Denel Aerostructures recapitalisation; South African Airways turnaround strategy progress

Meeting report

Denel Aerostructures recapitalisation: briefing by Public Enterprises (DPE)
Ms Vuyo Tlale, DPE Chief Director: Financial Analysis, apologised for the absence of the Chief Executive Officer of Denel Aerostructures. He said that it was important to outline the journey undertaken by the company over the previous two years. R700 million had been allocated, and it was important to understand how this money would be spent. Jobs at the company had been cut from over 700 to about 250. The Airbus contract had to be negotiated. There was still a restructuring process under way. There was still an Airbus A400M requirement. The analysis showed that aerospace was a key industry, and fitted into the Industrial Policy Action Plan (IPAP2). The company was still in a turnaround phase. It was a long journey still, but the horizon was just becoming visible. The company was now known as Denel Aerostructures to reflect the exit of Saab as a shareholder.

Ms Tlale said that the core components included the design of aeronautical products. Design was the key concept, as the manufacture could be allocated elsewhere. It would be easy for Airbus to move this capability elsewhere, but design was a strong capability in South Africa. This distinguished Denel from other companies.

Ms Tlale outlined the key achievements of the previous year. Deliveries for Airbus had been on time, and had achieved the required quality. Denel was in the green zone with Airbus. The A400M was making the business case for Denel. Many of the other contracts were small, and some were approaching the end of their life cycle. The footprint of Denel had been reduced by about 60%.

Ms Tlale said that there would be fewer audit queries on the past financial year (FY). He was expecting better financial results.

Ms Tlale outlined the strategic challenges. Offsets should be used to support the entire aerospace industry. Market access should be leveraged through fleet procurement offsets. Denel Aerostructures was still in its infancy, only having been formed in 2005/06. It was still not a competitive entity. Skills development and retention was the third challenge. Skills were recognized as a market differentiator.

Ms Tlale listed the outcomes of the A400M negotiations. Airbus had agreed to increase the prices for the work packages. The price for fuselage sections had almost doubled, and prices for other components had also increased. While the contracts were still being amended, invoices were being issued on the agreed new prices already. Denel had not got everything that it wanted. Airbus had conducted an independent study on pricing, and had found that it was not fair in certain aspects. A parent company guarantee had been negotiated which had agreed to a cap of 101 million Euros. As a result, Denel expected to break even by the 2016/17 FY.

Ms Tlale said that the net loss position had been improved by better debt collection. Waiting times for payments had been reduced from almost a year to two months. The work force had been restructured. The manufacture of some components had been shifted to other companies. By the end of 2012, the accommodation occupied by Denel would have reduced from 70 000 sq metre to 25 000.

Ms Tlale said that a lot of testing was needed to maintain accreditation. These accreditations were all in place. There was a strong capability in the country. The sustainable transformation enhancement program had been completed.

Ms Tlale demonstrated the turnaround restructuring plan for 2012/13. Pricing was important.
Denel needed the market intelligence to know what its competitors were doing. Long term support and strategic alignment was needed. Marketing was an issue.

Ms Tlale said that the lowest point regarding revenue was expected in the 2012/13 FY. The first A400M would be delivered to the French Air Force before the end of 2012, six months ahead of schedule. As aircraft were delivered so revenue would increase. This would lead to an improvement in net profit and cash flow, as opposed to a loss of approximately R200 million in the previous FY. The R700 million requested would assist the company. It was no longer a question of prototypes and testing. The base line had been set and it was now a matter of mass production.

Ms Nonny Mashika, Deputy Director: Aviation, DPE, said that the R700 million would fund the capital plan. It would help to recapitalise Denel Aerostructures. It would address the worries over the going concern status of Denel, and would reassure customers on its financial stability. It would assist Denel in stabilising its costs.

Ms Tlale explained what new business was being targeted. Denel was targeting Tier 2 aerostructure work of similar technology as that used on the A400M. Areas of interest were composite structures. There would be bids for work within the capabilities of Denel. The company had world class facilities. Outsiders visiting the premises were stunned at what was available. So much had been invested in Denel. Denel had accreditations from major companies such as Airbus, Boeing and Lockheed. Airbus was confident enough to introduce Denel to other customers. There was good support from government. The South African Air Force (SAAF) and commercial airlines would be needing new aircraft. Any offset contracts from the purchase of aircraft should be invested in the aerospace industry.

