Financial Director’s review
| Mohammed Abdool-Samad Financial Director |
 |
|
Salient features
PurposeThe purpose of this review is to provide insight into the financial performance and financial position of the group and should be read in conjunction with the summary financial statements, together with the notes to the financial statements on the Illovo website at www.illovosugar.com. Key financial risksExchange ratesAs the group enters into purchase and sale transactions denominated in foreign currencies, it is subject to transactional exposure from fluctuating foreign currency exchange rates. To protect the business from the effects of transactional exchange rate volatility, forward exchange contracts are utilised, enabling more effective management of export realisations and cash flows. All forward exchange contracts are entered into in accordance with the Group Treasury Policy and individual contracts are approved by the Treasury Committee. The group is further exposed to currency fluctuations with respect to the translation of profits into Rand, with 86% of the group’s operating profit being derived from operations outside South Africa. During the current year, the Malawian Kwacha began to stabilise with year-on-year devaluations of 29% and 9% against the US Dollar and the Rand respectively, compared to 83% and 60% in the prior year. The benefit of a stronger Zambian Kwacha, Tanzanian Shilling and Mozambique Metical on translation offset the impact of the weaker Malawi Kwacha. The table below summarises the average translation exchange rates for the relevant currencies: |
 |
| Average translation exchange rates | 2014 | 2013 |
| Rand/Euro | 13.58 | 10.97 |
|---|---|---|
| Rand/US Dollar | 10.12 | 8.51 |
| Malawian Kwacha/Rand | 37.52 | 34.53 |
| Zambian Kwacha/Rand | 0.544 | 0.609 |
| Tanzanian Shilling/Rand | 160.41 | 187.48 |
| Mozambican Metical/Rand | 3.01 | 3.42 |
World sugar prices
The South African business is the only operation that exports sugar on the world market and is exposed to the world sugar price directly. World sugar exports, together with the related hedging activities, are undertaken on behalf of the sugar milling companies by SASA. The company participates in all decisions made by SASA relative to its pricing and hedging activities.
Low-cost imported sugar has placed South Africa’s domestic market under pressure which, combined with increased production, has led to an additional 149 000 tons being sold on the world market, increasing the group’s world market exposure to 11% of total sales (2013: 4%). The world sugar price remained depressed with average price realisations of US18.1 cents/lb being achieved compared to US22.9 cents/ lb achieved in 2013. The world sugar price is currently trading at around US17.5 cents/lb and is expected to remain under pressure during the 2014/15 season following expectations of a fourth year of surplus in the world sugar market.
While high inland transport costs continue to protect pricing in certain of the group’s regional markets, pricing in other regional markets began to feel the effect of competing with an abundance of low-cost, duty-free imported sugar. Domestic prices and volumes in Tanzania continued to be impacted by competition from low-cost, duty-free imported sugar.
The impact of inflation and cost containment
Inflation in most countries in which the group operates has been relatively stable in the past year, except in Malawi where inflation at 27%, albeit lower than the 38% in the prior year, continued to have a substantial impact on input costs. The high inflation in Malawi was largely mitigated by domestic price increases to protect operating margins. Illovo maintains focus on its continuous improvement programme to reduce costs through efficiency and productivity improvements. Where possible, purchasing contracts are negotiated for bulk commodities.
Interest rate risk management
The group is exposed to interest rate risk with respect to variable rate loans and short-term cash investments. During the year, the external debt in Zambia was refinanced using internal funding to maximise the group’s arbitrage opportunity of funding operations in high-interest rate environments from low-interest rate jurisdictions. While an interest saving was realised in the current year, the full benefit will be realised next year.
If interest rates applicable to existing borrowings increase by 50 basis points, the group’s profit before tax will reduce by R13.3 million.
Accounting policies
The financial statements are prepared in accordance with International Financial Reporting Standards and the requirements of the Companies Act of South Africa. During the current year, the group adopted IAS 1 Presentation of Financial Statements, IAS 19 Employee Benefits, IFRS 11 Joint Arrangements and IFRS 13 Fair Value Measurement. The comparative results and disclosures have been restated.
The revised provisions of IAS 19 Employee Benefits relate to the accounting for defined benefit pension obligations. Under the revised standard, operating profit for 2013 reduced by R6.6 million to reflect a change in the treatment of fund administration costs, while finance income reduced by R16.5 million as a lower rate of return is required to be applied to fund assets. Taxation decreased by R6.5 million. As a result of this restatement, profit attributable to equity holders reduced by R16.6 million while headline earnings per share reduced from 189.6 cents per share to 186.0 cents per share.
IFRS 11 Joint Arrangements requires all joint ventures to be equity accounted, eliminating the proportionate consolidation option which the group previously adopted. The change from proportionate consolidation to equity accounting resulted in a change to various asset, liability, income, expense and cash flow line items, but had no impact on equity, the profit attributable to equity holders or headline earnings per share.
The adoption of the other two standards has resulted in additional disclosures.
Acquisitions, disposals and investments
On 30 April 2013, the group acquired 51% of the equity in Mitra Sugar Limited from ABF Investments plc, a subsidiary of Associated British Foods plc, for a purchase consideration of €1. The acquisition increases the group’s interest in Mitra Sugar Limited, a sugar export agent, from 49% to 100%. The bargain purchase price resulted in a gain of R2 million which is reflected as a material item in the income statement.
The new potable alcohol distillery in Tanzania was successfully commissioned within budget with extra-neutral alcohol first produced in August 2013. Total capital spend was R309 million.
Material items and impairment
Insurance proceeds of R19 million were received as compensation for damage to a boiler at South Africa’s Noodsberg operation.
Financial performance
The financial performance of the group is measured in terms of various key financial ratios which include the operating margin, headline earnings growth, gearing and cash flow generation, as set out overleaf.
Operating performance
Revenue increased by 20% due to higher sales volumes and inflationary domestic price increases being achieved in all operations except for Tanzania and Malawi. Malawian domestic prices continued to increase above inflation with a 36% increase necessary to mitigate inflationary cost pressure and maintain a US Dollar equivalent sugar price. In Tanzania, the continued presence of low-cost, duty-free imported sugar resulted in sugar sold at prices below that of the prior year to generate cash flow. The group continued to grow its European speciality sugar market out of Malawi and enhance its distribution channels in Tanzania. Downstream revenue benefited from higher sales volumes and improved pricing in both the furfural and alcohol businesses, as well as additional ethanol sales following the commissioning of the distillery in Tanzania. A weaker Rand exchange rate improved export realisations for all the South African downstream operations.
However, growth in revenue did not translate to operating profit, which remained in line with the prior year, resulting in the operating margin decreasing from 17.2% to 14.3%. An unfavourable growing cane fair value movement, resulting from the stability of the Malawian Kwacha relative to the prior year and the negative outlook on 2014/15 sugar pricing, contributed considerably to the lower operating margin. Lowcost imported sugar has also impacted upon South Africa’s domestic market and had an adverse effect on profits as large volumes of domestic-designated sugar were sold on the lowmargin world market. While production and sales volumes increased, the overall impact on the group was negative, with growth mainly achieved in lower-margin sugar operations like South Africa and Tanzania. Production decreased in higher-margin sugar operations like Malawi and Zambia. The group maintained its focus on its continuous improvement programme and realised material cost savings, most notably the benefit of the central distribution warehouse in South Africa. The benefits of these cost savings, helped negate the impact of declining regional and EU export pricing.
The downstream and co-generation businesses performed exceptionally well with profits increasing by 94% on the back of higher furfural and alcohol revenue, energy efficiency saving initiatives at the Merebank distillery as well as additional power being exported to the Swaziland national grid.
| (Rm) | 2014 | % | 2013* | % |
| Malawi | 2 341 | 18 | 1 830 | 17 |
|---|---|---|---|---|
| Mozambique | 553 | 4 | 536 | 5 |
| South Africa | 4 504 | 34 | 4 081 | 37 |
| Swaziland | 1 601 | 12 | 1 315 | 12 |
| Tanzania | 925 | 7 | 699 | 6 |
| Zambia | 3 266 | 25 | 2 520 | 23 |
| (Rm) | 2014 | % | 2013* | % |
| Malawi | 762 | 39 | 899 | 48 |
|---|---|---|---|---|
| Mozambique | 33 | 2 | 109 | 6 |
| South Africa | 266 | 14 | 150 | 8 |
| Swaziland | 257 | 14 | 156 | 8 |
| Tanzania | 11 | 1 | 94 | 5 |
| Zambia | 558 | 30 | 479 | 25 |
Operating profit over the previous year is graphically depicted in the waterfall chart below.
Finance costs
| Rm | 2014 | 2013* | Variance |
| Malawi | (48) | (44) | (4) |
|---|---|---|---|
| Mozambique | (8) | (17) | 9 |
| South Africa | (78) | (73) | (5) |
| Swaziland | (80) | (97) | 17 |
| Tanzania | (65) | (31) | (34) |
| Zambia | (228) | (233) | 5 |
| Group operations | 193 | 200 | (7) |
| Translation | (22) | n/a | (22) |
| Total | (336) | (295) | (41) |
Despite strong cash generation and improved working capital management, finance costs increased by R41 million compared to 2013. In Tanzania, the successful commissioning of the potable alcohol distillery resulted in the cessation of finance costs being capitalised while higher sugar stocks throughout the year, due to the continued presence of lowcost imported sugar, weighed heavily on the group’s increased finance costs. At the group level, finance costs were affected by the full-year impact of funding the new central distribution warehouse. Translation losses arose from a stronger Zambian Kwacha and Tanzanian Shilling against the Rand. Finance costs in Swaziland and Mozambique reflect the full-year interest saving from restructuring external debt in the prior year, while Zambia’s external debt restructuring realised an interest saving, with the full-year benefit to be realised next year.
Taxation
The effective tax rate decreased marginally from 31.7% to 31.3% in the current year.
| EFFECTIVE TAX RATES (%) | 2014 | 2013* |
| Current tax | 13.3 | 12.7 |
|---|---|---|
| Deferred tax | 14.8 | 15.9 |
| Withholding tax | 3.2 | 3.1 |
| Effective tax rate | 31.3 | 31.7 |
Headline earnings
Headline earnings increased by 4% to R894 million (2013: R856 million). The weighted average number of shares in issue increased by 175 500 shares to 460.5 million as a result of the issuance of shares in terms of the Illovo Sugar 1992 Share Option Scheme.
Cash flow
The group continued its focus on operating cash flows with the objective of ensuring that operating profit is largely covered by cash. With fair value movements stabilising, cash operating profit showed a substantial increase of R370 million to R1 922 million, representing an improvement in the cash conversion ratio from 82% to 102% of operating profit. Management continues to focus on revenue enhancements, cost reductions and continuous improvement initiatives across the group to maximise cash flow generation, optimise working capital requirements and minimise financing costs.
The group invested R379 million in expansion capital projects which primarily relate to the construction of the potable alcohol distillery in Tanzania, a packed sugar warehouse in Malawi and a packing station in South Africa. In addition to this, R343 million was spent on ongoing replacement capital and minor capital projects. Distributions to shareholders totalled R557 million (2013: R458 million).
Borrowings
At year-end, the group had banking facilities totalling R4 807 million of which R2 683 million was drawn down. Committed facilities totalled R2 943 million while the group has access to R1 864 million of uncommitted facilities. Cash-on-hand at year-end totalled R597 million, resulting in a net borrowings position of R2 086 million.
The net borrowings position at year-end was made up as follows:
| Rm | 2014 | 2013* |
| Long-term borrowings | 1 825 | 1 164 |
|---|---|---|
| Current portion of long-term borrowings | 151 | 744 |
| Short-term borrowings | 297 | 223 |
| Bank overdraft | 410 | 195 |
| Total borrowings | 2 683 | 2 326 |
| Less: Cash and cash equivalents | (597) | (453) |
| Net borrowings | 2 086 | 1 873 |
| Increase in funding | 213 | 1 141 |
Net borrowings increased from the prior year largely as a result of a R349 million loss that arose on translation of obligations into Rand. If translation losses are excluded, this would result in a reduction of net borrowings of R136 million which is attributable to stronger cash generation and improved working capital management, particularly in Zambia and Malawi. In Tanzania, long-term borrowings increased following the completion of the potable alcohol distillery, while bank overdrafts increased to fund higher sugar stocks. Zambia’s external debt was refinanced with internal funding.
The borrowings profile is largely long-term in nature which reflects both the capital investment programme and working capital requirements of the business. Capital projects are largely funded by each of the individual businesses, primarily in the currency of that business’ operations. Any residual funding is financed through group treasury which in turn is financed by the local debt markets. Capital expansion projects are financed by floating rate long-term debt and are repaid from project cash flows.
