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Review from the CFO

Philisiwe Buthelezi

Against extremely tough markets
we focused on limiting margin erosion
on contracts and preserving cash.

Ensuring the optimal balance
between short term investment
and long term returns
is constantly evaluated.

Cristina Teixeira  
 

The group defines group goals which provide a dashboard to continuously monitor the group’s health, with a particular focus on sustainable shareholder returns. Refer to page 44 of this report. These targets are revised from time to time to take into account changes in the group’s strategic outlook. The material issues discussed below are referenced back to the group’s delivery against the four primary financial group goals of margin , cash , gearing and return on equity .

  • Introduction

    South Africa has an informal target of increasing gross domestic fixed investment (GDFI) spend to over 25% of gross domestic product (GDP) and maintaining it at that level. Internationally there is a reasonably clear relationship between increased investment spend and sustained GDP, with the level of investment ultimately determining the level of employment. The rapid slowdown in investment activity over the past year in South Africa has therefore meant that investment spending now represents only 18% of local GDP. This is the lowest level since 2006 and at extremely low levels by emerging market standards.*

    Managing the downturn

    Against this economic backdrop, the group had to consider a number of difficult decisions.

    Rightsizing the business

    A year and a half ago the group identified the need to begin rationalising its operational and support structures in preparation for a reduced construction order book. The decreased activity was pre-empted and based on the completion of mega local public infrastructure contracts and the worsening global economic conditions.

    At the time, the group had to decide whether it was going to increase order in-take, at potentially low margin and cash negative returns to cover unutilised assets, or whether it would reduce the asset base and focus on margin and cash retention. The group has clearly communicated its strategy of choosing to focus on operating margins and cash while managing the risk of losing key capacity.

    During the last 18 months, the group has therefore successfully:

    Reduced non-core costs
    Retained core skills required in anticipation of a market return
    Consolidated support structures at business unit and corporate level
    Reduced the extent of “holding costs” of unutilised resources which are unable to provide immediate returns

    * Stanlib economic commentary – Kevin Lings – 30 June 2011.

    This process is not complete. In support of the group’s strategy, in particular its geographic expansion, a restructure of the business and not only a consolidation thereof is therefore required and will be progressively implemented during F2012

    Furthermore, in the last few years the group has served a mainly South African public sector market whereas its traditional client base has previously been private sector oriented with a strong track record of trading over-border. Our businesses must therefore once again structurally adapt to cater for a return to over-border operations. We have started to successfully address this in support of the over-border revenue of 25% in the year under review.

    Address non-performing businesses

    Construction Materials cluster

    As outlined in various reviews in this integrated report, the Construction Materials cluster required substantial management intervention to address its negative returns and cash absorption.

    Impairment

    A lack of clarity on the timing for recovery of construction materials markets, including no visible recovery in the private residential and building sector and a delay in contract roll out and awards in the public sector, required management to apply a cautious approach to determining the carrying value of Construction Materials assets.

    The group processed an impairment of R325,6 million in the prior year and a further R550,5 million in the current financial year. Tests performed at year end indicated that no further impairment adjustments were required. The R550,5 million impairment adjustment includes a R24,9 million goodwill write off relating to the acquisition of the group’s cement extender business in the 2008 financial year.

    The assessment of the carrying value of assets is dependent on expected cash flows which are inherently uncertain and could change over time. They are affected by a number of factors. These include estimates of costs of production, sustaining capital expenditure and product markets. This assessment required a considerable amount of attention to ensure fair presentation of the financial results.

    Operational cash costs

    Following a difficult six months to December 2010, as previously reported, management took a conscious decision to refocus the Construction Materials cluster in support of a cash preservation strategy. This required a radical shift in operational structure and significant change management.

    A full review of the business and their cost structures was performed with certain functions decentralised to site level and a number of functions consolidated into a group shared services environment. Although this may have introduced additional costs in the short term, in the form of restructuring and impairment charges, the group is confident that these actions were the optimal route to take as cash absorption has reduced and some operational efficiency improvements noted.

    However, as a capital intensive group of businesses, this cluster is highly geared and is currently unable to service lease repayments from operational cashflow. This risk is being mitigated by reallocating unutilised financed assets to other segments of the group, such as our plant business, to ensure a return on this investment.

