In this article, we will take a closer look at South Africa’s (EZA) largest state-owned enterprise, the utility parastatal Eskom. Eskom recently outlined its funding plans for the 2018/19 financial (March year-end) and is also expected to shortly release its annual financial results for the 2017/18 financial year. The reason we believe that it will be important for investors to closely follow both operational and financial developments at Eskom is not only because it still accounts for 90% of South Africa’s electricity generation, but also the dire financial situation that parastatal finds itself in.
The company’s debt rating (despite being 100% owned by the national government) was recently downgraded even further into junk status by ratings agency Moody’s. Given its large size and the fact that its outstanding debt has ballooned to nearly ZAR 400bn (estimated at end-March 2018) or roughly 10% of South Africa’s Gross Domestic Product (GDP), it also has significant potential ramifications for the national balance sheet and sovereign debt ratings.
Eskom is a South African electricity public utility, established in 1923 as the Electricity Supply Commission (ESCOM) by the government of the Union of South Africa in terms of the Electricity Act (1922). Further useful background information can be found at Wikipedia as well as Eskom’ official website.
Although Eskom’s dire financial situation cannot be blamed on the newly incumbent Ramaphosa administration, it was quite startling to learn of Eskom’s newly outlined funding plan for 2018/19. The new plan detailed below shows that Eskom is actually planning to raise even more money in the next financial year than it did in 2017/18. According to a press release (released on the Johannesburg Stock Exchange News Service) reprinted below, Eskom expects to raise at least ZAR 72bn in the 2018/19 financial year, up from ZAR 57bn in 2017/18 financial year.
|Eskom Funding Plan 2017-2019|
|FUNDING SOURCE||AMOUNT||FUNDING SOURCE||AMOUNT|
|ZAR Bn||ZAR Bn|
|Development Institutions||18.6||Development Institutions||15.3|
|Export Credit Agencies||3.8||Export Credit Agencies||5.8|
|Swap Restructuring||2.5||Bonds - International||20|
|Domestic Bonds/Notes||8.4||Domestic Bonds/Notes||23|
|Commercial Paper||4.2||Structured Products||8|
|* 2018/19 planned funding , of which only 16% secured at end-March 2018|
Source: Eskom, JSE SENS
This suggests that the company’s financial situation remains quite dire and has shown little real improvement. Confirmation of this should become apparent when the company unveils its latest set of annual financial results. Of course, Eskom may be planning to increase its capital expenditures necessitating a higher level of planned funding or it may simply be bracing itself for lower than expected tariff increases or revenues. The National Energy Regulator of South Africa (Nersa), a notionally independent public body, is tasked with regulating and setting electricity prices in South Africa.
Public backlash with regard to a large increase in electricity prices since 2008 has forced Nersa to award Eskom much lower than requested tariff increases over the past two years, something which no doubt has compounded Eskom’s strained financial situation. With an election approaching in 2019, it's also unlikely that the ruling ANC would support a very high tariff adjustment next year, something that opposition parties would likely use to their advantage.
Putting Eskom’s funding plans into context
Based on the ZAR 57bn in debt raised in 2017/18 and ZAR 72bn in planned debt issuance, Eskom notional net debt is likely to rise from ZAR 330bn at the end of March 2017 to roughly ZAR 460bn by March 2019. This assumes that the above debt issuance is a net figure (taking into account the potential repayment of any debt) and covers any operational shortfall including interest payments. The debt figure of ZAR 460bn compares with annual revenues of around ZAR 200bn (projected for FY19).
If we assume an average interest cost of 9% (more or less where Eskom bonds currently price) it would imply an annual cash flow requirement of ZAR 42bn or roughly 20% of sales. If we assume roughly ZAR 30bn for annual maintenance (5% of the value of fixed assets on the balance sheet) capital expenditures (therefore excluding planned capital expenditures earmarked for the completion of its two new coal-fired power plants), that would imply a further 15% margin.
So Eskom needs to generate an EBITDA margin of roughly 35% just so that it can revert to a cash neutral position and thus preventing its debt level from rising any further. This is fairly high and well above the margins Eskom has achieved historically (between 16% and 20%, as indicated in the chart below) and also critically assumes that Eskom can “rollover” any debt that comes due.
Source : Eskom Integrated Report 2017
However, looking at a comparative based on the reported figures by one of the United States' (US) largest utility companies, Duke Energy (NYSE:DUK), perhaps not impossible. Although not strictly comparable, we can see that Duke Energy has managed to generate an EBITDA margin of between 30% and 40% for the past decade.
