team keep each other informed on all significant developments in their business area and align on all cross- functional measures. In 2018, further increasing the diversity of the team, Sami Naffakh, a French national, will join Arla as an Executive Vice President and Head of Supply Chain. Functional experts and commercial leaders The leadership teams within the functional areas and commercial zones are Arla’s other executive bodies and focus on ensuring that Arla is result-oriented across organisational units, while also defining policies and sharing and implementing best practices. Employees Arla has 18,973 employees globally, compared to 18,765 last year. Our employees are represented by three members in the Board of Directors and 12 members in the Board of Representatives. OUR GOVERNANCEARLA FOODS ANNUAL REPORT 2017 Executive Mangagement Team The Executive Management Team consists of the Executive Board plus three functional experts and two commercial leaders: Europe and International. With a range of different backgrounds and expertise, the Executive Management Team is responsible for Arla’s day-to-day business operations, preparing strategies and planning the future operating structure. In addition to their overall responsibility, the members of the Executive Management Team are individually responsible for managing their respective business areas. Executive Board Other Executive Management Team 1 Peder Tuborgh CEO Head of Milk, Members and Trading Head of Arla Foods Ingredients Year of birth: 1963 Nationality: Danish 3 Natalie Knight CFO Executive Vice President, Finance, IT and Legal Year of birth: 1970 Nationality: American 5 Hanne Søndergaard CMO Executive Vice President, Marketing and Innovation Year of birth: 1965 Nationality: Danish 7 Tim Ørting Jørgensen Executive Vice President, International Year of birth: 1964 Nationality: Danish 5 6 Peder has been with Arla for 30 years, formerly under MD Foods, and has held various senior management and executive positions including Marketing Director, Divisional Director and Executive Group Director. He has worked in Germany, Saudi Arabia and Denmark as part of his longstanding career with Arla. He is also the Chairman of the Board of Pandora and the Vice Chairman of Aarhus University. Above all, he enjoys spending time with his wife, son and four daughters. His favourite product is an Arla classic, Castello®. Natalie joined Arla Foods as CFO in 2016, following 17 years at adidas where she held several senior finance positions, including SVP Group Functions Finance, SVP Brand and Commercial Finance, CFO of adidas North America and VP Investor Relations and M&A. Prior to adidas, Natalie held Investor Relations roles in BASF and Bankgesellschaft Berlin. After having lived and worked in five countries, Natalie is now based in Aarhus, Denmark with her husband and teenage daughter. Her favourite product is Arla® Protein, which she loves as a healthy follow-up to a variety of sport activities. Hanne has been with Arla for 28 years, first joining under MD Foods and then moving to the UK where she played a leading role in developing the Arla UK business. She became the Vice CEO for Arla UK before moving back to Denmark in 2010. With a natural ability for marketing, Hanne was responsible for Global Categories and Brands before taking on her current role. She lives in Aarhus with her partner and enjoys kayaking and cooking. If she were an Arla product, it would have to be Arla® skyr with its Nordic heritage, and strong and healthy characteristics. Tim joined Arla in 1991 under MD Foods. He has worked in many senior and executive positions across Denmark, Saudi Arabia, Brazil and Germany before becoming the Executive Vice President for International. Tim has been part of the team since 2007. When he is not working, Tim loves spending time with his wife and four children. When he gets the chance, he enjoys hunting and music. If he was an Arla product, Tim would be Lillebror®, he is the youngest brother, and after 26 years in Arla, his favourite product is the staple Danish summer dessert, Koldskål®. 2 Povl Krogsgaard* Vice CEO Executive Vice President, Supply Chain Year of birth: 1950 Nationality: Danish 4 Ola Arvidsson CHRO Executive Vice President, HR and Corporate Affairs Year of birth: 1968 Nationality: Swedish 6 Peter Giørtz-Carlsen Executive Vice President, Europe Year of birth: 1973 Nationality: Danish Povl has been with Arla for more than 30 years, and has served as Vice CEO since 2004 with the responsibility for Arla’s supply chain and CAPEX. In his longstanding career at Arla, Povl has also held various senior management and executive positions from Product Manager to Executive Group Director. Povl is known for his constant focus on increasing profitability everywhere in the company. His big passion is reading about history, bird watching and his family, which includes his wife and their three grown-up sons. His favourite Arla product would have to be Castello® Danablu cheese. Ola joined Arla in 2006 as Corporate HR Director, and has been the Chief HR Officer of Arla since 2007. He previously came from Unilever, where he held various director positions across Europe and the Nordics, with his last position as Vice President in HR. Prior to Unilever, Ola served as an Officer in the Royal Combat Engineering Corps in the Swedish Army. Ola dedicates his free time to his wife and three children. His favourite product is a cold glass of Arla® Mellanmjölk together with one of his children’s homemade cinnamon buns. Peter joined Arla in 2003 as Vice President of Corporate Strategy, and has held various senior positions in Arla, including Managing Director of Cocio Chokolademælk and Executive Vice President of Consumer DK and most recently Consumer UK. He has been Executive Vice President of Europe since 2016. Outside of Arla, Peter has also served as the Vice CEO at Bestseller China Fashion Group (Tianjin). Peter is currently an executive advisor at FSN Capital Partners AS since 2012. He enjoys road biking, skiing and golfing, and spending time with his partner their two children. His favourite product is Unika® rød løber. * In January 2018, Povl Krogsgaard retired after a longstanding career with Arla. Sami Naffakh joined Arla as an Executive Vice President and Head of Supply Chain. OUR GOVERNANCEARLA FOODS ANNUAL REPORT 20171 4 2 3 6 7 5 5 7 OUR GOVERNANCEARLA FOODS ANNUAL REPORT 2017Board of Directors Our Board of Directors has a wealth of knowledge, consisting of 15 elected Arla farmer owners and three employee representatives. In 2017, we welcomed two new members to the Board, Inger-Lise Sjöström and Simon Simonsen. The composition of the Board of Directors reflects Arla’s ownership. One of the Board of Directors’ responsibilities is to ensure that Arla is managed in the best interest of all farmer owners. 5 8 6 7 8 9 10 2 11 12 1 3 4 5 15 16 17 13 14 OUR GOVERNANCEARLA FOODS ANNUAL REPORT 20171 Åke Hantoft Chairman 2 Jan Toft Nørgaard Vice Chairman Year of birth: 1952 Nationality: Swedish Member of the board since 2000 Year of birth: 1960 Nationality: Danish Member of the board since 2000 3 Manfred Sievers 4 Harry Shaw Year of birth: 1955 Nationality: German Member of the board since 2013 Employee representative Year of birth: 1952 Nationality: British Member of the board since 2013 5 6 7 8 Heléne Gunnarson Johnnie Russell Viggo Ø. Bloch Markus Hübers 5 9 Year of birth: 1969 Nationality: Swedish Member of the board since 2008 Year of birth: 1950 Nationality: British Member of the board since 2012 Year of birth: 1955 Nationality: Danish Member of the board since 2003 Year of birth: 1975 Nationality: German Member of the board since 2016 9 10 11 12 Steen Nørgaard Madsen Simon Simonsen Ib Bjerglund Nielsen Bjørn Jepsen Year of birth: 1956 Nationality: Danish Member of the board since 2005 Year of birth: 1970 Nationality: Danish Member of the board since 2017 Employee representative Year of birth: 1960 Nationality: Danish Member of the board since 2013 Year of birth: 1963 Nationality: Danish Member of the board since 2011 13 14 Inger-Lise Sjöström Torben Myrup 15 Manfred Graff Year of birth: 1973 Nationality: Swedish Member of the board since 2017 Year of birth: 1956 Nationality: Danish Member of the board since 2006 Year of birth: 1959 Nationality: German Member of the board since 2012 16 Håkan Gillström Employee representative Year of birth: 1953 Nationality: Swedish Member of the board since 2015 17 Jonas Carlgren Year of birth: 1968 Nationality: Swedish Member of the board since 2011 Not pictured: Thomas Johansen and Palle Borgström, served until May 2017; Jonathan Ovens, served until December 2017; and Arthur Fearnall, appointed in February 2018. OUR GOVERNANCEARLA FOODS ANNUAL REPORT 2017Management remuneration Arla’s executive remuneration policy is designed to encourage high performance and support value creation. The policy supports alignment with our strategic direction and the interests of our farmer owners. We have a structured approach to remuneration, ensuring that salaries are unbiased towards gender, nationality and age. Our philosophy We want our executives and senior management to share our farmer owners interest. The remuneration package is constructed to ensure attraction, engagement and retention of the best senior leaders, at the same time driving strong performance by means of both short and long-term business results. This is achieved by offering a benchmarked remuneration package with the right balance of fixed and variable pay. The competitive remuneration package is reviewed annually by external advisors using market data sources. Bringing together the interests of our farmer owners and top management Supporting the growth of the business Retaining senior executives in critical positions Making sure we offer a competitive remuneration package 6 0 Our performance measures Arla’s remuneration is designed to enable us to recruit and retain individuals with the expertise and ability required to run a growing international company, and to do so in a way that drives our business success and rewards executives and senior management when farmer owners are rewarded. Levels of fixed remuneration are set based on individuals’ experience, contribution and function. Board of Directors The remuneration of the Board of Directors comprises a fixed fee and is not incentive-based. This ensures that the Board pursues the cooperative’s long-term interests without taking into consideration what this may mean in terms of the value of incentive-based remuneration. The Chairman and the Vice Chairman receive a fee that is three times and two times the base fee respectively, and the remaining members of the Board receive equal compensation. Beyond a minimal travel per diem, no additional compensation is paid for meeting attendance or committee services. In 2017, the Board of Directors received a three per cent fee increase, in line with the by-laws. The Board of Directors’ remuneration for the year is approved annually by the Board of Representatives. Executive Board, Executive Management Team and other senior management The Executive Board consists of Arla’s CEO and Vice CEO, appointed by the Board of Directors and elevated from the Executive Management Team. During 2017, other senior management included 92 employees defined as Vice Presidents and above. The Board of Directors seeks to incentivise executives and senior management to ensure the continued positive development of Arla and, as a result, good value creation for our farmer owners. The Board of Directors finds that the best results are achieved when a relatively high proportion of an executive’s or senior leader’s total remuneration is dependent on achieving Arla’s financial, social and environmental targets. The remuneration package is based on external benchmarks against European and international FMCG companies, providing a competitive and sustainable mix of fixed and variable pay. The majority of the package is fixed pay and consists of an annual base salary, as well as a matching benefit package including a pension contribution. The variable pay component consists of both an annual short-term variable incentive (STI) plan, as well as a three-year long-term variable incentive (LTI) programme. During 2017, the STI was based on internally measured profitability, strategic branded revenue growth, net working capital and leadership index, and the LTI was based on strategic branded revenue growth and performance according to peer group index. The Board of Directors assesses the fees paid to the Executive Board annually, based on recommendations from the Chairmanship. In making Fixed pay its recommendations, the Chairmanship is guided by relevant benchmarks, including Arla’s peers and for 2017, the salary was maintained on par with last year. Refer to Note 5.3.a. The Board of Representatives is regularly updated on variable pay parameters and the development in variable pay for executives and senior management. All executives and members of senior management are employed on terms according to international standards, including adequate non-compete restrictions, as well as confidentiality and loyalty restrictions. Variable pay (STI) Variable pay (LTI)* Benefits (pensions etc.) *LTI only applies to a small number of senior and executive management. OUR GOVERNANCEARLA FOODS ANNUAL REPORT 2017Diversity and inclusion In Arla, we believe that no matter who you are, you can be yourself. Diversity and inclusion are imperative to the success of our business and a diverse and inclusive workforce creates energy, innovation and results. We define diversity broadly as differences between people with a diverse range of backgrounds, while inclusion is about valuing differences among individuals to create synergies. Promoting diversity and inclusion As an organisation, we strive for an inclusive and welcoming culture for all employees. To achieve a diverse and inclusive workforce, the 30 to 70 per cent ambition guides our initiatives and targets. Our aim is that all teams have a representation of a minimum of 30 per cent and no more than 70 per cent of the same gender, nationality and age group. This is to secure diversity of thought in all teams and an environment of inclusivity, creativity engagement and performance across Arla. In our recruitment processes, we have a strong focus on ensuring high predictive validity in our assessment tools. We apply a competency-based approach when assessing candidates to ensure decisions are data-based, thereby removing the bias in the selection process. All recruiters are continuously trained in securing unbiased processes and being close to our hiring managers is also a way of making sure that we hire based on sound arguments not led by intuition. As men are highly overrepresented in our industry, the gender composition in our owner group reflects the composition among our farmer owners. Similarly, the demographics of the Board of Representatives is representative of the owner group due to democratic elections every other year. Our workforce Nationality Arla has employees from a total of 74 countries. We focus on non-core nationality parameters to ensure continuous progress towards a diverse workplace regarding nationality. In 2017, the majority of our workforce originated from Denmark, Sweden, the UK and Germany, with other countries including Poland, the Netherlands, Finland, India, Saudi Arabia and the US, amongst various others. Age Our employees have a wide range of ages and we believe that a workforce diverse in age groups helps us better fulfil the wishes and multi-faceted demands of our consumers around the world. In 2017, the average employee age across Arla as a whole was 40 years. Across all main age brackets, Arla had balanced distribution of employees. Gender Gender is another important element of diversity, however, we believe that experience, back- ground, knowledge, skills and insight are equally important. Total Arla Women comprise 28 per cent of Arla’s entire workforce, consistent with last year. White collar Blue collar Total Arla 33% 40% 11% 21% 19% 14% 9% 10% 28% 15% <30 22% 30-39 25% 40-49 24% 50-59 22% 7% >60 Other 2017 28% 72% 2016 28% 72% Executive Management Team In 2017, the Executive Management Team is unchanged from last year, having a female representation of 29 per cent. 6 1 Our owners In accordance with section 99b of the Danish Financial Statements Act, Arla has set a medium-term target to achieve a female representation in the Board of Directors of at least 20 per cent, to be reviewed going forward. In order to work towards this target, members of the underrepresented gender are put forward in the elections for the Board of Representatives. Board of Directors 2017 12% 88% 2016 7% 93% Board of Representatives 2017 29% 2017 71% 8% 92% 2016 29% 71% 2016 13% 87% OUR GOVERNANCEARLA FOODS ANNUAL REPORT 2017 I L A C N A N I F R U O I W E V E R We add the natural power of milk to the best branded products in the world, making it easier to live a healthy life. The new doubleshot espresso with no added sugar offers coffee lovers the opportunity to experience coffee with a great StarbucksTM experience when on-the-go. Market overview High market and farmer milk prices, as well as significant volatility characterised 2017 both on a European and global scale, mainly driven by record-high fat price increases. 2017 again proved that milk price fluctuations remain a fundamental reality within the dairy industry. Worldwide milk production increased only modestly compared to last year on the back of higher market prices. Whilst the overall macroeconomic environment was healthy, the GBP remained under significant pressure as uncertainty continues to strain the UK economy during Brexit negotiations. 6 4 Healthy macroeconomic environment Macroeconomic development was positive by nearly all measures during 2017, with stock markets up at record levels globally. Gross Domestic Product (GDP) increased in all major regions, with Europe and the US growing 2.2 per cent and China up 6.8 per cent. The development across emerging markets varied, with oil producing countries such as Saudi Arabia and Nigeria being impacted by continued relatively low oil prices. Ongoing discussions about increased protectionism and potential negative impacts on international trade from political events abated following major elections in France and Germany, signalling a lessening of nationalist agendas throughout Europe. Despite positive macroeconomic indicators, exchange rates for the GBP remained low and the USD deteriorated when measured against the EUR. The GBP averaged 10.6 per cent below average rates of the last three years due to ongoing Brexit negotiations and open scenarios of negotiation outcomes. For currency development and risk mitigation measures refer to Note 4.3.2. Strong milk price development driven by historic increases in fat prices Following milk price increases in late 2016, markets were characterised by significant volatility throughout 2017. European and global prices diverged, which became most obvious with European cheese prices increasing significantly and then dropping again towards the end of the year. This was in contrast to Global Dairy Trade prices, which remained relatively stable in 2017. In Europe, prices of fat and protein, the two main components in milk, deviated significantly. Fat moved from a 27 per cent discount in 2016 to a 47 per cent premium versus protein in 2017, due to a lack of supply and increasing demand for fat-rich products versus plant-based alternatives. As a result, fat reached an all-time high price level at EUR 6,371 per tonne in the autumn of 2017. This led to a unique market situation, where prices paid to farmers hit three-year highs at year-end, driven exclusively by the value of fat, while skim milk products continued to sell at or near intervention prices throughout the year. The market for organic milk is relatively more stable than the market for conventional milk, therefore, given the increases in conventional milk prices, the price difference between organic and conventional milk became smaller. Milk production increases in the second half of the year due to higher milk prices Since the removal of milk production quotas in 2015, European milk production has followed price changes with a time lag of approximately six to nine months. Milk production followed the same pattern in 2017, with lower volumes in the first half of the year, followed by an increase in the second half. This development is the opposite of the market price and production patterns of 2016. As a result, European milk production increased 1.5 per cent in 2017, driven strongly by a surge in production late in the year. Milk production in other regions also increased in the second half of 2017, however only moderately due to unfavourable weather conditions in Oceania. New Zealand and US full-year milk volumes grew by 2.5 per cent and 1.5 per cent respectively. Global dairy demand grows modestly driven by emerging markets In a pattern similar to the last five years, increasing demand for dairy products continued to be driven largely by emerging markets, where expanded distribution and increasing consumption ensured demand growth at levels at or above GDP growth rates. Two examples were Nigeria and China, where dairy demand grew 2.6 per cent and 8.7 per cent respectively. Dairy demand remained solid in Europe and the United States, driven mainly by cheese and Global Dairy Trade development, average, Whole Milk Powder USD/TONNE 3,057 2,418 2,463 2015 2016 2017 OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017butter, while relatively low oil prices in MENA resulted in continued subdued demand. Milk price volatility a fundamental reality for the dairy industry The paradigm of milk price volatility highlighted in recent years is now a fundamental reality for the dairy industry. While milk prices and volumes both grew in 2017, this development masks the strong movements, up and down, that were now largely caused by changes in market supply. Global markets moved from a supply deficit in the first half of 2017 to a growing surplus towards the end of the year. The growing farmer milk supply towards the end of 2017 was driven by high milk prices. Hence, global market milk prices revealed the shifting supply and demand balance throughout 2017. More concrete signs of sustained supply growth from major exporters indicated that global prices had peaked for the current cycle and hence prices eased towards year-end. 7,000 6,000 5,000 4,000 3,000 0 Monthly average protein and fat prices EUR/TONNE Fat 47% 6 5 Protein -27% 2016 2017 6.8 Real GDP growth 2017 ANNUAL PER CENT CHANGE 1.9 2.0 1.8 1.7 2.2 2.2 3.1 3.6 China Den m ark Germ any 0.8 Nigeria Russian Federation 0.1 Saudi Arabia S w eden U nited Kingdo m U nited States Europe W orld OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017Financial review In 2017, Arla delivered a 27.4 per cent increase in milk prices to our farmer owners with a performance price of 38.1 EUR-cent/kg. Our commercial efforts in 2017 focused on converting increasing market prices for milk into tangible sales price increases while also delivering strategic branded volume growth. These efforts were rewarded with both an increase of EUR 1 billion in sales prices and nearly achieving our Good Growth 2020 share of strategic branded sales target of 45 per cent three years ahead of schedule. 6 6 In 2017, revenue grew to EUR 10.3 billion despite unchanged sales volumes, and a leverage of 2.6 underlined our strong financial position and cash flow. All key performance indicators developed positively, with the exception of conversion cost and working capital, which were negatively impacted by scale challenges in supply chain to accommo- date growth in consumer demand for new milk types and an increasingly complex brand and product portfolio, as well as higher underlying raw material prices respectively. Milk price to farmer owners increases due to strong commercial execution Arla’s mission is to secure the highest value for our farmers’ milk while creating opportunities for their growth. This commitment to maximise both short- and long-term value for our farmer owners requires strong commercial execution on all levels of our business. This is achieved by constantly honing our price management practices to succeed in increasingly volatile markets, delivering favourable branded growth to improve our product mix and profitability for the future and always delivering firm cost control. In most years, our development tends to favour either high milk prices for our farmer owners or taking important steps to enhance the shape of our business going forward. In 2017, however, we were able to deliver on both of these important objectives. The performance price is the most relevant KPI for Arla, measuring the value Arla creates per kg of owner milk. In 2017, the average performance price increased by 23.3 per cent versus the prior year to 38.1 EUR-cent/kg, compared to 30.9 EUR-cent/kg in 2016. The drivers of this increase were higher sales prices, as well as improving geographical and product mix. The prepaid milk price represents the on-account payment farmer owners receive per kg of milk delivered during the settlement period. The prepaid price increased to 35.8 EUR-cent/kg during the 2017 year versus 28.1 EUR-cent/kg during last year, which represents a 27.4 per cent increase for our farmer owners. Milk volumes from farmer owners versus prepaid milk prices e k a t n i k l i M G K N O I L L I M 1,200 1,100 1,000 900 800 Jan 2017 Feb 2017 M ar 2017 Apr 2017 M ay 2017 Jun 2017 Jul 2017 Aug 2017 Sep 2017 O ct 2017 N ov 2017 Dec 2017 Milk intake Prepaid milk price 40 35 30 E U R - C E N T / K G P r e p a d m i i l k p r i c e Arla milk intake in 2017 grew by 0.5 per cent compared to 2016 levels. The overall year-on-year stability masks a significant seasonality in milk intake throughout the year. During the first and second quarter of 2017, milk intake contracted by -4.5 and -1.2 per cent year-on-year in the aftermath of the low milk prices of 2016. During the third and fourth quarter of 2017, milk intake grew by 2.2 and 4.1 per cent year-on-year, driven by the significant milk price increases over the last 12 months. Strong revenue growth due to higher sales prices and product mix improvements In 2017, revenue increased by 8.1 per cent to EUR 10.3 billion, compared to EUR 9.6 billion in 2016. At Arla, there are four components of revenue development: sales prices, volumes and product mix, exchange rates, as well as changes due to acquisitions and/or divestments. Sales prices and to a lesser extent product mix were the drivers of sales growth in 2017 despite negative development of exchange rates and lost revenues from divestments. As a result, the underlying revenue development, excluding foreign exchange effects and prior year divestments, was 11.6 per cent. The biggest impact on revenue development in 2017 was higher sales prices. Our strategic decision to focus on increasing sales prices to allow us to maximise milk prices paid to our farmer owners resulted in EUR 1 billion in sales price increases. We are especially proud that in a year with significant price increases, we achieved unchanged sales volumes and a favourable volume/mix effect. Improving product mix, especially the continued strategic branded volume driven revenue growth, representing an increase of 3.0 per cent compared to last year, versus private label business, which declined 4.1 per cent compared to last year, also contributed positively to revenue development in 2017. As a result, the share of branded business at Arla OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017 148 million interactions Digital interactions, million 2017 2016 148 87 6 7 years following commercial launch. Arla’s innovation pipeline focuses on strategic growth areas, with particular focus in 2017 placed on Arla® Lactofree and Organic products, as well as dairy products to be consumed on-the-go. In recognition of increasing digital interfaces with consumers, we began to officially measure digital engagement for our brands in 2017. Digital engagement measures interactions on digital platforms such as Google, YouTube and Facebook, through actions such as number of likes, shares, comments, clicks, as well as website and video viewing based on a predefined time, as is an important indicator in measuring our digital reach. 