    Middle East operations

    The group experienced operational difficulties on the construction of a pipeline in Jordan. This loss contributed to the increase in the group’s loss-making ratio which is currently reported at 15% (2010: 13%). The contract generated negative returns and has required interim funding while it progresses to completion. The extent of recoverability of this loss is being assessed.

    Lessons learnt on this contract have been implemented into the group’s contract lifecycle to ensure that these risks are mitigated in the future.

    Positioning for growth

    The group strategy includes geographic expansion and growing the contribution from turnkey multi-disciplinary construction contracts. To support this strategy an assessment of the extent to which costs can be incurred, and resources allocated, without an immediate return on this investment is required.

    The group incurred certain business development and administrative costs in the Middle East which have not provided a return to date due to the slow rate of contract awards. In addition, it established a presence in two new countries where contracts are currently being tendered.

    During the year, management requested the board’s independent assessment of its Middle East strategy. Refer to the review from the chairperson of the audit and remuneration committees for more information.

    Some establishment costs were also incurred in Africa as the group re-established itself on the continent.

    Going forward, the contribution from turnkey multi-disciplinary contracts as well as private public partnerships (PPPs) and independent power projects (IPPs) will provide margin-enhancing returns for the group. However, the lack of traction and delay in contract delivery in South Africa and other emerging countries, both in the rest of Africa and Eastern Europe, have slowed the growth plans of the group’s Engineering and Construction (E+C) business and required the Infrastructure Concessions business to manage its resources effectively in preparation for the recovery of development costs as these long term concession contracts are secured.

    Finding the optimal balance between short term investment and long term returns therefore needs to be constantly evaluated in the current uncertain markets. The group is confident of the robustness of its long term strategy.

    Monitoring credit risk

    The evaluation of the collectability of the group’s trade and contract debtors is particularly relevant during these difficult economic times. Pleasingly, from a concentration of risk perspective, the group’s top five debtors (based on value of debt) represent 16.2% of total trade and other receivables compared to 31.9% in the prior year.

    As expected, the group’s credit risk is concentrated in southern Africa and the Middle East, with 56% and 32% of total trade and other receivable balances in those regions (2010: 55% and 32%) respectively. In addition, the group reported R508 million (2010: R484 million) of debts past due but not impaired. This was largely due to the debtor balances on cancelled contracts to be recovered in the Middle East.

    Trade receivables which have been impaired increased from R46 million in the prior year to R73 million in the current year. This is due to an increase in provisioning in southern Africa as a result of a potential bad debt on one specific contract in the Steel business. This credit risk is being carefully monitored and preventative controls have been implemented within the business to ensure that similar exposures do not reoccur.

    During the year, substantial commercial resolution was achieved in the close out of our cancelled and almost complete contracts in Dubai. We have now concluded and signed a formal settlement agreement with our one client, Meraas, with a payment schedule spanning five years. Payment commenced in June 2011. No amendment to the previously certified value of the debt was required in the year, although a discounting adjustment to record the debt to present date value was necessary. In addition, the group incurred commercial costs to attend to this resolution for which no additional return will be received. We increased engagement with our client, the Dubai Civil Aviation Authority (DCA), in terms of the commercial resolution of legacy contracts, with constructive steps towards finalisation. The group is satisfied with its progress in this regard and with the support provided by our joint venture partner in the United Arab Emirates.

    Managing liquidity

    A key focus area included the management of working capital in a year where previously awarded contracts, secured with advance payments and excess billings, drew to completion and new contract awards were slow to come to market. Although cash from operations for the year discloses an unwind of R481,5 million and a net decrease in cash and cash equivalents of R871,0 million, the group is pleased to report that this cash outflow was in line with the group’s expectations and forecasts and incurred mainly within the first half of the financial year. Furthermore, the contracts to which the initial upfront payments relate have been profitable. This working capital change therefore reflects a normalised unwind to completion as opposed to an absorption of cash. With a contracting cycle of between two to three years on large infrastructure contracts, the assessment of working capital on a 12-month basis is not representative of the full cash cycle.

