The latest Fitch rating for South African State-owned defence conglomerate Denel reflects what the United States (US) credit rating agency says are “continuing operational, strategic and liquidity uncertainties despite recent cash equity injections and financial debt repayment”.
Its July rating of CC(zaf) in the national long-term category shows, according to the credit rating agency, weaknesses exacerbated by regular changes in executive management, which limit effective implementation of the group’s turnaround strategy. “Further, the lack of clear, consistent financial reporting provides additional uncertainty to Denel’s financial position and its ability to monitor the progress of its operational and financial initiatives.”
Denel was rated C(zaf) in the Fitch national short-term category. The ratings are unchanged from 2023.
The Fitch credit rating scale uses categories ‘AAA’ to ‘BBB’ (investment grade) and ‘BB’ to ‘D’ (speculative grade) with an additional +/- for AA through CCC levels indicating relative differences of probability of default or recovery from issues. The terms “investment grade” and “speculative grade” are market conventions and do not imply recommendation or endorsement of a specific security for investment purposes. Investment grade categories indicate relatively low to moderate credit risk, while ratings in the speculative categories signal either a higher level of credit risk or that a default has already occurred.
In commentary on its July rating of the South African State-owned enterprise (SOE), Fitch notes the lack of clarity on contracts, coupled with the absence of a long-term funding structure and requirements for repeated equity contributions, highlights the high liquidity risk Denel continues to face.
A lack of financial transparency is cited by Fitch as a key driver of the latest Denel rating. In this regard it notes Denel has an increasing lack of financial transparency as it has not produced independently audited information since the financial year ended 2020.
“Our conservative rating case is based on Denel’s management accounts and related notes and we continue to assume that it has only a limited ability to improve operational capacity and thereby generate sufficient profitability to support liquidity.”
As far as liquidity is concerned Fitch has it that while Denel’s liquidity position has improved as a result of the government’s equity contributions, uncertainty remains over its operating profitability and free cash flow (FCF) generation. The equity contributions have significantly reduced Denel’s debt burden, interest costs and liquidity risk.
“Nevertheless, we expect that the longer Denel takes to generate operating profitability the higher the risk to liquidity arising from claims either from suppliers for non-payment or from claims under guarantees provided by the group (be that either advance payment or performance guarantees),” Fitch stated.
Other negatives influencing its latest rating are what Fitch terms “continued management volatility” and “uncertain operational turnaround”.
“Denel has agreed a turnaround plan with its key stakeholders and is in the process of implementation. While the group maintains that it has simplified its operating structure and has re-established a focus on core projects and capabilities, we are as yet unable to ascertain this and expect poor performance in the near term,” Fitch cautioned.
It added that the government has continued to provide significant additional liquidity support to Denel through direct equity contributions during 2021-2023. In the 2023 financial year, management indicated they had received a further R3.5 billion, enabling some debt repayment, payments to employees and creditors and providing working-capital support to enable resumption of operations for key projects.
“Denel continues to benefit from various forms of government support, which had previously allowed the rating to be notched up from its Standalone Credit Profile (SCP). However, under our Government-Related Entities (GRE) Rating Criteria, where near-term default is a real possibility, notching up from the SCP becomes irrelevant and might not adequately reflect near-term default risk. Given continuing operational and liquidity risks, we do not employ any upward notching for state support and Denel remains rated on a standalone basis,” the credit agency stated in its July commentary.
Due to its weak operating and financial profiles, Denel is rated significantly below entities like Rand Water, Fitch stated, with the CC national rating denoting a high level of default risk. The ratings agency added that Denel’s links to the state no longer benefit the company.
However, Denel could improve its ratings by successfully implementing its turnaround plan, leading to normalised operations and production under existing contracts with a sustainable capital structure. Other factors that could lead to improvement would be operational profitability and further demonstration of government support and stronger links.
If Denel does not improve liquidity, or it begins to start to default or launch insolvency proceedings, that would negatively affect future ratings.