Ms Tlale said that government should invest in Denel because of security considerations. If a country did not have a capability it would lose out to foreign companies. No country could afford to abandon support for its domestic aerospace industry. Government could provide support by creating educational, defence and research infrastructure. Government funding was needed for fundamental (so called blue sky) projects. Offsets had to be used correctly. The new Boeing Dreamliner had been based on aerospace research, which had been integrated into the commercial design. Money channelled through military projects was an indirect form of government subsidy to the private sector.

Discussion
Mr C Gololo (ANC) queried the continued relationship with Airbus. There had been major cost overruns and delays in delivery schedules. He did not understand that Denel was now saying that production was on schedule. This was one of the reasons for the South African order being cancelled. Equity partners would have been invited to work with Denel, but he was not seeing anything about this now.

Ms Tlale replied that the delays on the A400M had been about four years. As a result the SAAF order had been cancelled as more delays were possible. Saab had initially held 20% of the shares. There had been a thought that Denel could not execute its mandate while Saab was established in the industry. At the same time their development had been closer to that of Denel compared to other international companies. Saab had then walked away. This was not due to a lack of confidence in Denel, but Saab had undergone a major restructure. The aeronautical component had been halved. There were huge risks but low returns in the aerospace industry. The international economic crisis had forced Saab to revise its priorities. This had happened at Denel's time of need.

Ms N Michael (DA) needed more information on the link between the Airbus contract and the SAAF requirement for transport aircraft. Skills development and retention were noted as a challenge. Engineering skills must be sufficient to complete the project. She asked why rental space had been so much more than what was the requirement. She asked who had allowed this situation to arise. South African Express Airways (SAX) had acquired aircraft from Embraer. If one person fell out of the scheme, the whole project would collapse. She was concerned about the reference to political ambition in the need for government to invest in the aerospace industry.

Ms Tlale said that the link with Airbus and the SAAF had been from the start of the project. Denel had taken an interest as part of the SAAF order. Denel had gone so far by the time that the order had been cancelled that it had been a risk to Airbus not to proceed with the arrangement. Airbus had not given up on South Africa. The A400M was the biggest military aircraft in the Airbus range, but there were smaller aircraft on the drawing board. Africa was seen as one market.

Ms Tlale said that the reduction in rental space had been a legacy issue. The property had been owned by Denel originally before being sold to the Airports Company of South Africa (ACSA). The company had been forced to cut back its operations due to financial constraints. Revenue was only covering half of the company's running costs at one stage. The Department of Trade and Industries was responsible for offset arrangements. It was not a matter of two companies getting together. Policy on aeronautical development came from government.

Mr A Mokoena (ANC) said that government needed to support Denel in order to maintain their design expertise. The key word for him was design, as this capability worldwide was limited. The funding model needed to be unpacked. It looked like a “dog's breakfast” to him. He asked if the money would be used exclusively for the purpose for which it was allocated. Stellenbosch University had designed a satellite with Russian assistance. The Square Kilometre Array (SKA) project had been awarded mainly to South Africa. He asked if Denel had played any role in the bid, and if Denel would be making any contribution to the project.

Ms Tlale said that he was not sure about the satellite developed by Stellenbosch University. The business unit which might have been involved was Denel Dynamics. The SKA was an opportunity and Denel had to consider how it could become involved. Denel did not have concrete plans on how it could be involved.

Dr Koornhof (ANC) said it was clear that Denel was a strategic asset for the country. Members had visited the factory and concluded that the R700 million was a wise investment. It seemed from the presentation that the most important project was the A400M development. He asked if it was wise to have such a major reliance on a single project. He noted that contracts with Westland, Saab and others were coming to an end. He asked if there had been any move to establishing strategic partnerships which would produce revenue while retaining intellectual property rights. He asked what was the guarantee that the R700 million grant would not become an annual subsidy. He asked if there were any legal risks, given the number of role players. He asked how skills would be retained. The engineers were highly skilled and were in international demand. More needed to be trained, especially black engineers.

Ms Tlale said that other potential business had been highlighted. Denel was asking Airbus to link it with other companies to access other revenue opportunities. The sustainability of Denel was important. Airbus was just as concerned about this. Offset obligations were an important aspect to sustainability. There were inherent risks in the industry. There was competition for skills. Even developed countries needed to develop their skills pools and could be expected to target South Africans. There were systems designers and manufacturers, and all had to be kept busy. The systems engineers had finished their task now on the A400M programme as it shifted towards manufacture from design. The dilemma currently facing Eskom was an example of how a lack of attention to skills maintenance could harm capacity.

