Presentation to the Portfolio Committee for Department of Public Enterprise Review Committee

Presentation to the Portfolio Committee for

Department of Public Enterprise

Review Committee

Recapitalisation of Denel Aerostructures

29 May 2012

RESTRICTED

Executive summary

• Denel Aerostructures (DAe) has undertaken fundamental restructuring during the past 2 years which has resulted in improved financial and delivery performance, and contracted key performance indicators being met.

• DAe has successfully renegotiated its Airbus A400M work packages, subject to formal contract amendments. The A400M programme now supports a viable and sustainable business case for the Aerostructures entity in the long term.

• Further Industrial restructuring is underway to reduce rental costs and improve productivity. On-going interventions are being implemented to achieve operational excellence, a high performance culture and continually improve commercial competiveness.

• The strategy going forward is to scale capabilities to A400M requirements and to simultaneously secure new orders aligned to such A400M technologies & capabilities. The Business Development function has been strengthened to target revenue growth.

• Within the context of the New Growth Path (NGP) and Industrial Policy Action Plan (IPAP2), DAe must fulfil its strategic responsibility as a SOC to mature and deepen the world class Aerostructures advanced manufacturing capability in South Africa, integrated into the global Aerostructures supply chain.

• DAe remains in a turnaround phase, and due to the historic structural misalignment between its revenue and cost bases, it will continue to post losses in the short to medium term, before achieving breakeven in 2016/17. The entity has been renamed to Denel Aerostructures (DAe) to reflect the exit of SAAB as shareholder.

Strategic relevance of DAe• Catalyst for Aerostructures advanced manufacturing in the broader economy and foreign currency

earner through exports.

Core products• Design and manufacturing of metallic and composite aerostructures at Tier 2 level (i.e. major

aerostructures subsystems)

Key achievements 2011/12• Re-negotiated the Airbus A400M contract terms and conditions as well as substantial price uplift subject to final contract amendment by Q2 2012.•Airbus A400M deliveries: Engineering/Certification and production on-time and on-quality. Airbus praised DAe as one of its most reliable and technically competent A400M suppliers. • Restructured non-A400M programs such as AgustaWestland, Saab and G150•Rental footprint reduction by more than 60% (ongoing) and headcount restructuring completed to A400M focused capability.•Substantially reduced reported audit queries, obtained an unqualified (2011/12) audit opinion and improved cash control. 2011/12 audit in process.

Strategic Challenges• Revenue growth – Government support through finalization/implementation of Aerospace Sector Development Plan (SDP), market access via leveraging of Fleet Procurement offset programs (NIP)

• Competitiveness – Improve our competitive position as an international Tier 2 company connected to major Tier 1 / OEM’s in Europe and US through increased operational efficiencies and inculcating a high performance culture.

• Skills development and retention – Retain strong Engineering design capability – acknowledged by OEM as market differentiator

Entity Overview

Outcome & Impact of A400M Negotiations

NB – Prior to the A400M contract re-negotiation the DAe Business Plan remained unsustainable and required continued Indemnity funding for the duration of the Program. Following renegotiation breakeven is achieved in Fin year 2016/17 with improved net margins going forward. The contract amendment process is in an advanced state and is expected to be concluded by June 2012.

Main goals DAe set out to achieve during the A400M contract negotiations Achieved

Price Negotiation: A price uplift on the A400M WFF, TS and RSS work packages to ensure programme profitability and a viable business case for DAe.

Non Recurring Cost (NRC) Claim: Although NRC for modifications from 31 December 2008 to 31 December 2010 remains not claimable as per the contract, Airbus has agreed to pay DAe for all modification claims from 1 January 2011 to 31 December 2011.

Future NRC: All major modifications above agreed thresholds will be paid by Airbus.

Review of Contract Terms and Conditions: DAe had conducted a comprehensive review of the contracts and identified all issues that were considered key to a sustainable contract and to reduce the balance of risk – partially achieved.

Schedule Security: It was proposed that the Airbus requirement of early ramp-up of WFF ship set deliveries from MSN005-011 in 2010/2011, be further rolled out into the main ramp-up phase i.e. 8 WFF ship sets in 2012/13, 16 in 2013/14 and 24 in 2014/15.

Parent Company Guarantee (PCG): A cap of Euro101m was agreed upon between the parties. The PCG was previously open-ended.

Item Actions

Financial• Improvement in Net Loss position by approximately R200m since 2010/11.• Improvement in Cash utilization by approximately R200m since 2010/11.• Debtors days improvement from 306 days at March 2010 to below 60 days at March 2012.

Industrial restructuring

• Completed workforce restructuring.• Optimised supply chain efficiency.• Outsourced non-core functions.• Liquidated non-productive inventory.• Reduced rental footprint from 70,000 sqm in 2009/10 to 25,000 sqm by Dec 2012• Implemented shared services for HR and IT

A400M contractual commitments

• Passed WFF Final Design Acceptance and Bird-strike certification tests.• Maintained Green status on Program Review Meetings.• Achieved First Article Inspection on WFF.• Delivered first WFF new design baseline unit and started serial production.• Achieved Restricted Certification for A400M WFF and TS.

Quality and On-time deliveries

• Maintained NADCAP accreditations within Composites, Heat Treatment, Non Destructive Testing, Surface Treatment/Paint and Shot Peening.

• Completed phase 5 of STEP: Sustainable Transformation Enhancement Program

Governance

• Developed new inventory policy: Stock turns, Cycle counting and Buffer Stock.• Improved procurement management and stock accuracy.• Completed internal audit plan implementation.• Mitigated risk of external audit Internal Control Matters.• Unqualified audit report

Restructuring Summary

AIRBUS A400M NEGOTIATION• Time frame (Term Sheet concluded end November

2011)• Review and agree RC Prices and treatment of NRC

and Modification Cost• Review and agree contractual Terms and

Conditions

AIRBUS A400M NEGOTIATION• Time frame (Term Sheet concluded end November

2011)• Review and agree RC Prices and treatment of NRC

and Modification Cost• Review and agree contractual Terms and

Conditions RESTRUCTURING• Contract negotiations with key customers• Further reduction in the rental footprint from

50,000m2 to 25,000m2 through consolidating all activities into the A2 building - including the composites facility

• Reduction in key cost drivers• Further outsourcing of non-core activities to

reduce fix costs to variable costs• Enhance cash flow management

RESTRUCTURING• Contract negotiations with key customers• Further reduction in the rental footprint from

50,000m2 to 25,000m2 through consolidating all activities into the A2 building - including the composites facility

• Reduction in key cost drivers• Further outsourcing of non-core activities to

reduce fix costs to variable costs• Enhance cash flow management

OPERATIONAL EXCELLENCE

• Meet all contractual commitments including (A400M WFF and TS, Gripen RF and MLGU, G150, A109 and Rooivalk)

• Implement A400M WFF early Production Ramp-up (8 in 2012/13 and 16 in 2013/14)

• Sustainable Transformation and Enhancement Project (STEP)

• Interrogation of programme performance and improvement of programme management methodologies

• Strengthen bid room management and processes

OPERATIONAL EXCELLENCE

• Meet all contractual commitments including (A400M WFF and TS, Gripen RF and MLGU, G150, A109 and Rooivalk)

• Implement A400M WFF early Production Ramp-up (8 in 2012/13 and 16 in 2013/14)

• Sustainable Transformation and Enhancement Project (STEP)

• Interrogation of programme performance and improvement of programme management methodologies

• Strengthen bid room management and processes

LEARNING CULTURE & SKILLS RETENTION• Critical skills mapping, retention incentives and

reward and recognition programs• Promote a high performance learning culture• Revised skills development plan, mentorship and

coaching including Young Leaders Forum

LEARNING CULTURE & SKILLS RETENTION• Critical skills mapping, retention incentives and

reward and recognition programs• Promote a high performance learning culture• Revised skills development plan, mentorship and

coaching including Young Leaders Forum

LONG TERM SUPPORT & STRATEGIC ALIGNMENT

• Align DAe to DPE ‘s national strategic goal linked to IPAP2 and Aerospace Sector Development Plan

• Ongoing restructuring and negotiations to reduce funding requirement

• Improving balance sheet solvency

LONG TERM SUPPORT & STRATEGIC ALIGNMENT

• Align DAe to DPE ‘s national strategic goal linked to IPAP2 and Aerospace Sector Development Plan

• Ongoing restructuring and negotiations to reduce funding requirement

• Improving balance sheet solvency

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DAe Turnaround Restructuring 2012/13

Turnaround Financial Trend

-600

-400

-200

-

200

400

600

800

08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17

Revenue Net profit Cash Flow

Impact of restructuring costs

• The Minister of Finance announced during his budget speech on 22 February 2012 that the budget includes R700 million in the 2012-13 financial year to recapitalise Denel Aerostructures.

