Denel turnaround progress report, with Deputy Minister

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Public Enterprises

17 June 2020
Chairperson: Mr K Magaxa (ANC) & Mr T Matibe (ANC, Limpopo)
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Meeting Summary

Video: JM: PC on Public Enterprises & SC on Public Enterprises and Communication, June 2020

The Denel presentation covered seven topics: Strategic relevance of Denel , Turnaround Strategy, New Denel, Risks to Future Sustainability, Key Achievements, Revenue Opportunities, Utilization of the Recap. The Denel Board Chairperson said that there were great challenges, but the situation could be stabilised. Unfortunately it was going to take a lot of pain to get there. Denel believed that with the turnaround actions, it would be able to stand on its own. One of the weaknesses was Denel had been dependent on one programme for too long. No company could survive depending on just one programme. She said the chickens were coming home to roost as Denel had more staff than necessary for the production happening at the company plus it had taken advance payment on projects and used the money for operational costs because it was not generating enough revenue.

Members asked how the turnaround plan performed against Denel’s key strategic objectives for improving corporate governance and cost reductions; Denel presented its revenue but did not indicate profit which The Committee needed to know; the investigation outcome of the 2018 explosion at the Rheinmetall Denel Munition plant and compensation for those killed; what it was doing to promote localisation of its supply chain; update on current project delays; about the Covid-19 UIF TERS relief package for unpaid workers; if June salaries would be met; dependency on Middle East clients; its compliance with the regulations of the National Conventional Arms Control Committee; employee morale and the way forward for staff; and how it was decided which state owned entities got government bail-outs.

Meeting report

Denel turnaround strategy: progress report
Mr Danie du Toit, Denel Group CEO, presented.

Strategic Relevance of Denel
The Defence Review, which is the blue print of Government’s defence policy, classified Denel as a national security asset, with the prime purpose of designing, developing, manufacturing and supporting defence materiel. In addition, the Defence Review expected Denel to:
• Take custodianship of assigned sovereign or strategic defence capabilities, technologies and abilities, inclusive of those that may be at risk, and which loss would threaten SA’s defence capability.
• Design, develop, manufacture and support of important capabilities which may not be commercially viable.

The National Defence Industry Council has identified the financial liquidity challenges facing Denel as having the potential impact of:
• Compromising South Africa’s national security;
• Collapsing the entire defence industry irretrievably;
• Exposing South Africa to a mass exodus of skilled personnel in sensitive defence domains to countries that are not necessarily aligned to SA’s national interests;
• Loss of critical defence capabilities, including sovereign and strategic capabilities.

Denel Turnaround Strategy
The turnaround strategy consisted of ten points: secure funding; improve programme delivery; improve order intake; improve governance; improve Denel reputation and stakeholder relations; drive cost reduction; achieve the reset of Hoefyster Programme and execute it; deliver strategic partnerships and the disposal of non-core assets; ensure DoD-Armscor alignment and consultation; deepen leadership capacity, skills retention and transformation.

A New Denel
Graphs were shown of the rise and fall of Denel revenue between 2013 and 2019. It also gave a projected potential revenues between 2020 and 2025. The third graph showed the declining Armscor acquisition and support budget between 2015 and 2019.

Slide 9 showed the roadmap and where Denel was currently in its road to recovery, beginning in 2018 and ending in 2025. The 2018/19 period was fact-finding and assessment. The company diagnosed its shortcomings as being fragmented, defocused, loss-making, having weak business systems and suffering poor governance and corruption.

The current period, 2020/21, was one of stabilizing and reforming the organisation. During this period, the organisation would terminate onerous contracts, divested from non-core business activities, restructured itself for future sustainability, rebuilt its reputation, built order stock, recovered its balance sheet, improved commercial skills, performance and governance and focused its capabilities and portfolio.

The 2022/23 period was planned to be where a performance culture would be entrenched, staff would be re-skilled and there would be a competence shift within the company. It would have a strong balance sheet, fit for purpose business systems, good governance, clean audits and a recurring annuity income.