Ms Mashika said that the business plan regarding the R700 million had to address a turnaround strategy approval of Cabinet. They were working on the model at present. The cash position of Denel would be improved, but additional revenue streams were essential. Potential customers had been wary of trusting the sustainability.

Ms G Borman (ANC) asked what plans were in place. She was concerned about the capacity to deliver. There had been a painful process of retrenchments. She asked what skills had been lost in the process. She asked if there was a good relationship with local airlines.

Ms Tlale said that there had been desperate times. The company was now showing an upward trend. He reminded Members that the delegation was from the DPE and not from Denel.

Mr K Dikobo (AZAPO) asked where the company executives were. The graphs in the presentation looked good, but were based on assumptions. His first question was what if the assumptions were wrong. He asked where the risks were. These had not been addressed. It was very optimistic to expect a turnaround by 2016. Saab had walked out on their partnership with Denel. This was why the R700 million had been needed. The biggest risk was in basing everything on a single client. He asked why Denel thought Airbus was so committed to Denel that they would not terminate their relationship.

The Secretary reminded Members that DPE had been invited and not Denel.

Ms Tlale said that some employees had been absorbed into the Denel environment. Normally there would be a social plan regarding retrenchments.

South African Airways (SAA) presentation
Ms Cheryl Carolus, Chairperson of the Board of South African Airways (SAA), said that the past year had been one of new opportunities but also of economic problems.

Ms Siza Mzimele, SAA Chief Executive Officer (CEO), said that SAA found itself in a challenging environment. She listed a number of international airlines facing difficult circumstances, some to the point of bankruptcy and closure. Even Emirates had suffered a decline in profit of 61%. Velvet Sky had been a local casualty while Comair had posted its first ever loss.

Ms Mzimele said that fuel costs and other charges had increased while passenger demand was declining. African airlines faced specific challenges in that revenue was in local currency while costs were in US Dollars or Euros. There was a premium on fuel prices in Africa while markets were not opening up fast enough.

Ms Mzimele said that SAA had faced an increase of R1.3 billion in fuel costs despite the levy on fares. It looked as if the tendency would increase. SAA was operating to 37 cities in 26 countries, serving six continents. There were 6.53 million customers per year on 52 000 flights, while the number of aircraft had remained static.

Ms Mzimele said that SAA was part of a group including Mango, SAA Cargo and SAA Technical. SAA made a direct contribution to the gross domestic product (GDP) of R2.7 billion, which was 0.12%. There was direct employment of 11 097 persons. There was an indirect contribution of R3 billion and 18 000 jobs. There was also an induced spending impact valued at R1.2 billion and 7 000 jobs.

Ms Mzimele said that a third of visitors to South Africa arrived by air, 31% of these on group flights. Their spending in the country was R5.9 billion, supporting 40 000 jobs. The aviation industry contributed R14 billion to the GDP.

Ms Mzimele highlighted some new projects. New routes had been introduced to Ndola, Kigali and Bujumbura, Ponte Noire, Beijing and Cotonou. More were being planned. This was being done by improving the utilisation of aircraft. Wide-bodied aircraft were being used in the day on domestic and regional routes instead of standing idle between long-haul flights. A new cabin design had been used on the Airbus A330.

Ms Mzimele said that innovative ways were being found to address challenges. One of these was the customer requirement for better in-flight entertainment (IFE) on regional flights. SAA had achieved a four star rating for the tenth consecutive year in 2012. Priority boarding had been implemented to enhance the service. Baggage handling was being enhanced. In the previous year SAA had achieved its best ever rate of on-time departures. Other focus areas were customer service training and zero tolerance for baggage discrepancies.

Ms Mzimele said that SAA was trying to improve its position in terms of the environment.

Ms Mzimele said that progress had been made in terms of competition issues. All legacy issues had been closed except for a domestic matter with Comair. There were no new issues raised during the previous year.

Ms Mzimele said that SAA had established a Flight Academy. SAA was looking for a partner to develop a curriculum for pilots. The Academy would provide training for all South African entities as well as for other African countries. An annual intake of between 150 and 250 was anticipated. The targets for cadet pilots had been met in the current year, although only 47 had been trained. The Academy would increase this capability. SAA was also involved in artisan training through SAA Technical, which had trained 105 apprentices the previous year.

Ms Mzimele said that SAA had a strategy to contain costs. There were 25 projects at present looking at cost-saving measures throughout the environment. SAA wanted to avoid having to play catch-up in later years. The issue of sponsorships had been overhauled. Two big sponsorships for the Association of Tennis Professionals (ATP) Tour and the South African Rugby Union (SARU) had been reviewed. Some schemes involving free tickets where available instead of cash payments to SARU, was being investigated.

