Dear President, Cosatu’s plan for Eskom is feasible - the numbers add up
In a recent article, Cosatu general secretary Bheki Ntshalintshali gave insight into Cosatu’s plans on Eskom. Based on what he said, my bottom-up analysis of Eskom indicates that Cosatu’s plan for Eskom is a long way down the line to proper restructuring.
The plan is to reduce Eskom’s debt from R450 billion to R200bn through a special-purpose vehicle (SPV) involving the government, the PIC, Industrial Development Corporation and the Development Bank of Southern Africa.
Cosatu’s call for a comprehensive audit of all Eskom contracts and expenditure will open a hornet’s nest. An independent audit is likely to reveal severe understatements of Eskom’s true financial position.
Just recently, I pointed out in an article in Business Report that Eskom’s currency risk through borrowings in hard currencies was humungous and it is clear from Eskom’s financials that very little, if any, provisions have been made for currency losses running up to R150bn.
My calculations indicated that Eskom probably has off-balance sheet finance of more than R100bn.
Cosatu’s plan is, therefore, to effectively reduce Eskom’s debt from R560bn to R310bn if the potential off-balance sheet is taken into account.
At this stage, roughly R104bn has already been committed to Eskom in the form of Eskom bonds being converted into equity, mainly by the PIC.
In my bottom-up analysis I assumed that all Eskom listed rand-denominated bond liabilities amounting to R152bn are taken over by the SPV in exchange for equity in Eskom
I have also assumed that the SPV take over Eskom’s US dollar bond liabilities of $5.5bn at an exchange rate of R14.50 to the US dollar. In total R232bn would be swopped for equity in Eskom.
From Eskom’s recent interim results it emerged that the government’s future funding contribution will be in the form of capital injections: equity and debt. I assumed that cash flow shortfalls will be funded by equity capital and debt on a 50:50 basis.
Cosatu’s plans for Eskom also call for coal suppliers and independent power producers (IPPs) to reduce prices, or have their contracts cancelled. In the last bid windows it was evident that prices of renewables were slashed from exorbitant levels in the preceding bid windows.
I have slashed the weighted average price of IPPs to 82c per kWh in 2029/30 from 235c to 82c in 2018/19 with the steepest drop from 2020/21 onwards. The IPPs will have no choice as Eskom’s generation mandate will be expanded to expand its own renewable capacity and the IPPs will have severe competition.
The comprehensive audit will also focus on coal supply contracts and the biggest anomaly is in the medium-term contracts. These contract prices are likely to fall soon while they will be phased out in favour of the lower cost plus contracts.
Cosatu’s plan also calls for a comprehensive maintenance plan to end load-shedding. I assumed that previously deferred plant maintenance will be expedited that could lead to efficiencies in coal energy production increasing by 10 percent over the next two years. The total cost of energy produced by Eskom’s own primary sources is likely to increase by less than 3 percent a year over the next 10 years and compares to an increase of 4 percent assumed for the South African production price index.
A revision of upper-level management benefits will probably lead to sub-CPI inflation rate increases over the next two years in employment costs per kWh sold by Eskom, excluding IPPs. Total operating costs per unit of electricity sold, excluding IPPs, are expected to increase by 3.2 percent a year over the next decade and compares favourably to the PPI inflation rate of 4 percent.
Where the onerous power supply contracts with the aluminium smelters that ripped Eskom’s financial heart out should be closed out when they reach the end of their terms, it is evident that they will be extended for the next 10 years, but on revised terms.
Eskom will continue to subsidise the smelters though, but at a reduced rate. Despite the subsidies, Eskom’s revenue per kWh is likely to increase by a mere 2.5 percent a year over the next 10 years – compare that to assumptions of 4 percent producer price inflation and 5 percent CPI inflation rate per year used in the calculations.
Eskom’s capital expenditure over the next 10 years could amount to more than R500bn in 2020 money-terms, averaging R50bn a year. That assumes that Eskom will be successful to avoid installing emission controls at Matimba and push out the installation of emission controls at Medupi.
To me the impact of the execution of Cosatu’s plan for Eskom is highly supportive of economic growth as business confidence will be restored, inflation kept in check, fixed investment boosted and consumer confidence will gain traction.
But what about Eskom financially?
A major factor in the proper restructuring of Eskom is how to get money owed by Eskom’s customers repaid.
According to Cosatu’s plan, the National Treasury should just deduct money owed by state entities and municipalities from their budget allocations and pay the funds over to Eskom.
Eskom also faces challenges on the financial side. There is much uncertainty over potential claims by contractors involved in the build of Medupi and Kusile to name a few. I have assumed that Eskom will pay claims of R60bn over the next six years.
In calculating the financial outlook and future financial position given the execution of Cosatu’s plan for Eskom I assumed zero gross domestic product growth in constant money terms for the current 2019/20 financial year, 0.5 percent in the following year and 3 percent a year subsequently.
I have also assumed that the South African rand depreciates by 5percent a year as it is particularly relevant in the repayment of offshore borrowings and interest thereon.
My calculations indicate that Eskom’s earnings before interest and depreciation and amortisation will grow by 9 percent a year to R86bn in 2029/30 from my estimate of R36.8bn for the current financial year.
Eskom will continue to require funding, but at a much-reduced and manageable rate. The utility will continue to make losses but circumstances can change to return to profits after tax.
The Cosatu plan for Eskom ticks all the boxes as the entity will return to solvency as total equity and reserves will exceed borrowings over the next decade. Yes, the debt “death cross” will be reversed. It will also allow the utility to increase borrowings to finance projects that will add to Eskom’s bottom line in future.
Eskom’s currency risk will be reduced from humungous to acceptable levels. Economic stability and growth will be on the horizon.
Further credit downgrades may be averted and South Africa’s outlook may change to positive.
There are huge risks as fiscal, political and labour discipline combined are of utmost importance. Civil obedience and the buy-in by the general public are crucial factors.
The question is whether it is achievable or not.
The major concern is that the new holders of equity will not get a return on their investment in Eskom through income distributions. That is, unless Eskom increases borrowings to fund distributions to the Special Purpose Vehicle (SPV).
The outlook for the SPV is favourable though. The SPV is likely to participate in the eventual spinning off of the three divisions and the possible listing of some of it and likely to participate in any new development initiative in future.
The loss of income on the Eskom equity holding is a low price to pay to avoid significant capital losses on the new equity holders’ other investments as a result of economic and political mayhem caused by further significant credit rating downgrades.
In fact, it may lead to the new equity holders’ funds to appreciate by far more than the loss of income on their Eskom equity holdings.
Dear President, Cosatu’s plan for Eskom is feasible. The numbers add up. You and your team have my support. Put South Africa first.
Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own. He has no direct interest in any company mentioned in the article. You should consult your broker and/or investment adviser for advice.