Group chief executive's and financial director's report
HENRY LAAS AND DANIËL GROBLER
MULTINATIONAL ENGINEERING AND
CONSTRUCTION GROUP, WITH A
FOCUSED PORTFOLIO OF BUSINESSES
PROVIDING SERVICES PRIMARILY IN THE
NATURAL RESOURCES MARKET
SECTORS OF METALS & MINERALS,
OIL & GAS AND POWER & WATER.”
The significant reshaping and alignment of the organisation is the most evident feature of the progress we have made over the past few years to change the strategic direction of the Group, with a large portion of its operations, assets and profits derived outside of South Africa.
The milestones achieved over this period coincide with distinct phases of strategic delivery since 2011. The immediate challenge at that time was to restore liquidity and profitability. Then came a period of active risk and portfolio management to secure a base of high-quality assets, a platform for future growth. In tandem, we formulated and began to systematically implement the New Strategic Future – a strategy for sustainable growth widely supported by our shareholders and the broader investment community. Throughout this period, a focused effort to address the legacy issues that have undermined the Group’s reputation and returns, has continued.
The business portfolio optimisation envisaged in the first phase of the New Strategic Future has been largely achieved. The last remaining items are to close our buildings business in the Middle East once our projects there have been completed, which we expect to do in FY2018, and to sell our strategically non-core steel fabrication business, Genrec. Although we will continue to evolve our strategy in response to market dynamics, the financial year to June 2018 will essentially be our first year as a fundamentally reshaped Murray & Roberts.
The Group’s strong year-end cash position, after several years of difficult trading conditions, is an outcome of the work done to restore the Group’s statement of financial position. This has supported the Group’s resilience through the commodity down-cycle and in withstanding the impact of the oil price collapse in November 2014. It has also enhanced our ability to create value for stakeholders, despite these pressures.
Another feature of repositioning the Group over the last six years has been the attention we have given to Engineered Excellence. While the excellence we strive for in every aspect of the business is fundamental to our competitiveness and reputation, it also supports the quality of the Group’s earnings, and ultimately investment returns. It is a non-negotiable requirement for our three business platforms.
It is worth noting (as shown in the figure below) that the Group’s average attributable earnings over the last five years, despite cyclical pressures, extensive portfolio management and the negative impact of exceptional items, compare well with those achieved historically. Generally, this demonstrates the benefit of narrowing the Group’s focus to businesses able to deliver sustainable returns over the longer term.
In the last year, we redefined the role of the corporate office in relation to the business platforms (illustrated on page 8). This has consolidated the Group’s business model, clarifying the organisational framework for a multinational business and the governance structure required to protect and grow shareholder value in the years ahead.
Critical to achieving the Group strategy and performance aspirations, and therefore an important aspect of the role of the corporate office, is to ensure strong leadership at business platform level. The process to appoint a candidate to succeed Orrie Fenn, chief executive officer of the Underground Mining business platform, when he retires in June 2018, is underway. A suitably experienced executive is being sought to lead this business into the future, given its strategic maturity and international footprint.
Notwithstanding the impact of persistently difficult market conditions and the potential for future losses from the remaining non-core businesses in its portfolio, an improvement in the Group’s performance can be expected with renewed confidence, supported by analyst and third-party assessments.
The Group took a strategic decision to exit the civil engineering and building market and to sell its Southern African Infrastructure & Building businesses. As this sale excluded the building business in the Middle East, the board of directors (“the Board”) decided to close this business. In terms of the International Financial Reporting Standards, the business in the Middle East is to be abandoned and is not yet a discontinued operation. Its financial results are hence reported as continuing operations.
As the business in the Middle East recorded a substantial loss of R570 million for the year under review, Group revenue, EBIT, HEPS and earnings per share (“EPS”) for FY2017 is reported as ‘including and excluding’ the Middle East. This is to enable a clear understanding of the negative impact of the Middle East business on the continuing operations’ earnings profile.
It is anticipated that future losses in the Middle East will be limited to a reduced overhead cost and legal fees associated with pursuing the Dubai Airport claim, as all known project losses have been accounted for in FY2017.
