Unpacking the accounting disclosures on the discontinuance of the Construction Materials cluster

Based on the group’s operational and strategic focus, as well as the poor outlook for the construction market in the South Gauteng region, the board of directors of the group resolved in December 2011 to dispose of the businesses that constitute the Construction Materials cluster. We believe it would have been even more costly for shareholders to wait for a market recovery before exiting the business.

Accounting practice thus requires that:

The Construction Materials operating performance and impairment adjustments to fixed assets be reflected as a discontinued operation for both the current and prior reporting periods (thus requiring a restatement of disclosure for the prior year)

The assets and liabilities to be transferred to non-current assets classified as held for sale only from the date the decision to dispose was made. There was therefore no restatement required for the prior year’s statement of financial position

During the current year, the group incurred a further two additional impairments relating to:

The Construction Materials businesses being disposed of

The group’s long-standing Indian contract claim

Operating losses are not adjustable for headline earnings and impairments are adjustable in the determination of headline earnings.

To unpack the financial effects of this change in disclosure, a summary of the reconciliation of earnings to headline earnings for both the current and prior year is set out below. The previously reported results for F2011 has also been included to assist the user with comparison.

Disclosure is also provided on the breakdown of the loss from discontinued operations for both the current and prior year.

Financial update on Construction Materials The group invested in the Construction Materials businesses which comprise sand and aggregates, readymix and extenders and mining crushing services during F2007, with a few smaller acquisitions in F2008. This acquisition was concluded at the top of the construction cycle. The table below discloses the value of these acquisitions.

The two impairments were:

The operating performance of this cluster has been as follows since acquisition:

The motivation for the acquisition of the quarry and readymix concrete businesses we acquired from F2007 was on the basis of a long term cycle of public infrastructure spend that was to include a number of phases of the Gauteng freeway projects, the expansion of Johannesburg to the East and West, as well as a buoyant residential and emerging social housing market. Our initial strategy when acquiring this business in terms of feeding materials into our construction operation remains relevant. However, a construction company running quarries is not optimal as we mainly draw for our own contracts, which does not provide the required volumes. However, in the hands of owners who are suppliers of finished product they can more easily absorb this in their manufacturing value chain. It would be even more costly for shareholders if the group waited for a market recovery before exiting the business. The board of directors of the group thus resolved in December 2011 to dispose of the businesses that constitute the Construction Materials cluster.

The group’s operating margin would have reduced to 2.9% from 3.8% had the cluster been recorded as continued operations.

At year end, an impairment to the carrying value of the Construction Materials cluster was recorded. The effect is as follows:

Regarding the remaining assets within the Construction Materials cluster, the group is currently engaging with a number of parties who have made firm offers. These are under negotiation. The group expects these sales to be completed before December 2012.

The carrying value of this discontinued cluster at year end was as follows:

Operational contract performance

The group monitors its contract profit/loss-maker ratio both in value and in number of contracts. It is a ratio of loss-making versus profit-making active contracts with a profit or loss greater than R100 000 for the year. In addition, it monitors the value generated or absorbed (and the number of contracts to which this is associated) for:

Contracts where the actual margin exceeds the tender margin

Contracts where the tender margin exceeds the actual margin

These indicators are reported to the audit committee and the main board of directors on a quarterly basis at a group and business unit level.

During the year the group has seen a significant weakening in the contract profit/loss ratio with the single largest loss generated by the previously reported DISI pipeline contract in Jordan.

Financial impact of Middle East operations on the group’s results

The group has operated in the Middle East since it established a presence in 2004. It has successfully operated with local joint venture partners in the United Arab Emirates (UAE) and in Jordan for the past few years. The joint venture partner relationships were developed based on the ability of the local partner to procure opportunities in the region, with the group being able to provide the technical skill.

The group was awarded material contracts since it arrived in the region and healthy contact margins were extracted in previous years. Unfortunately due to the financial crisis and the clients’ inability to fund the contracts to completion, two of the group’s contracts, DPF for the Engineers’ office (Meraas) and 470A&B for the Department of Civil Aviation (DCA), were terminated by the clients in January 2009. Since then the group has invested much time and effort, along with its joint venture partner in Dubai, in closing out these terminated contracts.

The group is pleased with the progress it has been able to make in the close out of these two terminated contracts.

As reported previously, no adjustment to carrying value on these terminated contracts and their claims were required as the group had been conservative in its accounting. The only adjustment processed, as previously disclosed, was the “time value of money” discounting adjustments on DPF of R13 million as the group agreed to a payment plan of quarterly instalments over five years.

During the last financial year the group was awarded a pipeline contract in Jordan which was not managed in accordance with the group’s standard policies and procedures and which incurred substantial costs. The group recorded a R111 million loss over the two financial years while it was under construction. This has been an expensive lesson.

