Denel & Armscor on Defence Projects Hoefyster, Biro, Hotel; with Deputy Minister

Defence

28 May 2020
Chairperson: Mr C Xuma (ANC)
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Meeting Summary

Audio: Denel & Armscor on Defence Projects Hoefyster, Biro, Hotel; with Deputy Minister

Both Denel and Armscor briefed the Committee on its Department of Defence (DoD) projects, specifically Projects Hoefyster, Biro and Hotel.

Denel spoke about its Department of Defence-funded multi-year programmes and especially to Project Hoefyster which was the development of a replacement infantry combat vehicle for the Ratel. It gave a background to the programmes, the current status of programmes and the remaining funding required which centered around funding for Project Hoefyster until 2028/29. It then spoke to the challenges in Project Hoefyster, namely the scope and complexity of the project leading to the technical integration of sub-elements being time consuming. It covered the spending on the project and the status of deliverables to date including the status of Phase 1 and of Phase 2. It spoke on Denel’s capability to deliver on the project and said that while Denel had the internal capability to deliver, some external skills were negatively impacted by the project’s delays and by Denel’s financial position resulting in some suppliers no longer existing and components would need to be sourced and industrialised again to ensure integrity in supply. Other challenges Denel faced, were a liquidity crunch, the closure of VR Lazer and the fact that project delays created misalignment at the programme level leading to decision making time taking longer than necessary. It spoke to programme spend on Phase 1 Development, and on Phase 2 Production, as well as on the development and production schedules of Phases 1 and 2. It gave reasons why the project should continue and the lessons learnt to date. It concluded with contract alignment actions taken between December 2019 and April 2020 where the premise for the Denel proposal was to engage with Armscor to align the contract with current realities as the contract currently has delivery dates in the past that could not be achieved.

Armscor said the challenges faced by Denel on Project Hoefyster was on the integration of the turret, which resulted in the project being four years behind schedule and these integration challenges needed to be looked at very closely. Denel had said it would not be able to meet the specification nor be within budget. The budget Denel proposed would be unaffordable to the Armscor client (DoD) and certain key requirements were not met which would be catastrophic for the client. Armscor had been meeting with Denel. It felt Denel’s presentation had been highly optimistic and certain decisions would have to be taken on Project Hoefyster around salvaging the project. Project Hoefyster was 45 months behind schedule and R7.3bn had been paid to date. In the latest proposals, Denel was still unable to complete Phase 1 Development and the cost of completing the project was not affordable to both Denel and to the client (DoD) and a decision to cancel the contract needed to be taken as any delay in making a decision increased the risk to the DoD.

Project Hotel, the construction of a hydrographic survey vessel, had a project completion date 11 months behind the scheduled completion date of November 2022. Delays due to Covid-19 still had to be assessed. The current funding deficit placed the project at severe risk as the shortfall coincided with peak production in 2021/22.

Project Biro, the supply and delivery of three inshore patrol vessels, was on schedule and only faced financial risk through a possible budget shortfall due to a reduction in the Strategic Capital Acquisition Master Plan (SCAMP) allocation after 2020/21. Delays due to Covid-19 still had to be assessed.

Members said the presentations presented a bleak picture which emphasised the vulnerability of the capability of the South African National Defence Force (SANDF). Members asked if the hull was manufactured in Finland or under licence in South Africa. Members were concerned that Denel did not have enough experienced engineers as this exposed Denel to risk. Members asked what Denel’s capacity to source funding was. Members said the Armscor presentation was a reality check and the Committee needed a meeting where Denel, Armscor and the SANDF were present so the Committee could make a decision as there was huge risk. Members asked if there was a need for an infantry fighting vehicle or was the need for an armoured patrol vehicle. On Project Hotel, Members said there appeared to be cash flow concerns at the SA Shipyard. If this was a challenge, how would it be mitigated? On Project Biro, Members asked what the organic sea boats and boarding boats were as they were not part of the original tender. Members asked how often Denel met its client, SANDF, when they had met and when would they be meeting again?