Ms Mzimele said that growth was needed on the continent. Fuel-efficient aircraft were needed to make this possible. Joint venture opportunities would be taken up with Star Alliance partners. Airbus A320 aircraft would be replacing some of the Boeing 737-800 fleet. Twenty of these aircraft would be delivered in the following five years, with two already delivered. Long haul aircraft would provide non-stop services to distant destinations such as New York. Six A330 aircraft had already being delivered.

Ms Mzimele said that it was a difficult environment, but measures to reduce costs were paying dividends. The load factor had increased by 2% in 2012. There were priority markets such as the United Kingdom. Mishandled baggage had decreased by 8%. Passenger compliments had increased by 10% while complaints had reduced by 13%.

Ms Mzimele said that key success factors were fleet renewal, the introduction of a premium economy class section, expanded business class cabins and improved service.

Discussion
Ms C September (ANC) noted an improvement in SAA's situation. She asked for the economic motivation for billing everything in US Dollars and Euros. This affected the Voyager programme. This was also leading to problems with the South African Reserve Bank. She had noted the way in which Emirates was competing with SAA. There were huge numbers of South Africans in the area. Many young South Africans were being attracted to the cadet schemes in the Emirates.

Mr Gololo noticed that tablet technology would be introduced for IFE. Passengers were not allowed to make telephone calls on board, and he wanted to know if the prohibition on cell phone usage would be lifted. There had been a poor relationship with pilots in the past, leading to cancellation of flights. Learners from previously disadvantaged backgrounds would be recruited for the Academy. He asked how their training costs would be covered.

Mr E Marais (DA) noted the reported increase in load factor and the utilisation of aircraft by 4%. He asked what this meant in real numbers.

Ms Michael said that a stranger would feel that everything was excellent in SAA given the presentation. However, one had to remember the R6 billion bail-out given to SAA this month. She had noted an accelerated training course for pilots. This was concerning, as she suspected that standards might be being compromised. She asked where the breakdown was between SAA and the SAAF, as she understood that the SAAF had assisted SAA with pilot training. She did not agree that complaints were decreasing. In particular, there were extreme delays on the Port Elizabeth route. She asked what rights the customers had when flights were delayed or cancelled.

Mr Dikobo said the presentation did not indicate an airline in distress. He felt that some things might have been hidden. It was a terrible thing to expand at the expense of a neighbour. He asked if the number of 105 artisans was for those entering or successfully competing the programme.

Mr Mokoena said that a national carrier was needed for strategic national security. He could not think of any country that would start an airline and then abandon it. There was a new board with a dynamic Chairperson and CEO. It was nothing short of a miracle that SAA had survived the global economic crunch. There was a long-range prospect for profitability. He congratulated SAA on their modesty. The airline had volunteered to fly the Olympic squad to London. Other sponsors had not come forth. His constituency office in Soweto had interviewed a young man who had received a R500 000 bursary from SAA for pilot training. He had met all the criteria. He had gone to a flight school in George where he had walked into a “wall of racism”. He had not been allowed to write the final examination despite having done well in all the previous examinations. The young man had been demonised at the Civil Aviation Authority. Living conditions were deplorable. SAA must establish what was happening in George.

Dr Koornhof congratulated SAA on their continued service excellence. He was pleased to see members of the audit committee present, as this was an important committee in any organisation. The international situation was dire, and SAA was very much affected as well. He felt that the fuel price increases had been understated. He asked how SAA planned to renew their fleet. He asked if the audit committee was satisfied that SAA was still a going concern. The airline had a weak balance sheet. The committee might want to pronounce on operational expenses.

Ms Borman said that there were challenges, but they could be dealt with. She asked how the Flight Academy would be marketed amongst the previously disadvantaged community. Fuel and other fixed costs were huge, and affected the airline's growth. She asked if there was any adjustment to make the airline cost-effective. She asked if hedging was purely a gamble. Aircraft were now being replaced, but not for growth. There was a strategy now for growth. She asked where the extra aircraft would be sourced. SAA faced pressures, such as fuel and catering costs. She asked why catering should be a source of pressure. She had personal experience of claiming free miles from her Voyager miles. The costs were still so high that her 'free' ticket was almost the same price as a flight on one of the low-cost airlines, whose costs were dramatically lower.

