Denel restructuring process, mandate, funding and challenges

Meeting report

Chairperson’s opening remarks:
The Acting Chairperson said that the role of state-owned enterprises (SOEs) in the defence sector was critical for South African stability. This was especially important in the South African Development Community (SADC) regions, as this sector helped to bring peace and stability, and contributed to peace-keeping missions. Part of the oversight function of this Committee was to look at the state of affairs in Denel. This company had originated during the apartheid years, when the then-government could not source weapons from outside countries, owing to sanctions. Denel now played a very important role in making the South African National Defence Force (SANDF) a strong unit. The key issue was to look at why the current capacity of Denel had decreased.

Denel state of affairs presentation
Mr Talib Sadik, General Chief Executive Officer, Denel, gave the presentation on the state of affairs in Denel, which he outlined would include an overview of Denel, the build up to Denel’s strategy, turnaround progress achieved, and the steps to position Denel for growth as well as group initiatives. Denel’s value-add to South Africa as part of the National Growth Path (NGP) was also on the agenda. In terms of the Shareholders’ Compact, Denel’s key role was to supply strategic defence capabilities and technologies to the SANDF and also to export products to improve revenue.

He explained that Denel’s product and service portfolio included humanitarian demining services and products. It was also responsible for maintenance, repair and overhaul (MRO). It dealt with technical training. It also worked to produce munitions and subcomponents, mine protected vehicles and missiles. It was concerned with command and control. Its services included land-based systems (artillery, infantry, and armour systems), engineering services, work in aerostructures and unmanned Aerial Vehicles (UAVs)

Mr Sadik went on to outline the Denel group structure. Both the Minister of Public Enterprises and the Minister of Defence and Military Veterans were involved. There were 6 494 personnel employed by the Denel group as at February 2011, and this included approximately 470 engineers and scientists. Revenue distribution for the Denel group in 2009/2010, including its associates, was 53% locally and 47% export. Associated companies were Turbomeca Africa (Pty) Ltd, Carl Zeiss Optronics (Pty) Ltd, and Rheinmetall Denel (Pty) Ltd.

The build up to Denel’s strategy included looking at the company’s financial summary pre-2005/2006. Denel had posted significant losses, year on year, since 1998, other than for 2001 when it posted R40 million profit owing to a once off pension holiday. Losses from 2005 to 2008 were caused by a loss of export markets, high interest cost resulting from loans, legacy contracts, inadequate orders, and equity partnerships restructuring. Reserves and capital were significantly eroded, due to these losses, by 2004, and this necessitated a review and change of the strategy in 2005/2006.

Mr Sadik outlined that the defence budget, as a percentage of Gross Domestic Product (GDP), was 4.5% in 1974, and increased up to 5.1% in 1981. However, by 1994 it had decreased significantly to 1.5% and by 2010 it was at 1.3%. The World Bank recommendation was that defence spending should not be less than 2% of GDP. The Department of Defence’s budget pressures were related to personnel costs, facilities maintenance, and operations outside of the borders, the fact that Military Veterans were added to the Department of Defence, and the addition of border control.

Mr Sadik highlighted that inaccessible global defence spend had contributed strongly to Denel’s losses. There was significant global industry consolidation and intense competition in Denel’s traditional developing country markets from large defence companies. It was near-impossible for independent contractors to serve USA and North Atlantic Treaty Organisation (NATO) countries. The competition to serve remaining markets was intense, as exports mainly came from major US and European players, and an increase in political constraints and alignments.

Denel had developed five pillars which represented the restructuring phase 1 of its turnaround strategy. The first pillar was to secure privileged access to a guaranteed minimum portion of South Africa’s defence development and procurement spend. The second pillar was to partner with state agencies to do joint business planning and to establish export marketing. The third pillar involved focusing on growing the commercially viable businesses where Denel had real technological leadership. The fourth pillar was to secure equity business partnerships with major global players. The final pillar was to raise capabilities and productivity to world class levels.