Members asked if Denel’s financial situation would remain for some time and would Denel look for funding from the state. Members said the delays and the financial constraints meant there was reputational risk and due to its link to government there was a risk to the country as well whose name could be dragged down. Members said it appeared that the fundamental issue was the liquidity of Denel which had to be addressed They noted its inability to meet finishing dates which led to escalation costs and a shrinking Special Defence Account (SDA) budget which could reach zero in its outer years. Members asked if the continuous delays did not affect the technology being developed and make this obsolescent. Denel’s inability to deliver to specification and its stated revised delivery date as 2029 while Armscor believed the revised date was 2026 was a concern as was the escalation costs, obsolescence factor of the delays, and non-payment of suppliers, especially in light of the shrinking SDA budget and the illiquid position of Denel.

Deputy Minister Thabang Makwetla said the DoD, as the customer had lots of apprehension on the progress of a number of projects, but especially Project Hoefyster. He commended Armscor on Projects Hotel and Biro but was worried that Denel’s presentation on Project Hoefyster was optimistic. A meeting was planned to get to the nub of the project’s issues. He had no reasons to doubt the Armscor report that there were integration complexities in the project that Denel did not have the capability to address. He felt that Project Hoefyster was ‘in the middle of nowhere’ and there was even consideration to walk away from the project. This would not be easy because of the sunk costs and opportunities. If phase 1, which was still incomplete, had been completed, DoD could have walked away and could have returned at a later stage. Advance payments had been made and the DoD would be investigating if these monies could be retrieved as the DoD budget was under serious threat. The Ministry would follow up this discussion with Denel and Armscor and a workshop with the Committee would stand in good stead.

Members asked Denel about the need for the release of Armscor guarantees to raise funds in the capital market; a Denel tender for reputation management; to what extent Denel relied on Rheinmetall Denel Munition (RDM) where it was a 49% shareholder; and what effect the cancellation of Project Hoefyster would have on Denel going forward.
 

Meeting report

Opening remarks
Mr V Xaba (ANC), Co-Chairperson, said the Denel contracts with the Department of Defence (DoD) totalled R10bn and comprised a major share of the Denel order book. Armscor was the acquisitions agent for DoD and would give an overview of the DoD multi-year projects, especially on Project Hoefyster where R9bn was allocated for the development and delivery of a combat vehicle. He expected the presentations to provide details on the contract’s date of completion, its value and the current status of the project as well as whether the rescheduling of the project would have penalty implications.

Denel Presentation
Mr William Hlakoane, Denel Group Chief Operations Officer, spoke to Denel’s DoD funded multi-year programmes and especially to Project Hoefyster. He gave a background to the programmes, the current status of programmes and the remaining funding required which centered around funding for Project Hoefyster until 2028/29. He spoke to the challenges in Project Hoefyster , namely the scope and complexity of the project, leading to the technical integration of sub-elements being time consuming.

He addressed the spending on the project and the status of deliverables to date including the status of Phase 1 and of Phase 2. On Denel’s capability to deliver on the project, he said that while Denel had the internal capability to deliver, some external skills were negatively impacted by the project’s delays and by Denel’s financial position resulting in some suppliers no longer existing and components would need to be sourced and industrialised again to ensure integrity in supply. Other challenges Denel faced were a liquidity crunch, the closure of VR Lazer and the fact that project delays created misalignment at the programme level leading to decision-making time taking longer than necessary.

He outlined the programme spend on Phase 1 Development and on Phase 2 Production as well as the development and production schedules for Phases 1 and 2. He gave reasons why the project should continue and the lessons learnt to date. He concluded with contract alignment actions taken between December 2019 and April 2020 where the premise for the Denel proposal was to engage with Armscor to align the contract with current realities as the contract currently has delivery dates in the past that could not be achieved.

The Chairperson noted that Denel did not touch on the impact of contract penalties for late delivery.