Nevertheless, given that operating costs have historically increased by at least 6% per annum* (in fact between 2012 and 2017 they increased by 53% or 10% per annum) this would indicate the minimum tariff increase that Eskom would need per annum in order to sustain any kind of margin over time. However, we know that Eskom is still completing the construction and ramp-up of its two new coal-fired power plants, Medupi and Kusile.
* Given that electricity prices are a key input cost, it is also loosely indicative of the likely long-term core inflation rate for the country. As such, an attempt by the central bank to target a lower inflation rate would arguably result in monetary policy being tighter than suggested in order for the economy to remain in some kind of equilibrium and would raise the risk of a renewed recession
Therefore Eskom is likely going to need to spend a bit more than the assumed maintenance capital level of ZAR30bn between now and 2021. Based on the most recent interim presentation, the current build programme (due for completion by the end of 2021) envisages a further ZAR 86bn in capital spending or roughly ZAR 20bn a year over the next four years, which would be in addition to any recurring maintenance capital expenditures.
Therefore, even with a generous tariff award of 6% or more, Eskom will more than likely see its net debt level rise to at least ZAR 500bn before possibly stabilizing. Further to this, there is no guarantee that Eskom’s operating costs will increase by only 6% per annum, particularly given the evolving risks with regard to the parastatal’s coal supplies.
As far back as 2015, the then public enterprise minister warned that Eskom faced a growing coal supply shortfall. Eskom's coal supply problems add an additional layer of complexity to parastatal's existing power constraints. Eskom derives most of its fuel for its power stations from domestically produced coal, consuming as much as 120mn tonnes of coal per annum.
Eskom has benefitted from very low coal costs in the past, a function of long-term supply contracts entered into when individual power stations were built in the 1970s and early 1980s. The power stations were often built in the vicinity of a major coalfield, resulting in little or no transport costs, which further lowered the price at which Eskom was able to procure coal.
However, these long-term contracts were designed to terminate when the neighbouring power station reached the end of its expected life. Given the limited availability of electricity now, these older power stations are being run longer than originally envisaged and beyond the original supply contract termination date.
Although there remain substantial coal reserves in the country, the newer coal fields are situated much further from these existing power stations, which have resulted in a jump in transportation costs and therefore procurement costs for Eskom. Some analysis also suggests that as much as 70% of Eskom's existing coal supply and therefore requirements may come off contract in the next several years. This risk has euphemistically been dubbed the "coal cliff."
Eskom will need to enter into new supply contracts or purchase coal from the spot market in order to fill this gap, while the lead time on building these new mines suggest that the only immediate solution for Eskom would be to purchase more expensive industrial or export quality coal, which trades at a multiple of the historic coal cost reported by the parastatal. This would have an obvious negative impact on Eskom's primary fuel expenditures and by implication total operating costs.
**If Eskom is forced to purchase export coal it could also lead to a reduction in the country’s coal exports. Thus far there has been no real evidence of this but if this were to happen it would at the margin impact negatively on the country’s trade balance. Coal exports are one of the four largest mineral exports, while mineral exports all together account for roughly 60% of total exports.
Based on Eskom’s coal supply complexities and a more militant and unionized labour force, it is very difficult to see how the parastatal will be able to contain its operating costs below the rate of inflation. Therefore any credible financial model that extrapolates parastatal’s revenues and costs, should assume a baseline annual increase in operating costs of at least 6% per annum.
There is also another problem facing Eskom and that is the issue of stagnant demand. Although Eskom has been capacity-constrained (due to a high level of planned and unplanned outages) in the past which has forced it to implement mandatory rolling blackouts, the rise in electricity prices since 2008 coupled with the slump in the country’s mining and manufacturing sectors, has also led to stagnation in overall electricity demand and sales. This is reflected in the chart below:
Source: Statistics South Africa
So despite the fact that Eskom’s net available capacity has remained largely unchanged, stagnant demand has also meant that mandatory rolling blackouts have not been implemented for more than two years now. Although this is marginally positive in that businesses have not had to endure periodic disruptions, on the other hand, it has also meant that Eskom relies solely on tariff increases in order to increase its revenues, as sales volumes have remained flat.