    An analysis of the working capital unwind for the year confirms the following:

    Contracts to which the initial upfront payments were received have been profitable. This working capital change therefore reflects a normalised unwind
    Working capital was not applied to fund construction contracts, other than the loss-making contract in the Middle East discussed previously
    Construction contracts with bullet payments on completion have not been entered into and the group continues to adopt unchanged contractual payment regimes
    Cash losses incurred within the Construction Materials cluster resulted in working capital absorption
    Cash losses in the Middle East, with respect to “holding costs”, resulted in working capital absorption
    The group continues to structure and receive advance payments and excess billing payments
    Payments received in advance are reported at R788,3 million (2010: R1,1 billion) and excess billings at R492,1 million (2010: R1,0 billion)
    Under-certified contract assets reduced from R754,5 million to R506,5 million

    Achieving the required return on equity

    The group has not met its return on equity target of 20% with the current return before impairments at 11.8% (2010: 21.8%). This is mainly due to losses from the Construction Materials cluster and a weak performance in the Manufacturing cluster. Continued focus on these businesses’ performance will be required. In addition, with weaker market conditions expected to extend for longer, an improvement in returns will require a focus on asset optimisation. This will include a critical assessment of capital expenditure.

    Below are the details of the capital expenditure incurred for the year and forecast for F2012.

    Capital expenditure by cluster R’000

                Nature of 2011 spend %      
      Cluster Budget 2012  
    Actual 2011
     
    E
     
    R
     
    S
     
    Budget 2011  
      Investments and Concessions 35 492  
    6 376
     
    78%
     
    22%
     
    0%
     
    10 089  
      Manufacturing 25 244  
    32 020
     
    83%
     
    17%
     
    0%
     
    46 325  
      Construction Materials 20 674  
    15 616
     
    0%
     
    100%
     
    0%
     
    47 000  
      Construction 122 335  
    96 340
     
    27%
     
    9%
     
    64%
     
    106 163  
      Total 203 745  
    150 352
     
    38%
     
    21%
     
    41%
     
    209 577  

    * E = expansion, R = replacement, S = contract-specific.

    For additional information on the group’s performance please go to our website at www.groupfive.co.za and access the group’s year-end results presentation.

    Corporate governance and compliance

    The group considered a number of issues during the year with respect to corporate governance and compliance matters. These included:

    Fraud and ethics

    An increase in fraud and ethics-related transgressions occurred in the year. These are fully disclosed in the operational overview from the group risk officer on the CD contained within this integrated report. Where these had a bearing on the group’s control environment, it was necessary for the group to evaluate the adequacy of its policies and procedures.

    Regulatory compliance

    The group currently operates in 22 countries. Each has unique finance and taxation regulatory requirements. Adhering to continually changing and developing regulations has become more onerous, especially as the group focuses on a reduction of resources in managing its costs base. With a strategy of geographic expansion, the challenges will become more prevalent and the group will therefore continue to adequately resource its compliance function.

    Competition Commission

    As discussed within the review from the chairperson and the review from the CEO, the group proactively engaged with the Competition Commission in its investigation into the construction sector. We have been granted conditional leniency by the Commission pending the finalisation of the broader industry investigation. On this basis, these financial results do not include any provision for possible fines or penalties levied by the Commission.

  • Looking forward

    Key focus areas for F2012 Desired results
    Re-engineer support structures for effective collaboration of group strategy, including geographic expansion. Structural and effective alignment to the group’s stated strategy.
    Ongoing working capital and liquidity management. Adequate liquidity available in line with the board’s stated targets on gearing.
    Continued focus on credit control and related policies and procedures. Reduce the risk of irrecoverable debt.
    Stringent capital allocation, management and measurement against return on investment and internal rate of return targets. Maximise return on equity.
    Further strengthen finance-related compliance functions within all our countries of operation. Full compliance to applicable laws and regulations.
    Further develop the group’s current assurance model. Full compliance with the recommendations of King III.
  • Appreciation

    This has been a challenging year. I therefore thank my team members for their unwavering commitment in driving our key strategy of cash preservation and margin protection. A special word of thanks to our CEO for his support and leadership. I also wish to express my appreciation to the board for their guidance and continued interrogation of our strategy and deliverables.

    CMF (Cristina) Teixeira
    Chief financial officer

    5 August 2011

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