The 2024/25 period was planned to be where Denel would be a high-performing, modern company with a transformed portfolio and operational efficiency. It would be sustainable and an employer of choice. It would be a recurring annuity income business and would incorporate an advanced centre for engineering capabilities. It would create spin-off technologies for other industries and an exemplary corporate citizen.

Slide 10 showed Part 3 of the New Denel, dealing with how the organization would be restructured. The areas which would be invested in and grown were Missiles and PGMs, Artillery Systems, Infantry Systems, System Integration, and Cyber. The areas which would stay as is are the Overberg Test Range, S&M Munitions (PMP) and Large Munitions (RDM).

Strategic partnerships Denel was planning to build were aircraft and engine maintenance and maritime repair operations (MRO), Rooivalk helicopters, UAVs, infantry weapons, mechatronics and armoured vehicles.

Denel would be disposing of Aerostructures, PMP Foundry, Properties, Gear Ratio, S3 Command and Control System, Mechem Mineclearing, Spaceteq (loss making; planned to send to Department of Science and Technology), LMT Products (in business rescue), Densecure, Optronics.

Management had identified six workstreams for areas which needed improvement:

Debt: Denel worked towards improving its debt situation. The Denel Medium Term Note (DMTN) Programme, which was a government guarantee of R3.4 billion. Against that guarantee it was taken to the financial markets on a note programme and Denel paid interest on it every quarter. Three and a half years remained of the government guarantee. Most notes were of a short term nature, typically every 12 months, and the investors then decided if they wanted to extend it. This programme needed to be restructured to be more effective and supportive of Denel’s business.

Stakeholder: Denel needed to improve stakeholder engagements. Denel stakeholders were the Ministry of Public Enterprises as shareholder, National Treasury, Armscor/DoD, South African Defence Industry (SADI), Directorate for Conventional Arms Control Committee (DCACC), End-users – Chief of Army, Chief of SAAF, Research institutions - CSIR, universities, Lenders group and other financial institutions.

Future Denel: This focused on cost reductions on labour and overheads. Its organisational redesign was looking at new operating and staff structures. It also needed to find new revenue streams.

Projects: This workstream dealt with programme management improvements, operational efficiency and creating a performance culture in the organisation.

Inventory: This workstream was about the fact that Denel had a lot of inventory. A lot of stock was procured in advance and became redundant. The objective was to turn it into cash as rapidly as possible.

Associates: This workstream was about Denel’s associate companies, like Denel Munitions where Denel had 49% equity, and the same with Barij Dynamics in the UAE. It was about re-visiting the contractual arrangements, commercial arrangements, making sure the dividend policies were optimised and memorandums of operation and proper structures were in place.

Risks to Future Sustainability (see document for detail)
• If Denel failed in making Project Hoefyster a success it would have a significant negative effect on business, in terms of the advance payment of R2.8b, which would have to be paid back and the guarantees Denel had on the programme, which would have to be cancelled.
• Denel incurred penalties to the value of R857m on projects delayed or cancelled.
• It had high debt levels and high debt servicing costs as explained earlier.
• Liquidity constraints was one of Denel’s challenges for the next 2-3 months. Denel required R370m per month to run smoothly. The Covid-19 pandemic would have a delaying effect on the turnaround strategy.
• Low levels of liquidity opened Denel up to attack and business rescue proceedings from debt providers, creditors and even employees for non-payment of salaries.

Key achievements to date
Denel remained committed to its turnaround plan and progress made to date included:
• Cumulative cost savings of over R1bn since April 2018 driven mainly by 27% reduction in employees.
• Exit of Aerostructures with an annualised benefit of R260m from 30 June 2020 going forward.
• Exit of loss-making and onerous contracts, that is: Venezuela, DRC and Chad.
• Closure of the loss-making LMT subsidiary, LMT Products (Pty) Ltd which is in business rescue and in its final stages of closure. It is anticipated that Denel will save an annualised R48m in support costs.
• Good progress made with the establishment of the production baseline on the Hoefyster Section Variant, which will open the way for re-set of the production baseline and enable delivery of vehicles to SANDF.
• Significant future business potential exists with an order pipeline in excess of R40bn.
• Concluding the Hensoldt transaction – transaction finalised; however, delayed due to COVID-19 impact.
• Overdue creditors have been reduced by more than 80% and payment plans for the remainder are in place.