Mr Sadik gave an outline of the company’s journey to sustainability for the four years up to 2010. Denel’s challenges in 2005/2006 were identified as limited market access, centralised organisation, poor programme management, governance challenges, poor human capital development and transformation, and poor stakeholder alignment. As a result of these challenges, the company had a loss of R1.3 billion in the defence, security and certification sector, and a R300 million loss in aerostructures. The gross margin was 5% and staff turnover was at 13.8%.

In 2007 to 2010, Denel had taken some major steps as part of its restructuring process. These included the decentralisation of operations, which led to entrepreneurial and accountability improvements. It disposed of non-core entities. Governance policies were implemented, and internal control systems and processes were improved. Denel established entity boards, audit and risk committees, risk management and better financial discipline. The organisation was restructured and there were some retrenchments. It entered into strategic equity partnerships with a view to increasing technology and international market access. It also improved local client relationship and stakeholder alignment. As a result of these steps taken, Denel managed, in 2010, to report a profit of R200 million in the defence, security and certification sector. Gross margins had increased to 16% and staff turnover had reduced to 4.5%. The order pipeline was at R25 billion and the company received a Level 4 Broad Based Black Economic Empowerment (BBBEE) rating.

Transformation achievements to date included having transformation committees in place and functioning, as well as having a central reporting system. Steady progress was made in addressing inequalities and a transformation policy was recently approved by the Denel Board. The impact of strategic equity partnerships included a major investment in a new plant, equipment and skills development. Access to new markets had been achieved, together with an increase in high value-added exports. There had been a significant increase in self-funded research and development (R&D) and Centres of Excellence had been established in Turbomeca Africa, Carl Zeiss Optronics and Rheinmetall Denel. There was security of supply to the SANDF.

Mr Sadik explained that the 2009 strategic drivers were based on performance, integrity, innovation, caring and accountability. The aims included an improved market access, operational excellence, deepening the relationship with the defence community, and strengthening governance and financial management. Denel sales in Africa in 2009/2010, including South Africa, but excluding associated companies, amounted to 82% of overall sales. Including associated companies, the sales amounted to approximately 70%. Some of the major programmes included clients such as Rheinmetall, SAAB, Turbomeca France, the South African Department of Defence, and Brazilian entities.

At 31 March 2010, Denel posted a loss of R264 million, due to Denel SAAB Aerostructures (DSA) recording a loss of R328 million, and further due to interest having accrued, mainly because there had not been recapitalisation. Key actions to reduce these losses were to implement the DSA turnaround plan, which included applying for recapitalisation to repay debt, and cost cutting initiatives.

Denel opportunities in the pipeline were worth R43 billion. Of this amount, 77% came from international clients, mainly from Middle Eastern and Asian countries. However, DSA continued to make a loss, impacting on the financial performance of the Denel Group. Improved performance was expected for 2010/2011, following restructuring and an improvement in operations. An alternative for DSA was a domestic transfer to Aerosud. Aerosud submitted an unsolicited conditional proposal to acquire DSA in December 2010. Discussions were ongoing and two key conditions were outstanding. Further announcements could only be made once the discussions were finalised. A revised business plan was in process.

Mr Sadik gave an outline of Denel’s value-add to the national growth. The contribution to primary and secondary jobs was very high. It was also adding much to foreign exchange savings. There was also a very high contribution to extend mining potentials and alternative energy initiatives. Anther value-add areas was in national security, as South Africa had strategic military independence, peacekeeping and civilian campaigns.  It also contributed to industrial strategy and competitiveness. Denel had taken a skills development approach, by dedicating a significant amount from its own resources for employee skills development. In the previous financial year, the company had spent R26.7 million on skills, and had budgeted to spend 3% of payroll in the current financial year. Key skills development initiatives were the University of South Africa (UNISA) School of Business Learning (SBL) collaboration on the Denel Leadership and Management Development programme, which was launched in 2009. The three levels of the programme covered the junior, senior and executive level education. Lecturing would commence in July 2011.