2017 was the year of step change for digital engagement of our brands. With increased media investment into prioritised channels, our brands achieved an impressive digital engagement of 148 million interactions versus 87 million in 2016. As a result of this increased brand prioritisation throughout the Group, our brand recognition equity and market share increased in 2017. In particular, the Arla® brand won over 21 awards during the year, based on campaigns and new product launches, and ranked as the fastest growing FMCG brand in many countries, for example the Netherlands and the UK. In 2017, revenue were also negatively impacted with a full-year effect of EUR 90 million, due to the sale of the Rynkeby juice business in 2016, which was Arla’s last remaining non-dairy business unit. For more detail on revenue development please refer to Note 1.1. Brand growth and innovation journey continues Our brands are at the heart of our business and drive the majority of Arla’s profitability, and we are committed to strengthening and growing them further. In May, we opened the doors to our new Innovation Centre, which will now serve as the home to many product and brand developments. Increasing branded sales is critical for us to achieve stronger relative profitability on a medium- and long-term basis. We also know that branded revenue is less volatile and drives a fundamentally strong connection with consumers. For this reason, Arla continues to focus on growing our branded share of volume and increasing our investments in product innovation. Strategic branded volume driven revenue grew 3.0 per cent, a significant achievement in an inflationary price environment. This development was led by Nigeria in Sub-Saharan Africa, as well as China and South-East Asia for International, and Germany, the UK, the Netherlands and Belgium for Europe. Brand share for 2017 was 44.6 per cent, compared to 44.5 last year, illustrating continued growth in our brands despite significant raw material price increases, which impact non-branded revenue significantly more and faster than branded revenue. At constant prices, the brand share has improved to 46.4 per cent, which represents a very positive development. In 2017, we identified an opportunity to strengthen the positioning of the Arla® brand with a renewed focus on innovation. We formalised how we capture Arla’s innovation pipeline and measure, monitor closely and increase the value of products during the three reached 44.6 per cent. This is already very close to our Good Growth 2020 long-term ambition of 45 per cent and represents our most important quality of business indicator within the Group. Due to our increasing share of sales outside the eurozone, Arla is also exposed to currency fluctuations. In 2017, these negatively impacted our revenue by EUR 250 million, primarily due to the weakened GBP in the UK. Revenue development MILLION EUR 111 -90 1,000 -250 10,500 10,000 9,567 9,500 Revenue 2016 Sales prices Volume/mix 10,338 M&A Revenue 2017 Currency OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017Sales increase for all strategic brands Strategic branded revenue by brand Arla® The Arla® brand is at the heart of our global business and is the key driver of our branded growth. In 2017, Arla® brand sales grew 10.1 per cent to EUR 3,026 million. This development was largely driven by sales price increases. Nevertheless, Arla® branded volumes grew by 3.4 per cent. This improvement was primarily a result of the expansion in the milk- based beverages, family and child nutrition and mozzarella categories. It was also strongly impacted by new growth platforms such as Arla® BoB (Best of Both), Arla Baby & Me®, Arla® skyr and Arla® Protein. The Arla® brand also gained market share in most markets. In Europe, we recorded market share gains in the UK, Germany, and the Netherlands. In our International commercial segment, Arla market share grew most significantly in Nigeria, Saudi Arabia, and China. 66% Lurpak® Revenue for Lurpak®, our leading brand for butter and spreads, increased 8.3 per cent to EUR 528 million in 2017. This was driven by sales price increases at double-digit rates in all core markets. However, in maximising these revenue gains, volumes decreased by 2.7 per cent. Nevertheless, Lurpak® remains the world’s biggest global butter brand. We believe that we are the industry leader in innovation for this category. 12% 6 8 Castello® Sales of our Castello® specialty cheese brand grew 3.1 per cent to EUR 181 million. However, volumes increased 2.7 per cent, and product mix also improved through good growth in Australia and Norway. Puck® MENA’s leading brand, Puck®, continued to perform strongly for Arla in 2017. This multi-faceted brand is core to our sales in our largest international commercial region. Puck® revenues grew 6.8 per cent in 2017 to EUR 339 million. In line with all of Arla’s brands, higher sales prices were the biggest contributor to sales growth for the Puck® brand. Volumes increased by 4.4 per cent in 2017. Puck® also made strong market share gains in all markets where it is sold, and achieved the number one position in Saudi Arabia. 4% 8% Other supported brands : 10% OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017Revenue by commercial segment MILLION EUR Europe 6,568 2016: 6,321 Arla Foods Ingredients 651 2016: 545 International 1,616 2016: 1,428 Trading 1,503 2016: 1,273 6 9 Sales grow in all commercial segments Europe Sales to European retail and foodservice comprise our largest commercial segment, accounting for 63 per cent of total revenue during 2017, and excludes European revenue from Arla Foods Ingredients and Trading. Sales in Europe grew 3.9 per cent to EUR 6,568 million compared to EUR 6,321 million last year, driven by higher sales prices and an improved product mix. Despite volume declines, adverse currency effects and declining consumption for the entire industry, we maintained our position with unchanged volumes of strategic branded products. This proves that we were able to deliver the optimal mix of maximum sales price increases while avoiding volume trade-offs for our big brands. In the European market, the branded business grew approximately one per cent, driven by butter and yoghurt. For developments of each of our strategic European markets please refer to page 30. International Our International commercial segment comprised 16 per cent of total revenue during 2017. This business focuses on sales to retail and foodservice partners in countries outside Northern and Central Europe, and excludes the International revenue from Arla Foods Ingredients and Trading. International sales grew 13.2 per cent to EUR 1,616 million, compared to EUR 1,428 million last year. This development was the result of strong volume increases and to a lesser extent price increases. In this high-margin segment, volumes of our strategic brands grew by 10.5 per cent despite challenging market dynamics in the Middle East, our largest International commercial region. China and Nigeria, where sales grew 49.5 per cent and 55.6 per cent respectively, performed particularly well. For more detail on the performance of each of our strategic International markets please refer to page 32. Arla Foods Ingredients Arla Foods Ingredients (AFI) was our fastest growing commercial segment and delivered 6 per cent of Arla sales in 2017. This subsidiary, which is separately managed and 100 per cent owned by Arla, excels in producing highly specialised whey-based ingredients and child nutrition products for Arla and third parties. In 2017, sales grew 19.6 per cent to EUR 651 million versus EUR 545 million last year. This strong revenue development was driven by the sale of higher volumes in our third party manufacturing business, as well as strong price and volume growth in the value-added protein segment. Refer to page 34 for more on our AFI journey. Trading Trading encompasses our business-to-business sales to other companies for use in their production, as well as industry sales of cheese, butter or milk powder. Although this is not a core business segment, it is critical to our success because it allows us to better manage seasonal and geographical availability in milk intake. Trading and other sales increased 18.0 per cent to EUR 1,503 million versus EUR 1,273 million last year as a direct result of higher market prices. This represents 15 per cent of total revenue for Arla in 2017. However, the trading share of overall milk intake volumes remained stable at 20.2 per cent compared to 20.1 per cent last year, a result of our continued focus on growing the strategic branded portion of our business. OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017A growing range of milk types increases complexity and cost in our production, but as the world’s largest organic dairy producer with 931 organic farms, Arla is in a unique and strong position to profit from the growing demand for lifestyle dairy products such as organic. Net profit hitting target range At Arla we target an annual net profit share in the range of 2.8 to 3.2 per cent of revenue. This allows us to balance the retained capital for future investments, and provide supplementary payment for our farmer owners while continuing to pay out the largest possible share of our profit to our farmer owners via the prepaid milk price. To maximise overall prepaid prices to farmer owners, which also helps drive increased sales prices towards retail and foodservice customers, we prioritised prepaid prices throughout the year and thereby achieved a profit share of 2.8 per cent for 2017. This compares to a profit level of 3.6 percent last year, when the sale of our Rynkeby subsidiary impacted profit by 1.2 percentage points or EUR 120 million. Net profit achieved in 2017 was positively influenced by 0.4 percentage points or EUR 44 million, as a result of the sale of shares in the Brazilian-based associate, Vigor. The divestment was a strategic choice to reduce our position in markets not driving sizeable growth, as part of our ambition to focus on continually expanding into growth markets as the preferred dairy company for consumers. Cost development in supply chain challenged by growing complexity Costs for Arla include four major areas: milk, production, sales and distribution, as well as administration. Operating expenses increased 8.8 per cent in 2017 to EUR 10.1 billion 7 0 compared to EUR 9.3 billion last year. However, the majority of this increase was in the form of higher milk prices paid to our farmer owners. Costs excluding milk prices decreased by 3.9 per cent due a strong focus on cost management, as well as due to the valuation of inventory on the basis of the prepaid milk price and currency translation rates. Read more in Note 1.2. As part of our efforts to prioritise sales prices over volumes in 2017, sales volumes to retail and foodservice customers declined slightly. This meant scale efficiencies, which are only possible with increasing volumes could not be achieved in 2017. In addition, consumer demand for a diverse range of dairy products meant increased complexity caused by a broader and more diverse portfolio of branded products and use of different milk types, and corresponding supply chain production costs. As a result, our conversion cost index, which measures the total cost of supply chain per kg of processed milk, increased to an index of 103.9 compared to 99.2 last year. Supply chain efficiency was especially challenged in Germany, where strategic commercial decisions throughout 2017 to step out of significant UHT private label contracts negatively impacted supply chain costs in this region. We have a strong focus on monitoring cost developments. In 2017, scalability became a Composition of total operational costs MILLION EUR 10,500 7 4 5 4 , 7 4 8 9 , 8 2 0 4 , 4 5 2 9 , 8 4 0 5 , 6 6 0 0 1 , 5,250 0 0 3 5 , 6 2 2 5 , 8 1 0 5 , 0 2015 2016 2017 Weighed-in raw milk Other non-milk costs Total operational costs OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017less relevant cost performance indicator for our business, as it measures the relationship between retail and foodservice volume growth and capacity costs. With increased volatility in the dairy industry, the ability to manage an optimal trade-off between retail and food service and more trading-related products becomes increasingly important and we therefore need a core value driver that holistically reflects our cost development. The capacity cost index exempli- fies the cost of running our general business as a suitable performance driver. In 2017, we reached a capacity cost index of 101.9, primarily driven by Arla Foods Ingredients and International to support the strong commercial growth. Strong financial leverage proves increasing cash generation capabilities in 2017 Our balance sheet is a critical lever for success. It provides Arla the financial strength to invest in delivering our strategy, Good Growth 2020, and continually developing to create the future of dairy. Arla is considered to be a robust investment grade company, and we continually strive to uphold this status, which requires a strong balance sheet. Financial leverage is calculated as the ratio of net interest-bearing debt to profitability, i.e. EBITDA. The ratio measures Arla’s ability to generate profit compared to our net financial debt. Financial leverage is our most important balance sheet performance indicator, and we have therefore defined a long-term target range of 2.8 to 3.4 for this key ratio. In 2017, financial leverage was successfully delivered below our target range at 2.6. The underlying performance excluding gains from one-offs, Rynkeby in 2016 and Vigor in 2017, was stable at approximately 2.8. Net interest- bearing debt, excluding pension liabilities, was unchanged at EUR 1.6 billion in 2017, compared to EUR 1.6 billion last year. EBITDA was EUR 738 million in 2017 versus EUR 839 million in the prior year. The increase in milk prices negatively impacted working capital. Inventory values on our balance sheet grew 18.5 per cent to EUR 1,126 million versus EUR 950 million last year, driven by higher underlying raw material prices and slightly higher stock on hand. Receivables, also impacted by higher sales prices, further increased 7.5 per cent to EUR 942 million versus EUR 876 million last year, and reduced our absolute cash position. Working capital in days also slightly deteriorated compared to last year despite significant improvements in trade payables and trade receivables due to the increased use of our supply chain financing programme as well as a continued focus on cash collection and overdue reduction. However, the slightly increased stock on hand, to improve delivery accuracy as well as a change in product mix, partly offset these improvements. Approved capital expenditure, also referred to as CAPEX, for 2017 was EUR 335 million in 2017, increasing by 46.9 per cent from EUR 228 million last year. Actual spend of EUR 298 million was incurred in 2017 due to the timing of finalising investment projects. Major CAPEX focus areas in 2017 included new production methods, production capacity expansions, and investments based on non-GMO feed milk and organic. Solid cash flow in 2017 Cash flow from operating activities decreased to EUR 386 million compared to EUR 806 million last year, mainly due to the increase in milk price and the corresponding increase in trade receivables and inventory values. Consequently, free operating cash flow for 2017 was EUR 100 million, compared to EUR 501 million last year. Cash flow from investing activities was EUR -219 million compared to EUR -167 million in 2016. The difference was mainly driven by the sale of Rynkeby in 2016. Furthermore, our increased approved CAPEX volume did not fully materialise in 2017 due to the timing of projects. As a consequence of the reduced free cash flow, less debt was paid off in 2017 resulting in cash flow from financing activities of EUR -155 million compared to EUR -624 million last year. A supplementary payment of EUR 120 million was made in line with the Board of Representative’s decision to pay out 1 EUR-cent/ kg of member milk to our farmer owners. 7 1 Leverage 2.6 Net interest-bearing debt including pensions MILLION EUR 7 9 4 2 , 7 1 0 2 , 3 1 9 1 , 2017 2016 2015 2.6 2.4 3.3 Target 2017 2.8 - 3.4 2015 2016 2017 OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017Financial outlook In 2018, we will continue our journey of branded transformation and are committing our investments into areas that deliver the most growth to our business, guided by our strategy, Good Growth 2020. The dairy industry remains volatile, and market price declines in the first quarter of the year are creating further uncertainty in the marketplace. However, demand for our products continues to be strong as we shape and shift our global strategic brands to create the future of dairy. 7 2 Solid underlying economic growth continues, driven by emerging economies We enter 2018 with the expectation of slightly higher GDP growth in most markets compared to 2017. Demand signals for dairy products also look positive. Underlying growth is again expected to be predominantly driven by a growing demand from emerging economies where rising business investment, increasing disposable incomes, better infrastructure, and growing access to the Internet have contributed to strong growth rates in markets like China, Nigeria, Ghana, and Bangladesh. Despite solid macroeconomic signals overall, uncertainty remains in several European and global countries where recent and pending elections have the potential to impact trade as well as fiscal and monetary policies. We do not currently foresee significant changes in global consumption trends or big shifts in global trade patterns during 2018. Continuous monitoring and ensuring our ability to react and adapt quickly will be imperative in the year ahead, and beyond. Continued focus on managing sales prices and margins across our portfolio Within Arla, we will continue to focus on delivering the highest possible milk price for our farmers, and a competitive milk price in the market. As volatility in the underlying commodi- ty market continues, we are strengthening our efforts in price management with our retail and foodservice customers. successful 2017, where we achieved sales price increases of EUR 1 billion across our portfolio, we expect revenue in 2018 to be at a similar level of between EUR 10 to 10.5 billion. This will result from higher milk volumes and improving product mix being at least partially offset by lower milk prices and negative exchange rate developments. Market milk price environment declining from a high level Market milk prices have begun to decline as we enter 2018. However, even if price declines persist, we continue to expect reasonable price levels in 2018. In response to strong market and farmer milk price increases in 2017, Arla expects a growing milk supply in 2018 as farmer owners react to higher prices and increase their production on the farm. Accelerated focus on branded growth In 2018, we will continue to expand the value of our business by accelerating and sharpening the profile of our strategic brands Arla®, Castello®, Lurpak® and Puck®. We will introduce new sub-brands to our broad product portfolio and continue to invest in our brands to increase the share of branded sales, thereby ensuring our future growth and profitability. We plan to deliver a strategic branded volume driven revenue growth of 1 to 3.5 per cent, and a brand share greater than 45 per cent as we invest in areas where we see the most growth potential, supported by exciting new marketing initiatives. Managing an increasingly diverse milk pool to meet the demand for a broad range of lifestyle dairy products, we aim to implement gross margin-enhancing initiatives to optimise the balance between complexity and customer requirements, short-term price volatility and long-term market positions. After a very International growth remains a firm focus As part of our ambition to secure a high milk price for our farmer owners in the long-term, we will focus on driving growth in high-profit areas, including many of our International markets. In 2018, we plan to launch new and innovative products in profitable categories across the globe. This includes boosting our milk-based beverages business, building infant formula, relaunching our successful Arla Dano® brand, driving Arla® Organic into International markets, and accelerating our foodservice business. Also, we are planning to strengthen our local partnerships and production footprint in International markets to provide a sustainable base supporting our growth. As a result, we aim to achieve an International share of our business greater than 20 per cent in 2018. Approved CAPEX investments MILLION EUR 527 527 335 228 210 2015 2016 2017 2018 OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017Significantly investing in marketing and CAPEX Safely within our leverage target range of 2.8 to 3.4, in 2018, we will increase our CAPEX significantly, enabling further growth and value creation by investing in innovative technology and new, expanded and improved production capacity. We will focus on increasing our European production capacity in 2018. A large part of investments targets projects aimed at growing Arla’s business outside of Europe, where our strategic growth markets include the MENA, China and Southeast Asia, Sub-Saharan Africa and the US. With a continued investment in healthy and natural lifestyle dairy products, a new Lactofree production will be established in the UK. In addition, Arla Foods Ingredients will drive value-add speciality products by investing in groundbreaking technology and capacity expansions. Furthermore, we will pursue renewable energy sources, helping to reduce our carbon emissions and achieve our goal of having at least half the energy we use derived from renewable sources like biomass, wind and water by 2020. Profit share expected within target range of 2.8 to 3.2 per cent As we continue to focus on paying out the largest possible share of our profit via the prepaid milk price to our farmer owners, we continue to target a profit share for 2018 in the range of 2.8 to 3.2 per cent of revenue. More visibly than in previous years, we expect to see seasonality in our operations impacting the 2018 half-year results. Our net profit target range is a full-year target, and results at half-year 2018 are expected to be below the annual target range. Committed to our strategy Good Growth 2020 We are committed to our strategy Good Growth 2020, and will continue to focus management attention where we believe it adds most value for our farmer owners. In a volatile market and an uncertain geopolitical environment, we will build the strength of our brands and business. In 2018, we will also focus energy to realise efficiencies through our transformation programme, Calcium. Calcium will cover activities throughout Arla and our ambition is to achieve a bottom line impact of EUR 30 million in 2018. Moving forward, we anticipate even greater savings and plan to reinvest significantly into areas that fuel future growth. The Executive Management Team has presented eight essential business priorities for 2018. Read more on page 22. Expectations for 2018 7 3 Revenue Profit share 10-10.5 BILLION EUR 2.8-3.2% OF REVENUE Brand share >45% International share >20% Strategic branded volume driven revenue growth 1-3.5% Calcium 30 MILLION EUR Leverage 2.8-3.4 OUR FINANCIAL REVIEWARLA FOODS ANNUAL REPORT 2017D E T A D I L O S N O C S T N E M E T A T S I L A C N A N I F Whatever moves you, Arla® skyr brings you further. Arla® skyr is a great source of go-to goodness being low fat, high in protein and low in sugar. Arla® skyr has been hugely successful in Europe. In Germany, for example, sales nearly doubled in 2017, making an important contribution to achieving our Good Growth 2020 strategy. Income statement (EURm) Revenue Production costs Gross profit Sales and distribution costs Administration costs Other operating income Other operating costs Gain from sale of enterprise Share of results after tax in joint ventures and associates Earnings before interest and tax (EBIT) Specification: EBITDA excluding gain from sale of enterprise Gain from sale of enterprise Depreciation, amortisation and impairment losses Earnings before interest and tax (EBIT) Financial income Financial costs Profit before tax 7 6 Tax Profit for the year Minority interests Arla Foods amba's share of profit for the year Note 2017 2016 Development 1.1 1.2 1.2 1.2 1.3 1.3 3.6 3.4 3.6 1.2 4.1 4.1 5.1 10,338 -8,063 2,275 -1,584 -419 71 -39 44 37 385 694 44 -353 385 13 -77 321 -22 299 -14 285 9,567 -7,177 2,390 -1,642 -435 91 -29 120 10 505 719 120 -334 505 7 -114 398 -42 356 -9 347 8% 12% -5% -4% -4% -22% 34% -63% 270% -24% -3% -63% 6% -24% 86% -32% -19% -48% -16% 56% -18% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Profit appropriation (EURm) 2017 2016 Profit for the year Minority interests Arla Foods amba's share of net profit for the year Proposed profit appropriation: Supplementary payment for milk Interest on contributed capital Total supplementary payment Transferred to equity: Reserve for special purposes Contributed capital Total transferred to equity Appropriated profit 299 -14 285 124 3 127 120 38 158 285 356 -9 347 121 3 124 193 30 223 347 Significant increase in performance price A key measure expressing Arla’s overall performance is the performance price. This measures the value added to each kg of milk supplied by our farmer owners. The performance price is calculated as the standardised prepaid milk price, included in production costs, plus Arla Foods amba’s share of profit for the year, divided by milk volume supplied. In 2017, the performance price was 38.1 EUR-cent/kg owner milk, compared to 30.9 EUR-cent/kg owner milk last year. For more detail, please refer to the financial review on page 66. The higher sales prices achieved during 2017 significantly impacted both revenue and our ability to increase the payment for milk from farmer owners and thereby our cost. Furthermore, the income statement was again impacted negatively by effects from currencies this year. Revenue was adversely impacted by EUR 250 million, while operational costs were reduced by EUR 192 million. For more detail refer to Note 1. Net profit of the Group was EUR 299 million compared to EUR 356 million last year, corresponding to a 16 per cent decrease, due to the effect from the divestment of Rynkeby in 2016. Net profit allocated to the farmer owners of Arla Foods amba amounted to EUR 285 million, which constitutes 2.8 per cent of revenue compared to 3.6 per cent last year. 7 7 The proposed supplementary payment is EUR 127 million, including interest, corresponding to 1 EUR-cent/kg owner milk. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Comprehensive income (EURm) Profit for the year Other comprehensive income Items that will not be reclassified to the income statement: Actuarial gains and losses on defined benefit plans Income tax on actuarial gains and losses on defined benefit plans Items that may be reclassified subsequently to the income statement: Value adjustments of hedging instruments Value adjustments of financial assets classified as available for sale Adjustments related to foreign currency translation Income tax on items that may be reclassified to profit or loss Other comprehensive income, net of tax Total comprehensive income Allocated as follows: Owners of Arla Foods amba Minority interests Total 7 8 Note 4.7 4.4.b 2017 299 58 -10 48 14 -77 -1 32 331 321 10 331 2016 356 -132 21 -22 -2 -40 -5 -180 176 169 7 176 Comprehensive income Total comprehensive income amounted to EUR 331 million, compared to EUR 176 million last year. Other comprehensive income amounted to EUR 32 million and was affected by a positive development in defined benefit plans amounting to EUR 58 million, compared to a loss of EUR 132 million last year. Read more about pension liabilities in Note 4.7. Adjustments related to currency translation had a negative effect of EUR 77 million, while the value adjustment of hedging instruments had a positive impact of EUR 48 million. Other comprehensive income explained Other comprehensive income includes revenue, expenses, gains and losses that are excluded from the income statement. Typically, they have not yet been realised and mainly relate to adjustments related to currency translation, actuarial gains and losses on pension plans and unrealised value adjustments on hedging activities to secure future cash flow. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Balance sheet (EURm) Assets Non-current assets Intangible assets Property, plant and equipment Investments in associates Investments in joint ventures Deferred tax Other non-current assets Total non-current assets Current assets Inventory Trade receivables Derivatives Current tax Other receivables Securities Cash and cash equivalents Total current assets Total assets Equity and liabilites Equity Common capital Individual capital Other equity accounts Proposed supplementary payment to owners Equity attributable to the parent company's owners Minority interests Total equity Liabilities Non-current liabilities Pension liabilities Provisions Deferred tax Loans Total non-current liabilities Current liabilities Loans Trade payables Provisions Derivatives Current tax Other current liabilities Total current liabilities Total liabilities Total equity and liabilities Note 2017 2016 Development 3.1 3.3 3.4 3.4 5.1 2.1 2.1 4.7 3.5 5.1 4.2 4.2 2.1 3.5 811 2,212 401 53 43 31 3,551 1,126 942 19 1 181 511 91 2,871 6,422 1,781 502 -77 127 2,333 36 2,369 277 12 59 1,206 1,554 1,013 1,098 11 87 11 279 2,499 4,053 6,422 825 2,310 434 51 74 20 3,714 950 876 31 1 222 504 84 2,668 6,382 1,595 503 -65 124 2,157 35 2,192 369 12 80 1,281 1,742 947 995 13 168 18 307 2,448 4,190 6,382 7 9 -2% -4% -8% 4% -42% 55% -4% 19% 8% -39% 0% -18% 1% 8% 8% 1% 12% 0% 18& 3% 8% 3% 8% -25% 0% -26% -6% -11% 7% 10% -15% -48% -39% -9% 2% -3% 1% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Changes in equity Common capital Individual capital Other equity accounts t n u o c c a l a t i p a C 829 - - - - - - 48 48 3 - - - 15 18 895 909 - - - - - - -111 -111 - - - - - 31 31 829 l a i c e p s r o f e v r e s e R s e s o p r u p 766 - - 120 - - 120 - 120 - - - - - - 886 573 - - 193 - - 193 - 193 - - - - - - - 766 s e t a c fi i t r e c r e n w o d e s a b - y r e v i l e D 87 - - - - - - - - - -7 - - -1 -8 79 94 - - - - - - - - - -6 - - - -1 -7 87 l a t i p a c d e t u b i r t n o C 416 - - - 38 - 38 - 38 - -21 - - -10 -31 423 422 - - - 30 - 30 - 30 5 -16 - - - -25 -36 416 s r e n w o o t t n e m y a p y r a t n e m e l p p u s d e s o p o r P 124 124 3 - - - 127 - 127 - - - -120 -4 -124 127 113 121 3 - - - 124 - 124 - - - - -108 -5 -113 124 s t n e m u r t s n i i g n g d e h e u l a v r o f e v r e s e R f o t n e m t s u d a j -122 - - - - - - 47 47 - - - - - - -75 -95 - - - - - - -27 -27 - - - - - - - -122 e l a s r o f e l b a l i a v A e v r e s e r 3 - - - - - - 14 14 - - - - - - 17 5 - - - - - - -2 -2 - - - - - - - 3 e g n a h c x e n g e r o f i s t n e m t s u d a j r o f e v r e s e R 54 - - - - - - -73 -73 - - - - - - -19 92 - - - - - - -38 -38 - - - - - - - 54 l a t o T 2,157 124 3 120 38 - 285 36 321 3 -28 - -120 - -145 2,333 2,113 121 3 193 30 - 347 -178 169 5 -22 - - -108 - -125 2,157 s t s e r e t n i y t i r o n M i 35 - - - - 14 14 -4 10 - - -9 - - -9 36 35 - - - - 9 9 -2 7 - - -8 1 - - -7 35 y t i u q e l a t o T 2,192 124 3 120 38 14 299 32 331 3 -28 -9 -120 - -154 2,369 2,148 121 3 193 30 9 356 -180 176 5 -22 -8 1 -108 - -132 2,192 8 0 (EURm) Equity at 1 January 2017 Suplementary payment for milk Interest on contributed capital Reserve for special purposes Contributed capital Minority interests Profit for the year Other comprehensive income Total comprehensive income Capital issued to new owners Payments to owners Dividend to minority shareholders Supplementary payment to owners Foreign exchange adjustments Total transactions with owners Equity at 31 December 2017 Equity at 1 January 2016 Suplementary payment for milk Interest on contributed capital Reserve for special purposes Contributed capital Minority interests Profit for the year Other comprehensive income Total comprehensive income Capital issued to new owners Payments to owners Dividend to minority shareholders Disposal of non-controlling interests Supplementary payment to owners Foreign exchange adjustments Total transactions with owners Equity at 31 December 2016 Understanding equity Equity accounts regulated by the Articles of Association can be split into three main categories: common capital, individual capital and other equity accounts. The characteristics of each account are explained in detail: Common capital Common capital is by nature undivided and consists of the capital account and the reserve for special purposes. The capital account represents a strong foundation for the cooperative’s equity, as the non-impairment clause, described on page 81, ensures that the account cannot be used for payment to owners. The reserve for special purposes is an account that in extraordinary situations can be used to compensate owners for losses or impairments affecting the profit for appropriation. Amounts transferred from the annual profit appropriation to common capital are booked to this account. Individual capital Individual capital is capital allocated to each owner based on their delivered milk volume. Individual capital consists of delivery-based owner certificates and contributed capital. Amounts registered to these accounts will, subject to approval by the Board of Representatives, be paid out when owners leave the cooperative. Amounts allocated to individual capital as part of the annual profit appropriation are interest-bearing. Also characterised as individual capital is the account for proposed supplementa- ry payment to owners that will be paid out following the approval of the annual report. Other equity accounts Other equity accounts include accounts prescribed by IFRS that are disclosed separately and cannot be used for payment to owners. These include reserves for value adjustment of hedging instruments, the available for sale reserve and the reserve for foreign exchange adjustments. Minority interests Minority interests include the share of Group equity attributable to holders of minority interests in Group companies. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Equity improved During 2017, equity increased by EUR 177 million compared to last year. Profit appropriation Proposed supplementary payment is EUR 124 million, corresponding to 1 EUR-cent/kg owner milk. Interest on consolidated contributed capital amounts to EUR 3 million, which gives rise to a proposed supplementary payment of EUR 127 million. The average supplementary payment of 1 EUR-cent/kg owner milk is unchanged compared to last year. Profit appropriation cooperative. It is expected that EUR 30 million will be paid out in 2018 to owners resigning or retiring. The gain on the divestment of the associated company Vigor, amounting to EUR 44 million, was transferred to the reserve for special purposes in accordance with the consolidation policy approved by the Board of Representatives. The basis for consolidation, after adjusting for the gain on divestment, is EUR 114 million. This is split into 1/3 to individual capital (contributed capital), amounting to EUR 38 million, and 2/3 to common capital (reserve for special purposes), amounting to EUR 76 million. Other comprehensive income Other comprehensive income amounting to a gain of EUR 32 million is primarily attributable to actuarial gains on pension liabilities, value adjustments on hedging instruments and net assets measured in foreign currencies. Payments to and from owners A supplementary payment relating to 2016 totalling EUR 120 million was paid out in March 2017. Additionally, EUR 28 million was paid out to owners resigning or retiring from the Performance price 38.1 EUR-cent/kg Prepaid 35.8 EUR-cent/kg Profit for the year 285* 2.30 EUR-cent/kg EURm Supplementary payment: 1 EUR-cent/kg owner milk Supplementary payment 124 EURm 3** 127 EURm EURm Consolidation 114 EURm 44*** 158 EURm EURm Consolidation principles: Common capital 2/3 Individual capital 1/3 Common capital 76 EURm 44*** 120 EURm EURm Individual capital 38 EURm 8 1 * Based on profit allocated to owners of Arla Foods amba ** Interest on contributed capital: 0.04 EUR-cent/kg owner milk *** Gain on the divestment of associated company Vigor Regulations according to Articles of Association and IFRS Recognised within the capital account are technical items such as movements on actuarial gains or losses on defined benefit pension schemes, effects from disposal and acquisitions of non-controlling interests in subsidiaries and exchange rate differences in the owners’ equity instruments. Furthermore, the account is impacted by agreed contributions from new members of the cooperative. Recognised within the reserve for special purposes is the annual profit appropriation to common capital. It may, upon the Board of Director’s proposal, be applied by the Board of Representatives for the full or partial off-setting of material extraordinary losses or impairment in accordance to article 21(iii) of the Articles of Association. Delivery-based owner certificates are established in accordance with article 21(1)(ii) of the Articles of Association and related regulations. Consolidation on this account was suspended from 2010. Contributed capital is established in accordance with article 21(1)(iii) of the Articles of Association and regulation. Amounts consolidated as contributed capital via the annual profit appropriation carry interest at CIBOR 12 months + 1.5 per cent. Amounts paid into the contributed capital in connection with mergers carry no interest. Interest is paid out along with the supplementary payment. Individual owners’ balances on delivery-based owner certificates and on contributed capital can be paid out over three years upon termination of membership of Arla Foods amba in accordance with the Articles of Association, subject to the Board of Representatives’ approval. Balances on individual accounts are denominated in the currency relevant to the country in which the members are registered. Foreign currency translation adjustments are calculated annually, the amount of which is then transferred to the capital account. Proposed supplementary payment to owners is recognised separately in equity until approved by the Board of Representatives. Reserve for value adjustments of hedging instruments comprises the fair value adjustment of derivative financial instruments classified as and meeting the conditions for hedging of future cash flows and where the hedged transaction has not yet been realised. Available for sale reserve comprises value adjustments on securities classified as held for sale. Reserve for foreign exchange adjustments comprises currency translation differences arising during the translation of the financial statements of foreign companies, including value adjustments relating to assets and liabilities that constitute part of the Group’s net investment, and value adjustments relating to hedging transactions that hedge the Group’s net investment. Non-impairment clause Under the Article of Association, no payment may be made by Arla Foods amba to owners that impair the sum of the capital account and equity accounts prescribed by law and IFRS. The non-impairment clause is assessed on basis of the most recent annual report presented under IFRS. Individual capital accounts and reserve for special purposes are not covered by the non-impairment clause. Minority interests Subsidiaries are fully recognised in the consolidated financial statements. Minority interests’ share of the results for the year and of the equity in the subsidiaries that are not wholly owned are recognised as part of the consolidated results and equity, respectively, but are listed separately. On initial recognition, minority interests are measured at either the fair value of the equity interest or the proportional share of the fair value of the acquired companies identified assets, liabilities and contingent liabilities. The measurement of minority interests is selected on a transactional basis, and disclosure is made in the note pertaining to business combinations. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Cash flow (EURm) Note 2017 2016 EBITDA Gain from sale of enterprise EBITDA excluding gain from sale of enterprise Share of results in joint ventures and associates Change in net working capital Change in other working capital Other operating items without cash impact Dividends received, joint ventures and associates Interest paid Interest received Tax paid Cash flow from operating activities Investment in intangible fixed assets Investment in property, plant and equipment Sale of property, plant and equipment Operating investing activities Free operating cash flow Acquisition of enterprises Sale of enterprises Financial investing activities 8 2 Cash flow from investing activities Free cash flow Supplementary payment regarding the previous financial year Paid out from equity regarding terminated membership contracts Loans obtained, net Payment to pension liabilities Cash flow from financing activities Net cash flow Cash and cash equivalents at 1 January Exchange rate adjustment of cash funds Transferred to asset held for sale Cash and cash equivalents at 31 December 3.6 3.4 2.1 5.1 3.1 3.3 3.3 3.6 3.6 4.2 738 -44 694 -37 -200 8 -10 7 -52 5 -29 386 -50 -248 12 -286 100 -7 74 67 -219 167 -120 -28 32 -39 -155 12 84 -5 - 91 839 -120 719 -10 138 -3 22 12 -59 5 -18 806 -58 -263 16 -305 501 - 138 138 -167 639 -108 -22 -449 -45 -624 15 70 -8 7 84 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Accounting policies The consolidated cash flow statement is presented according to the indirect method, whereby the cash flow from operating activities is determined by adjusting EBITDA for the effects of non-cash items such as undistributed results in joint ventures and associates and the effects of changes in working capital items during the period. flow is a measure of the amount of cash generated after investing activities. A supplementary payment of EUR 120 million was made in relation to the 2016 profit allocation. Further payments, representing EUR 28 million in individual capital, were paid out to owners who resigned or retired. Combined cash and cash equivalents as at 31 December 2017 were EUR 91 million, compared to EUR 84 million last year. Solid cash flow Cash flow from operating activities was EUR 386 million, significantly impacted by additional cash tied up in working capital due to higher milk prices. This represents a reduction compared to last year, where lower milk prices had a positive effect on working capital. After operating investments of EUR 286 million, the free operating cash flow was EUR 100 million. Free operating cash flow is a measure of the amount of cash generated by normal business operations. As a result of our financial investing activities, primarily related to sale of the investment in Vigor, the free cash flow was EUR 167 million. Free cash Development in cash flow (EURm) 900 800 700 600 500 400 300 200 100 0 694 -200 -286 -148 84 -7 -46 91 Loans obtained, Cash 1 January 2017 Supplementary payment EBITDA excluding gain Operating investing activities Net working capital including pensions and leaving members from sale of enterprise Other Cash 31 December 2017 8 3 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Statement by the Board of Directors and the Executive Board Today, the Board of Directors and the Executive Board discussed and approved the annual report of Arla Foods amba for the financial year 2017. The annual report was prepared in accordance with International Financial Reporting Standards as adopted by the EU and additional disclosure requirements in the Danish Financial Statements Act. It is our opinion, that the consolidated financial statements and the parent company financial statements give a true and fair view of the Group’s and the parent company’s financial position as at 31 December 2017 and of the results of the Group’s and the parent company’s activities and cash flows for the financial year 1 January to 31 December 2017. In our opinion, management’s review of the annual report includes a true and fair view of the developments of the Group’s and the parent company’s financial position, activities, financial matters, results for the year and cash flow, as well as a description of the most significant risks and uncertain- ties that may affect the Group and the parent company. We hereby recommend the annual report for adoption by the Board of Representatives. Aarhus, 20 February 2018 8 4 Peder Tuborgh CEO Åke Hantoft Chairman Jan Toft Nørgaard Vice Chairman Viggo Ø. Bloch Jonas Carlgren Arthur Fearnall Manfred Graff Heléne Gunnarson Markus Hübers Bjørn Jepsen Steen Nørgaard Madsen Torben Myrup Johnnie Russell Manfred Sievers Simon Simonsen Inger-Lise Sjöstrom Håkan Gillström Employee representative Ib Bjerglund Nielsen Employee representative Harry Shaw Employee representative CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Introduction The following sections provide additional disclosures supplementing the primary financial statements. This section gives a summary of the basis for preparation, applied materiality, description of significant accounting estimates and assessments performed by management and currency translation exposure. Further detail can be found in the individual notes to the financial statements. Basis for preparation The annual report is based on the Group’s monthly reporting procedures, where Group entities follow a structured process, providing consistent financial reports, which form a basis for both internal and external reporting purposes. Group entities are required to report using standard accounting principles in accordance with the International Financial Reporting Standards (IFRS). At year-end, ordinary monthly reporting is supplemented with additional disclosures. and coordinated with the respective sub-entities. Consolidation also follows a standardised monthly process, supported by relevant controls. The Group uses a standard ERP system implemented in the majority of Group entities. Through standardised and harmonised processes and controls, there is a continuous focus on securing the reporting quality and avoiding surprises. EY, the Group’s external auditors, conducts an annual audit, which is centralised The information in the annual report is presented in classes of similar items in the financial statements as required by IAS 1. For more detail on the basis for preparation and accounting policies applied, please refer to chapter 5.6. Applying materiality When preparing the annual report, management seeks to improve the value of the information in the report by focusing on information that will help the understanding of the Group’s performance in the reporting period and the financial position at year end. The focus is on presenting information that is considered of material importance for our stakeholders, rather than generic descriptions. Disclosures that are required by IFRS are included in the annual report, unless the information is considered of immaterial importance to the users of the annual report. Materiality is not applied for items where disclosures are required for control purposes. 8 5 Significant accounting estimates and assessments by management Preparing the Group’s consolidated financial statements requires management to make accounting estimates and judgements that affect the recognition and measurement of the Group’s assets, liabilities, income and expenses. The performed estimates and judgements are based on historical experience and other factors. By nature, these are associated with uncertainty and unpredictability, which can have a significant effect on the amounts recognised in the consolidated financial statements. The most significant accounting estimates relate to: Measurement of revenue and rebates Revenue, net of rebates, is recognised when goods are transferred to customers. Estimates are applied when measuring the accruals for rebates and other sales incentives. The majority of rebates are calculated using terms agreed with the customer. For some customer relationships, the final settlement of the rebate depends on future volumes, prices and other incentives. Thus, there is to some degree an element of uncertainty relating to the exact value. Read more in Note 1.1 Revenue. Valuation of goodwill Estimates are applied in assessing the value in use of goodwill. Goodwill is not subject to amortisation but is tested annually for impairment. Significant estimates are performed when assessing expected future cash flow and setting discount rates. The majority of our goodwill is allocated to the activitives in the UK. Following the Brexit vote, expected cash flows supporting the carrying value of goodwill are inherently more uncertain. Read more in Note 3.2 Impairment tests. Classification of investment in associated companies To classify an investment as an associated company requires significant influence in the company. Judgement is necessary in determining when significant influence exists. The Group has exercised judgement in classifying the investments in COFCO Dairy Holdings Limited and Lantbrukarnas Riksförbund. Read more in Note 3.4 Joint ventures and associates. Valuation of inventory Estimates are applied in assessing net realisable values of inventory. Most significantly, this includes the assessment of expected future market prices and the quality of certain products within the cheese category, some of which need to mature for up to two years. Read more in Note 2.1 Net working capital. Valuation of pension liabilities The Group uses external and independent actuaries when determining the value of pension liabilities. When measuring the Group’s defined benefit plans, judgements are performed when setting actuarial assumptions such as discount rate, expected future salary increases, inflation and mortality. The actuarial assumptions vary from country to country, based on national economic and social conditions. They are set using available market data and compared with benchmarks to secure that they are set consistently from year to year and in compliance with best practice. Read more in Note 4.7 Pension liability. Currency exposure The Group’s financial reporting is significantly exposed to currencies, both due to transactions conducted in currencies other than the EUR, and due to the translation of financial reporting from entities not part of the eurozone. The most significant exposure relates to financial reporting from entities operating in GBP and SEK, and to transactions relating to sales in USD or USD-related currencies. Read more in Note 4.3.2 Currency risk. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 NOTE 1 REVENUE AND OPERATIONAL COST Note 1 Operating profit 87 Note 1.1 Revenue 88 Note 1.2 Costs 90 Note 1.3 Other operating income and costs Note 2 Net working capital 92 Note 2.1 Net working capital Note 3 Capital employed 95 Note 3.1 Intangible assets 96 Note 3.2 Impairment tests 97 Note 3.3 Property, plant and equipment 99 Note 3.4 Joint ventures and associates 101 Note 3.5 Provisions 101 Note 3.6 Purchase and sale of business or activities Note 4 Funding 104 Note 4.1 Financial items 105 Note 4.2 Net interest-bearing debt 110 Note 4.3 Financial risk 110 Note 4.3.1 Liquidity and Funding risk 112 Note 4.3.2 Currency risk 114 Note 4.3.3 Interest rate risk 115 Note 4.3.4 Commodity price risk 116 Note 4.3.5 Credit risk 117 Note 4.4 Derivative financial instruments 119 Note 4.5 Financial instruments disclosed 120 Note 4.6 Transfer of financial assets 120 Note 4.7 Pension obligations Note 5 Other areas 125 Note 5.1 Tax 127 Note 5.2 Fees to auditors appointed by the Board of Representatives 127 Note 5.3 Management remuneration and transactions 128 Note 5.4 Contractual commitments and contingent liabilities 128 Note 5.5 Events after the balance sheet date 128 Note 5.6 General accounting policies 130 Note 5.7 Group chart Note 1.1 Revenue Higher sales prices and better brand positions Revenue increased by 8.1 per cent to EUR 10,338 million, compared to EUR 9,567 million last year. The underlying revenue development, excluding foreign exchange effects and divestments, was 11.6 per cent. Milk intake was 13.9 billion kg in 2017, unchanged compared to the milk intake of 13.9 billion kg last year. The strong increase in revenue was a direct result of higher sales prices in 2017 compared to last year. Arla’s strategic decision to focus on achieving sales prices to allow us to maximise owner milk prices contributed to a EUR 1,000 million, or a 10 per cent increase in revenue. In a year with significant price increases, sales volumes were unchanged and a favourable volume/mix effect contributed to an increased revenue of EUR 111 million. Branded sales represented 44.6 per cent of total sales in 2017, compared to 44.5 per cent last year, and strategic branded volume revenue growth was 3.0 per cent. represented the last non-core business activity within Arla, thus enabling sole focus on the dairy sector. In 2017, Arla divested Vigor. This has and will not impact revenue as it was an associated company. The increase in revenue was negatively impacted by exchange rate developments of EUR 250 million, driven primarily by the weakened GBP with the UK representing approximately 25 per cent of total revenue. The divestment of the Rynkeby juice business including the related distribution activities in 2016 attributed to a negative full-year impact of EUR 90 million. Rynkeby Europe is Arla’s largest commercial segment, comprising 63 per cent of total revenue, compared to 66 per cent last year. International accounts for 16 per cent of Arla’s revenue compared to 15 per cent last year. The increase in revenue for International reflects a revenue growth of 13.2 per cent and a retail and foodservice volume driven revenue growth of 8.4 per cent, primarily resulting from increased sales in China and Nigeria. The remaining part is contributed by Trading and other with 15 per cent, up 2 per cent due to price increases on the commodity market. Arla Foods Ingredients comprises 6 per cent of total revenue, remaining on the same level as last year. The strategic branded revenue split by brand remains largely unchanged compared to last year. The four strategic brands, Arla®, Lurpak®, Castello® and Puck®, all achieved higher sales in 2017 as a result of the Group’s strategic focus on branded sales. The cornerstone Arla brand contributed to 66 per cent of the overall branded revenue in 2017. Development in revenue (EURm) Revenue split by commercial segment, 2017 Revenue split by commercial segment, 2016 11,000 10,500 10,000 9,567 9,500 Revenue 2016 1,000 111 -90 -250 15% 13% 6% 10,338 million EUR 63% 15% 9,567 million EUR 10,338 6% 16% 8 7 66% Sales prices Volume/mix M&A Currency Revenue 2017 (EURm) Europe International AFI Trading and other 2017 6,568 1,616 651 1,503 2016 6,321 1,428 545 1,273 Table 1.1 Revenue split by country (EURm) 2017 2016 Revenue split by country, 2017 UK Germany Sweden Denmark Netherlands Finland China Saudi Arabia Belgium USA Other* Total 2,614 1,525 1,522 1,031 460 304 302 276 215 179 1,910 10,338 2,532 1,302 1,463 1,062 373 329 202 247 197 180 1,680 9,567 4% 3% 3% 3% 2% 2% 15% 15% 10% 25% 18% *Other countries include, amongst others, Nigeria, Bangladesh, Oman, Canada, Spain, France, Australia and Russia. Table 1.1 represents the total revenue by country and includes all sales that occur in the countries, irrespective of organisational structure. Therefore, the figures cannot be compared to our commercial segment review on page 30 to 35. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Strategic branded revenue by brand 2017 2016 Arla® Lurpak® 66% 65% 12% 11% Castello® 4% 5% Puck® 8% 8% Other supported brands 10% 11% Accounting policies Revenue is recognised in the income statement when the performance obligation was satisfied, meaning all obligations stated in the contract are fulfilled. This is defined at the point in time when all risks and rewards of the products have been passed on to the buyer, the amount of revenue can be measured reliably, and collection is probable. The transfer of risks and rewards to customers takes place according to the trade agreement terms, i.e. the Incoterms. Revenue comprises invoiced sales for the year less customer specific payments such as sales rebates, cash discounts, listing fees, promotions, VAT and duties. Revenue by commercial segment/market and brand is based on the Group’s internal financial reporting. Accumulated experience with customers is used to accurately estimate variable parts of contracts to correctly recognise revenue. In general, contracts with customers have industry-wide payment terms with a short duration, therefore an adjustment of the transaction price with regards to a financing compo- nent in the contracts is not necessary. Uncertainties and estimates Revenue, net of rebates, is recognised when goods are transferred to customers. Estimates are applied when measuring the accruals for rebates and other sales incentives. The majority of rebates are calculated using terms agreed with the customer. For some customer relationships the final settlement of the rebate depends on future volumes, prices and other incentives. Thus, there is an element of uncertainty relating to the exact value. 8 8 Note 1.2 Costs Tight cost control challenged by higher production complexity Operational costs were EUR 10,066 million compared to EUR 9,254 million last year, representing an increase of 8.8 per cent. million, compared to EUR 43 million last year. Additionally, EUR 20 million related to development activities was capitalised. Cost of production increased to EUR 8,063 million from EUR 7,177 million last year. Excluding costs of raw milk, production costs decreased to EUR 3,014 million compared to EUR 3,149 million last year primarily due to currency. Our strong focus on cost management was challenged by increased complexity caused by a broader and more diverse portfolio of branded products and use of different milk types. Thus, the conversion cost index, which measures the total cost of production per kg of milk processed, grew to an index of 103.9 compared to 99.2 in last year. Sales and distribution costs decreased by 3.5 per cent, mainly due to currency effects and lower marketing spend. Research and development spend incurred amounted to EUR 37 Administration costs decreased by EUR 16 million, primarily due to savings in salaries and the non-recur- rence of one time expenses in 2016 related to the restructure programme, Organise-to-Win. Cost of raw milk The cost of raw milk increased by EUR 1,020 million or 25.3 per cent. This was primarily driven by higher milk prices to our owners. Owner milk Costs related to owner milk increased by EUR 975 million, representing an increase of 27.8 per cent. A higher average prepaid milk price increased the costs by EUR 949 million, and higher volumes attributed to an increase of EUR 26 million. Other milk Costs of other milk increased by EUR 45 million, equivalent to 8.6 per cent, due to higher market prices partly offset by currency effects. Other milk consists of speciality milk and other contract milk acquired to meet local market demands. Staff costs Staff costs amounted to EUR 1,218 million, a decrease of EUR 5 million compared to last year. Staff costs were positively impacted by the results of Organise-to-Win programme, the divestment of Rynkeby and currencies. Within sales and distribution, as well as administration, staff costs decreased EUR 19 million, which were offset by increases within production to manage the more diverse product portfolio. Marketing spend EUR 300 million was spent on marketing activities in 2017, compared to EUR 309 million last year. Marketing spend increased in International due to new initiatives, for example, the launch of Arla® Organic Milk in MENA. In Europe, marketing spend was slightly lower than last year with the exception of Germany, where the marketing of especially Arla® skyr increased the spend. Depreciation, amortisation and impairment Depreciation, amortisation and impairment amounted to EUR 353 million, corresponding to an increase of EUR 19 million compared to last year. The increase in amortisation was mainly related to the investments in IT and other development projects. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Development in costs (EURm) Cost split by type, 2017 Cost split by type, 2016 10,500 10,000 9,500 9,000 949 26 45 72 -88 -192 10,066 9% 4% 3% 10% 4% 3% 9,254 2016 Milk price effect Milk volume effect Other milk Growth in cost base excluding milk M&A effect Currency 2017 10,066 million EUR 10% 12% 50% 11% 9,254 million EUR 43% 13% 12% 16% Weighed-in raw milk Other production materials* Staff costs Transportation costs Marketing costs Depreciation, amortisation and impairment Other costs** Table 1.2.a Operational costs split by functions (EURm) Production costs Sales and distribution costs Administration costs Total Specification: Weighed-in raw milk Other production materials* Staff costs Transportation costs Marketing costs Depreciation, amortisation and impairment Other costs** Total *Other production materials includes packaging, additives, consumables and changes in inventory **Other costs mainly includes maintenance, utilities and IT Table 1.2.b Weighed-in raw milk Table 1.2.c Staff costs (EURm) 2017 2016 Weighed in mio. kg. 12,373 1,564 13,937 EURm 4,478 570 5,048 Weighed in mio. kg. 12,320 1,554 13,874 EURm 3,503 525 4,028 Wages, salaries and remuneration Pensions - defined contribution plans Pensions - defined benefit plans Other social security costs Total staff costs Owner milk Other milk Total Staff costs relate to: Production costs Sales and distribution costs Administration costs Total staff costs 2017 2016 8,063 1,584 419 10,066 5,048 1,231 1,218 1,002 300 353 914 10,066 8 9 7,177 1,642 435 9,254 4,028 1,463 1,223 1,010 309 334 887 9,254 2017 2016 1,034 72 4 108 1,218 691 336 191 1,218 1,038 73 3 109 1,223 677 346 200 1,223 Average number of full-time employees 18,973 18,765 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 1.2.d Depreciation, amortisation and impairment (EURm) Intangible assets, amortisation Property, plant and equipment, depreciation Total depreciation, amortisation and impairment Depreciation, amortisation and impairment relate to: Production costs Sales and distribution costs Administration costs Total depreciation, amortisation and impairment 2017 2016 54 299 353 280 36 37 353 42 292 334 269 32 33 334 Accounting policies Production costs Production costs comprise purchased goods, including the purchase of milk from cooperative owners, as well as direct and indirect costs including depreciation and impairment losses on production plant as well as payroll costs related to production. The purchase of milk from cooperative owners is recognised at prepaid prices for the accounting period and therefore does not include the supplementary payment, which is classified as distributions to owners and recognised directly in equity. Sales and distribution costs Costs incurred on the sale and distribution of goods sold in the course of the year, and for promotion- al campaigns are recognised as sales and distribution costs. Costs relating to sales staff, write-down of receivables, sponsorship, research and development, advertising and exhibits, depreciation and impairment losses, are also recognised as sales and distribution costs. Administration costs Administration costs incurred in the course of the year relate to management and administration, including administrative staff, office premises and office costs, as well as depreciation and impairment losses. 9 0 Note 1.3 Other operating income and costs Positive hedging effects Other operating income and costs consist of items outside the regular course of dairy business activities. It mainly includes items such as gains and losses relating to divestments of non-current assets, financial instruments and compensation from insurance contracts. Furthermore, it includes income and costs related to sales of surplus power from condensation plants. compared to EUR 62 million last year. Gains on financial instruments used for hedging of sales in 2017 amounted to EUR 29 million. Net other operating income amounted to EUR 32 million, CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 NOTE 2 NET WORKING CAPITAL Note 1 Operating profit 87 Note 1.1 Revenue 88 Note 1.2 Costs 90 Note 1.3 Other operating income and costs Note 2 Net working capital 92 Note 2.1 Net working capital Note 3 Capital employed 95 Note 3.1 Intangible assets 96 Note 3.2 Impairment tests 97 Note 3.3 Property, plant and equipment 99 Note 3.4 Joint ventures and associates 101 Note 3.5 Provisions 101 Note 3.6 Purchase and sale of business or activities Note 4 Funding 104 Note 4.1 Financial items 105 Note 4.2 Net interest-bearing debt 110 Note 4.3 Financial risk 110 Note 4.3.1 Liquidity and Funding risk 112 Note 4.3.2 Currency risk 114 Note 4.3.3 Interest rate risk 115 Note 4.3.4 Commodity price risk 116 Note 4.3.5 Credit risk 117 Note 4.4 Derivative financial instruments 119 Note 4.5 Financial instruments disclosed 120 Note 4.6 Transfer of financial assets 120 Note 4.7 Pension obligations Note 5 Other areas 125 Note 5.1 Tax 127 Note 5.2 Fees to auditors appointed by the Board of Representatives 127 Note 5.3 Management remuneration and transactions 128 Note 5.4 Contractual commitments and contingent liabilities 128 Note 5.5 Events after the balance sheet date 128 Note 5.6 General accounting policies 130 Note 5.7 Group chart Note 2.1 Net working capital Higher milk prices drove an increase in net working capital The increases in market and sales prices for milk increased the value of Arla inventory and receivable positions in 2017. Higher absolute valued inventory and receivables increased the net working capital position. Despite multiple initiatives which offset some of the increase. Net working capital increased by 17 per cent to EUR 970 million, compared to EUR 831 million last year. Working capital in days deteriorated slightly compared to last year with improve- ments in trade payables (DPO) and trade receivables (DSO) as a result of a continued focus on cash collection and payment terms. These improvements were more than offset by the increased inventory levels (DIO) due to slightly higher volumes on hand. Excluding payables relating to owner milk, net working capital increased by EUR 173 million. Inventory Inventory increased by EUR 176 million to EUR 1,126 million, compared to EUR 950 million last year. Excluding currency effects, the inventory increased by EUR 217 million, attributable to the market milk price developments and increased volumes. Trade receivables Trade receivables increased to EUR 942 million, compared to EUR 876 million last year. The net movement, excluding currency effects, was an increase of EUR 100 million. The increase was mainly attributed to the significantly higher sales prices in 2017. Exposure to credit risk on trade receivables is guided by Group-wide policies. Credit limits are set based on the customer’s financial position and current market conditions. Generally, Arla does not hold collateral as security for trade receivables. The customer portfolio is diversified in terms of geography, industry sector and customer size. In 2017, the Group was not extraordinarily exposed to credit risk related to significant individual customers but to the general credit risk in the retail sector. Historically, amounts written off as irrecoverable have been relatively low, which was also the case in 2017. Trade receivable balances overdue above 90 days amounted to 1.3 per cent, compared to 1.5 per cent last year. Trade payables Trade payables increased by EUR 103 million to EUR 1,098 million, compared to EUR 995 million last year. The movement in trade payables, excluding owner milk and currency effects, was an increase of EUR 90 million. The increase was driven by Arla’s continuous effort to improve payment terms. Payables related to owner milk increased by EUR 34 million as a result of a 3 per cent increase of member milk intake in December 2017, compared to the same month last year, as well as a significantly higher milk prices, representing an increase of 15 per cent. Net working capital (EURm) 9 2 Development in net working capital (EURm) 1,150 1,100 1,050 1,000 950 900 850 800 750 700 650 600 1 January 2017 1,177 1,233 1,199 906 928 999 1,004 831 1,175 970 1,500 1,000 500 0 2013 2014 2015 2016 2017 Net working capital excluding owner milk Net working capital Table 2.1.a Net working capital (EURm) Inventory Trade receivables Trade payables Net working capital 100 -90 217 -34 -54 970 831 Inventory owner milk Trade receivables Trade payables excluding Owner milk 31 December 2017 Currency 2017 1,126 942 -1,098 970 2016 950 876 -995 831 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 2.1.b Inventory (EURm) Inventory before the write-downs Write-downs Total inventory Raw materials and consumables Work in progress Finished goods and goods for resale Total inventory Table 2.1.c Trade receivables (EURm) Trade receivables before provision for bad debts Write-downs for bad debts Total trade receivables 2017 1,153 -27 1,126 264 366 496 1,126 2017 954 -12 942 2016 969 -19 950 257 292 401 950 2016 887 -11 876 Accounting policies Inventories Inventories are measured at the lower of cost or net realisable value, calculated on a first-in, first-out basis. The net realisable value is established taking into account the inventories, marketability and estimate of the selling price, less completion costs and costs incurred to execute the sale. The cost of raw materials, consumables as well as commercial goods includes the purchase price plus delivery costs. The prepaid price to Arla’s owners is used as the purchase price for owner milk. The cost of work in progress and manufactured goods also includes an appropriate share of production overheads, including depreciation, based on the normal operating capacity of the production facilities. Trade receivables Trade receivables are recognised at the invoiced amount less write-downs for amounts considered irrecoverable (amortised cost). Write-downs are measured as the difference between the carrying amount and the present value of anticipated cash flow. Write-downs are assessed on major individual receivables or in groups at portfolio level based on the receivables’ age and maturity profile as well as historical records of losses. Trade payables Trade payables are measured at amortised cost, which usually corresponds to the invoiced amounts. Uncertainties and estimates Inventories The Group uses monthly standard costs to calculate inventory and revises all indirect production costs at least once a year. Standard costs are also revised if they deviate materially from the actual cost of the individual product. A key component in the standard cost calculation is the cost of raw milk from farmers. This is determined using the average prepaid milk price that matches the production date of inventory. Indirect production costs are calculated based on relevant assumptions with respect to capacity utilisation, production time and other factors characterising the individual product. The assessment of the net realisable value requires judgement, particularly in relation to the estimate of the selling price of certain cheese stock with long maturities and bulk products to be sold in the world market. 9 3 Receivables Receivables are written down based on individual assessment if signs of impairment regarding customers’ insolvency are present and insolvency is anticipated. Furthermore, a mathematical computation is used based on several parameters including number of days overdue. The financial uncertainty associated with write-downs for bad debt losses is usually considered to be limited. However, if a customer’s ability to pay deteriorates in the future, further write-downs may be necessary. Customer specific bonuses are calculated based on actual agreements with retailers, however, some uncertainty exists when estimating exact amounts to be settled and timing of these settlements. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 NOTE 3 CAPITAL EMPLOYED Note 1 Operating profit 87 Note 1.1 Revenue 88 Note 1.2 Costs 90 Note 1.3 Other operating income and costs Note 2 Net working capital 92 Note 2.1 Net working capital Note 3 Capital employed 95 Note 3.1 Intangible assets 96 Note 3.2 Impairment tests 97 Note 3.3 Property, plant and equipment 99 Note 3.4 Joint ventures and associates 101 Note 3.5 Provisions 101 Note 3.6 Purchase and sale of business or activities Note 4 Funding 104 Note 4.1 Financial items 105 Note 4.2 Net interest-bearing debt 110 Note 4.3 Financial risk 110 Note 4.3.1 Liquidity and Funding risk 112 Note 4.3.2 Currency risk 114 Note 4.3.3 Interest rate risk 115 Note 4.3.4 Commodity price risk 116 Note 4.3.5 Credit risk 117 Note 4.4 Derivative financial instruments 119 Note 4.5 Financial instruments disclosed 120 Note 4.6 Transfer of financial assets 120 Note 4.7 Pension obligations Note 5 Other areas 125 Note 5.1 Tax 127 Note 5.2 Fees to auditors appointed by the Board of Representatives 127 Note 5.3 Management remuneration and transactions 128 Note 5.4 Contractual commitments and contingent liabilities 128 Note 5.5 Events after the balance sheet date 128 Note 5.6 General accounting policies 130 Note 5.7 Group chart Note 3.1 Intangible assets Intangible asset reduction driven by currency Intangible assets amounted to EUR 811 million, representing a decrease of EUR 14 million compared to last year related to effects of changes in currencies. to activities in the UK, compared to EUR 488 million last year. This decrease in goodwill was due to exchange rate adjustments. Refer to Note 3.2 for detail on the impairment test. Goodwill The carrying value of goodwill amounted to EUR 596 million compared to EUR 615 million last year. EUR 470 million hereof related Licences and trademarks Licences and trademarks recognised at a total carrying amount of EUR 26 million include Cocio®, Anchor® and Hansano®. Other brands including the strategic brands, Arla®, Lurpak®, Castello® and Puck®, are internally generated trademarks and are not recognised with any attributed value. IT and other development projects The Group continued to invest in the development of IT. During 2017, SAP was implemented in the Netherlands and in the UK at the Westbury dairy, thereby completing the integration into the Arla SAP platform. Further- more, IT development projects in 2017 also included stregthened SAP access controls, Arlagården Plus, warehouse distribution and milk allocation projects. Other capitalised development costs relate to innovation activities and to the development of new products. Table 3.1 Intangible assets (EURm) 2017 Cost at 1 January Exchange rate adjustments Additions Mergers and acquisitions Reclassification Disposals Cost at 31 December Amortisation and impairment at 1 January Exchange rate adjustments Amortisation and impairment for the year Amortisation on disposals Amortisation and impairment at 31 December Carrying amount at 31 December 2016 Cost at 1 January Exchange rate adjustments Additions Reclassification Disposals Cost at 31 December Amortisation and impairment at 1 January Exchange rate adjustments Amortisation and impairment for the year Amortisation on disposals Amortisation and impairment at 31 December Carrying amount at 31 December Goodwill Licenses and trademarks IT and other development projects 615 -19 - 1 - - 597 - - -1 - -1 596 678 -63 - - - 615 - - - - - 615 100 -2 - 1 - - 99 -70 2 -5 - -73 26 102 1 - - -3 100 -65 -1 -6 2 -70 30 327 -2 50 - 7 -2 380 -147 2 -48 2 -191 189 281 -1 58 -1 -10 327 -123 2 -36 10 -147 180 9 5 Total 1,042 -23 50 2 7 -2 1,076 -217 4 -54 2 -265 811 1,061 -63 58 -1 -13 1,042 -188 1 -42 12 -217 825 Intangible assets 2017 Intangible assets 2016 23% 22% 3% 811 million EUR 4% 74% 825 million EUR 74% Goodwill Licences and trademarks IT and other development projects CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Accounting policies Goodwill Goodwill represents the premium paid by the Group above the fair value of the net assets of an acquired company. On initial recognition, goodwill is recognised at cost. Goodwill is subsequently measured at cost less any accumulated impairment. The carrying amount of goodwill is allocated to the Group’s cash-generat- ing units that follow the management structure and internal financial reporting. Cash-generating units are the smallest Group of assets which are able to generate independent cash inflows. Licences and trademarks Licences and trademarks are initially recognised at cost. The cost is subsequently amortised on a straight-line basis over their expected useful lives. IT and other development projects Costs incurred during the research phase in carrying out general assessments of the Group’s needs and available technologies are expensed as incurred. Directly attributable costs incurred during the development stage for IT and other development projects relating to the design, programming, installation and testing of projects before they are ready for commercial use are capitalised as intangible assets. Such costs are only capitalised provided the expenditure can be measured reliably, the project is technically and commercially viable, future economic benefits are probable and the Group intends to and has sufficient resources to complete and use the asset. IT and other development projects are amortised on a straight-line basis over five to eight years. Note 3.2 Impairment tests Goodwill supported by market development and Good Growth 2020 Goodwill in the UK originated from the purchase of Express Dairies Limited in 2003 and 2007, the acquisition of AFF in 2009 and the merger with Milk Link in 2012. In Finland, goodwill arose in connection with the purchase of Ingman in 2007. The remaining goodwill arose primarily from the purchase of Tholstrup in 2006. Goodwill is allocated to relevant business units, primarily to our activities in the UK and Finland within the Europe commercial segment. Impairment tests are performed at business unit level, being the lowest cash generating unit. Basis for impairment test and applied estimates Impairment tests are performed annually and based on expected future cash flow derived from forecasts and targets supporting the Good Growth 2020 strategy. The impairment tests do not include growth in the terminal value, as the growth rate has been set to the expected inflation rate. Procedure for impairment tests Milk costs are recognised at a milk price that corresponds to the price at the time the test is performed. In the applied forecasts, the key operational assumption is future profitability 9 6 based on a combination of the impact from moving milk intake into value added products and more profitable markets. Other key assumptions are sustainable cost reduction initiatives. Nevertheless, impairment testing performed showed that expected future cash flow can support the carrying value of our net assets, including goodwill. Test results Impairment testing showed that there was no need for impairment in 2017. In this regard, sensitivities to changes in milk prices and discount rates were calculated. The discount rate could rise up to 3 percentage points, compared to 4 percentage points last year, before the goodwill in the UK would be at risk of being impaired. The market conditions were challenging in Finland in 2017. Table 3.2 Impairment tests (EURm) 2017 UK Finland Sweden Other Total carrying amount at 31 December 2016 UK Finland Sweden Other Total carrying amount at 31 December Carrying amount, goodwill 470 40 23 63 596 Applied key assumptions Discount rate, net of tax 6.9% 6.3% 6.5% 6.4% Discount rate, before tax 8.4% 7.6% 8.3% 7.1% 488 40 23 64 615 7.1% 6.2% 6.4% 6.2% 8.9% 7.6% 8.3% 6.9% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Accounting policies Impairment occur when the carrying amount of an asset is greater than its recoverable amount through either use or sale. For impairment testing, assets are grouped together into the smallest group of assets that generates cash inflows from continuing use (cash-generating unit) that are largely independent of the cash inflows of other assets or cash-generating units. The cash-generating units are determined based on the manage- ment structure and the internal financial reporting. The cash-generating units are reassessed each year. Uncertainties and estimates The carrying amount of goodwill is tested for impairment together with the other non-current assets in the cash-generating unit to which the goodwill is allocated. The recoverable amount of goodwill is recognised as the present value of the expected future net cash flows from the cash-generating unit to which the goodwill is allocated, discounted using a pre-tax discount rate that reflects the current market assessment of the time value of money and risks specific to the asset or cash-generating unit. Any impairment of goodwill is recognised as a separate line item in the income statement and cannot be reversed. The carrying amount of other non-current assets is assessed annually to determine whether there is any indication of impairment. The assets are measured on the balance sheet at the lower value of the recoverable amount and the carrying amount. The recoverable amount of other non-current assets is the higher value of the asset’s value in use and the market value, i.e. fair value, less expected disposal costs. The value in use is calculated as the present value of the estimated future net cash flows from the use of the asset or the cash-generating unit of which the asset is part of. An impairment loss on other non-current assets is recognised in the income statement under production costs, sales and distribution costs or administration costs, respectively. Impairment made is reversed to the extent that the assumptions and estimates that led to the impairment have changed. An impairment loss is reversed only to the extent that the asset’s carrying amount does not exceed the carrying amount that would have been determined, net of depreciation or amortisation, if no impairment loss had been recognised. 9 7 Goodwill is allocated to the cash- generating unit it concerns. The cash-generating units are defined based on the management structure and are linked to individual markets. Cash generating units are assessed each year. The impairment test of goodwill is performed annually for each cash-generating unit to which goodwill is allocated. The most important parameters in the impairment test include expectations on future free cash flow and assumptions on discount rates. Anticipated future free cash flows The anticipated future free cash flows are based on current forecasts and targets set in the strategy period 2018-2020 within the Good Growth 2020 strategy. These are based on management’s best estimates and expectations, which are judgmental by nature. They include expectations in strategy period on revenue growth, EBIT margins and capital expenditures. This includes moving milk intake into value-added products, more profitable markets and cost reduction initiatives. The growth rate beyond the strategy period has been set to the expected inflation rate in the terminal period. Following the Brexit vote, expected cash flow supporting the carrying value of goodwill in the UK is inherently more uncertain. This was reflected in our impairment test. Read more about Brexit on page 50. Discounts rates A discount rate, namely Weighted Average Cost of Capital (WACC), is applied for the specific business areas based on assumptions regarding interest rates, tax rates and risk premiums. The WACC is recalculated to a before-tax rate. Changes in the future cash flow or discount rate estimates used may result in materially different values. Note 3.3 Property, plant and equipment Strategic capital expenditure supporting innovation Main tangible assets are located in Denmark, the UK, Germany and Sweden. The carrying value decreased by EUR 98 million to EUR 2,212 million in 2017, driven by higher depreciation than capital expenditures and changes in currencies. Capital expenditure decreased 5.7 per cent to EUR 248 million compared to EUR 263 million last year. This reflects our continued focus on the utilisation of our production capacity. In 2017, a higher CAPEX budget was approved, however due to the timing of projects, this approval has not yet materialised in higher CAPEX expenditure. Major investments in 2017 included a general upgrade and expansion of production facilities with a particular focus on the child nutrition category, as well expenditure on existing sites and finalisation of the investment in our new global Innovation Centre. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 3.3 Property, plant and equipment (EURm) Land and buildings Plant and machinery Fixture and fitting, tools and equipment Assets in course of construction 2017 Cost at 1 January Exchange rate adjustments Additions Mergers and acquisitions Transferred from assets in course of construction Disposals Reclassification Cost at 31 December Depreciation and impairments at 1 January Exchange rate adjustments Depreciation for the year Depreciation on disposals Reclassification Depreciations and impairment at 31 December Carrying amount at 31 December Of which assets held under finance lease 2016 Cost at 1 January Exchange rate adjustments Additions Transferred from assets in course of construction Disposals Cost at 31 December Depreciation and impairment at 1 January Exchange rate adjustments Depreciation for the year Depreciation on disposals Depreciations and impairment at 31 December Carrying amount at 31 December Of which assets held under finance lease 9 8 1,430 -28 5 2 43 -36 26 1,442 -573 9 -46 30 -22 -602 840 34 1,466 -64 2 37 -11 1,430 -553 20 -43 3 -573 857 37 2,664 -41 30 4 142 -19 -14 2,766 -1,499 23 -209 13 14 -1,658 1,108 18 2,547 -84 41 227 -67 2,664 -1,402 45 -204 62 -1,499 1,165 13 500 -14 7 - 29 -13 -7 502 -376 10 -44 13 7 -390 112 2 519 -34 12 28 -25 500 -375 22 -45 22 -376 124 1 164 -2 206 2 -214 - -4 152 - - - - - - 152 - 255 -7 208 -292 - 164 - - - - - 164 - Total 4,758 -85 248 8 - -68 1 4,862 -2,448 42 -299 56 -1 -2,650 2,212 54 4,787 -189 263 - -103 4,758 -2,330 87 -292 87 -2,448 2,310 51 Property, plant and equipment by country 2017 Property, plant and equipment by country 2016 Investments and depreciation property, plant and equipment (EURm) 7% 8% 13% 26% 2,212 million EUR 42% 13% 27% 2,310 million EUR 40% 12% 12% 500 400 300 200 100 0 2013 2014 2015 2016 2017 Denmark Sweden UK Germany Other Investments property, plant and equipment Depreciation property, plant and equipment CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Accounting policies Property, plant and equipment are measured at cost less accumulated depreciation and impairment. Assets under construction, land and decommissioned plants are not depreciated. Cost Cost comprises the acquisition price as well as costs directly associated with an asset until the asset is ready for its intended use. For self-construct- ed assets, cost comprises direct and indirect costs relating to materials, components, payroll and the borrowing costs from specific and general borrowing that directly concerns the construction of assets. If significant parts of an item of property, plant and equipment have different useful lives, they are recognised as separate items (major components) and depreciated separately. When component parts are replaced, any remaining carrying value of replaced parts is removed from the balance sheet and recognised as an accelerated depreciation charge in the income statement. Subsequent expenditure items of property, plant and equipment are only recognised as an addition to the carrying amount of the item, when it is likely that incurring the cost will result in financial benefits for the Group. Other costs such as general repair and maintenance are recognised in the income statement when incurred. Depreciation Depreciation aims to allocate the cost of the asset, less any amounts estimated to be recoverable at the end of its expected use, to the periods in which the Group obtains benefits from its use. Property, plant and equipment are depreciated on a straight-line basis from the time of acquisition, or when the asset is available for use based on an assessment of the estimated useful life. The estimated useful lives are as follows: Office buildings: 50 years Production buildings: 20 to 30 years Technical facilities and machinery: 5 to 20 years Other fixtures and fittings, tools and equipment: 3 to 7 years Uncertainties and estimates Estimates are made in assessing the useful lives of items of property, plant and equipment that determine the period over which the depreciable amount of the asset is expensed to the income statement. The depreciable amount of an item of property, plant and equipment is a function of the asset’s cost or carrying amount and its residual value. Estimates are made in assessing the amount that the Group can recover at the end of the useful life of an asset. An annual review is made with respect to the appropriateness of the depreciation method, useful life and residual values of items of property, plant and equipment. The depreciation base is measured taking into account the residual value of the asset, being the estimated value the asset can generate through sale or scrappage at the balance sheet date if the asset was of the age and in the condition expected at the end of its useful life, and reduced by any impairment made. The residual value is determined at the date of acquisition and is reviewed annually. Depreciation ceases when the carrying value of an item is lower than the residual value. Changes during the depreciation period or in the residual value are treated as changes to the accounting estimates, the effect of which is adjusted only in the current and future periods. Depreciation is recognised in the income statement within production costs, sales and distribution costs or administration costs. 