One of the greatest sporting spectacles of all time (behind the Rumble in the Jungle and the 1995 Rugby World Cup Final) was the Race of the Century, a horse race between War Admiral and Sea Biscuit. Dubbed the Match Race of the Century, one of the main reasons why the race was popular was because it featured two horses of extremely contrasting styles.
A lot has happened in the business rescue industry over the past two years. The most notable event is undoubtably the business rescue of South African Airways. It not only answered the question as to whether a State-Owned Entity (SOE) can be a suitable candidate for the business rescue process, the execution of the rescue, it showed that there is some conflict between the Companies Act and the Public Finance Management Act.
What does this have to do with the race between War Admiral and Sea Biscuit? The Match Race of the Century captured the attention of every American; and I feel that the SAA rescue was significant for the simple reason that we are now seeing two other SOE’s that are in their own race to see who the next candidate will be to be placed into business rescue.
On Friday, 5 November, Turnaround Talk published an article which pointed out that Eskom may be closer to entering into business rescue than many think.
Eskom needs drastic interventions in terms of Business Restructuring/Turnaround to prevent it from going into Business Rescue. Andre de Ruyter was appointed to turn Eskom around but the loadshedding figures for this year is worse than it was in the past. More drastic action seems to be needed to shakeup a company that is vital to National Interests. Eskom should be allowed to retrench people to contain cost (government only allows natural attrition) but the biggest problem is maintenance planning and skills that need drastic interventions.
The other company that is making major strides towards business rescue is Transnet.
Early signs of trouble
You do not have to work in an organization to know that they are in trouble. In the case of Eskom the constant loadshedding and the severity thereof in terms of the levels is plain for everybody to see. The availability of 62% (according to recent reports) indicates that more than a third (38%) of the equipment is not available (at all times) due to planned maintenance and breakdowns. The design capacity of this type of equipment is normally based on availability of 90% or more. This means that the norm is 10% for maintenance and breakdowns but the Eskom figure is almost 4 times as much (38%). This is pathetic and it does not seem to get any better.
In the case of Transnet they cannot supply enough rolling stock to transport coal and iron ore which has forced companies to switch to road transport at huge cost. They also have failing infrastructure and theft as well as operational problems such as maintenance. All of this sound exactly the same as Eskom.
The article points out that Transnet declared an R8.8 billion loss for the year ended March 2021 for the first time in decades. This was down from a R2.3 billion profit the year before (a swing of R11.1 billion).
Management puts the blame squarely on lower volumes and revenues related to the Covid-19 pandemic and ensuing lockdowns. However, escalating theft from its multi-product fuel pipeline and rail system also weighed heavily on its results, with third-party claims and environmental provisions relating to pipeline spills amounting to R5-billion.
The article adds that the results, which were audited by the Auditor-General rather than a private sector firm, were released with a qualified opinion and reflected irregular expenditure of R104 billion, down from the R131 billion recorded for the previous year.
“We did not enter the 2020 year in a strong financial position and faced a tough year as a result of the pandemic and the economic slowdown that resulted,” said CEO Portia Derby at the presentation of the company’s results.
The focus in the year has been on resolving irregular expenditure, strengthening governance systems, improving and simplifying procurement policies and maintenance, she said.
Lower volumes = declining revenue
The article points out that revenue fell 10.5% (by R7.9 billion from R75.1 billion to R67.2 billion). The 10.5% is significant. Transnet probably hopes that these sales will come back but if it is a permanent change in the Sales volumes, they will have to bring expenses in line with the reduced income to bring ti back to profitability. The change is due to lower volumes across the four biggest business units: Pipelines, Freight Rail, Engineering and Port Terminals. Rail moved 13.7% lower than budgeted rail tonnages, South African ports handled 11.5% lower than budgeted port container volumes, and the pipeline transported 26.4% lower than budgeted pipeline volumes.
Operating expenses rose 16% from R41.2 billion to R47.8-billion (R6.6 billion), which limited any wiggle-room management may have had
Both the decline in sales (R7.9 billion) and the increase in cost (R6.6 billion) on their own would explain most of the reported loss of R8.8 billion. Both are going in the wrong direction which resulted in a swing of R14.5 billion (R7.9 billion lost income + R6.6 billion increase in expenses).
If management could contain cost, they could have reached breakeven despite the lower sales. They will have to cut back the expenses to previous levels to get back to profitability and then try to increase sales.
The article adds that management impaired financial assets to the tune of R987 million, and non-financial assets (notably trains) by R3.3 billion. After finance costs and other costs and adjustments, the company found itself in a loss-making position.
The article points out that Nonkululeko Dlamini, Transnet CFO since July 2020, notes that gearing, at R129 billion, remains within Group covenants. However, finance costs of R11.2 billion are becoming a noose around the proverbial albatross’s neck. This also does not bode well. It is normally a recipe for distress and ultimate failure. Management will have to find a way to reduce debt by selling off assets.