Armscor Presentation
Adv Solomzi Mbada, Armscor Chief Executive Officer, said the challenges faced by Denel on Project Hoefyster was due to the integration of the turret which resulted in the project being four years behind schedule and this integration challenge needed to be looked at very closely. Denel had said it would not be able to meet the specification nor the budget. The budget it proposed would be unaffordable to Armscor’s client and certain key requirements were not met which would be catastrophic for the client. Armscor had been meeting with Denel. He felt Denel’s presentation had been highly optimistic. He said certain decisions would have to be taken on Project Hoefyster on salvaging the project.

Mr Sipho Mkwanazi, Armscor Acting Group Executive: Acquisition & SCM, gave the background and status on Project Hoefyster, Project Hotel, Project Biro. He said Project Hoefyster, the development of a replacement infantry combat vehicle for the Ratel, was 45 months behind schedule and R7.3bn had been paid to date. In the latest proposals, Denel was still unable to complete Phase 1 Development and the cost of completing the project was not affordable to both Denel and to the client (DoD). A decision to cancel the contract needed to be taken as any delay in making a decision increased the risk to DoD.

Project Hotel is the construction of a hydrographic survey vessel and the project’s completion date is 11 months after the scheduled completion date of November 2022. Delays due to Covid-19 still had to be assessed. The current funding deficit placed the project at severe risk as the shortfall coincided with peak production in 2021/22.

Project Biro is the supply and delivery of three inshore patrol vessels. The project was on schedule and only faced financial risk through a possible budget shortfall due to a reduction in the Strategic Capital Acquisition Master Plan (SCAMP) allocation after 2020/21. Delays due to Covid-19 still had to be assessed.

Discussion
Mr M Nchabeleng (ANC; Limpopo), Committee Co-chairperson, said he was concerned about the role Denel and Armscor were playing in contributing to innovation and technology and to economic development and the role it should play in ‘silencing the guns on the African continent’ and developing technology that brings peace on the African continent. He noted he was between two virtual meetings happening at the same time and would return occasionally to the meeting.

Mr S Marais (DA) said the presentations presented a bleak picture which emphasised the vulnerability of the capability of the SANDF. He pointed out to Denel that most of the vehicles in the photo in the presentation were without turrets. He asked if it was only the turrets that were manufactured in Finland. Was the hull manufactured there also or was the hull manufactured under licence in South Africa? He referred to the photo of young engineers and asked where the other engineers were that had started the project development. If Denel had engineers of only four to six years’ experience then it exposed Denel to risk to some extent. Denel depended on the Department of Defence (DoD) for 80% of its business. He had read in the media that Denel had not paid staff its salaries. What was Denel’s capacity to source funding as his big fear was about its capacity to support the C130 and Rooivalk aircraft as it was the Original Equipment Manufacturer. The Armscor presentation was a reality check and the Committee needed a meeting where Denel, Armscor and the SANDF were present where the Committee could make a decision as there was huge risk. He asked if there was a need for an infantry fighting vehicle or was the need for an armoured patrol vehicle. On Project Hotel, he said there appeared to be cash flow concerns at SA Shipyard. If this was a challenge, how would it be mitigated? On Project Biro, he asked what the organic sea boats and boarding boats were as they were not part of the original tender.

The Chairperson asked Denel to respond to Mr Marais and also to the Armscor CEO's initial statements.
 
On Armscor’s initial statements, Mr Daniel Du Toit, Group CEO: Denel, replied that the most important action was that there was a need for a better alignment between Armscor and Denel. Denel was actively engaged in seeking solutions. A common executive committee had been established but more work needed to be done going forward. He said the new Denel management team was committed to fixing the issues. On Mr Mkhwanazi’s comments on the affordability of the project, he said Denel was willing to find solutions. Project progress was significantly late, but Denel had the capacity and the capability to do the project and good progress had been made in the last 15 months.

On the photo of engineers, Mr Du Toit replied that Denel did have more experienced talent. A recent skills assessment register showed that it had a staff of 3 300, 67% of whom were technical staff with 540 engineers and the rest technicians in manufacturing and support. The intent of the photo was to show that Denel was attracting young talent.