Ms Carolus said that SAA was happy that there was a better relationship between management and the work force, from the pilots to the unskilled labourers. There had been tough negotiations, but all grades of workers felt respected and had a mutual respect for management. There had been two sets of negotiations with the pilots. The pilots were recruited from all over the world. They were well trained. Some of the training was outdated. There had been investment in simulators. Young people were paying huge amounts of money to go through outdated and expensive training. No chances were taken with safety. The modernisation of the training would be an exciting process. There were much better synergies between SAA, the South African National Defence Force (SANDF) and Denel. There was a good agreement with SANDF where in the past the SAAF would invest huge amounts of money in pilot training only to see them poached by airlines. An agreement was now in place where SAA pilots would still fly part-time for the SAAF. Management had been improved, and some negative people had been dismissed. The Academy was being run by some of the most experienced pilots who were excited about current developments.

Mr Zakhele Sithole, Chairperson of the Audit Committee, SAA, said that costs were affected by fuel prices and fluctuating foreign exchange rates. Sales of tickets overseas were made in local currencies and repatriated to South Africa. The balance sheet did not look good at present, but was being restructured. Aeroplanes had been ordered, and monthly pre-delivery payments were needed. This was coming out of working capital. Fuel efficient aircraft were needed. DPE was SAA's shareholder, while a company like Comair had shareholders who could raise capital. Expansion capital was needed. The figure was not R6 billion. There was 184% debt. This was not good. Hedging policies were in place to guard against fuel price increases and were working well. All other costs within the reach of management were being controlled.

Mr Louis Rabbets, Non Executive Director, SAA, said that the impact of high fuel prices on the economy as a whole must not be overlooked. People flew less while costs increased. Oil prices were varying between $90 and $120. While prices remained high, there would be fewer passengers while routes still had to be flown. Aircraft prices were also increasing. When SAA had incurred big losses, there had been hopes of a return to profitability. Even leasing costs, normally in dollars, were high. Bullet proof balance sheets were not possible.

Ms Mzimela said that specific technology would be introduced for cabin devices. Cellular telephones could now be used on Mango flights while there would be some capability on SAA aircraft as well, although use of voice calls might remain restricted for the convenience of fellow passengers. SAA was looking at a growth strategy. Aircraft were now being fully utilised. Currently, each aircraft was flying eleven hours a day. The average load factor was 73%, which was an improvement but still below the target. The figure of 105 artisans was the starting figure. There was a consistently high pass rate, of around 98%. The same criteria were being maintained.

Ms Mzimela said that a new training programme was being introduced at the academy. Training there was world class. Once technical training for pilots was completed, the students had to fly a certain number of hours. SAA had the simulators, and students would acquire much more time on simulators than they would be able to achieve flying real aeroplanes. The best pilots in the world were in charge of SAA aircraft. She did not see recruitment as a challenge. Ten bursaries had been on offer for qualified private pilot licence holders, and there had been hundreds of applications. The publicity bus was being renovated, but would soon be touring the country again.

Ms Carolus added that the best ambassadors were the young pilots. These people did visit all parts of the country to advertise opportunities.

The Chairperson related the example of a driving school and a testing centre having an agreement. A number of students would be loaded into a truck. While one student performed the necessary skills, all were given licences.

Ms Carolus said that the school at George did not belong to SAA, but they would pursue the matter especially if SAA was paying for training. SAA did not operate between Cape Town and Port Elizabeth. Weather was a big issue with coastal destinations, and SAA pursued a policy of safety first. This might lead to unexpected delays.

Ms Mzimela said that SAA had been working hard on the Voyager programme. Fuel levies depended on various factors such as the length of the sector. Other airlines might factor in provision for fuel costs in different ways. She accepted that there were still potential areas for improvement.

Ms Mzimela said that SAA hoped to attract more students to the Academy to compete with the programme offered in the Emirates. Airlines from this part of the world had been poaching pilots trained by SAA. People would still be attracted to higher paid positions in the Gulf states.

Oversight visit
Members discussed arrangement for a forthcoming visit. This would include a visit to Medupi power station, the date for which had been shifted due to a Presidential visit to the province. Members would be briefed on the winding-down process of the Pebble Bed Modular Reactor (PBMR) programme. There would also be a meeting with the Board of SAX.

Members felt that the programme put forward was unrealistic given the time schedules. The best opportunity to interact with airline staff and passengers was early in the morning and late in the afternoon. Members saw little point in visiting Pelindaba and it would be better to have the briefing at DPE.

Mr Dikobo said that Members should either be satisfied with doing many things superficially, or some items should be dropped from the programme to give Members more opportunity to engage on some of the issues.

The meeting was adjourned.