The downgrade of South Africa’s credit rating to sub-investment grade is also of concern, as it raises the cost of capital going forward.
Pushing a boulder uphill
The article adds that the newly appointed management team, led by Derby (who joined earlier in 2020) has worked hard to set the giant organisation on a sustainable trajectory. A new strategy, the Growth and Renewal Strategy, aims to reposition Transnet for growth with partnerships and collaborations at its core.
But within the business units, there are significant operational and financial problems that need to be resolved.
The article adds that Transnet’s pipeline business, which transports 70% of the refined fuel, crude oil, gas and jet fuel used in inland areas, saw revenue fall by 14.6% to R4.8 billion as demand for fuel (driven by declining demand for aviation fuel) plummeted during the 2020 lockdowns.
While volumes may rebound, rocketing fuel theft from the pipeline, which in some places is less than a metre underground, is becoming a liability. This forced Transnet to make an almost R1 billion provision for environmental remediation and rehabilitation, and a R4 billion provision for possible claims against the company.
As a result, Pipelines reported a R2 billion loss before interest, tax and other accounting treatments. It reported a R3.8 billion profit in the previous year.
The article points out that Transnet Freight Rail (TFR), the biggest of the operating units, saw revenue fall by 11.6% to R39.4 billion as freight volumes fell during the pandemic. However, while iron ore and coal are expected to recover, general freight, which fell by 21%, may not recover.
The division reported earnings before accounting treatments of R14.3 billion, a 24% decline on the previous year. Debt stands at R75.5 billion and the net debt-to-Ebitda ratio is 5.3. Generally a ratio of less than three is acceptable. The lower the ratio, the better the chance the debt will stabilise. This is another sign of debt levels that are too high.
The article further added that anything above four is a red flag. Transnet’s Port Terminals division, once the cash cow of the organisation, saw revenue fall by 5.2% to R13.1 billion as a result of Covid, adverse weather conditions, unfavourable market conditions, poor rail supply, poor maintenance and equipment challenges. Recent fires in Richards Bay, for instance, caused R1-billion worth of damage to container belts and related infrastructure. While operating costs were well maintained, earnings fell by 24% to R3.6 billion and profit before tax by 65% to R1.3 billion.
The article points out that Transnet Engineering (TE), which reported a R1.5-billion loss, is in deep trouble. The advanced manufacturing unit, which once planned to build 70% of the infamous and now aborted locomotive project, is in the throes of a business reorganisation to ensure it is sustainable and less dependent on TFR for income. Derby noted that TE could in future provide its engineering capabilities to the port operations.
The article adds that Derby acknowledges that, across the board, Transnet’s operational performance has been declining in recent years, resulting in a financial position that is “marginally constrained”. “This means we cannot make the required infrastructure investments to grow the freight system for the benefit of the economy from the strength of our own balance sheet alone.”
Partnerships — not privatisation, she stresses — are the way forward.
More caution, less speed
Like Eskom, Transnet serves a much greater national interest than SAA. Therefore, the sustainability of the company is non-negotiable. All signs point to the fact that the company is in need of the business restructuring/turnaround/rescue process. And with the privatisation option seemingly out of the window, we will see a much similar outcome of this process than we saw with SAA when they entered into a private equity agreement with Takatso Consortium who now owns 51% of the airline.
We need to be aware of two things when approaching this situation:
First, we need to find a private equity partner who knows the rail business and knows how to address the bottleneck and demand issues that Transnet faces.
Second, and this is very important, we need to be aware that the sale of part of the company to a private equity partner is not an immediate guarantee of cash. In a recent interview with Moneyweb, when Takatso CEO Gidon Novick was pressed about the R3 billion in funding, Novick said that it is an estimated commitment over time. It is certainly not an upfront commitment. Takatso needs to learn more about the SAA business before agreeing to exact quantum’s. When Moneyweb pressed about a timeline of putting pen to paper, again, Novick was vague saying: I’m actually not even going to give a timeline, because you just can’t predict these things. On the one hand we want to do it sooner rather than later, but on the other hand we’ve just got to get it right. And in my mind, that’s more important than speed.
The partnership with a private equity partner may be the biggest outcome of any of the two SOE business rescues we may see next year. If we read between the lines of Novick’s comments, Takatso may be taking the time to learn more about the SAA business model or the company may be taking a back step to see if the leadership of the company (SAA) are steadfast in delivering on the promises made at the time of the sale. Takatso will commit funds if SAA is serious about reform.
The same will apply to Eskom and Transnet, the private equity partner may take time so see how many holes need to be plugged, but it may also be taking the time to make sure it is not throwing money at a company that will ultimately be liquidated a year down the line because of mismanagement.
Hannes Brits is the Director of Kubu Business Optimization Consultants