Eskom’s risk profile poses challenges for debt restructuring

The ministers of finance and of public enterprises have proposed that a chief restructuring office (CRO) be established to sort out Eskom’s financial position.

The CEO of the South African Institute of Chartered Accountants (Saica), Freeman Nomvalo, will lead a team of specialists in establishing this office.

It is to be noted that:

• Nomvalo will remain CEO of Saica, but will report into the ministers of finance and public enterprises, as well as the Eskom board, on the CRO.
• The CRO will be expected to build its capacity, particularly in corporate finance, debt management and balance sheet optimisation.
• Its immediate tasks will be to ascertain Eskom’s debt profile, and engage with investors and the Eskom executive.
• “Saica’s assistance will aim to reorganise the operational and funding structures of Eskom and to contribute to Eskom’s future sustainability in the interest of our country and economy.”

Three immediate questions arise from this proposal

Potential investors and the rating agencies will no doubt be interested in:

1. Nomvalo’s expertise (with the backing of Saica) in debt restructuring, corporate finance, debt management and balance sheet optimisation?

2. The length of time this process will take?

3. Whether the appointments made in “corporate finance, debt management and balance sheet optimisation” will have to comply with black economic empowerment (BEE) requirements?

Will the establishment of this office be sufficient to stay South Africa’s imminent downgrade to junk? It is unlikely that rating agencies (or investors) will have the patience to wait for concrete results (for example, a turnaround in collecting debt and cutting costs). Are rating agencies not tired of government’s empty promises? (An analysis of empty promises over the last couple of years will fill an article on its own.)

 Never mind ‘restructuring’ the debt

Eskom has an interesting risk profile, not great for raising money nor looking for investors:

• Musical chairs – the CEOs, they are-a-changin’. Ad nauseum. In any event, neither a CEO nor a board of directors, no matter how good they are, can alone fix a massive entity with operations all over the country. Good appointments will have to be made throughout, at all levels.
• Non-payment of electricity – what is the point of propping up an entity if it cannot even manage its bad debts? 60% of Eskom’s debts have been written off.
• Irregular expenditure – Eskom incurred an additional R4.6 billion to its 2018 irregular expenditure amount of R21 billion (2017: R17.8 billion). The total figure is now a whopping R25.7 billion. To twist the knife, the auditors were not able to determine the full extent of the understatement of the irregular expenditure.
• Eskom has “significant internal control deficiencies”: the accounting authority did not exercise adequate oversight regarding compliance with applicable legislation and internal controls (procurement processes, contract management processes, consequence management, shoddy record-keeping).
• Is the government guarantee enough to secure additional debt? Have we reached 70% of government debt to GDP yet?
• Do Eskom’s assets provide any collateral? See below.

Looking for collateral value

The carrying value of property, plant and equipment for 2019 is R651.6 billion (2018: R630.6 billion), and includes capitalised finance costs of R128 299 (19.7%) in 2019, and R112.9 billion (17.9%) in 2018.The annual capitalised finance costs for 2019 are R15.4 billion (2018: R15.5 billion). (It is to be noted that Eskom does not allocate the specific capitalised finance costs to generating, transmitting or distributing plant, nor to work under construction – hence, I have calculated the percentage of capitalised finance costs on the entire portfolio).

Eskom is mandated in terms of International Financial Reporting Standards (IFRS) to capitalise its finance costs incurred in the construction of its plant and machinery. This means capitalised finance costs are not expensed to the income statement, but are amortised and deducted from profit when the plant is brought into production. (In the opinion of a cynic who does not believe in the infallible status of IFRS, capitalising finance costs in a zombie company riddled with corruption overstates the profits or understates the losses, and inflates the value of plant and machinery).

My questions are:

• Where additional construction costs are incurred resulting from cost overruns, delays in construction caused by strikes, procurement corruption and so on, resulting in additional finance costs incurred – does Eskom capitalise these additional finance costs? Is this correct? Surely these are not part of the costs of construction?
• If a company will not be profitable for many years to come, what is the point of capitalising finance costs?
• Eskom does not disclose the period over which the capitalised interest will be depreciated once the plant is in production. Generating plant can be depreciated over periods ranging from three to 80 years. Is it possible that the capitalised finance costs will only be depreciated over 80 years commencing sometime in the future?

The impact of capitalised interest on the profits/losses

Capitalising finance costs in a scenario where it takes longer to complete the construction of plant and bring it into production than it should will have the effect of overstating profits or understating losses.

To illustrate the effect, I have calculated the impact on the annual and the cumulative profits/losses, shown below.

To obtain a proper understanding of Eskom’s real loss, should the capitalised interest not be added back?

Is this not what a rating agency would do?

Brought to you by Moneyweb