Denel, the state-owned defence company, is in a spiral of terminal decline.
Yet there is no urgency or apparent strategy from the government to deal with the situation. The delay and indecision from Denel’s sole shareholder has made its predicament all the worse.
Denel has cutting-edge technology in drones, fifth generation air-to-air missiles, naval missiles, artillery systems, and protected vehicles. It has been the core of the local defence industry since manufacturing was separated from arms acquisition in 1992.
Denel required a bailout in 2006, but its decline in recent years has been precipitous and rapid. Revenue in its 2019/20 financial year of R2.7 billion was 68 percent below what it had been five years previously. That’s a small percentage of Eskom’s R200 billion in revenue, but nevertheless Denel is important for defence, exports, and skills.
The company last made a small profit of R282 million, which amounted to about 3.5 percent of sales, in 2016/17. In the financial year ending in 2020 its losses were R1.9 billion, mainly due to rising operating costs, which is often a sign of high management overheads.
With its liabilities exceeding its assets, there must be a rising risk that Denel will default on its obligations and head into bankruptcy. Since 2019, Denel has received R2.3 billion in government bailouts, but there was no further support in the Budget presented last month.
The big problem in trying to assess Denel’s degree of financial distress is that there is no reliable information on this, at least in public hands. Denel’s annual results were only released last week, nearly a year after the end of its 2019/20 year, and even then the auditor was of the opinion that they were probably unreliable.
For a number of years, the Auditor General has issued the most damning qualification possible on an audit. That is, a refusal to express an opinion on the financial statements as the information given by the company cannot be trusted.
In its report on the latest financial statements the Auditor General also said Denel could not be considered a going concern. This gives some validity to the argument made by the Democratic Alliance that the company is trading recklessly, in contravention of the Companies Act. Denel’s management insists that things are improving and its turnaround strategy is working, although there is no sign of this. Denel is still able to borrow from the banks, but this is on the basis of a government guarantee of its debt.
The causes of Denel’s fall are broadly similar to those of other state enterprises, with bad management and corruption playing large roles. Over a number of years, poor financial controls have been pointed to by the office of the Auditor General, so there is no sign that there is, at least, an improvement in some of the basics. State capture through the Gupta family and its associates played a large role, but in the more than three years since then, there has been time for a turnaround. Corruption, now being investigated by the Special Investigating Unit, has helped drain the company.
Some of the most highly qualified staff, including its rocket scientists, have left in the face of the company’s inability to meet its payroll on time, lack of projects to work on, and concerns about the future. Former Denel engineers are now working on missile development for competitors in the United Arab Emirates and Saudi Arabia. This has raised allegations of theft of intellectual property, which are being investigated.
Adding to Denel’s financial strains has been its acquisition of BAE Land Systems South Africa from the UK defence giant BAE Systems and an empowerment group in 2014. It turned out that the acquisition for R855 million was an overpayment, as the company’s contracts for sales of protected vehicles to the US Army were coming to an end with its withdrawals from Afghanistan and Iraq.
Concerns for potential clients
Due to its financial distress, many potential clients are reluctant to enter into long-term contracts. They worry that they may not be able to obtain service and upgrades for the lifespan of systems, which can be as long as 30 years. Cash flow shortages also mean that there have been long delays in the completion of projects as the company is not able to buy equipment and parts.
Last year the Egyptian Navy cancelled a R4.5 billion order for surface-to-air Umkhonto missiles, due to Denel’s inability to provide financial guarantees, according to DefenceWeb. The deal went instead to France’s MBDA, although the Umkhonto is in service with the South African and Algerian navies on their German-made frigates, and is also used by the Finnish Navy.
Denel’s reputation has also been damaged by its failure to complete some major projects on time. Project Hoefyster, for supplying the South African Army with new generation infantry fighting vehicles, is nine years behind schedule. One of the reasons for the delay is that Denel does not have the cash available for parts.
The larger factor in Denel’s fall has been its precarious strategic position in the post-1994 world. The fall in South Africa’s defence spending after 1994 substantially reduced the size and growth of the local market. Growing into international markets has been difficult, with South Africa not being a member of any large military alliance. About 60 percent of Denel’s sales remain local. The arms deals of the mid-1990s were meant to give exporters of South African weapons systems a major boost into the world market, but never really did so.
Denel could have been turned around over the past three years, but its shareholder has been paralysed in its decision-making on the issue. The Department of Public Enterprises oversees Denel, but there are multiple government departments and agencies that feed into what has to be a highly political decision-making process on the company. The Departments of Trade and Industry, the Treasury, and Defence often have conflicting agendas. Treasury wants to reduce the company’s burden on the state, but Public Enterprises may push for a bailout, and in the absence of leadership there is indecision.
This and the desire to retain an avenue for patronage for jobs and contracts makes Denel and other state enterprises political footballs.
Denel is not as central to South Africa’s future as Eskom, and clearly in government eyes is not worthy of the same sort of bailout as SAA. The chances that Denel can trade itself out of financial distress are negligible, and yet there have been no moves to either liquidate or sell off Denel subsidiaries.
Selling off Denel’s subsidiaries to large foreign defence contractors with good access to international markets is the only real way to ensure economies of scale and their viability. Denel’s subsidiaries in joint ventures with German electro-optical company Hensoldt and munitions maker Rheinmetall have flourished.
Government’s failure to act amounts to pure negligence, as it has meant reputational damage, lost contracts, delayed projects, and often an inability to pay suppliers and its employees. That indicates poor management, but also gross lack of accountability.
(Credits -The Daily Friend) – Jonathan Katzenellenbogen is a Johannesburg-based freelance financial journalist. His articles have appeared on DefenceWeb, Politicsweb, as well as in a number of overseas publications. Jonathan has also worked on Business Day and as a TV and radio reporter and newsreader.