The progress made on strategic actions and the support received from the shareholder was acknowledged when Denel was moved from a rating of Negative Watch to Stable Outlook in the latest Fitch review. The recent Fitch downgrade of South Africa from BB+ to BB will affect Denel’s next rating review as its rating is largely based on the support it receives as a government owned entity.

At least 15 revenue opportunities were outlined (see document).

Utilisation of the R1.8b recapitalisation
This would be used as follows: R133m to sustainability investment, R225m to overdue taxes, R842m to re-start operations and creditors, R528m to interest and loans, R48m to legacy costs R24m to investigations.

Discussion
The following members posed questions: Mr S Gumede (ANC), Mr G Cachalia (DA), Ms O Maotwe (EFF), Ms V Malinga (ANC), Ms L Bebee (ANC, KZN), Mr A Arnolds (EFF, Western Cape), Mr A Cloete (FF+, Free State), Ms W Ngwenya (ANC, Gauteng)

Mr Gumede asked how state owned entity qualified to get bail-outs from government. In his opinion, Denel was as important as Eskom and SAA, so, how did those entities qualify for bail-outs? He asked of the seven entities, which were those that qualify to get funding from government and which were self-sustainable. He would like proper clarification on what criteria was used to decide if to grant a bail-out or not. He asked which of the entities were on the verge of being liquidated.

Mr G Cachalia (DA) asked how the turnaround plan performed against its key strategic objectives for improving corporate governance, cost reductions and so on.

A member was interested in the overarching manner in the rationale for the survival of Denel, given the private sector defence industry’s ability to deliver and Denel’s frankly proven inability to deliver.

Other questions from the MPs were:
- Denel’s graphs painted a pretty picture, but it reminded Denel that revenue was vanity, but profit was sanity, so more data was needed on that.

- All the material indicators were down apart from debt which was up, and that presented a significant problem in spite of the Committee being told that there was no backlog, and that there was a strong pipeline of lucrative projects lined up. Going forward, there had to be more profitability. What was the rationale for Denel’s survival?

- An update was requested on the delays on current projects, in the light of the fact that penalties were raised as a result, and Denel already had liquidity constraints.

- Once again, the Committee found itself listening to a presentation which was somehow misaligned to the Department’s strategic intent and did not talk about its contribution to transformation or the support or development of small and medium enterprises.

- When it comes to supply chain management, Denel imported equipment and components from abroad. SA was at a stage where the government was pushing localisation. When was Denel going to start contributing to localisation? If Denel was sourcing equipment and components locally, what percentage of the activities related to localisation? What measures were in place to promote localisation of the supply chain?

- Would Denel be ready to embrace the opportunities after Covid-19?

- What was the employees’ productivity level currently and what impact would restructuring have on employees?

- If Denel applied for Covid-19 UIF TERS relief package for workers and if workers received the money?

- If Denel obtained the services of business consultants to develop this roadmap, and if so, could Denel state whose services it made use of and the cost attached to it?

- What would happen to the staff working in the nine businesses Denel planned to dispose of?

- If Denel planned to offer a voluntary severance package to employees? If yes, how many requested it and how many have been approved ? Did Denel have programmes to improve employee morale, and if yes, what were they?

- Which of its seven divisions it planned to restructure?

- What amount of money have been lost due to corruption, how much of that money have been recovered, and if not yet, were there processes in place to ensure that Denel recovered the lost money?

- Denel had to share the truth about the Covid-19 UIF relief package because the MP heard that workers received only half and had to go to the UIF or the pension fund to get the other half.

- Severance packages had been paid to employees, but there was an indication that the interest had not been paid - what was the situation and when would the interest be paid?