Mr Du Toit replied that the infantry vehicles were prototypes with some having turrets. He said the hulls were manufactured under licence in South Africa. The initial prototype hulls were imported.

On the non-payment of salaries, the Denel CEO replied that the board had held a lot of meetings because Denel was in a desperate liquidity crunch. Denel generated cash through trading, but R400m worth on invoiced goods could not be shipped due to not being able to get export permits and the lack of international flights. Covid-19 had caused a backlog of work as Denel could not work at full production capacity. Its second income source was through turnaround and strategic initiatives where it worked with international partners, but these organisations were all preserving cash in the face of Covid-19. Its third source of income was recapitalisation and the Minister of Finance had said in February that Denel would receive R500m.

The Denel CEO replied that even in lockdown, essential services staff had provided C130 and Rooivalk aircraft support.

Mr T Mmutle (ANC) asked how often Denel met its client, the SANDF; when they had met; and when would they be meeting again. The Committee needed another day, but Denel and Armscor first had to meet to correlate their presentations. He wanted clarification on Phases 1 and 2 of Project Hoefyster. Were both phases running concurrently? The project was taking very long to complete. How far was Denel in terms of delivery percentage given the R7.3bn Armscor had already paid?

Mr D Ryder (DA, Gauteng) said he would put forward written questions, but asked if Denel’s financial situation would remain the same for some time and would Denel look for funding from the state. The delays and the financial challenges meant there was reputational risk and due to its link to government, there was a risk to the country whose name could be dragged down as well. He asked if Denel customers were aware of the delays.

The Chairperson said it appeared that the fundamental challenge was the liquidity of Denel which had to be addressed. He was not convinced that Denel had improved and this was borne out by its non-payment to sub-contractors. Other challenges were its inability to meet finishing dates which led to escalation costs. He point out the shrinking Special Defence Account (SDA) budget which could reach zero in its outer years.

Mr J Maake (ANC) asked what was meant by ‘projects not funded’. He questioned Denel’s business arrangement of continual postponements. He asked if some companies that had gone into liquidation because Denel had not paid them would be reindustrialised through payments by Denel.

Ms M Modise (ANC) said there was no alignment between Denel and Armscor. She asked if the continual delays did not affect the technology that was developed and make this obsolescent. She asked if the Project Hoefyster vehicle variants provided for patrol vehicles.

On Denel’s dependency on the SANDF, Mr Du Toit replied that sales to the SANDF totalled 50% and the rest were exports and some to the SAPS. Viewed historically, there was a decline in the percentage of sales to the SANDF.

On Phases 1 and 2, he replied Phase 1 was for R8.5bn and R1.7bn was invoiced.

Denel was going through a severe liquidity crisis but he was confident it would get through the short term of two to three months. Denel’s reputation had taken a beating during the time of State Capture, but there was still appreciation of its skills, expertise and technology. Its products were wanted. The media stories of salaries not being paid created nervousness. Denel had a turnaround plan and would be meeting with the Committee in June to discuss this.

On its contractual arrangements, Mr Du Toit replied that Denel and Armscor had solid contracts in place.

On non-payment to small businesses, he replied that when payments had been made, R170m had been paid to SMEs, but it could only pay 70% of its suppliers.

Mr Du Toit replied that in some instances obsolescent technology was a challenge such as in electronics where there was rapid change, but in the mechanical aspect it was not a big concern.

On whether the vehicles could do patrolling, he replied that he would not venture into the doctrine behind the vehicles but the vehicles were infantry vehicles and were the backbone of the infantry. 

Mr Makhwanazi of Armscor replied there would be levels of obsolescence. He not that the infantry vehicles were not suited for patrol purposes, there were specific patrol vehicles which Denel also manufactured. Armscor was looking into the obsolescent electronic equipment.

Mr Makhwanazi replied that the vehicles in the photo were prototypes which were not ready for usage.