Mr Sadik said that Denel launched an Engineering Academy in 2009 as a means of ensuring that newly qualified engineers were afforded the opportunity to learn the business, in a co-ordinated fashion. There were currently 20 Junior Engineers registered in this programme. Denel also had an engineering internship, which currently housed 11 learners. Other skills development programmes were workplace skills plans, mentorships, and career paths. Internal bursaries were also awarded to employees in order to augment their development in areas that were complementary to the jobs they performed. To date, 74 employees had been granted bursaries to do Masters in Engineering, BCom, BTech, MBA and various other fields of studies. Study loans were granted to employees who wished to further their studies in fields of their choice.

Denel had initiated youth development programmes as part of its social investment. These programmes focused on the development of maths, science and technology capability. The Denel Training Academy (DTA) supported Denel’s strategic objectives by training about 300 learners annually towards their qualifications as artisans. Approximately 30 new bursars were sponsored annually for engineering studies. Over and above the financial aid, Denel provided bursars with vacation work and mentors. To date, over 90% of the bursars who had completed their university studies were employed in the group. The Denel Youth Foundation Training Programme was a Grade 12 bridging programme for learners who had failed matric and required a second chance. The programme took in about 50 learners per year.

Denel also had collaborations with tertiary institutions through the Armscor Ledger Fund, by sponsoring students for post graduate studies. The schools outreach programme offered tuition by private tutors and Denel’s own engineers, on a Saturday, to learners from Grade 10 to 12.  The programme was currently running in Gauteng and the North West provinces. This programme was fully funded by Denel, at a cost of R1.2 million per year. This programme supported 80 learners in the previous financial year. A collaborative relationship was established with the SA Women in Engineering Programme (SAWOMENG) spearheaded by a group of young female engineers who believed strongly in the need for female learners to enter the field of engineering, science and technology. Denel spent about R100 000 on funding this programme per year.

Mr Sadik explained that funding and solvency was a critical matter. A recapitalisation of R3.5 billion was received for the repayment of debt, legacy issues and losses. The continued losses of DSA required shareholder funding. The debt/equity ratio was projected an R212 million equity and R1.85 billion debt at March 2011. Closing this “debt trap” would require recapitalisation of approximately R2 billion. Considering the solvency, debt level and latest loss forecasts, Denel required recapitalisation to strengthen its balance sheet.

Mr Sadik said that Denel also faced other challenges, which included the increased competition from developed economies due to defence cuts. There was a need to establish alignment between military acquisitions and industrial strategy. Denel needed to achieve better value for lower spend. Growing geo-political influences posed another challenge. Denel also needed to attract, develop and retain critical and core skills.

Mr Anthony Kamungoma, Acting Deputy Director General: Department of Public Enterprises, said that Denel had made significant progress since 2005. However, the positioning of the company was still challenging. DSA’s biggest challenge in the immediate future was in finding funding solutions. The main focus of DSA was to retain skills and capabilities through the work programmes. The current mandate of Denel occupied a key position in the Department of Defence. A more optimal alignment between the business models of the Department of Defence and Denel was needed. The Department of Defence was working on a strategy for these requirements. If losses in Denel continued, the Department of Public Enterprises’ input would be wasted. There was a need that this company’s reliance on the fiscus must decrease. R1.85 billion in guarantees had been allocated, as a roll over amount, to help stop the company’s reliance on the fiscus alone.  

Discussion
Mr Montsitsi (ANC, Gauteng) asked whether the reduction in staff was the reason for profit accrued in 2010.

Mr Fikile Mhlotho, Group Financial Director, Denel, replied that the high staff turnover was initially due to instability within the company. The turnover figures had dropped recently, but this had not contributed to the increase in profits. The number of employees had decreased from 10 000 to 7 500, but this was not the only reason for the profit increase. Other initiatives gave rise to profits, such as contracts that were concluded and completed, and the disposal of non business making elements.