The Group reported revenue from continuing operations, excluding the Middle East, of R20,8 billion (FY2016: R24,4 billion), or R21,4 billion (FY2016: R26,1 billion) including the Middle East. Attributable earnings were R48 million (FY2016: R753 million). Diluted continuing HEPS, excluding the Middle East, increased to 212 cents (FY2016: 197 cents), or decreased to 72 cents (FY2016: 178 cents) including the Middle East. The Group maintained its strong cash position with cash, net of debt, of R1,8 billion (30 June 2016: R1,8 billion).
As expected, the Oil & Gas platform delivered a reduced operating profit of R217 million (FY2016: R525 million). Major greenfields LNG projects in Australia that Clough worked on reached completion. Strategies are in place to secure work on brownfields, operations & maintenance, and public infrastructure projects. Meaningful earnings growth from this current low base is only expected in the medium term, as global energy producers’ confidence returns and they start investing in new projects. The platform’s operating margin declined to 3% (FY2016: 5%).
The Underground Mining platform delivered an operating profit of R464 million (FY2016: R506 million), a decline of 18% on the prior year, with a platform margin of 6% (FY2016: 6%). Decline in revenue and margins in the Americas were largely offset by an excellent year for RUC Cementation Mining in Australasia and Cementation Zambia in Africa.
The Power & Water platform delivered an operating profit of R171 million (FY2016: R27 million). The increase was underpinned by a strong performance on the power programme, resulting in higher revenues. The prior year result was negatively impacted by the impairment of revenue taken on legacy contracts and a loss-making contract in Namibia.
Net financing costs decreased to R42 million (FY2016: R71 million), mainly attributable to the repayment of the revolving credit facility in Australia, as well as the cash received through the settlement of all the development claims with the Gauteng Province in respect of the Gautrain.
The increase in the effective taxation rate to 36% (FY2016: 25%) was mainly attributable to substantial losses incurred in the Middle East, a tax free jurisdiction, foreign withholding taxes and profits earned in higher tax jurisdictions, partly reduced by tax free dividend income and capital profits.
Income from equity accounted investments decreased to R7 million (FY2016: R18 million), largely made up of the Group’s investment in BOC and a Mooikloof development.
The loss from discontinued operations for the year was R253 million (FY2016: R136 million). The disposal of the Southern African Infrastructure & Building businesses was effective 1 April 2017, and the Group recorded R71 million of retained liabilities on the sale of these businesses and other historical items. Genrec recorded a loss before taxation of R68 million for the year, primarily due to low levels of revenue and a weak order book. The R170 million net present value charge of future expenses in relation to the VRP agreement between the listed construction companies and the South African Government, as previously announced on SENS, was also recorded under discontinued operations.
Capital expenditure for the period was R564 million (FY2016: R431 million) of which R405 million (FY2016: R332 million) was for expansion and R159 million (FY2016: R99 million) for replacement. The capital expenditure was largely incurred in the Underground Mining platform.
Shareholders are referred to the announcement released on SENS on 30 June 2017, regarding the Company’s decision to repurchase shares to the value of R250 million.
The order book for continuing operations increased to R26,9 billion (30 June 2016: R28,7 billion).
As we move forward to realise the Group’s Vision for 2025, our strategic focus is shifting from portfolio management to optimising and aligning the earnings potential of the three business platforms. Each of the platforms are at different stages in their strategic development, with clear plans to deepen their specialist service offerings and achieve their growth aspirations through geographic and project life cycle diversification in their respective natural resources market sectors.
|Executing our strategy and delivering earnings|
The Group has not escaped the pressure our clients have felt at the bottom of the commodity cycle, with our financial performance in the year indicating the considerable impact of weak commodity and energy prices, as well as trading risk in the Middle East. However, signs are encouraging that the commodity cycle is turning, with producers expected to start investing in expansion and exploration in the near term, especially in the mining sector.
To be a specialist contractor in our chosen market sectors requires our business platforms to have a permanent presence in the geographies with the most compelling growth potential for clients, along with the ability to support them in other territories. It also requires that our service offerings provide coverage of clients’ requirements across the full project life cycle. This provides diversification benefits both in relation to geographic risk and the spread of revenue and earnings across all segments or phases of the project life cycle.