Mr Makhwanazi noted that the sea boats and patrol boats were small boats on board the bigger boat and launched from the bigger boat. They were part of the original tender.

On Phases 1 and 2, Mr Makhwanazi explained Project Hoefyster was done in a phased approach. The first phase was for the design of the prototypes which had to meet the client specifications fully. The prototypes did not meet this target and failed some critical specifications which needed to be corrected. The vehicles in the photo were pre-production vehicles. Phase 1 had to be completed in 2012. Because phase 1 was not completed there was an overlap with phase 2.

The Chairperson said Denel’s inability to deliver to specification and to the contract delivery date were challenges as well as Armscor’s belief that the revised delivery date was 2026 while Denel said it would be in 2029. He was concerned about the escalation costs and obsolescence factor of the delays as well as the non-payment of suppliers especially in light of the shrinking SDA budget and the illiquid position of Denel.

Deputy Minister Thabang Makwetla replied that DoD as the customer had lots of apprehension on the progress of a number of projects, but especially on Project Hoefyster. He commended Armscor on Projects Hotel and Biro but was worried that Denel’s presentation on Project Hoefyster was optimistic. A meeting was planned to get to the nub of the project’s issues. While Denel said agreement between Denel and Armscor had to be reached on the point of where the project stood, he had no reasons to doubt the Armscor report. He felt that Project Hoefyster was ‘in the middle of nowhere’ and there was even consideration to walk away from the project. This would not be easy because of sunk costs and opportunity costs. If phase 1, which was still incomplete, had been completed, DoD could have walked away and could have returned at a later stage. Advance payments had been made and DoD would be investigating if these monies could be retrieved as the Department budget was under serious threat.

On the engineers involved in the project, which had 13 years of experience on the project, he hoped the answers given by Denel were honest answers otherwise discussions to find solutions for the project would be made difficult. Armscor had said that there were integration complexities in the project that Denel did not have the capability to address. The Ministry would follow up this discussion with Denel and Armscor and a workshop with the Committee would stand in good stead.

Mr Marais asked Denel about the need for the release of Armscor guarantees to raise funds in the capital market. He had seen a tender for reputation management which he suspected was to correct Denel's image, but this would cost a lot of money. He asked to what extent Denel relied on Rheinmetall Denel Munition (RDM) where it was a 49% shareholder. He asked what effect the cancellation of Project Hoefyster would have on Denel going forward.

Mr Mmutle replied the longer a decision on Project Hoefyster was delayed, the more expensive it would be for government. The continual shifting of delivery to later dates was due to a lack of project management.

Adv Mbada replied that Armscor was the contracting agent and that reaching milestones triggered payments. Armscor got updated from time to time but the project was regulated by contract. In the previous year Armscor had met with Denel every second month. It had a good relationship with Denel and issues were resolved. He replied it was not a matter of Denel and Armscor being misaligned it was a matter of contractual obligations. Armscor could not relax its client's approval and there were no grey areas. Armscor had accommodated Denel over the years but certain issues could not be accommodated. Armscor continued to engage strategically and give Denel support where it could. It had engaged with Denel on 19 May on Project Hoefyster and Denel had not told them how it would resolve the failures the project was experiencing – which would have allowed Armscor to know how long a project delay to mitigate for.

On SA Shipyards, Mr Makhwanazi replied there had been challenges and Armscor had met with SA Shipyards but this was prior to the design phase. Once SA Shipyards had received payments the cash flow problems were overcome.

On the release of guarantees, Mr Du Toit replied this was a primary item, but Denel needed to perform and release the prototypes.

On the reputation tender he replied Denel had put the tender out for a consultant to help with reputation management. There was a small budget for it, but it was regarded as very important for the turnaround strategy.

On RDM, he replied RDM brought lots of benefits to Denel, the most important of which was developing technology together.

On the cancellation of Project Hoefyster, he replied it would be catastrophic.

The Chairperson said he would hold off on closing the discussion for the Deputy Minister to take their discussions forward because the Committee did not want to hear the diverging views expressed today.

The meeting was adjourned.

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