The group continued to incur annual holding costs in the form of overheads to:

Commercially close the above-mentioned two terminated contracts Continue business development opportunities in regions outside the UAE – see page 61 for further details on the group’s strategy with respect to this region Commercially close individually smaller, multiple contracts awarded and traded between F2004 – F2010, which required final certification and finalisation. Management, in collaboration with the group’s partners in the Middle East, took a proactive and pragmatic stance on these historic credit risks and claims awaiting commercial close in the current year to de-risk the business. This resulted in additional losses to reach closure

Although the local management team has always been confident of the full recovery of all contract claims and measure of works carried on each contract, effective and timeous closure on these contracts has become more difficult as: Client team changes occurred over time Opinions and decisions received from independent engineers supporting contract claims recorded were reversed by the client Internal team changes have taken place, including senior management changes Client supporting information requirements have become more onerous in light of the number of claims being presented by multiple contractors and limited liquidity available to clients

The group’s focus in the year was on commercial close out and the final settlement of as many of these aged contracts as possible to improve its return, remove any “lazy” assets from the group’s balance sheet and free up executive management time. The group has been able achieve this. However, this has come at some cost to the current year’s performance.

Management believe that, similar to the process followed with the terminated contracts, where costs have been incurred in prior years it would be more optimal to negotiate a settlement. Although this potentially leads to some write off against income, it allows the group to finally settle claims, collect debtors and work in progress balances and free up the balance sheet more timeously. All contract positions taken have been agreed with our joint venture partners and through engagement with client representatives.

The two most material individual charges to the income statement with respect to the Middle East operations were:

The net carrying value of the group’s Middle East assets and liabilities at 30 June are outlined in the table below:

R’000	2012
Trade and other receivables	433 929
Work in progress	142 733
Cash and cash equivalents	60 379
Net trade and other payables	(609 453)
Net asset value

The group does not expect further credit or collection risk exposures on these balances. We believe we have taken the necessary action to address this risk.

Diversification strategy

Investments and Concessions’ operating profit consists of mainly:

Profits on the operation and maintenance of toll roads Fair value adjustments on the group’s investment in service concessions, investment properties and investment in property developments

In the current year the group recorded the following fair value adjustments:

Net upward fair value adjustment on service concessions R56,7 million Net upward fair value adjustment on investment property R10,9 million

The group’s operating margin percentage is stated including these fair value adjustments. Excluding these, the group’s operating margin would have been as follows:

The group’s investment in service concessions represents a material long term investment for the group. Its carrying value at year end was as follows:

Fair values of investments in projects still under construction are considered to be the cost of the investment. Fair values of investments in projects where the effects of significant unmitigated project risks cannot be estimated with certainty, the discounted cash flow method is used at appropriately high start-up phase risk premiums. Where investments in service concessions are denominated in a currency other than Rand, the investments are translated at year end spot rates.

The investments in the A1 phase I and II road projects in Poland and M6 phase III project in Hungary are valued by using the discounted cash flow method on the underlying project cash flows due to operations having commenced on all these projects.

A basic sensitivity analysis, calculating the effect on investment valuation from differing exchange rates on the fair value of investment in these service concessions, was performed at 30 June 2012. The effect, when varying Euro-Rand exchange rates by 10% on fair values of these investments, was R29,6 million (2011: R25 million). Similarly, every 10% increase or decrease in the discount rates used in the discounted cash flow basis of valuation results in a decrease or increase in the valuation of between R29,9 million to R35,2 million (2011: R18,7 million – R21,8 million).

Cost management

The group disclosed earlier in the year that its operating profit would be impacted by certain investment costs. These include:

Growth costs

or capacity building to secure future growth opportunities for which no benefit would have been obtained in F2012. These include costs incurred in renewable energy submission bids, the establishment of the group’s nuclear business and in taking more of the group’s businesses into Africa

Holding costs

of key skills – where the group resolved to accept the cost of key skills in preparation for the execution of specific contracts where the group had been named either: • contractor • preferred bidder • reserve bidder However, these contracts were then subsequently delayed.

In addition, as disclosed on page 63, the group reviewed its costs and implemented a “cost out” programme aimed at reducing costs based on projections of limited growth in the short term.

At the end of the F2011 financial year, it was clear to management that the group’s structural steel business was not a market in which the group should be operating. It incurred losses in the F2011 year and a decision was made to cease operations and close this business. Operational losses, retrenchment costs and closure costs totalling R11 million with respect to this steel business were incurred in the first half of this financial year.

The table below discloses the effect of the holding costs, growth costs, closure costs and retrenchments on the operating margin for the current year.

The group was also able to remove overheads in F2012 to contribute to the operational results for the year. Certain of these costs will have once off benefits, while others will have an annualised benefit going forward. The total overhead costs removed as part of our “costs out” programme totalled R112 million in the year. This had a 1.3% positive impact on the group operating margin. These savings offset the holding and growth costs incurred, which are discussed above.

Driving growth

The group is conscious that a leading indicator of financial performance for the coming year is the group’s order book. For this reason the group independently assures its secured Construction order book to provide stakeholders with a level of confidence on this disclosure. It remains the only local construction company to do so.