Although the completion of Eskom’s two new coal-fired power plants is expected to add almost 10,000 MW in new baseload capacity by 2022, given the further required increase in electricity tariffs and still very challenging backdrop in the mining sector, it is difficult to forecast any real growth in generation volumes looking out over the next five years. Further to this, a number of Eskom’s existing coal-fired power plants in operation are very old and in some cases have been operating for more than 40 years.
These power plants will need to be retired over the next 5 years and therefore the completion of the Medupi and Kusile power plants should not be regarded as an expansion in Eskom’s capacity but rather replacement of its older plants with newer, hopefully more environmentally friendly plants.
Putting it all together – what are the implications?
In our view, Eskom is essentially a zombie company at present that survives based on the implicit guarantee of the state. Even if Eskom could generate an EBITDA margin of 35% from 2021 onwards at which time revenues could amount to ZAR 225bn (assuming an annual tariff increase of 6%), its net debt to EBITDA ratio would probably still be around 6x, a level inconsistent with an investment grade rating (assuming a net debt figure of ZAR 500bn).
And this all assumes that Eskom can contain the increase in its operational expenses to a level no higher than the annual increase in its tariffs. As we have discussed regarding the challenges the parastatal faces with regard to its future coal supply requirements, containing its operational costs below the rate of inflation will be very challenging, if not impossible.
The goal of the current administration should be to get Eskom’s debt rating back into investment grade territory, so that the company can issue debt into the capital markets without the need for a guarantee from the state or implicit backing. In order to achieve this, Eskom will need to reduce its leverage ratio (net debt to EBITDA) to below 4x, at the very least.
This goal could be achieved primarily in two ways. Firstly the energy regulator can award Eskom much higher tariff increases for a period of time (say 10 years) or secondly the national government can provide Eskom with a further equity injection, reducing its net debt level. The administration can also combine these two solutions, with higher tariff awards but still in the single-digit range, coupled with a smaller equity injection.
In order to provide some insight on the scale of the challenges faced by the current administration, we provide an indicative forecast or financial model for Eskom. The model below shows that if Eskom’s net debt ratio were to peak at ZAR 500bn in 2021 (when its current build programme terminates) and we further assume that it will at a minimum receive a tariff hike of 6% per annum going forward, while reducing its capital expenditure to ZAR 30bn by 2021 (increasing by 5% after that per annum), it would take until 2026 for Eskom to reduce its leverage sufficiently to reach an investment grade level.
|Net Debt (Year-end)||500||493.0||482.0||466.3||445.3||418.3||384.4|
Source : Eskom, Blue Quadrant Capital Management
By 2026, Eskom will likely need to replace more of its ageing power plants and embark on a new building programme. If we assume that the Medupi and Kusile power plants will replace the oldest of Eskom’s power plants, we estimate that by 2030, Eskom will require another 6,600 MWs to replace the Kriel and Matla power stations, originally slated for decommissioning between 2026 and 2033 (2010 Integrated Resource Plan).
Eskom will simply not be in a position to embark on a new building programme AND maintain a leverage ratio of less than 4x, suggesting that even under this scenario it will continue to rely on implicit state support well beyond 2030.
If Eskom were to obtain an annual tariff hike of 10% for eight consecutive years commencing in 2019, its total revenues would reach roughly ZAR 270bn by 2022. Assuming appropriate operational management enabled the company to also reach an EBITDA margin of 35% by 2021 and with its net debt level peaking similarly at around ZAR 500bn in 2021, it could reach investment grade status in 2024.
|Net Debt (Year-end)||500||482.2||454.9||416.4||364.8||297.8||212.9|
Source: Eskom, Blue Quadrant Capital Management
Under this scenario by 2026, when construction of at least 7,000 MWs in new baseload capacity would be required, it could theoretically reduce its leverage sufficiently (2x) in order to fund a new building programme without relying on implicit state support.
Our final scenario assumes the aforementioned annual tariff hike of 6%, but a large once-off equity injection at the end of 2020 in order to ensure that Eskom’s leverage ratio falls below 4x by 2024 and thus allowing for a new build programme to commence by 2026. Under this scenario, the required equity injection would be in the order of ZAR 100bn or roughly 2% of GDP.
|Net Debt (Year-end)||400||384.0||363.2||336.8||304.2||264.4||216.7|
Source: Eskom, Blue Quadrant Capital Management
As we can see in the various scenarios outlined above, there appears to be very little flexibility for the current administration if their intention is to return Eskom to an investment grade status. A combination of higher than inflation level tariff increases and/or large equity injection will be required at some point AS WELL as operational efficiency that improves the company’s EBITDA margins to at least 35%.