The external borrowings exposure at 31 March is analysed by currency:
| Rm | 2014 | % | 2013* | % |
| Rand | 24 | 1 | – | – |
|---|---|---|---|---|
| US Dollar | 1 959 | 73 | 913 | 39 |
| Euro | – | – | 205 | 9 |
| Malawian Kwacha | – | – | 5 | - |
| Zambian Kwacha | 20 | 1 | 791 | 34 |
| Tanzanian Shilling | 656 | 24 | 412 | 18 |
| Mozambican Metical | 24 | 1 | – | – |
| Total borrowings | 2 683 | 100 | 2 326 | 100 |
| Translational exposure | 2 659 | 99 | 2 121 | 91 |
| Transactional exposure | – | – | 205 | 9 |
| No currency exposure | 24 | 1 | – | – |
The group manages transactional exposure on external borrowings by ensuring that the businesses borrow in their local currency. The group’s treasury operation may borrow in a currency other than its local currency, provided the exchange exposure is appropriately hedged. Where internal financing is utilised for long-term funding and is designated as part of the investment in the operation, foreign exchange gains and losses are recorded directly in reserves.
Gearing increased to 22% which is within the group’s objective limit of 40%. The low level of gearing is expected to be maintained in the short term, however, over the medium to long term, in anticipation of large capital expansion projects, this gearing level is expected to reach the objective limit.
| Rm | CAPITAL EXPENDITURE | CAPITAL COMMITMENTS | ||||
| 2014 | 2015 | |||||
| Expansion | Ongoing | Total | Expansion | Ongoing | Total | |
| South Africa | 77 | 104 | 181 | 70 | 125 | 195 |
|---|---|---|---|---|---|---|
| Malawi | 72 | 104 | 176 | 100 | 131 | 231 |
| Zambia | 16 | 64 | 80 | 38 | 93 | 131 |
| Swaziland | – | 23 | 23 | 44 | 38 | 82 |
| Tanzania | 133 | 6 | 139 | 5 | 51 | 56 |
| Mozambique | 12 | 15 | 27 | 10 | 40 | 50 |
| Group | 69 | 27 | 96 | 272 | 25 | 297 |
| Total | 379 | 343 | 722 | 539 | 503 | 1 042 |
Shareholding and return
Trading activity by volume of shares traded on the JSE increased by 47% year-on-year. The share price decreased by 12% from 3 180 cents to 2 801 cents at year-end.
The group has maintained its policy to pay a distribution to shareholders twice a year (interim and final), in aggregate twice-covered by headline earnings. The board believes that this distribution cover ratio is appropriate given current and forecast cash generation, planned capital expenditure and gearing levels.
An interim capital distribution, in lieu of dividend, of 37 cents per share was paid and a final capital distribution, in lieu of dividend, of 60 cents per share has been approved. The total distribution of 97 cents per share is marginally higher than the 95 cents per share distributed in 2013. In accordance with International Financial Reporting Standards, no liability has been raised for the final distribution. As the source of the distribution is a reduction of contributed tax capital, the cost of the final distribution of R276 million has been transferred from share premium to a separate distribution reserve.
Return on net assets
The return on net assets for the group decreased from 19.6% to 16.1% year-on-year. This reflects the investment in the potable alcohol distillery in Tanzania and other expansion projects which are not yet fully utilised, combined with higher sugar stocks during the year due to the slowdown in the sales profile in key markets. A currency gain of R165 million arose on the translation of the group’s foreign currency denominated net assets into Rand.
Capital expenditure and commitments
A summary of the group’s capital expenditure and approved capital commitments as at 31 March is set out above.
The group continued to apply the following hurdle rates to new expansion capital projects:
| Internal rate of return | >20% |
|---|---|
| EBIT/capital at steady state | >20% |
The hurdle rates ensure that capital is applied to expansion projects that give the best return on investment. However, these hurdle rates do not apply to ongoing replacement capital and environmental capital where it is not always possible to demonstrate the financial returns. Equity injections into the operating subsidiaries are considered from time to time, as appropriate, in order to maximise shareholders’ returns.
Financial controls and risk management
The internal control systems are designed to provide reasonable assurance against material losses and misstatement of financial results, and are intended to manage all significant risks. The safeguarding and prevention of misuse of assets is an important aspect of internal control. An internal financial control framework has been developed, in line with King III, to improve the identification of financial reporting risks and to provide additional assurance that controls are adequate to address the risk of material misstatements of financial results. During 2014, internal control frameworks were tested by the internal audit division at numerous locations. Areas of non-compliance were reported and discussed with management, following which action plans were implemented to address the risk of material misstatement of financial results.
Going-concern assertion
The board has formally considered the going-concern assertion for the Illovo group and is of the opinion that it is appropriate for the forthcoming year.
Mohammed Abdool-Samad
Financial Director