The group applies a conservative approach to its disclosure of the order book, as can be seen with its current and past treatment of awards. It only accounts for formally secured contracts.

For example:   1. Although the N1-N2 contract has been awarded to the group, it is not disclosed in the order book nor in its forecasts due the legal disputes between SANRAL and Cape Town Metro 2. A secured contract was removed from the Building and Housing order book, as conditions have changed. Financial close on this award is no longer assured and the group therefore does not have clarity on its start date 3. A significant number of housing units have been awarded to the group, but not included within the order book as clarity on timing of receipt of cash and off-take of units has not been received

The order book also does not include any of the secured operations, maintenance or service contracts which are applicable to the group’s Investments and Concessions cluster and its Engineering segment within Construction. These maintenance and service contracts are multi-year annuity-type contracts and total R4,8 billion.

The group’s Construction order book at year end is as follows:

The group commences its financial year with an order book which is geographically diversified. (The strong focus on South Africa in the Building and Housing order book is due to the removal of an over-border contract which no longer meets the group’s definition of secured and due to recent local awards.) The group expects growth in its Construction revenue in F2013.

Margin expectations The group aims to deliver the following underlying operating margins by cluster and segment.

Investments and Concessions		Building and Housing		Civil Engineering
15 – 20%		3 – 4%		4 – 6%
Range, including fair value adjustments		Range		Range
Manufacturing		Projects		Engineering and Construction Services
5 – 7%		5 – 8%		3 – 5%
Range		Range		Range

The information contained in this section has not been reviewed or reported on by Group Five’s auditors.

Balance sheet positioning and the group’s liquidity

The weak trading performance and impairments in the year reduced the group’s net asset value per share from R22,38 to R18,72. The group’s non-current assets excluding non-current assets classified held for sale) decreased from R1,9 billion to R1,5 billion mainly as a result of a transfer of these assets to non-current assets held for sale.

The group’s liquidity position remains strong with:

An increase in cash from operations, including improvements in working capital management. This was generated even after absorptions of cash in both Construction Materials and Middle East businesses The current ratio that remains largely unchanged A profile of realisation of financial assets versus settlement of financial debt which remains cash positive. Refer to the group’s liquidity profile below

The following table details the group’s remaining contractual maturities for its financial assets and liabilities and indicates that the group should have adequate liquidity to meet its existing financial commitments:

Bond issuance in terms of Domestic Medium Term Notes (DMTN) Programme

The JSE Limited granted a listing to the group in respect of two Senior Unsecured notes issued under the group’s R1 billion Domestic Medium Term Note Programme. Two unsecured bonds were issued on 11 April 2012 as follows:

GFC03: R220 million, three-year 7.35% floating (3-month Jibar) interest rate payable quarterly. The bond settlement due date is 10 April 2015 GFC04: R280 million, five-year, 9.4850% fixed interest rate payable semi-annually. The settlement date for this bond is 11 April 2017

The primary application of these funds is intended to finance equity investments in power, transport, real estate opportunities and concessions.

Capital investment

During the year there were no business combinations. Following the group’s experience in investing in the Construction Materials businesses, the group has refined its merger and acquisition methodology and evaluation processes. Although certain investments have been earnestly investigated over the last few years, these have been declined as sufficient comfort on the acquisitions could not be obtained.

During the year the group grew its product and geographic diversification organically. A relevant change within the year has been the increased level of expenditure on capital equipment, specifically in the rest of Africa in support of the group’s strategy of growth into the region and the infrastructure-related and capital intensive contracts won.

Expenditure is only incurred once approved by the group’s central treasury. It is based on pre-required levels of return which are a function of either the group’s weighted average cost of capital (WACC) – which was 12.2% in the year – or on the WACC based on the cost of new capital, as applicable. The central treasury funding requirements are raised from local debt markets and take into account the group’s self-imposed net gearing ratio of a maximum of 33%. The group’s current net gearing ratio is nil.

The group purchased the following fixed assets in the year:

It was allocated to the following regions:

	R’000			2012		2011
	Eastern Europe			33 653		5 277
	Middle East			2 706		28 469
	Eastern Africa			660		–
	Southern Africa			172 275		84 059*
	Central Africa			92 878		7 126
	Western Africa			36 750		9 805
	Total			338 922		134 736*

The group’s total property, plant and equipment is allocated to the following regions:

	R’000		2012
	Eastern Europe		47 858
	Middle East		9 818
	Eastern Africa		642
	Southern Africa		659 409
	Central Africa		98 906
	Western Africa		67 734
	Total		884 367

In F2013 the group has the following capital requirements (committed or authorised):

Achieving the required return on equity

In the current year the group has not met its target, with a negative return on equity. This is as a result of losses from the Construction Materials cluster and operational losses from the Middle East.

With the actions taken in the current year, this should form a base from which growth and hence improved performance can take place.

The group provides the following voluntary disclosures: