Fitch Ratings has downgraded Denel’s national long-term rating amidst the embattled state-owned company’s severely strained liquidity position and lack of government support.
The ratings agency on 25 August said it had moved Denel’s national long-term rating to ‘CC(zaf)’ from ‘B(zaf)’ and the national short-term rating to ‘C(zaf)’ from ‘B(zaf)’.
“The downgrade reflects Denel’s severely strained liquidity position and the absence of timely government support, which under our criteria, leads us to now rate the group on a standalone basis without incorporating any upward notching for sovereign support. The liquidity position is a result of insufficient recapitalisation to effectively restart and maintain operating activities, while facing constraints imposed by the coronavirus pandemic,” Fitch Ratings said.
It added that Denel’s limited operating capacity, together with continuing management volatility, raises the prospect of inability to implement the restructuring and turnaround strategy as previously agreed with the state and Denel’s line Ministry, the Department of Public Enterprises (DPE).
One of the factors that led to the downgrade is insufficient recapitalisation. The 2019 equity injection of R1.8 billion “was insufficient to address liquidity constraints, working-capital requirements and operating capacity given the significant challenges posed by the coronavirus pandemic. The lockdowns in South Africa have severely limited operating activity between April and mid-August 2020. The resulting cash burn means Denel has insufficient liquidity to support operations, highlighted by its inability to pay salaries entirely and fund working capital,” Fitch Ratings said.
The agency said liquidity risks remained, with Denel reliant on operating profitability of restarted projects but these have been constrained by the lockdown and absence of timely (and sufficient) state support. Denel now faces multiple non-payment risks, both internal (salaries) and external (trade creditors and lenders).
The group’s business profile remains constrained by the weak operating performance of the underlying individual business units, with revenues dropping to R3.8 billion for the financial year to 31 March 2019 (FY18: R5.8 billion) and continuing significant operating losses.
The losses have placed pressure on the business to raise additional debt, Fitch said, adding that the inability to restart operations effectively raises the further prospect of fines or loss of advance payments if orders are cancelled, which would put further pressure on liquidity.
Denel Dynamics last year lost a multi-billion rand contract for Umkhonto surface-to-air missiles for Egypt because it could not provide guarantees for the contract.
Other concerns Fitch raised were lack of government support and inability to implement its turnaround plan. This was focused on operational cost reduction, exiting onerous contracts, divestment of non-core assets, and realising value through strategic equity partnerships. “We now expect implementation of the plan and timings thereof will be significantly impacted by the negligible operating activity and the limitations placed on both management and employees through the pandemic response.”
Fitch added that the departure of CEO Danie du Toit in August this year is a risk to the implementation of the turnaround plan and “highlights the elevated level of turnover of executive management over the past few years.” Du Toit was subsequently replaced by former chief executive Talib Sadik.
Regarding short-term capital, Fitch Ratings said “The capital structure of the business remains overwhelmingly short-term with the vast majority of funding on a single-year basis. The government has extended its government guarantee framework until September 2023, but it is evident that lenders remain cautious about committing to longer-term lending until operational, strategic and corporate governance issues have been addressed.”
While Denel has benefited from some government support (the recent equity contribution and increased levels of government guarantees), Denel’s operating and financial profile have deteriorated to such an extent where the ability to continue operations remains in question without continuing governmental support, Fitch said.
Looking ahead, Fitch expects a decline in revenue until FY2022, with return to solid growth thereafter as normal levels of deliveries from the backlog resume, and operating losses until FY22, although with smaller losses as the turnaround plan takes effect, with the group returning to operating profitability from FY23.
In February, Fitch praised Denel for its turnaround plan and state assistance, removing its negative watch rating and giving it a stable outlook. The agency at the same time cautioned that challenges remained at the company.