Mr M Steele (DA) asked whether the R5.5 billion needed by Denel for recapitalisation would be the last funding required for the company to become self-sustainable.

Mr Mhlotho replied that this amount could be the last needed as recapitalisation. The recapitalisation would provide relief from debt interest and it would ultimately give more faith to international investors.

Ms M Mafolo (ANC) wanted to know with which universities Denel partnered.

Ms Patience Mushungwa, Group Executive: Human Resources, Denel, replied that the company had partnerships with all universities who had engineering faculties, to offer bursaries to these students.

Mr D Maynier (DA) asked whether Denel had exported any form of arms to Libya or Syria.

Mr Sadik replied that Denel had marketed in these countries in previous years but had not sold any conventional arms to Libya or Syria in recent times. He explained that all intended international sales and exports had to go through a rigorous process of permit approval. The National Conventional Arms Control Committee (NCACC) had four processes that must be followed before arms could be exported.   

Mr P Pretorius (DA) questioned the viability of Denel, as defence budgets were decreasing globally. He wanted to know whether Denel could compete locally and internationally over a longer period of time, pointing out that the company was currently battling in the export market.

Mr Sadik replied that indeed he did consider Denel viable, because of the order pipeline. Denel had identified real opportunities and was engaging with customers. Internationally, the Middle East and Asia would provide the company with good growth. With regards to unmanned vehicles and optical sectors, the company had predicted a 20% growth in the rest of Africa.

Mr Montsitsi wanted more information regarding the demographics of schools that participated in the maths and science programmes.

Ms Mushungwa replied that the demographics were allocated to the company by the previous Department of Education. These were mostly schools in disadvantaged communities and informal settlements. The programme had resulted in a major improvement in science and maths learning in these areas.

Ms Mafolo asked in which areas of the North West the schools outreach programmes were running.

Ms Mushungwa replied that the Vaal Reef Technical School was the hub of the project, and it also took in surrounding schools as well. Denel had advertised in all provinces to ensure that maths and science was upgraded in schools.

Mr Montsitsi wanted to know what other aircraft manufacturing Denel had produced since the Rooivalk. He also asked to what extent the Rooivalk continued to sell in Africa.

Mr Sadik replied that approximately 11 aircrafts were sold in Africa and internationally per year. The Rooivalk had evolved over the last 25 years of development. Unmanned aerial vehicles were built from the idea of the Rooivalk. This had helped tremendously towards homeland security, and especially with rhino poaching surveillance. Optical division imaging systems were also derived from the Rooivalk.

Mr Maynier asked whether termination of the Airbus A400m contract posed any risk to Denel, as Airbus could request to have its packages returned.  

Mr Sadik replied that there was a risk to the company, as South Africa had cancelled the contract. However, Airbus had said that they would not remove the packages, which were worth just over R1 billion. There was a possibility of reopening the contract with Airbus.

Mr Montsitsi wanted more clarity on the transformation in skills training. It was good to have information of the capability of skills personnel, to make sure that the organisation was sustainable.

Ms Mushungwa replied that transformation and skills development was important for the retention of personnel. Over a period of time, the company had tried to retain critical skills due to the ageing workforce, which averaged 45 years old. There was a need to create a younger skills pool to retain business, which was why it had developed the training and bursary initiatives.

Mr Maynier wanted more clarity on the R1.8 billion guarantees that the Department of Public Enterprises had given Denel.

Mr Sadik replied that these funds had gone mostly towards the cost of the Airbus A400m, for its 15 year design and development.

Mr Kamungoma added that the balance of this money, which was R750 million, was used for an indemnity agreement to develop capability in South Africa, by retaining critical technical skills.

Mr Montsitsi asked what percentage of skilled personnel resigned from Denel to establish their own private businesses, and whether Denel was doing business with any of these private entities.

Mr Sadik replied that he did not have the exact figures of who had resigned but could state that Denel had not gone into business with anyone who had resigned to establish another private business.

The meeting was adjourned.