The reality of the situation can probably still be "ignored" for a few more years, allowing Eskom to survive as a “Zombie,” relying on its implicit state backing. However, as the company’s outstanding debt balance grows ever larger, the eventual required increase in tariffs and/or equity injection will only become larger and more painful.
What about privatization?
Many commentators have suggested that full or partial privatization of Eskom will solve the current crisis. Privatization may lead to an improvement in operational efficiencies and allow Eskom to reach an EBITDA margin of 35%. However, in the current political climate there is likely to be significant political resistance against such a policy choice.
Further to this, given the already large outstanding debt balance and large group overhead or cost structure, privatization also does not seem feasible at this juncture. No foreign investor or foreign utility company would consider buying or investing in Eskom while its leverage is so high. Some commentators have suggested that Eskom could sell individual power plants. However, it should be borne in mind that at the plant level, margins are actually around 50% (in the 2017 Annual Report Eskom disclosed that its marginal cost of electricity generation was around 40 cents per Kw/h).
Given that Eskom has a large legacy corporate cost structure as well being tasked with subsidizing the provision of electricity to the country’s poor (not to mention the annual subsidy paid over to support the country’s renewable power programme), selling an individual power plan would only worsen Eskom’s financial situation, unless it was at a significant premium.
In this regard, it is doubtful that any private investor would pay such a premium for any coal-fired power plant, especially if it was one of Eskom’s older power plants. It’s possible that a private investor could be enticed into paying an exorbitant premium for an old coal-fired power plant, if it came with an additional automatic allocation for new generation capacity. In this instance, the private investors would look to earn a return not from buying the old plant but from the new plant that they would now be allowed to construct.
The other potential solution would be for Eskom to transfer or sell its transmission and distribution infrastructure to another state-owned entity. This entity would then charge Eskom (as well as other Independent Power Producers) a distribution fee. If we assumed that this distribution fee is set at say 5% of revenues, Eskom could recoup this charge with a once-off increase in electricity tariffs (over and above annual tariff increases).
If Eskom could sell its transmission and distribution infrastructure, let’s say for a notional amount of ZAR 100bn AND the national government was to assume some ZAR 200bn of Eskom’s debt, Eskom would probably then be reasonably attractive to private investors and could even be listed. Listing Eskom by 2021 in this scenario (with only ZAR 200bn in debt) and assuming ZAR 225bn in revenues and a 35% EBITDA margin would imply the potential for an equity value (assume a 10x EV/EBITDA multiple) of roughly ZAR 600bn.
If the national treasury were to sell 20% of its stake in Eskom it would be able to repay a presumed loan by the state-owned entity purchasing Eskom’s transmission and distribution infrastructure, while still retaining an equity investment worth ZAR 480bn, double the ZAR 200bn in Eskom debt it would assume as part of the restructuring.
What is the bottom line for investors in South African financial assets?
What we have attempted to convey in this article is that the current situation at the country’s electricity parastatal is dire and reaching a point where some kind of significant action will be required. The challenges facing Eskom are not insurmountable as demonstrated in our final suggested restructuring scenario above. However, even in this scenario, electricity tariffs will still need to increase at or above the rate of inflation for several years, particularly where Eskom would still be required to pay additional distribution fees.
This will ultimately further erode the relative competitiveness of the country’s key export sectors, mining and manufacturing. In particular, certain sectors of the country’s mining industry (precious metals) are very energy or electricity-intensive (deep-level mining). In the absence of a marked rise in USD-denominated prices for these commodities, there is simply no choice but for the Rand to devalue in order to reduce the US Dollar price of electricity and labour cost inputs in order for the domestic mining sector to remain viable.
This is particularly relevant following the recent appreciation in the Rand, which has already placed the mining sector under further strain. In this context, foreign investors looking for hard currency returns will need to factor this dynamic into their investment analysis. Those investors buying South African financial assets at an exchange rate of USD/ZAR 12 or less will likely require a notional Rand-denominated return of at least 6% to 10% per annum going forward, solely in order to break even in hard currency terms.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The portfolios managed by Blue Quadrant Capital Management are specifically positioned to hedge against and/or benefit from a depreciation in the Rand consistent with the views expressed in this and other related articles. These views are based on fundamental analysis and the conclusion that the South African Rand is overvalued and does not sufficiently reflect the various risk factors relevant to the country's economic trajectory and structural features.