Our organic and acquisitive growth plans are therefore focused on positioning our businesses in key growth markets, specifically developed markets, and the higher-margin segments of the project life cycle. An important addition to engineering, construction and commissioning services, which are susceptible to volatile economic cycles, is for our business platforms to extend their service offering to include operations and maintenance work that provides more stable long-term income. Similarly, the Group will consider selective investments as a project developer to generate good returns over the life of a project.
The Oil & Gas business platform, which provides services across the project life cycle, has been significantly affected by the completion of all the major LNG projects in Australia and a depressed oil and gas market. This transition was anticipated with strategies in place to shift focus towards brownfields, operations and maintenance, and public infrastructure projects. Given its strong position in the Australasian region, the platform will also pursue LNG plant expansion opportunities and projects in the downstream petrochemicals industry.
Global LNG markets are forecast to remain in oversupply until around 2022 and additional capacity will have to be created timeously to meet the recovery in demand from then. New supply is likely to come from the USA, South East Asia, the Middle East and Africa. The North American market is expected to be buoyant over the short to medium term, with potential for midstream projects and LNG completions, commissioning, operations and maintenance opportunities.
As this platform is still predominantly a regional player, establishing a more meaningful presence outside the Australasian region, specifically in the USA, is critical to the platform’s strategic development in the medium term. The platform is already providing niche engineering and consulting services for large LNG projects in the North American region, but with the Trump administration’s emphasis on localisation, acquiring domestic project implementation capability is a necessity. We are in the process of identifying acquisition targets to secure an on-the-ground project construction capability to supplement our existing engineering capability.
To support its revenue aspirations while the plan to internationalise comes to fruition, the platform has the flexibility to broaden its market scope beyond its oil and gas focus, into complementary markets. This includes leveraging its capabilities and reputation in the Australian market to secure selected infrastructure projects coming to market as part of the large investment planned by Australian state governments over the next 10 years.
Underground Mining, the most mature business platform from a strategic perspective, is well diversified. Its balanced exposure to geographic regions and commodity types, which have displayed different patterns of upturn and downturn, have benefitted the platform over the past few years. The platform’s profitability was slightly lower than the previous financial year, despite a soft North American market and low margins in the South African business. The platform’s diversification has shielded it from the general commodity price decline in the sector that began in 2013, and positions it strongly for the upturn expected to gain traction from 2018.
Increased demand for mining equipment, evidenced by longer delivery times from original equipment manufacturers, as well as an increase in exploration activity, are early signs of a cyclical turnaround in the global metals and minerals sector. Whereas major mining houses have for the past six years been focused on lowering costs, improving production efficiencies and preserving cash, capital expenditure among multinational clients is now expected to grow.
With its strong brands and excellent reputation as an underground hard-rock mining contractor, the platform is ready to grow with the upturn in the commodity cycle. Most key commodities are represented in its project portfolio, and it is well positioned in regions where mining activity is high and projected to grow. Its focus will be on driving organic growth in the Americas, Australia and sub-Saharan Africa, although bolt-on acquisitions will be considered if the right asset at the right price becomes available. Furthermore, for the first time in the platform’s history, the business has contract mining projects in all its main geographic regions, providing a more stable base-load of work throughout the cycle.
We believe the platform has the strategic foresight and agility to respond effectively to changing circumstances, specifically the challenge of resourcing for the expected upturn, both in terms of capital expenditure and human capital. In the latter case, the requisite skills are likely to be in short supply, especially for projects in sub-Saharan Africa, which will require careful management to mitigate project delivery risk as the platform ramps up its capacity.
The full capacity of the Power & Water business platform has been largely dedicated to the power programme (the Medupi and Kusile power stations) for almost a decade. As the power programme nears completion, the business platform must re-establish itself as a contractor of choice with new clients in the broader power and water sectors. Sizeable project wins are required for it to meet our growth expectations. With demobilisation on the power programme to begin in the coming year and with completion anticipated in 2019, replacing this large volume of work remains the biggest challenge for the platform. The possibility of securing repair and maintenance contracts at Kusile and Medupi and other Eskom facilities is being explored.
The platform has lost opportunities due to political dynamics in the domestic power sector, including delays on the IPP programme. Another major setback was the loss of the Duvha power station’s boiler rebuild tender to Dongfang from China, the circumstances of which resulted in a court action by the Group and General Electric. The Johannesburg high court interdicted Eskom from continuing with the R4 billion tender due to irregularities in the process. We anticipate that Eskom will likely restart the bid process.
Over the longer term, there are opportunities in gas-topower, coal-fired and nuclear energy as the primary sources of base-load energy in the energy mix of African countries. The platform is specifically targeting gas-to-power opportunities in South Africa, Mozambique and Ghana. While it has the capacity to secure oil and gas projects in Africa, major projects will provide the opportunity to collaborate with the Oil & Gas platform.
The platform is also pursuing work in complementary markets to support its order book. The metals & minerals, oil & gas, pulp & paper, petrochemical and sugar industries in South Africa and neighbouring countries present opportunities to do so.
The platform is establishing a water business in sub-Saharan Africa, focused on water treatment solutions for acid mine water, industrial effluent, municipal wastewater and sea water desalination. Although it has taken time to clarify the service offering, positive progress has been made in establishing the strategic partnerships that will underpin its ability to compete in this market.
Outside of the three business platforms, and in terms of its project life cycle diversification focus, the Group invests in projects on a selective basis as a project developer and income from these investments are reported separately from platform earnings. In August 2017, we announced an investment of R405 million to increase the Group’s shareholding in BCC, from 33% to 50%. BCC holds the 15-year concession for operating and maintaining the Gautrain system until March 2026. We expect this low-risk investment in BCC to continue providing attractive returns, given that we know the business well and have representation on its board. The implementation of the transaction remains subject to BCC lenders’ and regulatory approvals.
An investment in the George Biomass project, where the Power & Water platform was selected as preferred bidder, will also be made as soon as all outstanding Eskom approvals have been obtained. This will be the Group’s second investment in project development.
In tandem with the implementation of the Group strategy, concerted effort to resolve claims on legacy projects has continued. The significant uncertified revenue historically carried on our balance sheet, associated with these claims, has created investor uncertainty and placed a drag on the Group’s market value. We are working steadily to remove this detraction, both in terms of the call on management’s time and the cost of lengthy legal proceedings.
The comprehensive settlement reached in the year on the Gautrain dispute, ending the almost decade-long legal process, has been a significant step forward. BCJV, the subcontractor responsible for the design and construction of the Gautrain system, in which the Group has a 45% stake, and the GPG reached agreement to settle all disputes relating to the development period of the project. GPG paid BCJV R980 million, with a further payment capped at R294 million (including interest) to be paid over two years.
The amount that accrued to the Group equated to the project’s uncertified revenue carried on the balance sheet for the period of the dispute and this settlement has significantly de-risked the Group’s financial position.
Given the protracted time, significant costs and uncertain outcomes of such legal processes, we believe the settlement is in the best interests of all stakeholders. Importantly, the parties have agreed that no further work is required to address water ingress in a specific part of the Gautrain tunnel, which was the subject of a claim against BCJV by GPG. Although the water ingress is not fully in accordance with the contract specification, appointed professionals have confirmed that the functionality and safe operation of the system is not compromised in any way.
The buildings business in the Middle East, formerly part of the Infrastructure & Building platform, was excluded from the sale of the platform. This necessitated the decision to close this business. The cost associated with completing the remaining projects, closing the business and recovering the uncertified revenue on the Dubai Airport and other claims, are the outstanding issues in resolving this overhang from the past. The protracted legal process on the Dubai Airport claim is finally in arbitration, with an award expected in FY2018.
The closing of the Middle East business is being carefully managed, with a focus on expediting the complicated legal processes and limiting the associated costs. All projects should be largely completed by the end of the 2017 calendar year. The R570 million loss recognised in the year relates to completed as well as de-risking results on current projects – this reflects the increasingly difficult trading conditions and commercial risk that underpinned our decision to exit the region.