• The DAe balance sheet will be restructured as follows:• Convert a portion of the Denel Shareholder loans to equity.• Recapitalised the DAe balance sheet in order to:

• Fund the 5 year business plan of DAe during the production ramp-up phase.• Fund the operational net working capital requirements.• Fund the capital equipment required for production ramp-up.• Fund non-recurring cost investment to secure new business.• Fund the essential restructuring including the rental footprint reduction.

• The benefit of the balance sheet restructuring of DAe are as follows:• With a solvent balance sheet, going concern risk is mitigated and compliance to

Companies Act regulations.• Prospective customer’s perception of DAe being a sustainable business partner

is considerably enhanced to ensure improved business prospects.• Normalised finance costs through capitalised shareholder loans.• Supports commitment to long term planning.

Restructuring of Balance sheet

Business Development Strategy

Targeted new business

•DAe is targeting Tier 2 Aerostructures work of similar technology and light weight as industrialized for A400M, such as advanced composites, thin web machinings etc

•Possible products are fuselage primary structure (such as Topshells), Fairings (such as WFF), control surfaces (flaps, ailerons etc), detailed parts (composites, complex machinings) etc.

•Focus on European and US OEM and Tier 1 suppliers, where Airbus agreed on marketing support

•Fleet procurement offset prospects, such as SA Express acquisitions of Embraer

Why can we win it?

•World class facilities & technology. Several customer (Airbus, Lockheed Martin, Embraer) facility visits over the past 18 months has confirmed this view.

•Very strong Engineering skills – from concept design to type certification. Strong positive track record and accolades from Airbus

•Several advanced technologies such as ultra-light composites and large thin web machinings were successfully industrialized as part of A400M program

•DAe has obtain NADCAP accreditations for all major disciplines required

•Airbus has agreed to introduce DAe to major Tier 1s in their supply chain and support with letters of reference to confirm DAe as one of their most reliable suppliers on A400M program.

•DAe has good government support from DTI & DPE for fleet procurement offset prospects.

Country / Client: Product:

USA (Business Jet) Winglets

France (Airbus)A400M Ribs, Swords & Spars

Brazil (Embraer)ERJ 170/190 Beams, Floors & Frames

• NB: Improving Market Intelligence and Competitive Price Benchmarking in support of bidding activities.

Business Prospects and Government Support Required

Focussed government support for DAe is required to:

•Leverage potential Government-related fleet procurement offset prospects including:

o Transport requirements by SAAF.

o Maritime Surveillance requirements by SAAF.

o VVIP helicopter requirements by SAAF.

o Regional Jet requirements by South African Express (SAX).

o Future lease or buy requirements by South African Airways (SAA).

•Finalize and implement the IPAP2 Aerospace Sector Development Plan.

•Implement the aerospace cluster policy framework

Why Governments Invest in Aerospace

Governments invest in their aerospace sectors for reasons of:• National security• Preservation of high tech employment in an area where many

developing nations are as yet unable to compete• The economic and social benefits of investment in aerospace

technology that also spill over into other sectors• Shareholder interests – some governments are shareholders in their

aerospace industries• Political ambition

No one country can afford to abandon state support; it’s not possible to compete unilaterally without it.

Government Support Spectrum

• Educational, defence and research infrastructure. Well trained R&D personnel is driving large transfers of R&D from high cost nations such as the USA to lower cost nations such as Russia, China and India.

• Government grants for fundamental (blue sky) and pre-competitive research

• Many governments support the launch of major projects with a form of limited recourse debt financing known as Repayable Launch Investment (RLI) at competitive rates of interest rolled up until the product starts to sell

• Governments use offset mechanisms to ensure that purchases made by state organs result in a proportionate share of output, technology and employment for the acquiring country

• Military projects