- SOEs came to Parliament with plans of how they were going to fight fraud and corruption, but could report very little on concrete actions and results. Denel had not achieved this key performance area. How long would it take Denel to act?

- If there was a plan to ask for a bail-out from government?

- If Denel would be able to pay salaries to its employees at the end of June?

- Denel's transformation programme for women representation in its workforce was appreciated. It had been reported that 58% of company staff were women and the board chairperson was also a woman.

- One of Denel’s major export markets was the Middle East. The risk was that if anything negative happened in that region, it could have a huge impact on Denel’s income. Has Denel tried to develop markets in other regions outside the Middle East to minimise risk?

- How long will Denel be called New Denel, because it was now almost two years since the beginning of the turnaround strategy?

Mr S Gumede (ANC) asked why Denel was still called New Denel instead of Renewed Denel to show that it existed before but was being renewed.

Mr T Matibe (ANC), Select Committee Chairperson, asked if Denel had a strategy to retain its 620 engineers, 1 740 operators as well as technicians. Denel had tabled a turnaround plan without funding. How did it plan to fund the plan?

Mr Arnolds asked why Denel did not involve the unions prior to the announcement that employees would not be paid for three months.

Mr Cachalia asked how Denel looked at its key performance indicators?

Responses
Ms Monhla Hlahla, Denel Board Chairperson, greeted the Deputy Minister Pumulo Masualle and the Committee. She admitted that the board was not as prepared as it would have liked to be to answer in-depth questions about the Denel turnaround strategy. She requested a follow-up engagement with the Committees on the same topic.

Denel representatives gave the following responses:
- In May 2020 Denel could not pay full salaries, so it applied a sliding scale. The lower paid workers received 100% of their salaries and top level executives received 20%.

- New Denel would contain elements of the past, but also elements for the new future. Denel had a model of the future regarding analysis and opportunity and it could be shared with the Committee. The key point was: What were the product lines and services which would make Denel successful and would ensure a sustainable future? Technology for the future was a real need. Some legacy portfolio elements could be positioned for future success if they took advantage of the new technologies available. Marketing and securing funding for the future would be essential elements which would contribute to success.

- Denel was actively tracking its performance against the well-defined performance parameters set as standards.

- Denel had an ongoing assessment which would be completed in July, and management had identified further areas in need of transformation.

- Denel fully conformed to and complied with the regulations of the National Conventional Arms Control Committee. Denel applied for export permits from the regulatory authority. It was fully compliant in terms of the control.

- Denel had nine different model variants of vehicles. It was doing its best to finalise the first variant. During the last 14 months Denel was in discussions with the end user.

- Denel was trying to avoid a dependency on a specific region, so over and above the opportunities in the Middle East it was also looking at Latin America, the Asia-Pacific region, and the rest of Africa. India was also a significant opportunity for business.

- Amongst others, Denel was in the process of diverting its inventory to get some cash.

- Denel was quite confident that it was well positioned to take advantage of opportunities in the international markets and especially its target markets for its products. Denel was working with international partners with strong balance sheets, so it was trying to find solutions around the problems.

- Management had looked at the short-term cash flow liquidity for the next three months. With continued support in a number of mitigating actions to ensure the target level for revenue was secured and negotiating with suppliers to delay some payments, Denel would still be a going concern in the year to come.

- It took anything between five to ten years to develop a product. When it neared completion one had to go back and re-think some aspects because the technology had changed in the meantime. This had financial implications and working capital was needed for this process.

- Another aspect which impacted the finances and cash flow of Denel was the practice of contract management. Denel needed to find the correct contract management philosophy to strike a balance between income and delivery. Its supply chain environment needed standardisation and improved governance structures.

- On the business development front, Denel was doing its work. It had enough manpower and skills to be able to deliver on its mandate. The challenge was to generate enough working capital to execute the work.

- Denel received a disclaimer from the Auditor General. A disclaimer meant that the AG was not able to arrive at an opinion on Denel’s financial statements and the disclaimer was for two years, 2018 and 2019. The disclaimer had been issued due to a number of technical issues from revenue to property, plant and equipment, investment in subsidiaries, and a whole host of other findings. The disclaimer was given because the business was unable to provide evidence in terms of supporting documents to support calculations for revenue, operating expenditure, contingent liabilities, property and plant and equipment. The other findings were around irregular, fruitless and wasteful expenditure and their disclosure. There was also emphasis of matter because there were repeated findings on vacancies and instability in key management positions. There were inadequate skills and knowledge of accounting standards, a lack of accountability and insufficient consequence management.

There were issues which could be addressed immediately, but in the longer term management had to look at the skills within Denel’s finance department to see how the staff could be up-skilled and given accounting support. Denel management would also have to address financial performance and governance, supply chain as well as IT challenges to get to a better level of compliance. From November 2019 to January 2020, Denel did a status-of-records review with the AG to see how far it had progressed in addressing findings but the results were not exactly the best. A deeper intervention was needed to ensure that teams were able to deliver on the AG requirements.

Further questions
Mr Arnolds asked about the outcome of the investigation of the explosion at the Somerset West Rheinmetall Denel Munition (RDM) plant in September 2018 where eight workers died. He asked if and how the workers’ families were compensated and supported. What was Denel’s accountability in terms of what happened?

Denel responded that the investigation into the explosion at Rheinmetall Denel Munition plant in September 2018 was still ongoing.

A committee member as if there were signs of political interference by politicians to channel money towards a specific individual. In response to this, Denel said it did not want to comment on political interference for the moment. It would be better to provide a report.

In response to a question on the cost to Denel for outsourcing its internal audit to Ernst & Young and why was the service outsourced, Denel said that the internal audit function originally had about four people working in the department. In July 2019 the decision was taken to outsource the internal audit function. The reason was that the function was really not working. As part of the solution, it was decided to get an independent professional opinion based on the control environment that Denel had in place. It was a good decision to outsource the function. The purpose of the outsourcing was to ensure that Denel would have specialists that could look in detail at items such as how it managed contracts and did project accounting.

Denel Board Chairperson remarks
Ms Hlahla said she did not want the Committee to walk away believing that things were going to be smooth because it was not going to be smooth. On behalf of the Denel Board she wanted to paint a picture of the current Denel and the challenges it faced. The meeting had to ask what could be the root cause for a company such as this to continue to depend on guarantees or cash injections from the state to run its operations when in fact it was positioned in such a way that it could create revenue from international sources as well from within the country. There was a challenge, but the situation could be stabilised. Unfortunately it was going to take a lot of pain to get there.

Denel believed that with the turnaround actions, it would be able to stand on its own. One of the weaknesses of Denel was that it had been dependent on one programme for too long. No company could survive depending on just one programme.

The chickens were coming home to roost. To give a good example, Denel had more staff than was necessary for the production that was happening in the company. It had taken advance payment on projects and used the money for operational costs because it was not generating enough. What had happened was that finally all that catches up.

Denel had not been making enough revenue to cover its operational costs. Revenue had been going down since 2015 and it was currently finding it difficult to pay salaries. The challenge with its turnaround strategy was it had to ensure that it did not repeat the same mistakes of the past. She asked for another opportunity as she was not prepared for giving responses with figures at this meeting.

The reality was there would be more challenges than what were seen at this point. Denel had to generate revenue to cover its own costs, and if it could not do that it would have to account to Parliament and the shareholder.

Chairperson concluding remarks
Mr Matibe said he appreciated the honesty of the Denel Board Chairperson. He hoped that the Committee and Denel would get time in the near future to discuss further the matters ailing Denel. It was the first time that Denel’s challenges had been explained with this much clarity. The Committees needed to get clarity on the financial side of the turnaround strategy. The turnaround strategy needed to be actionable and accountable. Another point for the follow-up engagement would be a report on the explosion at the Rheinmetall Denel Munition plant in September 2018 with a focus on the compensation of employees.

The meeting was adjourned.
 

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