Also noteworthy is the liability the Group retained in the disposal of the Infrastructure & Building platform in respect of the Grayston temporary works collapse. The Department of Labour’s inquiry is still in progress and we are disappointed at the slow pace that is delaying closure of this distressing incident for all parties involved.
|Unrelenting focus on Engineered Excellence|
Two major indicators of the progress we have made in Engineered Excellence, specifically in the quality of risk management and project delivery, are the Group’s safety performance and the reduction in number of loss-making projects.
The significant improvement in the safety performance of our business platforms is a competitive advantage and underpins their efforts to be recognised as employers of choice in their markets. The Group has introduced and embedded several key initiatives, including a focus on lead indicators and improved incident reporting and analysis. The Group-wide implementation over the last year of the MAP Programme, which empowers supervisors and the workforce to plan and take ownership of safety outcomes, has delivered excellent results and supported a record-low LTIFR for the Group.
However, this improved performance was overshadowed by a fatality at the start of FY2017 in the Infrastructure & Building platform, prior to its disposal. We deeply regret the death of Ditebogo Phuduhudu (27), an apprentice mechanic, in the service of the Group and again offer our condolences to his family and friends.
With safety a key differentiator for clients, and stringently enforced by regulators, it is commendable that the Underground Mining platform delivered its best-ever safety performance in the year. The Oil & Gas business platform also delivered a benchmark safety performance, exceeding its targets, with only one LTI incurred for the year and one of its major projects recording Zero Harm over the duration of the project. The Power & Water platform also delivered a good safety performance, with the implementation of MAP at Medupi and Kusile showing positive results.
The third annual Group Safety Conference identified important focus areas for the year ahead – as the reality of Zero Harm becomes more tangible despite the risky nature of project environments. The ‘Safety Pledge’, which emphasises the importance of personal leadership commitment, accountability and operational discipline in establishing a positive safety culture, was reconfirmed. Accountability and operational discipline were highlighted for improvement, through leaders modelling the desired safety behaviours, empowering employees with knowledge, skills and resources to perform their work safely and adopting a zero-tolerance approach to substandard behaviour.
In relation to loss-making projects, the improvement trend has been equally profound. The number of loss-making projects has reduced over the past five years to one in the year under review, a significant achievement considering the Group’s current volume of projects globally.
This improvement is a good indicator of the quality of management within the business platforms, and the frameworks the Group has put in place to govern and assure operational excellence. The Group’s risk tolerance is well defined and it has implemented specific parameters for risk and opportunity management at tender stage, contracting principles (which include a register of lessons learnt across the platforms), as well as clear limits of authority.
That the governance framework for operational excellence is entrenched and working well, is especially gratifying given the pressure on our business platforms to accept often onerous commercial demands from clients in tough economic and highly competitive environments.
|Ensuring an optimal capital structure and returning cash to shareholders|
The Group’s low order book is reflective of current market conditions, but it is of a high quality given the prudent approach we apply to mitigate project risk at tendering stage. While there is some cause for apprehension, near orders are looking robust and the medium-term project pipeline is strong in both the Underground Mining and the Oil & Gas businesses.
|Achieving rerating and attracting supportive shareholders|
With the extensive progress made in de-risking the Group, clarifying the business model and strategy, and devolving greater strategic responsibility to platform leadership to deliver on their medium-term business plans, the focus has shifted to optimising the Group’s businesses and growing shareholder value. The Group’s strong statement of financial position and improving performance expectations positions it well to fund its organic and acquisitive growth plans.
As such, we believe that the Group remains intrinsically undervalued, compared to international peer groups listed on exchanges in Australia, the USA and Europe. Our confidence in the Group’s long-term value proposition is further validated by our decision to pursue a R250 million share repurchase programme. Our efforts to communicate the repositioning of the Group to the investment community will continue with an expectation of achieving a more reflective market rating, and an appropriate balance of local and international shareholders supportive of the Group’s long-term strategic direction.
We thank the Board, our executive team and all our employees for their contribution to the progress we have made in pursuit of a New Strategic Future for the Group. With most of the groundwork done, the Group is set for growth and value creation for shareholders, and therefore for all stakeholders, in the next period of strategy implementation.