9 9 Vigor Alimentos S.A., Brazil In October, the Group sold the investment in Vigor Alimentos S.A, realising a gain on EUR 44 million. Read more in Note 3.6. Joint ventures The carrying value of joint ventures amounted to EUR 53 million at year-end, compared to EUR 51 million last year. The carrying value does not include goodwill. Note 3.4 Associates and joint ventures Investments in associates and joint ventures COFCO Dairy Holdings Limited (COFCO) and China Mengniu Dairy Company Limited (Mengniu) The Group has a 30 per cent investment in COFCO, which is considered an associated company based on a cooperation agreement extending significant influence, including the right of Board representation. The cooperation agreement with COFCO also entitles Arla to representation on the Board of Mengniu, a Hong Kong listed dairy company in which COFCO is a significant shareholder. It was agreed that Arla and Mengniu cooperate in relation to the exchange of technical dairy knowledge and expertise, and that Arla grants intellectual rights to Mengniu. Based on the underlying agreements, it is our assessment that Arla has significant influence in Mengniu. The Group’s proportionate share of the net asset value of COFCO including the investment in Mengniu is EUR 295 million, compared to EUR 309 million last year. The carrying amount of the investment in COFCO includes goodwill amounting to EUR 140 million, compared to EUR 160 million last year. The fair value of the indirect share in Mengniu equals EUR 519 million, compared to EUR 383 million last year. The investment in COFCO is part of the China business unit and is currently managed in China, along with sales activities with similar characteristics. A potential impairment of the investment is tested at the China business unit level, using expected future net cash flow. Impairment risks include substantial and long-term reductions in leading stock indexes in Asia, issue of import restrictions on dairy products in China, or an adverse and permanent reduction in the expected performance of Mengniu. As the fair value exceeds the carrying value of the investment, there is a no indication of impairment. Mengniu reported a group revenue of EUR 7,317 million and a result of EUR -111 million in 2016. Consolidated figures are not available for the COFCO group. See table 3.4.b for more details on COFCO. Lantbrukarnas Riksförbund, Sweden (LRF) Arla has an ownership interest of 24 per cent in LRF, which is a politically independent professional organisation for Swedish entrepreneurs involved in agriculture, forestry and horticulture. Based on a detailed analysis of the LRF arrangement, Arla’s active ownership interest constitutes significant influence over LRF. This includes, but is not limited to, representation on the Board of Directors. Owners of Arla have represented the Swedish dairy industry at the Board of Directors in LRF and both Arla and our Swedish owners are individual members of LRF. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Recognised value of associates 2017 Recognised value of associates 2016 Table 3.4.a Associates 26% 29% 401 million EUR 39% 434 million EUR 34% Reconciliation of recognised value of associates (EURm) Share of equity in COFCO/Mengniu Goodwill in COFCO/Mengniu Share of equity in non-material associates Recognised value 2017 2016 155 140 106 401 149 160 125 434 35% 37% Share of equity in COFCO/Mengniu Goodwill in COFCO/Mengniu Share of equity in non-material associates Table 3.4.b Material associates Financial information for associates that are considered material to the Group* (EURm) Revenue Results after tax Non-current assets 1 0 0 Dividends received Ownership share Group share of result after tax Recognised value COFCO has no other significant assets or liabilitites * Based on latest available financial reporting. Table 3.4.c Transactions with joint ventures and associates (EURm) Sales of goods to joint ventures Sales of goods to associates Total sale of goods to joint ventures and associates Purchase of goods from joint ventures Total purchase of goods from joint ventures and associates Trade receivables joint ventures* Trade receivables associates* Total trade receivables joint ventures and associates Trade payables joint ventures* Total trade payables joint ventures and associates * Included in other receivables and other payables COFCO Dairy Holdings Limited COFCO Dairy Holdings Limited 2017 2016 12 12 656 2 30% 16 295 15 15 789 4 30% -6 309 2017 2016 14 78 92 57 57 18 9 27 9 9 9 46 55 52 52 26 9 35 7 7 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Accounting policies Investments in which Arla exercises significant influence, but not control, are classified as associates. Investments in which Arla has joint control are classified as joint ventures. The proportionate share of results of associates and joint ventures after tax is recognised in the consolidated income statement, after elimination of the proportionate share of unrealised intra-group profit or loss. Investments in associates and joint ventures are recognised according to the equity method, and measured at the proportionate share of the entities’ net asset values, calculated in accordance with Arla’s accounting policies. The proportionate share of unrealised intra-group profits and the carrying amount of goodwill are added. Whereas the proportionate share of unrealised intra-group losses is Note 3.5 Provisions Provisions Provisions amounted to EUR 23 million in 2017, compared to EUR 25 million last year. Provisions primarily pertain to insurance provisions for insurance incidents that occurred but have not been settled. Insurance provisions primarily relate to occupational injuries. No major occupational incidents occurred Uncertainties and estimates Significant influence is defined as the power to participate in the financial and operating policy decisions of the investee, but does not constitute control or joint control over those policies. Judgement is necessary in determining when significant influence exists. When determining significant influence, factors such as representation on the Board of Directors, participation in policy-making, material transactions between the entities and interchange of managerial personnel are considered. deducted. Dividends received from associates and joint ventures reduce the value of the investment. For investments held in listed companies, computation of the Group’s share of profit and equity is based on the latest published financial information of the company, other publicly available information on the company’s financial development, and the effect of reassessed net assets. Investments in associates and joint ventures with negative net asset values are measured at EUR 0. If the Group has a legal or constructive obligation to cover a deficit in the associate or joint venture, the deficit is recognised under provisions. Any amounts owed by associates and joint ventures are written down to the extent that the amount owed is deemed irrecoverable. An impairment test is performed when there is objective evidence of impairment, such as significant adverse changes in the environment in which the equity-accounted investee operates, or a significant or prolonged decline in the fair value of the investment below its carrying value. Where the equity-accounted investment is considered to be an integral part of a cash generating unit (CGU), the impairment test is performed at the CGU level, using expected future net cash flow of the CGU. An impairment loss is recognised when the recoverable amount of the equity-accounted investment (or CGU) becomes lower than the carrying amount. The recoverable amount is defined as the higher of value in use and fair value less costs to sell, of the equity-accounted investment (or CGU). during the year. A general provision for occupational injuries of EUR 8 million is recorded as a long-term provision. Uncertainties and estimates Provisions are particularly associated with estimates on insurance provisions. The scope and size of onerous contracts are also estimated. Insurance provisions are assessed based on historical records of, amongst other things, the number of insurance events and related costs considered. 1 0 1 Note 3.6 Purchase and sale of business or activities Acquisitions and divestments Gefleortens Dairy, Sweden In December 2017, Arla acquired Gefleortens Dairy in Sweden, whereby 59 new owners with 30 million kg of milk joined Arla. The acquisition is in line with Arla’s strategy on branded local products. Net assets acquired amounted to EUR 6 million. Consideration paid was EUR 8 million in cash and EUR 2 million was issued out of common capital. Additionally, EUR 4 million was received in cash as part of the acquisition. No goodwill was recognised as part of the transaction. In 2017, the revenue contribution from the Gefleortens transaction was EUR 2 million. The effect on profit was insignificant. Divestment of Vigor Alimentos S.A., Brazil As a strategic choice to reduce our involvement in the Brazilian market, Arla divested its shares in the Brazilian based associate, Vigor Alimentos S.A, recognising a gain of EUR 44 million. The investment was previously classified as an associated company. Divestment of Rynkeby Foods A/S In May 2016, Arla concluded an agreement to divest Rynkeby Foods A/S. The company and its subsidiaries have juice activities primarily in Denmark, Sweden and Finland, and a production site in Denmark. The Rynkeby group had an annual revenue of EUR 130 million and 200 employees. This divestment represented the last non-core business activity within Arla, thus enabling sole focus on the dairy sector. The activities in Rynkeby Foods A/S were deconsolidated with effect from May 2016 and the divestment resulted in a gain of EUR 120 million. Certain distribution activities in Scandinavia continued until the end of 2016 and in total revenue was reduced by EUR 90 million compared to last year. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 3.6a Sale of business or activities (EURm) Selling price on divestment of enterprise Cash transferred as part of the transaction Net cash received Other assets transferred Liabilities transferred Gain on divestment 2017 2016 74 - 74 -30 - 44 145 -7 138 -52 34 120 Table 3.6b Mergers and acquisitions (EURm) Company / Country Gefleortens / Sweden Income statement consolidated from 1 December 2017 Holding acquired 100 % of shares Revenue per year 35 No. of employees 90 Accounting policies Recognition date and considerations Newly acquired companies are recognised in the consolidated financial statements at the date when the Group obtains control. The purchase consideration is generally measured at fair value. If an agreement relating to a business combination requires that the purchase consideration be adjusted in connection with future events or the performance of certain obligations (contingent consideration), this portion of the purchase consideration is recognised at fair value at the date of acquisition. Changes in estimates relating to a contingent consideration are recognised in the income statement. Costs directly attributable 1 0 2 to the acquisition are recognised in the income statement as incurred. The acquired assets, liabilities and contingent liabilities are generally measured at their fair value at the date of acquisition. Goodwill arises when the aggregate of the fair value of consideration transferred, previously held interest and the value assigned to non-con- trolling interest holders exceeds the fair value of the identifiable net assets of the acquired company. Any goodwill that arises, which is not amortised, is tested annually for impairment. The methodology outlined above also applies to mergers with other cooperatives, where the owners of the acquired company become owners of Arla Foods amba. The purchase consideration is calculated at the acquisition date fair values of the assets transferred and equity instruments issued. Positive differences between the consideration and fair value are recognised as goodwill. Enterprises divested are recognised in the consolidated income statement up to the date of disposal. Compara- tive figures are not restated to reflect disposals. Gain or losses on divestment of subsidiaries and associates are determined as the difference between the selling price and the carrying amount of the net assets, including goodwill, at the date of divestment and costs necessary to make the sale. Divestment Changes in the Group’s interest in a subsidiary that do not result in a loss of control are recognised as equity transactions. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 NOTE 4 FUNDING Note 1 Operating profit 87 Note 1.1 Revenue 88 Note 1.2 Costs 90 Note 1.3 Other operating income and costs Note 2 Net working capital 92 Note 2.1 Net working capital Note 3 Capital employed 95 Note 3.1 Intangible assets 96 Note 3.2 Impairment tests 97 Note 3.3 Property, plant and equipment 99 Note 3.4 Joint ventures and associates 101 Note 3.5 Provisions 101 Note 3.6 Purchase and sale of business or activities Note 4 Funding 104 Note 4.1 Financial items 105 Note 4.2 Net interest-bearing debt 110 Note 4.3 Financial risk 110 Note 4.3.1 Liquidity and Funding risk 112 Note 4.3.2 Currency risk 114 Note 4.3.3 Interest rate risk 115 Note 4.3.4 Commodity price risk 116 Note 4.3.5 Credit risk 117 Note 4.4 Derivative financial instruments 119 Note 4.5 Financial instruments disclosed 120 Note 4.6 Transfer of financial assets 120 Note 4.7 Pension obligations Note 5 Other areas 125 Note 5.1 Tax 127 Note 5.2 Fees to auditors appointed by the Board of Representatives 127 Note 5.3 Management remuneration and transactions 128 Note 5.4 Contractual commitments and contingent liabilities 128 Note 5.5 Events after the balance sheet date 128 Note 5.6 General accounting policies 130 Note 5.7 Group chart Note 4.1 Financial items Lower financial costs Net financial cost decreased by EUR 43 million to EUR 64 million in 2017, mainly due to currency adjustments. Net interest cost amounted to EUR 57 million, representing a decrease of EUR 6 million compared to last year. Net interest cost decreased due to a lower level of net interest-bearing debt, while the average interest cost, excluding pension liabilities, totalled 2.6 per cent compared to 3.0 per cent last year. Interest cover amounts to 12.9 compared to 13.3 last year. Interest cover is the ratio between EBITDA in 2017 of EUR 738 million and the net interest cost of EUR 57 million. Exchange rate losses were at a lower level compared to last year mainly as a result of the Nigerian devaluation in 2016 with a negative effect of EUR 28 million. The majority of exchange rate losses relates to cost of converting funding currencies into currencies with funding needs. Table 4.1 Financial income and financial costs (EURm) Financial income: Interest securities, cash and cash equivalents Fair value adjustments and other financial income Total financial income Financial costs: Interest on financial instruments measured at amortised cost Net exchange rate losses Interest on pension liabilities Interest transferred to property, plant and equipment Fair value adjustments and other financial costs Total financial costs Net financial costs 1 0 4 Accounting policies 2017 2016 5 8 13 -53 -18 -9 6 -3 -77 -64 5 2 7 -60 -48 -8 7 -5 -114 -107 Financial income and costs as well as capital gains and losses, are recognised in the income statement at amounts that can be attributed to the year. Financial items comprise realised and unrealised value adjustments of securities and currency adjustments on financial assets and financial liabilities, as well as the interest portion of financial lease payments. Additionally, realised and unrealised gains and losses on derivative financial instruments not classified as hedging contracts were included. Borrowing costs from general borrowing, or loans that directly relate to the acquisition, construction or development of qualified assets are attributed to the cost of such assets, and were therefore not included in financial cost. Capitalisation of interest was performed by using an interest rate of three per cent, matching the Group’s average external interest rate in 2017. Financial income and costs relating to financial assets and financial liabilities were recognised using the effective interest method. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 4.2 Net interest-bearing debt Lower pension liabilities resulting in reduced net-interest bearing debt Net interest-bearing debt, excluding pension liabilities were reduced to EUR 1,636 million compared to EUR 1,648 million last year. A solid cash flow from the underlying business was partly offset by higher working capital position, as well as capital expenditure and the supplementary payment for 2016. Working capital increased due to a higher inventory value from the increase in milk prices to farmer owners, and a higher trade receivables balance, caused by higher sales prices. The average maturity of the interest-bearing borrowings decreased by 0.2 years to 5.7 years. The average maturity is impacted by a lapse of time to maturity, refinancing of committed facilities, and the level of net interest-bearing debt. The equity ratio measured 36 per cent, compared to 34 per cent last year, which gives Arla an adequate position to support the investments for the future growth. The leverage ratio was 2.6, an increase of 0.2 compared to last year. This outperformed the Group’s long-term target range of 2.8-3.4, underpinning the Group’s strong financial position. Last year’s leverage ratio was significantly impacted by the Rynkeby divestment. Leverage, excluding the gain form the divestment of Vigor was 2.8. Pension liabilities decreased EUR 92 million to EUR 277 million mainly due to lower expected salary increases, contributions and currencies effects. As a result, net interest-bearing debt, including pension liabilities, amount to EUR 1,913 million compared to EUR 2,017 million last year. Funding The Group applies a diversified funding strategy in order to balance the liquidity and refinancing risk with the desire to achieve a low financing cost. Major acquisitions or investments are funded separately. A diverse funding strategy includes diversification of markets, currencies, instruments, banks, lenders and maturities in order to secure access to funding to ensure that the Group is independent of a single creditor or a single market. All funding opportunities are measured against EURIBOR 3 months and derivatives are applied to match the currency of our funding needs. The interest profile is managed with interest rate swaps independent of the single loan. The credit facilities contain financial covenants on equity/total assets and minimum equity, as well as standard non-financial covenants. The Group did not default on or fail to fulfil any loan agreements in 2017. During 2017, the Group raised the following mix of funding: Bank and credit institutions: exercised extension options in our revolving credit facilities for an amount of EUR 768 million, increasing maturity by 1 year. European Investment Bank: Arla was able to obtain a new 7 year credit facility from the European Investment Bank Commercial papers: the Group has a commercial paper programme in Sweden denominated in SEK and EUR. The average utilization in 2017 was EUR 232 million. Arla obtained debt with a negative interest including the credit margin. Repo: the Group entered into a sale and repurchase arrangement based on its investment in listed AAA-rated Danish Mortgage Bonds. This sale and repurchase agreement is described in further detail in Note 4.6. Leverage, 2017 2.6 1 0 5 Net interest-bearing debt (EURm) 3,000 2,500 2,000 1,500 1,000 500 0 3 4 8 , 2 0 4 7 3 7 6 , 2 1 7 1 2 9 4 , 2 2 0 3 3 6 9 , 1 6 4 8 2 7 7 , 1 6 3 6 2013 2014 2015 2016 2017 4 3 2 1 0 Table 4.2.a Net interest-bearing debt (EURm) Securities, cash and cash equivalents Other interest-bearing assets Long-term borrowings Short-term borrowings Net interest-bearing debt excluding pension liabilities Pension liabilities Net interest-bearing debt including pension liabilities Net interest-bearing debt consists of current and non-current liabilities, less interest-bearing assets. The definition of leverage is the ratio between net interest-bearing debt including pension liabilities amounting to EUR 1,913 million and EBITDA amounting of EUR 738 million, and expresses the Group’s capacity to service the debt. The Group’s long-term target range for leverage is between 2.8 and 3.4. Leverage Pension liabilities Net interest-bearing debt excluding pension liabilities Target range leverage 2.8- 3.4 2017 -602 -8 1,206 1,040 1,636 277 1,913 2016 -588 -12 1,281 967 1,648 369 2,017 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.2.b Borrowings (EURm) Long-term borrowings: Issued bonds Mortgage credit institutions Bank borrowings Finance lease liabilities Total long-term borrowings Short-term borrowings: Issued bonds Commercial papers Mortgage credit institutions Bank borrowings Finance lease liabilities Other current liabilities Total short-term borrowings Total interest-bearing borrowings 2017 2016 254 790 160 2 1,206 152 213 9 728 11 27 1,040 2,246 419 798 52 12 1,281 - 115 1 815 16 20 967 2,248 Table 4.2.c Cash flow, net interest-bearing debt (EURm) Pension liabilities Long-term borrowings Short-term borrowings Other interest-bearing liabilities Total interest-bearing debt 1 0 6 Securities and other interest-bearing receivables Cash Net interest-bearing debt Cash flow Included in financing activities Acquisitions Non-cash changes Foreign exchange movements Reclasses 1 January 2017 Fair value changes 31 December 2017 369 1,281 947 20 2,617 -516 -84 2,017 -39 -19 51 7 - 11 -12 -1 2 - - - 2 - 2 4 -1 -26 26 - -1 - -2 -3 -9 -18 -11 - -38 3 5 -30 -45 -12 - - -57 -17 - -74 277 1,206 1,013 27 2,523 -519 -91 1,913 Table 4.2.d Net interest-bearing debt excluding pension liabilities, maturity (EURm) December 31, 2017 DKK SEK EUR GBP Other Total December 31, 2016 DKK SEK EUR GBP Other Total Total 815 639 136 16 30 1,636 Total 872 558 175 37 6 1,648 2018 35 361 -3 5 30 428 2017 86 115 1 14 -9 207 2019 22 152 103 3 - 280 2018 12 181 134 12 15 354 2020 21 24 7 3 - 55 2019 20 157 7 3 - 187 2021 27 102 6 3 - 138 2020 20 - 7 3 - 30 2022 30 - 3 3 - 36 2021 32 105 6 3 - 146 2023 30 - 1 -1 - 30 2022 22 - 4 2 - 28 2024 2025-2027 After 2027 435 186 - - 16 3 - - - - 451 189 29 - - - - 29 2023 2024-2026 After 2026 498 153 - - 15 1 - - - - 513 154 29 - - - - 29 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Maturity of net interest-bearing debt excluding pension liabilities at 31 December 2017 (EURm) Maturity of net interest-bearing debt excluding pension liabilities at 31 December 2016 (EURm) 700 600 500 400 300 200 100 0 700 600 500 400 300 200 100 0 0-1Y 1-2Y 2-3Y 3-4Y 4-5Y 5-6Y 6-7Y 7-10Y 10Y> 0-1Y 1-2Y 2-3Y 3-4Y 4-5Y 5-6Y 6-7Y 7-10Y 10Y> Unused committed facilities Debt Unused committed facilities Debt Table 4.2.e Interest rate risk at 31 December (EURm) Interest rate Average interest rate Fixed for Carrying amount Interest rate risk 2017 Issued bonds: SEK 500m maturing 04.06.2018 SEK 800m maturing 28.05.2019 SEK 500m maturing 31.05.2021 SEK 1.000m maturing 04.06.2018 SEK 700m maturing 28.05.2019 SEK 500mmaturing 31.05.2021 Commercial papers Total issued bonds Mortgages credit institutions: Fixed-rate Floating-rate Total mortgage credit institutions Bank borrowings: Fixed-rate Floating-rate Total bank borrowings Other borrowings: Finance leases Other borrowings Total other borrowings Fixed Fixed Fixed Floating Floating Floating Fixed Fixed Floating Fixed Floating Floating Floating 3.25% 2.63% 1.88% 1.05% 0.52% 1.07% 0.03% 1.10% 1.15% 0.71% 0.73% -0.04% 1.25% 0.42% 2.15% 2.27% 2.23% 0-1 years 1-2 years 3-4 years 0-1 years 0-1 years 0-1 years 0-1 years 2-3 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 51 82 51 101 71 50 213 619 44 755 799 506 282 788 13 27 40 1 0 7 Fair value Fair value Fair value Cash flow Cash flow Cash flow Fair value Fair value Cash flow Fair value Cash flow Cash flow Cash flow CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.2.e Interest rate risk at 31 December (EURm) Interest rate Average interest rate Fixed for Carrying amount Interest rate risk 2016 Issued bonds: SEK 500m maturing 04.06.2018 SEK 800m maturing 28.05.2019 SEK 500m maturing 31.05.2021 SEK 1.000m maturing 04.06.2018 SEK 700m maturing 28.05.2019 SEK 500m maturing 31.05.2021 Commercial papers Total issued bonds Mortgages credit institutions: Floating-rate Total mortgages credit institutions Bank borrowings: Fixed-rate Floating-rate Total bank borrowings Other borrowings: Finance leases Other borrowings Total other borrowings Fixed Fixed Fixed Floating Floating Floating Fixed Floating Fixed Floating Floating Floating 3.25% 2.63% 1.88% 1.08% 0.56% 1.09% 0.07% 1.32% 0.75% 0.75% -0.30% 1.75% 0.57% 2.15% 2.87% 2.45% 1-2 years 2-3 years 4-5 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 0-1 years 52 84 53 105 73 52 115 534 799 799 497 370 867 28 20 48 Fair value Fair value Fair value Cash flow Cash flow Cash flow Fair value Cash flow Fair value Cash flow Cash flow Cash flow 1 0 8 Interest profile for net interest-bearing debt excluding pension Interest profile for net interest-bearing debt excluding pension liabilities at 31 December 2017 liabilities at 31 December 2017 (EURm) (EURm) Interest profile for net interest-bearing debt excluding pension Interest profile for net interest-bearing debt excluding pension liabilities at 31 December 2016 liabilities at 31 December 2016 (EURm) (EURm) D D B B N N I I 2,000 2,000 1,500 1,500 1,000 1,000 500 500 0 0 D D B B N N I I 2,000 2,000 1,500 1,500 1,000 1,000 500 500 0 0 1Y 1Y 2Y 2Y 3Y 3Y 4Y 4Y 5Y 5Y 6Y 6Y 7Y 7Y 10Y 10Y 15Y 15Y 25Y 25Y 1Y 1Y 2Y 2Y 3Y 3Y 4Y 4Y 5Y 5Y 6Y 6Y 7Y 7Y 10Y 10Y 15Y 15Y 25Y 25Y Floating Fixed via swap Fixed debt Floating Fixed via swap Fixed debt CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.2.f Currency profile of net interest-bearing debt excluding pension liabilities (EURm) Currency profile of net interest-bearing debt excluding pension liabilities before and after derivative financial instruments Original principal Effect of swap 2017 DKK SEK EUR GBP Other Total 2016 DKK SEK EUR GBP Other Total 815 639 136 16 30 1.636 872 558 175 37 6 1,648 - -457 254 203 - - - -470 261 209 - - After swap 815 182 390 219 30 1.636 872 88 436 246 6 1,648 Capitalised residual lease obligations related to financial lease agreements are recognised under liabilities, measured at amortised cost. Other financial liabilities are measured at amortised cost. For details on pension liabilities, see Note 4.7. 1 0 9 Accounting policies Financial instruments Financial instruments are recognised at the date of trade. The Group ceases to recognise financial assets when the contractual rights to the underlying cash flows either cease to exist or are transferred to the purchaser of the financial asset, and substantially all risk and reward related to ownership are also transferred to the purchaser. Financial assets and liabilities are offset and the net amount is presented in the balance sheet when, and only when, the Group obtains a legal right of offsetting and either intends to offset or settle the financial asset and the liability simultaneously. Available for sale financial assets Financial assets classified as available for sale consist of mortgage credit bonds, which correspond in part to raised mortgage debt. Available for sale financial assets are measured on first-time recognition at fair value plus transaction costs. The financial assets are subsequently measured at fair value with adjustments made in other comprehensive income and accumulated in the available-for-sale reserve in equity. Interest income, impairment and foreign currency translation adjustments of debt instruments are recognised in the statement of income on a continuous basis under financial income and financial costs. In connection with sale of financial assets classified as available for sale, accumulated gains or losses, previously recognised in the available-for-sale reserve, are recycled to financial income and financial costs. Financial assets measured at fair value Securities classified at fair value consist primarily of listed securities, which are monitored, measured and reported continuously, in accordance with the Group’s treasury and funding policy. Changes in the fair value are recognised in the income statement under financial income and financial costs. Cash and cash equivalents Cash and cash equivalents consist of readily available cash at bank and deposits together with exchange listed debt securities with an original maturity of three months or less, which have only an insignificant risk of changes in value and can be readily converted to cash or cash equivalents. Liabilities Debts to mortgage and credit institutions, as well as issued bonds, are measured at the trade date upon first recognition at fair value plus transaction costs. Subsequently, liabilities are measured at amortised cost with the difference between the loan proceeds and the nominal value recognised in the income statement over the expected life of the loan. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 4.3 Financial risks Financial risk management Financial risks are an inherent part of the Group’s operating activities and as a result the Group’s profit is impacted by the development in currencies, interest rates and certain types of commodities. The global financial markets are volatile and thus it is critical for the Group to have a properly implemented financial risk management approach in place in order to mitigate short-term market volatility, whilst simultaneously achieving the highest possible milk price. The Group’s comprehensive financial risk management strategy and system builds on a thorough understanding of the interaction between the Group’s operating activities and the underlying financial risks. The overall framework for managing financial risks, being the treasury and funding policy, is approved by the Board of Directors and managed centrally by the treasury department. The policy outlines risk limits for each type of financial risk, permitted financial instruments and counterparties. Each month, the Board of Directors receives a report on the Group’s financial risk exposure from the treasury department, who manage the financial risks on a continuous basis. Hedging the volatility of milk prices is not within the scope of financial risk management, but an inherent component of the Group’s business model. Note 4.3.1 Liquidity risk Strong liquidity reserves The stable cash generation in 2017 positively influenced the liquidity reserves by reducing the utilisation of loan and credit facilities. Liquidity reserves increased by EUR 101 million to EUR 1,038 million. Ensuring availability of sufficient operating liquidity and credit facilities for operations is the primary goal of managing liquidity risk. According to the liquidity model inspired by the rating agencies, the Group’s current liquidity reserves covering the next 12 months of expected cash flow is more favourable than required. The management of day-to-day liquidity flow, representing more than 95 per cent of the net revenue of the Group, is conducted by Arla Foods Finance A/S via cash pooling arrangements with the Group’s banks and credit institutions. This secures a scalable and efficient operating model. Within the Group, companies with excess liquidity finance companies with liquidity deficits. As a result, the Group achieves a cost-efficient utilisation of credit facilities. 1 1 0 Liquidity reserves 2017 Liquidity reserves 2016 21% 9% 1% 19% 9% 1% 1,038 million EUR 937 million EUR 69% 71% Cash and cash equivalents Securities (free cash flow) Unutilised committed loans facilities Unutilised other loan facilities Table 4.3.1.a Liquidity reserves (EURm) Cash and cash equivalents Securities (free cash flow) Unutilised committed loans facilities Unutilised other loan facilities Total 2017 91 6 721 220 1,038 2016 84 7 666 180 937 Table 4.3.1.b Gross financial liabilities (EURm) 2017 Issued bonds Mortgage credit institutions Credit institutions Finance lease liabilities Other non-current liabilities Interest expense - interest bearing debt Trade payable Derivative instruments Total Carrying amount 406 Total 406 2018 152 2019 152 2020 - 2021 102 2022 2023 - 2024 - 2025- 2027 - After 2027 - Non-discounted contractual cash flows 799 1,001 13 815 1,002 13 9 821 11 18 107 2 19 56 - 27 10 - 29 7 - 29 1 - 30 - - 193 - - 461 - - 27 27 26 1 - - - - - - - - 1,098 87 3,431 112 1,098 87 3,560 12 1,098 23 2,152 10 - 17 307 8 - 9 92 7 - 8 154 7 - 7 50 6 - 5 41 6 - 2 38 17 - 3 213 39 - 13 513 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.3.1.b Gross financial liabilities (EURm) 2016 Issued bonds Mortgage credit institutions Credit institutions Finance lease liabilities Other non-current liabilities Interest expense - interest bearing debt Trade payable Derivative instruments Total Carrying amount 419 799 982 28 20 - 995 168 3,411 Non-discounted contractual cash flows Total 418 2017 - 2018 157 2019 157 2020 - 2021 104 2022 - 2023 - 817 990 28 20 128 995 168 3,564 1 760 16 18 14 995 81 1,885 9 161 11 2 13 - 20 373 19 40 1 - 10 - 17 244 19 12 - - 9 - 9 49 27 10 - - 8 - 8 157 29 7 - - 6 - 7 49 29 - - - 6 - 6 41 2024- 2026 - After 2026 - 154 - - - 18 - 5 177 530 - - - 44 - 15 589 Assumptions Contractual cash flows are based on the following assumptions: The cash flows are based on the earliest possible date at which the Group can be required to settle the financial liability; and The interest rate cash flow is based on the contractual interest rate. Floating interest payments were determined using the current floating rate for each item at the reporting date. Risk mitigation Risk Liquidity and funding is vital for the Group to be able to pay its financial liabilities as they become due. It also impacts the ability to attract new funding in the long-run, and is crucial to fulfil the Group’s strategic ambitions. Policy The treasury and funding policy states the minimum average maturity threshold for net interest-bearing debt, and sets limitations on debt maturing within the next 12 and 24 month periods. Unused committed facilities are taken into account when calculating average maturity. Average maturity 2017 2016 Minimum Maximum Average maturity, gross debt Maturity < 1 year, net debt Maturity > 2 year, net debt 5.7 years 0% 97% 5.9 years 0% 94% 2 years - 50% - 25% - Policy 1 1 1 How we act and operate In addition to the treasury and funding policy, the Board of Directors has approved a long-term financing strategy which defines the direction for financing of the Group. This includes, for example, counterparties, instruments and risk appetite and describes future funding opportunities to be explored and implemented. The funding strategy is supported by members’ long-term commitment to invest in the business. It is the Group’s objective to maintain its credit quality at a robust investment grade level. The Group has, to a very high degree, centralised its funding and cash management to control and optimise its funding position. The Group aims for a diversified funding platform comprising bilateral bank financing, mortgage loans, supranationals, capital market bond issues, commercial papers and finance leases. The Group aims to have adequate liquidity and credit facility reserves, meeting the requirements for an investment grade company. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 4.3.2 Currency risk Significant currency fluctuations Compared to last year, the average rate of the GBP and USD weakened by more than 7 per cent and 2 per cent respectively. Our hedging strategies helped to mitigate a large part of the transactions impact from movement in USD and GBP in 2017. The hedging activities delivered a gain of EUR 29 million in 2017, compared to a gain of EUR 35 million last year. The result of hedging activities classified as hedge accounting is recognised in other income and other cost. The Group is increasingly involved in emerging markets where efficient hedging is not feasible, either due to currency regulations or illiquid financial markets. These markets are mainly Nigeria, Ivory Coast, Senegal, Egypt and Bangladesh. Access to foreign currencies in Nigeria and Egypt improved in 2017 but related currency values were lower compared to 2016. Our business in Saudi Arabia is a large part of the Group’s export to MENA. The Saudi Arabia currency (SAR) has been pegged to USD since 1986, however, given the budget deficit and uncertainty regarding the Saudi Arabia economy, we monitor the currency situation closely. Revenue split by currency in 2017 Revenue split by currency in 2016 6% 2% 8% 6% 2% 8% 32% 30% 13% 10,338 million EUR 13% 9,567 million EUR 1 1 2 14% 15% 25% 26% EUR GBP SEK DKK USD SAR Other Table 4.3.2.a Exchange rates EUR/GBP EUR/SEK EUR/DKK EUR/USD EUR/SAR 2017 0.8885 9.8476 7.4453 1.1943 4.4792 Closing rate 2016 Change 2017 Average rate 2016 Change 0.8554 9.5684 7.4333 1.0490 3.9367 -3,86% -2.92% -0.16% -13.85% -13.78% 0.8765 9.6317 7.4386 1.1277 4.2294 0.8176 9.4687 7.4452 1.1058 4.1473 -7.19% -1.72% 0.09% -1.98% -1.98% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.3.2.b Currency exposure (EURm) EUR/DKK USD*/DKK GBP/DKK SEK/DKK SAR/DKK 2017 External exposure: Financial liabilities Financial assets Derivatives Net external exposure Internal exposure: Financial assets Derivatives Net internal exposure Net exposure The net exposure relates to: Hedging of expected commercial cash flow that qualify for hedge accounting Hedging of expected commercial cash flow where hedge accounting is not used Exposure not hedged Applied sensitivity Impact on profit or loss Impact on other comprehensive income 2016 External exposure: Financial liabilities Financial assets Derivatives Net external exposure Internal exposure: Financial liabilities Financial assets Derivatives Net internal exposure Net exposure The net exposure relates to: Hedging of expected commercial cash flow that qualify for hedge accounting Hedging of expected commercial cash flow where hedge accounting is not used Exposure not hedged Applied sensitivity Impact on profit or loss Impact on other comprehensive income * Incl. AED -155 164 -367 -358 268 47 315 -15 218 -398 -195 3 - 3 -212 123 -803 -892 522 192 714 -844 34 592 -218 8 210 218 -2 76 -153 -79 13 - 13 -43 -192 -178 - -66 - -43 - 1% - - -235 - 43 5% 2 -12 -192 - 14 5% 1 -10 - - - 5% - - -58 -8 - 5% - -3 -191 148 -362 -405 -24 303 - 279 -26 190 -593 -429 - - - - -35 204 -538 -369 - 257 - 257 -126 -429 -112 - -126 - 1% -1 - -357 -72 - 5% -4 -18 -152 - 40 5% 2 -8 -710 39 499 -172 -4 - 216 212 40 - - 40 5% 2 - 1 1 3 -15 80 -198 -133 - 15 - 15 -118 -95 -23 - 5% -1 -5 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Risk mitigation The Group’s net external exposure is calculated as external financial assets and liabilities denominated in currencies different from the functional currency of each legal entity, plus any external derivatives converted on Group level into currency risk against DKK, i.e. EUR/ DKK, USD/DKK etc. The same applies to net internal exposure. These sum up to the Group’s aggregate currency exposure, net exposure. This analysis excludes net foreign currency investments in subsidiaries, as well as instruments hedging those investments. The hedging relation- ships are fully effective. Assumptions for sensitivity analysis The sensitivity analysis only includes currency exposure arising from financial instruments and thus the analysis does not include hedged future commercial transactions. The applied change in exchange rates is based on historical currency fluctuations. Risk Currency risk arises from the Group’s export activities, investments and financing activities. The Group Note 4.3.3 Interest rate risk 1 1 4 operates in many different countries and has significant investments in operations outside of Denmark, of which the UK, Germany and Sweden represent the largest part of the business by net revenue, profit and assets. A major part of the currency risk from net revenue denominated in foreign currencies is offset by sourcing in the same currency. Currency risks primarily exist due to transactional risks in the form of future commercial and financial payments and translation risks relating to investments in foreign operations in the form of subsidiaries, joint ventures and associated companies. Transaction risks arise from sales or sourcing in currencies different from the functional currency in each subsidiary. Measured in nominal EUR, the Group’s consolidated risk is largest in EUR, followed by USD, GBP, SEK and SAR. Income statement Volatility in currency rates impact the Group’s revenue, cost of sales and financial items with potential adverse or positive effects on milk prices and cash flow. Balance sheet Changes in currency rates could cause volatility in balance, equity and cash flow. The majority of the local funding is obtained in local currencies. Investments in subsidiaries are normally not hedged. Policy According to the treasury and funding policy, the treasury department can hedge: Up to 15 months of the net forecasted cash receipts and payables. The level of hedging activ- ity is affected by factors such as the underlying business development, currency rates and the time until forecasted cash flow occur. Up to 100 per cent of net recognised trade receivables and trade payables. How we act and operate Throughout the year, the Group continued to hedge the forecasted sales and purchases in foreign currency, always taking the current market situation into consideration. The currency exposure is continuously managed by the treasury department. Individual currency exposures are hedged in accordance with the treasury and funding policy. Financial instruments used to hedge the currency exposure does not necessarily need to qualify for hedge accounting, and hence some of the applied financial instruments, i.e. some option strategies, are accounted for as fair value through the income statement. Arla Foods amba’s functional currency is DKK. However, the risk in relation to the EUR currency is assessed in the same manner as for DKK, hence as an example, in companies using DKK as functional currency, a borrowing in EUR is treated the same as a borrowing in DKK. The Executive Management Team has the discretion to decide if and when investments in foreign operations should be hedged (translation risks) with an obligation to inform the Board of Directors at the next meeting. Limited hedging activities due to decreased debt levels The average duration of the Group’s interest on interest-bearing debt, including derivatives but excluding pension liabilities, has decreased by 0.7 to 3.8. The duration is reduced due to matured interest rate hedges and a reduction in time to maturity on the remaining hedges. Even though interest rates were low in 2017, our hedging activity was limited due to the decrease in net inter- est-bearing debt. Table 4.3.3 Sensitivity based on a 1 percentage point increase in interest rate (EURm) 2017 Financial assets Derivatives Financial liabilities Net interest-bearing debt excluding pension liabilities 2016 Financial assets Derivatives Financial liabilities Net interest-bearing debt excluding pension liabilities Carrying value Sensitivity -610 - 2,246 1,636 -600 - 2,248 1,648 1% 1% 1% 1% 1% 1% Potential accounting impact Income statement Other comprehensive income 4 7 -18 -7 -2 49 - 47 4 12 -22 -6 -2 63 - 61 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Risk mitigation Risk The Group is exposed to interest rate risk on interest-bearing borrowings, pension liabilities, interest-bearing assets and the impairment test of non-current assets. The risk is divided between profit exposure and exposure to other comprehensive income. Profit exposure relates to net interest paid, valuation of marketable securities and potential impairment of fixed assets. Exposure to other comprehensive income relates to revaluation of net pension liabilities and interest hedging of future cash flow. Fair value sensitivity A change in interest rates will impact the fair value of the Group’s interest-bearing assets, interest rate derivative instruments and debt instruments measured at either fair value through the income statement, or through other comprehensive income. Table 4.3.3 shows the fair value sensitivity. The sensitivity is based on a 1 per cent increase in interest rates. A decrease in the interest rate would have the adverse effect. Cash flow sensitivity A change in interest rates will impact interest rate payments on the Group’s unhedged floating rate debt. Table 4.3.3 shows the one-year cash flow sensitivity, depicting a 1 per cent increase in interest rates on the unhedged floating rate for instru- ments recognised as at 31 December 2017. A decrease in the interest rate would have the adverse effect. Policy Interest rate risk must be managed according to the treasury and funding policy. Interest rate risk is measured as the duration of the debt portfolio including hedging instruments, but excluding pension liabilities. Duration of net-interest bearing debt 2017 3.8 2016 Minimum Maximum 4.5 1 7 Policy How we act and operate The purpose of interest rate hedging is to mitigate risk and secure a relatively stable and predictable financing cost. The interest rate risk from net borrowing is managed by having an appropriate split between fixed and floating interest rates. The Group actively uses derivative financial instruments to reduce risks related to fluctuations in the interest rate and to manage the interest profile of the interest-bearing debt. By having a portfolio approach and using derivatives, the Group can indpendently manage and optimise interest rate risk, as the interest rate profile can be changed without having to change the funding itself. Thereby the Group can operate in a fast, flexible and cost efficient manner without changing underlying loan agreements. The mandate from the Board of Directors provides the Group with the opportunity to use derivatives like interest rate swaps and options, in addition to interest conditions embedded in the loan agreements. At present, no options have been utilised to the portfolio. 1 1 5 Note 4.3.4 Commodity price risk Limited hedging activities in accordance with strategy The supply contracts are predomi- nately related to a floating official price index. The treasury department uses financial derivatives to centrally hedge commodity price risk. This secures full flexibility to change suppliers without having to take future hedging into consideration. The hedging activities concentrate on the most significant risks, including electricity, natural gas and diesel in Denmark, Germany, Sweden and the UK. The total energy commodity spend, excluding taxes and distribution costs, amounts to approximately EUR 95 million a year. The purpose of hedging is to reduce a short-term volatility in costs related to energy due to changing commodity prices. In 2017 approximate 30% of the energy spend was hedged. End of 2017, 28 per cent of the energy spend for 2018 was hedged. A 5 per cent increase in commodity prices would negatively impact profit by approxi- mately EUR 3 million. Conversely, other comprehensive income would be positively impacted by EUR 1 million. Table 4.3.4 Hedged commodities (EURm) 2017 Diesel / natural gas Electricity 2016 Diesel / natural gas Electricity Sensitivity Contract value Potential accounting impact Income statement Other comprehensive income 5% 5% 5% 5% 1 - -2 -1 1 - 2 1 -3 -1 1 - CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Risk mitigation Risk The Group is exposed to commodity risks related to the production and distribution of dairy products. Increased commodity prices negatively impact the costs of production and distribution. The most significant risk relates to energy consumption. However, the Group is, to a minor extent, also exposed to commodities used in packaging, vegetable oils and other ingredients used within production. The risk is divided between profit exposure and exposure to other comprehensive income. The profit exposure relates to future purchases, whereas the exposure to other comprehensive income relates to the revaluation of commodities hedges. 1 1 6 Note 4.3.5 Credit risk Limited losses The Group has experienced very limited losses from defaulting counterparties such as customers, suppliers and financial counterparties. For financial counterparties, the credit risk is minimised by only entering into new derivative transactions with those that have a credit rating of at least A-/A-/A3 from either S&P, Fitch or Moody’s. All financial counterparties had satisfactory credit ratings at year-end. In some geographies which are not serviced by our relationship banks and where financial counter- Fair value sensitivity A change in commodity prices will impact the fair value of the Group’s hedged commodity derivative instruments, measured through other comprehensive income and the unhedged energy consumption through the income statement. The table shows the sensitivity of a 5 per cent increase in commodity prices for both hedged and unhedged commodity purchases. A decrease in commodity prices would have the reverse effect. Policy According to the treasury policy the forecasted consumption on electricity, natural gas and diesel can be hedged for up to 36 months for a limited proportion increasing to 100 per cent for consumption in the coming 18 months. How we act and operate Energy commodity price risks are managed by the treasury department. Commodity price risks are mainly hedged by entering into financial derivative contracts, independent of the physical supplier contracts. Arla is also exploring other commodities relevant for financial risk manage- ment. The Group can use derivative financial instruments such as swaps, futures and options to reduce the risk of fluctuations in the price of energy commodities. Currently no options are used. The energy exposure and hedging is managed as a portfolio across energy type and country. Not all energy commodities can effectively be hedged by matching the underlying costs, but Arla aims to minimise the base risk. Energy risk is not entirely separated from the commercial markets but is a part of a holistic risk approach. The Group is gaining experience in hedging price risk on selected milk commodity products with an insignificant value. The scope of hedging is still limited by the evolving but immature dairy derivative markets in the EU and New Zealand. The dairy derivative market is developing and will over years play a role in relation to managing fixed price commodity contracts with customers. Table 4.3.5 shows the counterparty exposure for those agreements covered by entering into netting agreements that qualifies for netting in case of default. parties with a satisfying credit rating do not operate, the Group deviated from the rating requirement. The maximum exposure to credit risk is approximately equal to the carrying amount. Other counterparties, customers and suppliers, are subject to continuous monitoring of fulfilment of their contractual obligations and credit quality. Outside the Group’s core markets, credit insurance and trade finance instruments are widely used to reduce the risks. Further information on trade receivables is provided in Note 2.1.c. The Group has, like in previous years, continuously worked with credit exposure and experienced a very low level of losses arising from customers. Netting of credit risk To manage the financial counterparty risk, the Group uses master netting agreements when entering into derivative contracts. Table 4.3.5 External rating of financial counterparties (EURm) Assets, carrying amount Qualifying for netting Net assets exposure Liabilities, carrying amount Qualifying for netting Net liabilities exposure 2017 AA- A+ A A- Total 2016 AA- A+ A A- Total 3 4 7 5 19 3 4 7 1 15 - - - 4 4 39 11 36 1 87 3 4 7 1 15 36 7 29 - 72 12 11 7 1 31 11 11 7 1 30 1 - - - 1 64 20 71 13 168 11 11 7 1 30 53 9 64 12 138 In addition, the Group has entered into sales and repurchase agreements on mortgage bonds, described in further details in Note 4.6. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017  Risk mitigation Risk Credit risks arise from operating activities and engagement with financial counterparties. Losses occur when customers, suppliers or financial counterparties default on their obligations towards the Group. Furthermore, a weak counterparty credit quality can reduce their ability to support the Group going forward, thereby jeopardising the fulfilment of our Group’s strategy. As an example, there is a risk when money is borrowed, and a counterparty is unable to refinance the credit facility due to its own financial difficulties. When investing in new entities, a thorough due diligence is performed, including a review of the financial condition of the partner. deviated in countries like Nigeria, Ghana and Saudi Arabia. Policy Financial counterparties must be approved by a member of the Executive Board and the CFO of Arla Foods amba, and have a credit rating of a least A-/A-/A3 by S&P, Fitch or Moody’s in order for the financial counterparty to have a liability towards Arla. In geographies, which are not properly covered by our relationship banks, Corporate Treasury may deviate from counterparty requirements. Corporate Treasury A credit assessment is performed of all new customers, and existing customers are subject to ongoing monitoring of their credit worthiness. The same process is applied to important suppliers, both for ongoing supply and capital expenditures. How we act and operate The Group has an extensive credit risk policy and uses credit insurance and other trade financing products extensively in connection with exports. In certain emerging markets it is not always possible to obtain credit coverage with the required rating, however, the Group then applies for the best coverage available. The Group has determined that this is an acceptable risk as the Group has decided to grow and invest in emerging markets. If a customer payment is late, internal procedures are followed to mitigate losses. The Group uses a limited number of financial counterparties where credit ratings are monitored on an ongoing basis. Note 4.4 Derivative financial instruments Hedging of future cash flows Hedging of future cash flows The Group uses forward currency contracts to hedge currency risks against expected future net revenue and costs. Interest rate swaps are used to hedge risks against movements in expected future interest payments and commodity swaps are used for energy hedging. Hedging of net investments The Group hedged an insignificant part of currency exposure relating to investments in subsidiaries, joint ventures and associated companies, using loans and derivatives. Fair value of hedge instruments not qualifying for hedge accounting (financial hedge) The Group uses currency options which hedge forecasted sales and purchases. Some of these options do not qualify for hedge accounting and hence, the fair value adjustment is recognised directly in the income statement. Currency swaps are used as part of the daily liquidity management. The objective of the currency swaps is to match the timing of in- and outflow of foreign currency cash flows. 1 1 7 Table 4.4 Hedging of future cash flow from highly probable forecast transactions (EURm) Expected recognition Fair value recognised in other comprehen- sive income Carrying value 2018 2019 2020 2021 2017 Currency contracts Interest rate contracts Commodity contracts Hedging of future cash flow 4 -77 1 -72 4 -77 1 -72 4 -17 1 -12 - -14 - -14 - -9 - -9 - -7 - -7 Fair value recognised in other comprehen- sive income Carrying value 2017 2018 2019 2020 2016 Currency contracts Interest rate contracts Commodity contracts Hedging of future cash flow -23 -23 -100 -100 3 3 -120 -120 -23 -20 - -43 - -17 - -17 - -15 - -15 - -9 - -9 Later than 2021 - -30 - -30 Later than 2020 - -39 - -39 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.4.b Value adjustment of hedging instruments (EURm) Deferred gains and losses on cash flow hedges arising during the period Value adjustments of hedging instruments reclassified to other operating income and costs Value adjustments of hedging instruments reclassified to financial items Value adjustments of hedging instruments reclassified to production costs Total 2017 2016 11 29 11 -3 48 -23 -34 17 18 -22 Accounting policies Derivative financial instruments are recognised from the trade date and measured in the financial statement at fair value. Positive and negative fair values of derivative financial instruments are recognised as separate line items in the balance sheet. Offsetting of positive and negative amounts only take place once the Group has obtained the legal right and intends to settle several financial instruments on a net basis. Fair value hedging Changes in the fair value of derivative financial instruments, which meet the criteria for hedging the fair value of recognised assets and liabilities, are recognised alongside changes in the value of the hedged asset or the hedged liability for the portion that is hedged. Cash flow hedging Changes in the fair value of derivative financial instruments, that are classified as hedges of future cash flows and effectively hedge changes in future cash flows, are recognised under other comprehensive income in a special reserve for hedging transactions under equity, until the hedged cash flows impact the income statement. The reserve for hedging instruments under equity is presented net of tax. The cumulative gains or losses from hedging transactions that are retained in equity are reclassified and recognised under the same line item as the hedged item (basic adjustment). If a hedging instrument no longer meets the criteria for hedge accounting, the hedge will cease from that point onward. The accumulated change in value recognised in other comprehensive income is recycled to the income statement once the hedged cash flows affect the income statement or are no longer likely to be realised. If the hedged cash flows are no longer expected to be realised, the cumulative value change is immediately recycled from equity to the income statement. For derivative financial instruments that do not meet the conditions for treatment as hedging instruments, changes in fair value are recognised on a continuous basis in the income statement under financial income and financial costs. 1 1 8 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 4.5 Financial instruments disclosed Table 4.5.a Categories of financial instruments (EURm) Available for sale financial assets Loans and receivables Financial assets measured at fair value through profit or loss Derivatives Financial liabilities measured at amortised cost 2017 511 968 56 87 3,344 2016 504 911 50 168 3,243 The fair value of financial assets and financial liabilities measured at amortised cost is approximately equal to the carrying amount. Table 4.5.b Fair vzalue hierarchy - carrying amount (EURm) Level 1 Level 2 Level 3 Total 2017 Financial assets: Bonds Shares Derivatives Total financial assets Financial liabilities: Issued bonds Mortgage credit institutions Derivatives Total financial liabilities 2016 Financial assets: Bonds Shares Derivatives Total financial assets Financial liabilities: Issued bonds Mortgage credit institutions Derivatives Total financial liabilities Risk mitigation 511 12 523 19 19 - 799 799 406 87 493 - 511 12 19 542 406 799 87 1.292 1 1 9 504 13 - 517 - 798 - 798 - - 31 31 419 - 168 587 - - - - - - - - 504 13 31 548 419 798 168 1,385 Methods and assumptions applied when measuring fair values of financial instruments: is determined as a termination price and consequently, the value is not adjusted for credit risks. Bonds and shares The fair value is determined using the quoted prices in an active market. Non-option derivatives The fair value is calculated using discounted cash flow models and observable market data. The fair value Option instruments The fair value is calculated using option models and observable market data, such as option volatilities. The fair value is determined as a termination price and consequently, the value is not adjusted for credit risks. Fair value hierarchy Level 1: Fair values measured using unadjusted quoted prices in an active market Level 2: Fair values measured using valuation techniques and observable market data Level 3: Fair values measured using valuation techniques and observable as well as significant non-observable market data CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 4.6 Transfer of financial assets Sale and repurchase agreements The Group has invested in mortgage bonds underlying its mortgage debt. The reason for investing in mortgage bonds is that the Group is able to achieve a lower interest rate than current market interest rates on mortgage debt by entering into a sale and repurchase agreement on the listed Danish mortgage bonds. The net interest rate payable, by raising financing through this kind of sale and repurchase agreement, is the interest rate inherent in the sale and repurchase agreement and the contribution to the mortgage institute. Due to the repurchase agreement, the risks and rewards arising from the ownership of transferred mortgage bonds have been retained by the Group. These mortgage bonds have been classified as available for sale with value adjustments recognised through other comprehensive income. The received proceeds create a repurchase obligation which has been recognised within short-term loans. Table 4.6 Transfer of financial assets (EURm) Carrying value Notional amount Fair value 2017 Mortgage bonds Repurchase liability Net position 2016 Mortgage bonds Repurchase liability Net position 1 2 0 504 499 504 -498 -497 -498 6 2 6 496 508 496 -496 -507 -496 - 1 - responsible for advising on the investment strategy and investing the assets. The pension plans do not include a risk-sharing element between the Group and the plan participants. Note 4.7 Pension liabilities Reduced pension liabilities Pension liability consists primarily of defined benefit plans in the UK and Sweden. The defined benefit plans provide pension disbursements to participating employees based on seniority and final salary. Net pension liabilities were EUR 277 million, a decrease of EUR 92 million compared to last year. The carrying value of defined benefit plans decreased primarily in the UK due to actuarial gains related to lower salary increase expectation as well as higher inflation expectation. Pension plans in Sweden The defined benefit plan in Sweden does not currently require the Group to make cash contributions. The recognised net liability was EUR 200 million, an increase of EUR 15 million compared to last year. An actuarial loss of EUR 19 million, resulting from a decrease in the discount rate, was partly offset by currency translation. These pension plans were contribu- tion based plans, guaranteeing defined benefit pension at retirement. Contributions are paid by the Group. The schemes do not provide any insured disability benefits. The plan assets are legally structured as a trust and the Group has control over the operation of the plans and their invest- ments. The investment of the assets is based on the investment strategy defined by the board of the trust. These pension plans do not include a risk-sharing element between the Group and the plan participants. Pension plans in the UK The recognised net liability was EUR 47 million, representing a decrease of EUR 103 million compared to last year. The reduction is primarily related to actuarial gains of EUR 77 million due to lower salary increase expectations. Additionally, payments to the plans reduced the liability with EUR 30 million. The defined benefit plans in the UK are administered by independent pension funds that invest deposited amounts to cover future pension payments. These pension plans are defined benefit final salary schemes. The schemes are closed to both new entrants and future accrual. Employer’s contributions are determined with the advice of independent qualified actuaries on the basis of tri-annual valuations. The schemes do not provide any insured disability benefits. The schemes are legally structured as trust-based statutory sectionalized pension schemes. The Group has limited control over the operation of the plans and their investments. The trustees of the schemes set the investment strategy and have established a policy on asset allocation to best match the assets to the liabilities of the schemes. The trustees appoint an independent external advisor to the schemes who is CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 4.7.a Pension liabilities recognised on the balance sheet (EURm) Sweden UK Other Total 2017 Present value of funded liabilities Fair value of plan assets Deficit of funded plans Present value of unfunded liabilities Net pension liabilities recognised on the balance sheet Specification of total liabilities: Present value of funded liabilities Present value of unfunded liabilities Total liabilities 2016 Present value of funded liabilities Fair value of plan assets Deficit of funded plans Present value of unfunded liabilities Net pension liabilities recognised on the balance sheet Specification of total liabilities: Present value of funded liabilities Present value of unfunded liabilities Total liabilities Table 4.7.b Development in pension liabilities (EURm) Present value of liability at 1 January Reclassification New pension liability from acquired companies Paid in by employees Current service cost Interest cost Actuarial gains and losses from changes in financial assumptions (OCI) Benefits paid Curtailments and settlements Exchange rate adjustment Present value of pension liability at 31 December Table 4.7.c Development in fair value of plan assets (EURm) Fair value of plan assets at 1 January Reclassification Interest income Return on plan assets excluding interest income (OCI) Contributions to plans Benefits paid Administration expenses Exchange rate adjustments Fair value of plan assets at 31 December 210 -11 199 1 200 1,336 -1,289 47 - 47 38 -20 18 12 30 210 1 211 1,336 - 1,336 38 12 50 196 -11 185 - 185 196 - 196 1,425 -1,275 150 - 150 1,425 - 1,425 45 -24 21 13 34 45 13 58 1,584 -1,320 264 13 277 1,584 13 1,597 1,666 -1,310 356 13 369 1,666 13 1,679 1 2 1 2017 2016 1,679 -3 2 1 3 42 -4 -60 - -63 1,597 1,610 - - 1 3 52 282 -59 -3 -207 1,679 2017 2016 1,310 -2 33 54 30 -50 -1 -54 1,320 1,316 - 44 150 34 -48 -2 -184 1,310 33 54 87 44 150 194 The Group expects to contribute EUR 35 million to the plan assets in 2018 and EUR 132 million in 2019-2022. Actual return on plan assets: Calculated interest income Return excluding calculated interest Actual return CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Maturity of pension liability at 31 December 2017 (EURm) Maturity of pension liability at 31 December 2016 (EURm) 600 500 400 300 200 100 0 600 500 400 300 200 100 0 >1Y 1-5Y 5-10Y 10-20Y 20-30Y 30-40Y >40Y >1Y 1-5Y 5-10Y 10-20Y 20-30Y 30-40Y >40Y UK Sweden Other Total Total 1,337 210 50 1,597 >1Y 43 10 9 62 1-5Y 177 35 7 219 5-10Y 10-20Y 20-30Y 30-40Y 132 19 6 157 430 61 10 501 278 40 9 327 231 38 5 274 >40Y 46 7 4 57 UK Sweden Other Total Total 1,425 196 58 1,679 >1Y 55 9 3 67 1-5Y 192 34  11 237 5-10Y 10-20Y 20-30Y 30-40Y 141 16 3 160 446 58 19 523 247 37 13 297 283 36 8 327 >40Y 61 6 1 68 Table 4.7.d Sensitivity of pension liabilities to key assumptions (EURm) 2017 2017 2016 2016 Impact on pension liabilities at 31 December Discount rate +/- 10bps Expected salary increases +/- 10bps Life expectancy +/- 1 year Inflation +/- 10 bps 1 2 2 + -19 2 64 17 - 20 -2 -64 -17 + -25 2 66 18 Table 4.7.e Pension assets recognised (EURm) Diversified Growth Funds & Debt vehicles Liability-Driven Investments Absolute return Bonds Equity instruments Properties Infrastructure Bonds Other assets Total assets 2017 579 163 143 165 100 70 11 89 1,320 % 44% 12% 11% 12% 8% 5% 1% 7% 100% 2016 486 246 198 154 88 42 11 85 1,310 - 25 -2 -66 -18 % 37% 19% 15% 12% 7% 3% 1% 6% 100% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Table 4.7.f Recognised in the income statement for the year (EURm) 2017 2016 Current service cost Administration cost Curtailments and settlements Recognised as staff costs Interest cost on pension liability Interest income on plan assets Recognised as financial cost Total amount recognised in the income statement Table 4.7.g Recognised in other comprehensive income (EURm) Accumulated actuarial losses at 1 January Actuarial gains/(losses) for the year Accumulated actuarial gains and losses at 31 December Table 4.7.h Assumptions for the actuarial calculations Discount rate, Sweden Discount rate, UK Expected payroll increase, Sweden Expected payroll increase, UK Inflation (CPI), Sweden Inflation (CPI), UK 3 1 - 4 42 -33 9 13 2017 -287 58 -229 2017 2.5% 2.5% 2.3% 2.5% 1.9% 3.1% 4 2 -3 3 52 -44 8 11 2016 -155 -132 -287 2016 2.8% 2.7% 2.2% 4.5% 2.2% 1.7% 1 2 3 Accounting policies Pension liabilities and similar non-current liabilities The Group has entered post-employ- ment pension plan agreements with a significant number of employees. The post-employment pension plan agreements take the form of defined benefit plan and defined contribution plan agreements. Defined contribution plans For defined contribution plans, the Group pays fixed contributions to independent pension companies. The Group has no obligation to make supplementary payments beyond those fixed payments, and the risk and reward of the value of the pension plan therefore rests with the plan members, and not the Group. Amounts payable for contributions to defined contribution plans are expensed in the income statement as incurred. Defined benefit plans Defined benefit plans are character- ised by the Group’s obligation to make specific payments from the date the plan member is pensioned, depending on, for example, the member’s seniority and final salary. The Group is subject to the risks and rewards associated with the uncertainty that the return generated by the assets are able to meet the pension liability, which are affected by assumptions concerning mortality and inflation. The Group provides both funded and unfunded defined benefit plans to certain employees. Funded plans are where the Group pays cash contributions into a separately administered fund, which invests the contributions into various assets, with the aim of generating returns to meet present and future pension liabilities. Unfunded plans are where no cash or other assets are set aside from the Group’s assets used in operations to cover the future pension liability. The Group’s net liability is the amount presented on the balance sheet as pension liability. The net liability is calculated separately for each defined benefit plan. The net liability is the amount of future pension benefits that employees have earned in current and prior periods (i.e. the liability for pension payments for the portion of the employee’s estimated final salary earned at the balance sheet date) discounted to a present value (the defined benefit liability), less the fair value of assets held separately from the Group in a plan fund. changes arising from contributions and benefit payments. The net interest cost and other costs relating to defined benefit plans are recognised in the income statement. The provision primarily covers defined benefit plans in the UK and Sweden. The Group uses qualified actuaries to annually calculate the defined benefit liability using the projected unit credit method. The balance sheet amount of the net obligation is impacted by remeasure- ment, which includes the effect of changes in assumptions used to calculate the future liability (actuarial gain and losses) and the return generated on plan assets (excluding interest). Remeasurements are recognised through other compre- hensive income. Interest cost for the period is calculated using the discounted rate used to measure the defined benefit liability at the start of the reporting period applied to the carrying amount of the net liability, taking into account Uncertainties and estimates The costs relating to defined benefit pension plans and their carrying amounts are assessed based on a number of assumptions, including discount rates, inflation rates, salary growth and mortality. A small difference in actual variables compared to assumptions and any changes in assumptions can have a significant impact on the carrying amount of the net liability. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 NOTE 5 OTHER AREAS Note 1 Operating profit 87 Note 1.1 Revenue 88 Note 1.2 Costs 90 Note 1.3 Other operating income and costs Note 2 Net working capital 92 Note 2.1 Net working capital Note 3 Capital employed 95 Note 3.1 Intangible assets 96 Note 3.2 Impairment tests 97 Note 3.3 Property, plant and equipment 99 Note 3.4 Joint ventures and associates 101 Note 3.5 Provisions 101 Note 3.6 Purchase and sale of business or activities Note 4 Funding 104 Note 4.1 Financial items 105 Note 4.2 Net interest-bearing debt 110 Note 4.3 Financial risk 110 Note 4.3.1 Liquidity and Funding risk 112 Note 4.3.2 Currency risk 114 Note 4.3.3 Interest rate risk 115 Note 4.3.4 Commodity price risk 116 Note 4.3.5 Credit risk 117 Note 4.4 Derivative financial instruments 119 Note 4.5 Financial instruments disclosed 120 Note 4.6 Transfer of financial assets 120 Note 4.7 Pension obligations Note 5 Other areas 125 Note 5.1 Tax 127 Note 5.2 Fees to auditors appointed by the Board of Representatives 127 Note 5.3 Management remuneration and transactions 128 Note 5.4 Contractual commitments and contingent liabilities 128 Note 5.5 Events after the balance sheet date 128 Note 5.6 General accounting policies 130 Note 5.7 Group chart Note 5.1 Tax Current and deferred tax Tax in the income statement The tax cost was EUR 22 million, compared to a tax cost of EUR 42 million last year. The reduction is mainly due to deferred tax and adjustments relating to previous years. The current tax cost primarily consists of EUR 7 million tax cost relating to cooperative tax, and a EUR 19 million tax cost relating to corporate income tax. The equivalent tax costs last year were EUR 10 million and EUR 16 million respectively. Deferred tax Net deferred tax liabilities amounted to EUR 16 million, which represents an increase of EUR 10 million compared to last year. Deferred tax assets of EUR 43 million are primarily based on temporary differences of property, plant and equipment, tax losses carried forward, and pension liabilities. Deferred tax liabilities of EUR 59 million mainly relate to temporary differences on property, plant and equipment and other temporary differences. The increase in the net liability position can be explained by a reduction in deferred tax assets arising from actuarial movements on pension liabilities. A deferred tax asset of EUR 32 million was not recognised, as the Group does not expect to be able to use the benefits arising from the associated temporary differences in the foreseeable future. Last year the unrecognised deferred tax asset amounted to EUR 154 million. The change reflects an updated approach in assessing historical unrecognised temporary differences. Table 5.1.a Tax in the income statement (EURm) Cooperative tax Corporate income tax Deferred tax Adjustments regarding previous years, actual tax Adjustments regarding previous years, deferred tax Total tax in the income statement Table 5.1.b Calculation of effective tax rate (EURm) Statutory corporate income tax rate in Denmark Net deviation in foreign subsidiaries' tax rates compared with the Danish tax rate Adjustments for cooperative tax Net non-taxable income less non-tax-deductible costs Change in tax percentage Adjustments regarding previous years Other adjustments Effective tax rate 2017 2016 7 19 2 -3 -3 22 2017 22.0% -4.7% -18.8% -2.6% 0.0% -1.9% 12.9% 6.9% 10 16 8 3 5 42 1 2 5 2016 22.0% -3.7% -13.1% -5.0% 0.1% 2.0% 8.2% 10.5% CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Table 5.1.c Deferred tax (EURm) Intangible assets Property, plant and equipment Financial assets Current assets Provisions Other liabilities Tax loss carry- forwards Other category Total 2017 Net deferred tax asset/liability at 1 January Income/charge to the income statement Income/charge to other comprehensive income Exchange rate adjustment Other adjustments Net deferred tax asset/liability at 31 December Specification: Deferred tax asset at 31 December Deferred tax liability at 31 December 2016 Net deferred tax asset/liability at 1 January Income/charge to the income statement Income/charge to other comprehensive income Change in tax rate Exchange rate adjustment Other adjustments Net deferred tax asset/liability at 31 December Specification: Deferred tax asset at 31 December Deferred tax liability at 31 December -2 -1 - - - -3 - -3 -1 - - - -1 - -2 - -2 8 4 - - -3 9 35 -26 1 -2 - -2 -3 14 8 39 -31 -3 -1 - - - -4 - -4 2 -5 - - - - -3 - -3 -3 - - - - -3 - -3 -3 - - - - - -3 - -3 27 -12 -10 -1 11 15 4 -11 26 -8 21 2 -3 -11 27 28 -1 1 2 6 Accounting policies Tax in the income statement Taxable income is assessed according to national rules and regulations that apply to the entities in the Group. Tax is assessed on the basis of cooperation or income tax. Tax in the income statement comprises current tax and adjustments to deferred tax. Tax is recognised in the income statement, except to the extent that it relates to a business combination or items (earnings and costs) recognised directly in equity or in other comprehensive income. Current tax Current tax is assessed based on cooperation or income tax. Cooperative taxation is based on capital, while income tax is based on the company’s income for the year. Current tax payable and receivable are recognised in the balance sheet as tax calculated on the taxable income for the year, adjusted for any tax from previous years’ taxable income as well as prepaid on-account taxes. The amount is calculated using tax rates enacted or substantively enacted at the balance sheet date. Deferred tax Deferred tax and related adjustments for the year are calculated applying the balance sheet liability method, this is the temporary differences between carrying amounts and the tax base of assets and liabilities. Deferred tax is not recognised on temporary differences relating to goodwill, which is not deductible for tax purposes, or arising at the acquisition date of an asset or liability without affecting either the profit or loss for the year or taxable income, except for those arising from business combinations. Deferred tax assets, including the value of tax losses carried forward, are recognised under other non-current assets at the value at which they are expected to be used, either by elimination in the tax of future earnings or by offsetting against deferred tax payable in companies within the same legal tax entity or jurisdiction. Deferred tax is calculated at the tax rates that are expected to apply to the respective countries and the period in which the asset will be realised or the liability is settled, based on tax rules and tax rates that are enacted or substantively enacted at the reporting date. Changes in deferred tax assets and liabilities due to changes in the tax rate are recognised in the comprehensive income for the year. 1 - - - -1 - - - 5 3 -4 - - -3 1 1 - 6 3 - - -1 8 8 - 10 -3 - - -1 - 6 6 - -40 8 -1 - -5 -38 4 -34 -41 2 -1 - - - -40 - -40 -6 1 -11 -1 1 -16 43 -59 -1 -13 16 - -8 - -6 74 -80 Uncertainties and estimates Deferred tax Deferred tax reflects assessments of future taxable income across all legal entities. Actual future taxes may deviate from these estimates due to changes to expectations relating to future taxable income, future statutory changes in income taxation or the outcome of tax authorities’ final review of the Group’s tax returns. Recognition of a deferred tax asset also depends on an assessment of the future use of the asset. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 5.2 Fees to auditors appointed by the Board of Representatives Fees paid to EY The fees to auditors are attributable to EY. Table 5.2 Fees to auditors appointed by the Board of Representatives (EURm) Statutory audit Other assurance engagements Tax assistance Other services Total fees to auditors 2017 2016 1.4 - 1.3 0.7 3.4 1.3 0.1 1.4 1.4 4.2 Note 5.3 Management remuneration and transactions Remuneration paid to management The remuneration of the Executive Board is annually proposed by the Chairmanship and approved by the Board of Directors and salary was maintained on par with last year. Remuneration for the Board of Directors is annually approved by the Board of Representatives. Principles applied to management remuneration are described on page 60. Related parties exercising significant influence comprise the Board of Directors and Executive Board. Members of the Board of Directors are paid for milk supplies to Arla Foods amba on equal terms with other owners of the company. Table 5.3.a Management remuneration (EURm) Board of Directors Wages, salaries and remuneration Total Executive Board Fixed compensation Pension Other benefits Short-term variable incentives Long-term variable incentives Total Table 5.3.b Transactions with the Board of Directors (EURm) Purchase of goods Supplementary payments received regarding previous years Total Trade payables Owner accounts Total 1 2 7 2017 2016 1.3 1.3 2.2 0.2 0.1 0.6 0.2 3.3 2017 14.0 0.4 14.4 1.2 1.4 2.6 1.3 1.3 2.2 0.3 0.1 0.6 0.2 3.4 2016 10.7 0.3 11.0 0.6 2.1 2.7 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 5.4 Contractual commitments, contingent assets and liabilities Contractual commitments The Group is party to a small number of lawsuits, disputes and other claims. Management believes that the outcome of these will not impact the Group’s financial position beyond what is already recognised in the financial statements. As security for mortgage debt based on the Danish Mortgage Act with a nominal value of EUR 815 million, compared with EUR 817 million last year, the Group provided security in property. Contingent assets The Finnish Supreme Administrative Court ruled on 29 December 2016, that the Finnish dairy company Valio violated the applicable competition law rules by its predatory pricing on the fresh liquid milk market in Finland. The decision is final. The violations by Valio have led to losses for Arla in previous years, for which Arla raised a claim for damages of approximately EUR 58 million. This civil claim for damages is being pursued by Arla before the Helsinki District Court in Finland. We expect the court proceedings to continue throughout the course of 2018. Table 5.4 Contractual commitments and contingent liabilities (EURm) 2017 2016 Guarantee commitments 0-1 years 1-5 years Over 5 years Operating rent and lease commitments Commitments in relation to agreements on the purchase of property, plant and equipment 2 53 108 43 204 112 5 65 139 39 243 92 Uncertainties and estimates 1 2 8 The Group entered into a number of lease agreements. Management assesses the substance of the agreements in order to classify the lease agreements as either financial or operating leases. The Group mainly entered into lease agreements for standardised assets that are short-term in relation to the asset’s useful lives. As such, the lease agreements have been classified as operating leases. First of January 2019 IFRS 16 Leasing standard will be applicable. Arla is currently preparing for implementation of this standard. For more details read note 5.6. Note 5.5 Subsequent events after the balance sheet date On 25 January 2018, the Board of Directors decided to close Brabrand Dairy in Denmark and move its production to other sites. The restructure is due to a lack of expansion options at the site, which is necessary to meet an increasing demand for yogurt products in Europe. The closure will take place mid-2019 and will affect 160 employees. The decision has no effect on the financial statements of 2017. spreads and cheese under an intellectual property license. On 8 February 2018, Arla announced the acquisition of Yeo Valley Dairies Limited, a subsidiary of the Yeo Valley Group Limited. The transaction will give Arla the rights to use the Yeo Valley® brand in the UK market for milk, butter, On 9 February 2018, Arla Foods Ingredients agreed to acquire the remaining 50 per cent of the Argentinian-based, Arla Foods Ingredients S.A (AFISA), currently owned by SanCor, to support the company’s ambition for market growth in South America. The investment was previously classified as a joint venture and will be recognised as a fully owned subsidiary following the acquisition. No other subsequent events with a material impact on the financial statements occurred after the balance sheet date. Note 5.6 General accounting policies Consolidated financial statements The consolidated financial statements included in this annual report are prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU, and additional disclosure requirements in the Danish Financial Statement Act for class C large companies. Arla is not an EU public interest entity as the Group has no debt instruments traded on a regulated EU market place. The consolidated financial statements were authorised for issue by the company’s Board of Directors on 20 February 2018 and presented for approval by the Board of Representatives on 28 February 2018. The consolidated financial statements are prepared as a compilation of the parent company’s and the individual subsidiaries’ financial statements, prepared under the Group’s accounting policies. Revenue, costs, assets and liabilities, along with items included in equity of subsidiaries are aggregated and presented on a line-by-line basis. Intra-group shareholdings, balances and transactions, as well as any unrealised income and expenses arising from intra-group transactions are eliminated. The consolidated financial statements comprise Arla Foods amba (parent company) and the subsidiaries in which the parent company directly or indirectly holds more than 50 per cent of the voting rights, or otherwise maintains control to obtain benefits from its activities. Entities in which the Group exercises joint control through a contractual arrangement are considered to be joint ventures. Entities in which the Group exercises a significant but not a controlling influence, are considered as associates. A significant influence is typically obtained by holding or having at the Group’s dispos- al, directly or indirectly, more than 20 per cent, but less than 50 per cent, of the voting rights in an entity. Unrealised gains arising from transactions with joint ventures and associates, i.e. profits from sales to joint ventures or associates and whereby the customer pays with funds partly owned by the Group, are eliminated against the carrying amount of the investment in proportion to the Group’s interest in the company. Unrealised losses are eliminated in the same manner, but only to the extent that there is no evidence of impairment. The consolidated financial statements are prepared on a historical cost basis, except for certain items with alternative measurement bases, which are identified in these accounting policies. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Translation of transactions and monetary items in foreign currencies For each reporting entity in the Group, a functional currency is determined, being the currency used in the primary economic environment where the entity operates. Where a reporting entity transacts in a foreign currency, it will record the transaction in its functional currency using the transaction date rate. Monetary assets and liabilities denominated in foreign currencies are translated into the functional currency using the exchange rate applicable at the reporting date. Exchange differences are recognised in the income statement under financial items. Non-monetary items, for example property, plant and equipment which are measured based on historical cost in a foreign currency, are translated into the functional currency upon initial recognition. Translation of foreign operations The assets and liabilities of consolidated entities, including the share of net assets and goodwill of joint ventures and associates with a functional currency other than EUR, are translated into EUR using the year-end exchange rate. The revenue, costs and share of the results for the year are translated into EUR using the average monthly exchange rate if this does not differ materially from the transaction date rate. Foreign currency differences are recognised in other comprehensive income and accumulated in the translation reserve. On partial divestment of associates and joint ventures, the relevant proportional amount of the cumulative foreign currency translation adjustment reserve is transferred to the results for the year, along with any gains or losses related to the divestment. Any repayment of outstanding balance considered part of the net investment is not in itself considered to be a partial divestment of the subsidiary. Alternative performance measures The Group presents a range of financial measures in the consolidated annual report that are not defined according to IFRS. The Group believes that these measures provide valuable information to external stakeholders and management and enable better evaluation of overall performance and trends. The financial measures should not be considered as a replacement for performance measures as defined under IFRS, but rather as supplementary information. Adoption of new or amended IFRS The Group implemented all new standards and interpretations effective in the EU from 2017. None of these newly adopted standards and interpretations had or are expected to have an impact on the consolidated financial statements of Arla. IASB issued a number of new or amended and revised accounting standards and interpretations that have not yet come into effect. Arla expects to incorporate the new standards when they become mandatory. transferred to the customer, generally on delivery of the goods. IFRS 9 – Financial instruments In November 2016, the EU endorsed IFRS 9 “Financial Instruments”, which is effective for annual periods beginning on or after 1 January 2018. IFRS 9 replaces IAS 39 and changes the classification and measurement of financial assets and liabilities. IFRS 9 introduces a logical classification of financial assets based on the Group’s business model and its underlying cash flow. Furthermore, a new “expected loss”-model is introduced, as opposed to an incurred credit loss model under IAS 39. The expected loss model requires an entity to account for expected credit losses and changes in those expected credit losses at each reporting date to reflect changes in credit risk. Furthermore, new requirements for hedge accounting will be more closely aligned to the Group’s business risk management policies. An assessment of the Group’s current hedging relation- ships indicates that they will qualify as continuing hedging relationships upon application of IFRS 9. An assessment was performed which indicates that the new standard would not have any material impact on the classification of financial assets. Analysis confirms that the expected loss model for trade receivables, nor the change in hedge accounting will have a material impact on the recognition or measurement in the Group’s figures. IFRS 15 – Revenue IFRS 15 was issued in May 2014 and amended in April 2016, and establishes a five-step model to account for revenue arising from contracts with customers. Under IFRS 15, revenue is recognised at an amount that reflects the consideration which an entity expects to be entitled to, in exchange for transferring goods or services to a customer. The new revenue standard will supersede all current revenue recognition requirements under IFRS. Either a full retrospective application or a modified retrospective application is required from 1 January 2018. Arla decided to apply the modified retrospective method. Arla sells consumer dairy products, ingredients and raw milk to customers. The goods are sold based on the respective contracts with customers. Arla conducted the assessment on the impact of IFRS 15. For contracts with customers in which the sale of goods is generally expected to be the only performance obligation, adoption of IFRS 15 is not expected to have an impact on Arla’s revenue or profit and loss. Arla expects the revenue recognition to occur at a point in time when control of the goods is In preparing to adopt IFRS 15, Arla is taking the variable considerations into account. Some contracts with customers provide trade discounts, listing fees or volume rebates. Currently, Arla recognises revenue from the sale of goods measured at the fair value of the consideration received or receivable, net of returns and allowances, trade discounts and volume rebates. Such provisions give rise to variable consideration under IFRS 15, and will be required to be estimated at contract inception and updated thereafter. IFRS 15 requires the estimated variable consideration to be constrained to prevent over-recognition of revenue. Arla expects that application of the constraint will have no significant change on the revenue being deferred compared to the current standard. The presentation and disclosure requirements in IFRS 15 are more detailed compared to the current standard, whereby several disclosure requirements in IFRS 15 are new. Arla expects that the notes to the financial statements will be expanded due to the disclosure of significant judgements made. In addition, as required by IFRS 15, Arla will disaggregate revenue recognised from contracts with customers into different categories. IFRS 16 Leases IFRS 16 was issued in January 2016 and replaces IAS 17 Leases, IFRIC 4 Determining whether an Arrangement contains a Lease, SIC-15 Operating Leases-Incentives and SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease. IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases and requires lessees to account for all leases on-balance, similar to the accounting treatment for finance leases under IAS 17. The standard, which is effective on 1 January 2019 for Arla, will significantly change the accounting treatment for lease contracts that are currently treated as operational leases to date. The standard requires that all lease contracts regardless of type, with some exemptions, need to be capitalised on the lessee’s balance sheet as an asset, representing the right to use the under- lying asset, with a matching lease liability, representing the lease payments. The standard includes two recognition exemptions for lessees – leases of ’low-value’ assets, for example personal computers, and short-term leases, i.e., leases with a lease term of 12 months or less. The income statement will also be impacted by the annual leasing costs. Annual leasing costs will be divided into two elements, depreciation and interest costs, as opposed to the current treatment whereby the annual costs relating to operational lease agreements are expensed solely as operating costs. This will have a positive impact on the Group’s EBITDA and to a lesser extent on EBIT. Furthermore, it is expected that the cash flow statement will be impacted due to the current operational lease payments. Operational lease payments are presently disclosed as cash flow from operating activities, and will be disclosed as financing activities as a result of the new standard. Arla will be required to remeasure the lease liability upon the occurrence of certain events, for example a change in the lease term or a change in future lease payments resulting from a change in an index or rate used to determine those payments. Arla will generally recognise the amount relating to the remeasurement of the lease liability as an adjustment to the right-of-use asset. IFRS 16 requires more extensive disclosures than its predecessor, IAS 17. Arla assessed the impact of the adoption of the new standard based on a preliminary analysis. The preliminary analysis indicates an increase in total assets of approximately 5 per cent. Arla’s 2019 income statement will show a shift from operating expenses to depreciation and interest. This will have an expected increase of around 14 per cent on EBITDA and 20 per cent on EBIT. It is expected that the net result will not be significantly affected. In accordance with IFRS 16, the annual operational lease payment of approximately EUR 100 million in 2017 needs to be presented as cash flow from financing activities, as opposed to the current treatment as cash flow from operating activities. This change in disclosure will improve the cash flow from operating activities by approxi- mately 25 per cent. In 2018, Arla will continue to assess the impact of IFRS 16 on its consolidated financial statements. IFRIC 22 – Foreign Currency Transactions and Advance Consideration IFRIC 22 addresses how to account for advance consideration in currencies different from the functional currency. IFRIC 22 is not expected to have a material impact on the Group’s consolidated financial statements because the Group already accounts for currency transactions and advance consideration in way that is consistent with the amendments. Other new or revised accounting standards and implementations are not expected to have a material impact on the consolidated financial statements of the Group. 1 2 9 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Note 5.7 Group companies Arla Foods amba Arla Foods Ingredients Group P/S Arla Foods Ingredients Energy A/S Arla Foods Ingredients KK Arla Foods Ingredients Inc. Arla Foods Ingredients Korea, Co. Ltd. Arla Foods Ingredients Trading (Beijing) Co. Ltd. Arla Foods Ingredients S.A. * Arla Foods Ingredients Singapore Pte. Ltd. Arla Foods Ingredients S.A. de C.V. Arla Foods Holding A/S Arla Foods Distribution A/S Cocio Chokolademælk A/S Arla Foods International A/S Arla Foods UK Holding Ltd. Arla Foods UK plc 1 3 0 Arla Foods GP Ltd. Arla Foods Finance Ltd. Arla Foods Holding Co. Ltd. Arla Foods UK Services Ltd. Arla Foods Nairn Ltd. Arla Foods Ltd. Arla Foods limited Partnership Milk Link Holdings Ltd. Milk Link Processing Ltd. Milk Link (Crediton No 2) Ltd. Milk Link Investments Ltd. The Cheese Company Holdings Ltd. The Cheese Company Ltd. Cornish Country Larder Ltd. The Cheese Company Investments Ltd. Westbury Dairies Ltd. Arla Foods (Westbury) Ltd. Arla Foods Cheese Company Ltd. Arla Foods Ingredients UK Ltd. MV Ingredients Ltd. * Arla Foods UK Property Co. Ltd. Arla Foods B.V. Arla Foods Ltda Danya Foods Ltd. AF A/S Arla Foods Finance A/S Kingdom Food Products ApS Ejendomsanpartsselskabet St. Ravnsbjerg Arla Insurance Company (Guernsey) Ltd. Arla Foods Energy A/S Arla Foods Trading A/S Arla DP Holding A/S Arla Foods Investment A/S Arla Senegal SA. Tholstrup Cheese A/S Tholstrup Cheese USA Inc. Arla Foods Belgium A.G. Walhorn Verwaltungs GmbH (Under liquidation) Arla Foods Ingredients (Deutschland) GmbH Arla CoAr Holding GmbH ArNoCo GmbH & Co. KG * Arla Biolac Holding GmbH Biolac GmbH & Co. KG * Biolac Verwaltungs GmbH * Arla Foods Kuwait Company LLC Arla Kallassi Foods Lebanon S.A.L. Arla Foods Qatar WLL AFIQ WLL ** Arla Foods Trading and Procurement Ltd. Arla Foods Sdn. Bhd. Arla Foods Panama S.A. Arla Foods Inc. Arla Foods Ltd. Arla Global Dairy Products Ltd. TG Arla Dairy Products LFTZ Enterprise TG Arla Dairy Products Ltd. Country Denmark Denmark Denmark Japan USA Korea China Argentina Singapore Mexico Denmark Denmark Denmark Denmark UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK UK Netherlands Brazil Saudi Arabia Denmark Denmark Denmark Denmark Guernsey Denmark Denmark Denmark Denmark Senegal Denmark USA Belgium Germany Germany Germany Germany Germany Germany Germany Kuwait Lebanon Qatar Bahrain Hong Kong Malaysia Panama Philippines Ghana Nigeria Nigeria Nigeria Group Equity interest (%) Currency DKK DKK DKK JPY USD KRW CNY USD SGD MZN DKK DKK DKK DKK GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP GBP EUR BRL SAR DKK DKK DKK DKK DKK DKK DKK DKK DKK XOF DKK USD EUR EUR EUR EUR EUR EUR EUR EUR KWD USD QAR BHD HKD MYR USD PHP GHS NGN NGN NGN 100 100 100 100 100 100 50 100 100 100 100 50 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 50 100 100 100 75 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 50 100 50 50 49 50 40 25 100 100 100 100 100 100 50 100 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Arla Foods AB Arla Gefleortens AB Arla Oy Massby Facility & Services Oy Osuuskunta MS tuottajapalvelu ** Restaurang akademien Aktiebolag ** Vardagspuls AB Arla Foods Russia Holding AB Arla Foods LLC Arla Foods Inc. WNY Cheese Enterprise LLC ** Arla Foods Production LLC Arla Foods Transport LLC Arla Foods Deutschland GmbH Arla Foods Verwaltungs GmbH Arla Foods Agrar Service GmbH Arla Foods Agrar Service Luxemburg GmbH Arla Foods Agrar Service Belgien AG Arla Foods LLC Martin Sengele Produits Laitiers SAS Team-Pack GmbH Arla Foods France, S.a.r.l Dofo Cheese Eksport K/S Dofo Inc. Aktieselskabet J. Hansen J.P. Hansen USA Incorporated AFI Partner ApS Arju For Food Industries S.A.E. Andelssmør A.m.b.a. Arla Côte d'lvoire Arla Foods AS Arla Foods Bangladesh Ltd. Arla Foods Dairy Products Technical Service (Beijing) Co. Ltd. Arla Foods FZE Arla Foods Hellas S.A. Arla Foods Inc. Arla Foods Logistics GmbH Arla Foods Mayer Australia Pty, Ltd. Arla Foods Mexico S.A. de C.V. Arla Foods S.A. Arla Foods S.a.r.l. Arla Foods S.R.L. Arla Foods SA Arla Foods Srl Arla Foods UK Farmers Joint Venture Co. Ltd. Arla Global Financial Services Centre Sp. Z.o.o. Arla Milk Link Limited Arla National Foods Products LLC Cocio Chokolademælk A/S Hansa Verwaltungs und Vertriebs GmbH (Under liquidation) Marygold Trading K/S Mejeriforeningen COFCO Dairy Holdings Limited ** Svensk Mjölk Ekonomisk förening ** Lantbrukarnas Riksförbund upa ** Country Currency Group Equity interest (%) Sweden Sweden Finland Finland Finland Sweden Sweden Sweden Russia USA USA USA USA Germany Germany Germany Luxembourg Belgium Russia France Germany France Denmark USA Denmark USA Denmark Egypt Denmark Ivory Coast Norway Bangladesh China UAE Greece Canada Germany Australia Mexico Spain France Dominican Republic Poland Italy UK Poland UK UAE Denmark Germany Denmark Denmark British Virgin Irlands Sweden Sweden SEK SEK EUR EUR EUR SEK SEK SEK RUB USD USD USD USD EUR EUR EUR EUR EUR RUB EUR EUR EUR DKK USD DKK USD DKK EGP DKK XOF NOK BDT CNY AED EUR CAD EUR AUD MXN EUR EUR DOP PLN EUR GBP PLN GBP AED DKK EUR DKK DKK HKD SEK SEK 1 3 1 100 100 100 60 37 50 100 100 80 100 20 100 100 100 100 100 100 100 20 100 100 100 100 100 100 100 100 49 98 51 100 51 100 100 100 100 100 51 100 100 100 100 100 100 100 100 100 40 50 100 100 91 30 75 24 * Joint ventures ** Associates The Group also owns a number of entities without material commercial activities. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Independent auditor’s report To the owners of Arla Foods amba Opinion We have audited the consolidated financial statements and the parent company financial statements of Arla Foods amba for the financial year 1 January – 31 December 2017, which comprise income statement, statement of comprehensive income, balance sheet, statement of changes in equity, cash flow statement and notes, including accounting policies, for the Group and the Parent Company. The consolidated financial statements and the parent company financial statements are prepared in accordance with International Financial Reporting Standards as adopted by the EU and additional requirements of the Danish Financial Statements Act. In our opinion, the consolidated financial statements and the parent company financial statements give a true and fair view of the financial position of the Group and the Parent Company at 31 December 2017 and of the results of the Group’s and the Parent Company’s operations and cash flows for the financial year 1 January – 31 December 2017 in accordance with International Financial Reporting Standards as adopted by the EU and additional requirements of the Danish Financial Statements Act. Basis for opinion We conducted our audit in accordance with International Standards on Auditing (ISAs) and additional requirements applicable in Denmark. Our responsibilities under those standards and requirements are further described in the “Auditor’s responsibilities for the audit of the consolidated financial statements and the parent company financial statements” (hereinafter collectively referred to as “the financial statements”) section of our report. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Independence We are independent of the Group in accordance with the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) and additional requirements applicable in Denmark, and we have fulfilled our other ethical responsibilities in accordance with these rules and requirements. Statement on the Management’s review Management is responsible for the Management’s review. Our opinion on the financial statements does not cover the Management’s review, and we do not express any assurance conclusion thereon. In connection with our audit of the financial statements, our responsibility is to read the Management’s review and, in doing so, consider whether the Management’s review is materially inconsistent with the financial statements or our knowledge obtained during the audit, or otherwise appears to be materially misstated. Moreover, it is our responsibility to consider whether the Management’s review provides the information required under the Danish Financial Statements Act. Based on our procedures, we conclude that the Management’s review is in accordance with the financial statements and has been prepared in accordance with the requirements of the Danish Financial Statements Act. We did not identify any material misstatement of the Management’s review. Management’s responsibilities for the financial statements Management is responsible for the preparation of consolidated financial statements and parent company financial statements that give a true and fair view in accordance with International Financial Reporting Standards as adopted by the EU and additional requirements of the Danish Financial Statements Act and for such internal control as Management determines is necessary to enable the preparation of financial statements that are free from material misstate- ment, whether due to fraud or error. In preparing the financial statements, Management is responsible for assessing the Group’s and the Parent Company’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting in preparing the financial statements unless Management either intends to liquidate the Group or the Parent Company or to cease operations, or has no realistic alternative but to do so. Auditor’s responsibilities for the audit of the financial statements Our objectives are to obtain reasonable assurance as to whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs and additional requirements applicable in Denmark will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they 1 3 2 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017 Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Group to express an opinion on the consolidated financial statements. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our audit opinion. We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. As part of an audit conducted in accordance with ISAs and additional requirements applicable in Denmark, we exercise professional judgement and maintain professional scepticism throughout the audit. We also: Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrep- resentations or the override of internal control. Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Group’s and the Parent Company’s internal control. Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by Management. Conclude on the appropriateness of Management’s use of the going concern basis of accounting in preparing the financial statements and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Group’s and the Parent Company’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause the Group and the Parent Company to cease to continue as a going concern. Evaluate the overall presentation, structure and contents of the financial statements, including the note disclosures, and whether the financial statements represent the underlying transactions and events in a manner that gives a true and fair view. Aarhus, 20 February 2018 Ernst & Young Godkendt Revisionspartnerselskab CVR no. 30 70 02 28 Jesper Koefoed State Authorised Public Accountant MNE no. 11689 Morten Friis State Authorised Public Accountant MNE no. 32732 1 3 3 CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Glossary 1 3 4 BEPS refers to Base Erosion and Profit Shifting, an initiative issued by the OECD which consists of 15 actions designed to equip governments with domestic and international instruments to address tax avoidance, ensuring that profits are taxed where economic activities generating the profits are performed and where value is created. Brand share measures the revenue from strategic brands as a proportion of total revenue, and is defined as the ratio of revenue from strategic branded products and total revenue. BSM is an abbreviation of the product category containing butter, spreads, and margarine. CAPEX is an abbreviation of capital expenditure. Capacity cost is defined as the cost for running the general business, and includes staff cost, maintenance, energy, cleaning, IT, travelling and consultancy etc. Conscious living means living by actively evaluating one’s activities, decisions and options, and making deliberate choices based on one’s values. FMCG is an acronym for fast-moving consumer goods. Free cash flow is defined as cash flow from operating activities after deducting cash flow from investing activities. Innovation pipeline is defined as the net incremental revenue generated from innovation projects up to 36 months from their launch. Interest cover is the ratio between EBITDA and net interest costs. International share of business is defined as the revenue from the zone International as a percentage of the revenue from the zones International and Europe. Leverage is the ratio between net interest- bearing debt inclusive of pension liabilities and EBITDA. It enables evaluation of the ability to support future debt and obligations; the long-term target range for leverage is between 2.8 and 3.4. MENA is an acronym referring to the Middle East and North Africa. Conversion cost refers to the total cost of production of finished and semi-finished goods, excluding the cost for milk, divided by the product volume. The conversion cost enables evaluation of efficiency improvements in the conversion of raw milk to production output over time. CPI is an abbreviation of Consumer Price Index. Milk volume is defined as total intake of raw milk in kg from owners and contractors. M&A is an abbreviation of mergers and acquisitions. MYPC is an abbreviation for Arla’s largest product category which contains’ milk, yoghurt, powder, and cooking. Digital engagement is defined as the number of interactions consumers have across digital channels. The interaction is measured in a number of different ways, for example, by viewing a video on all media channels for more than 10 seconds, visiting a webpage, commenting, liking or sharing on our social media channels. EBIT is an abbreviation of earnings before interest and tax, and a measure of earnings from operations. EBITDA is an abbreviation of earnings before interest, tax, depreciation and amortisation from ordinary operations. EBIT margin measures EBIT as a percentage of total revenue. Equity ratio is the ratio between equity excluding minority interests and total assets, and is a measure of the financial strength of Arla. Flexitarian refers to a diet which is plant-based with the occasional addition of meat. Flexitarians are also known as flexible vegetarians, casual vegetarians or vegivores. Net interest-bearing debt is defined as current and non-current interest-bearing liabilities less securities, cash and cash equivalents, and other interest-bearing assets. Net interest-bearing debt inclusive of pension liabilities is defined as current and non-current interest-bearing liabilities less securities, cash and cash equivalents, and other interest-bearing assets plus pension liabilities. OECD refers to the Organisation for Economic Cooperation and Development. Performance price for Arla Foods is defined as the prepaid milk price plus net profit divided by total member milk volume intake. It measures value creation per kg of owner milk including retained earnings and supplementary payments. Prepaid milk price describes the cash payment farmers receive per kg milk delivered during the settlement period. Private label refers to retail brands, which are owned by retailers but produced by Arla based on contract manufacturing agreements. Profit share is defined as the ratio between profit for the period allocated to owners of Arla Foods, and total revenue. Net working capital is the capital tied up in inventories, receivables, and payables including payables for owner milk. Net working capital excluding owner milk is defined as capital that is tied up in inventories, receivables, and payables excluding payables for owner milk. Retail and foodservice volume driven revenue growth is defined as revenue growth associated with growth in retail and foodservice volumes while keeping prices constant. Scalability measures the relative cost efficiency of the business and is defined as the ratio between retail and foodservice volume driven revenue growth and growth in total capacity cost adjusted for special items. The strategic ambition for scalability is > 2.0. Strategic brands are defined as products sold under branded products such as Arla®, Lurpak®, Castello® and Puck®. Strategic branded volume driven revenue growth is defined as revenue growth associated with growth in volumes from strategic branded products while keeping prices constant. Trading share is a measure for the total milk consumption for producing commodity products relative to the total milk consumption, i.e. based on volumes. Commodity products are sold with lower or no value added, typically via business-to-business sales for other companies to use in their production as well as via industry sales of cheese, butter, or milk powder. UHT is an abbreviation for ultra-high temperature (UHT) processing, which is a food processing technology that sterilises liquid food, for example milk, by heating it above 135 °C. Value-added protein segment contains products with special functionality and compounds, compared to standard protein concentrates with a protein content of approximately 80 per cent. Vegan refers to a diet which refrains from the consumption of animal products, not only meat but also eggs, dairy products and other animal-derived substances. Volume driven revenue growth is defined as revenue growth associated with growth in volumes while keeping prices constant. CONSOLIDATED FINANCIAL STATEMENTSARLA FOODS ANNUAL REPORT 2017Corporate calendar Financial reports and major events 28 February – 1 March 2018 Board of Representatives meeting in Sweden 2 March 2018* Publication of consolidated annual report for 2017 24 August 2018 Publication of consolidated half-year report for 2018 10-11 October 2018 Board of Representatives meeting *Subject to approval from the Board of Representatives. A R L A F O O D S A N N U A L R E P O R T 2 0 1 7 1 3 5 C O N S O L I D A T E D F I N A N C A L S T A T E M E N T S I E N DIC R O N V I RONME N T A L L A B E L A r l a F o o d s C o n s o l i d a t e d A n n u a l R e p o r t 2 0 1 7 541 006 Arla Foods amba Sønderhøj 14 DK-8260 Viby J. Denmark CVR no.: 25 31 37 63 Arla Foods UK plc 4 Savannah Way Leeds Valley Park Leeds, LS10 1AB England Phone +45 89 38 10 00 E-mail arla@arlafoods.com Phone +44 113 382 7000 E-mail arla@arlafoods.com www.arla.com www.arlafoods.co.uk 

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