Discuss the factors that zapphire and newco should consider
Zapphire Limited (‘Zapphire’) is a construction company listed in the Construction and Materials Sector of the Johannesburg Securities Exchange. The company provides civil and building construction, earthworks, road building and rehabilitation, as well as mechanical and electrical installation services to the private and public sectors. The general construction sector has been under pressure since early 2009 due to the prevailing economic conditions and the slowdown in government infrastructural spending. Zapphire was not as severely affected by the industry conditions as some of its competitors, because it performed significant work on constructing stadiums for the FIFA World Cup leading up to 2010 and did extensive work for mining clients.
Mr Ian Williams started Zapphire in 1980 and has been instrumental in developing the company into a formidable force in the local construction industry and in neighbouring countries. Mr Williams, through his family trust, is a major shareholder in Zapphire and is the executive chairman of the company.
Selected financial and other data
The most recent statements of financial position and of comprehensive income are summarised
below:
ZAPPHIRE LIMITED
STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER
2011 2010
R million R million
Non-current assets 448 430
Property, plant and equipment 398 380
Investment property 50 50
Current assets 1 490 1 488
Inventories 35 33
Contracts in progress 70 65
Trade and other receivables 710 720
Bank balances 675 670
TOTAL ASSETS 1 938 1 918
Issued ordinary share capital 150 150
Retained income 558 508
Equity attributable to shareholders 708 658
Current liabilities 1 230 1 260
Trade and other payables 775 835
Provisions 425 380
Taxation 30 45
TOTAL EQUITY AND LIABILITIES 1 938 1 918
2
ZAPPHIRE LIMITED
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED 30 SEPTEMBER
2011 2010
R million R million
Revenue 3 750 3 250
Contract costs (3 185) (2 700)
Gross profit 565 550
Other income 30 25
Operating costs (245) (215)
Earnings before interest, taxation and depreciation 350 360
Depreciation (55) (50)
Operating profit 295 310
Investment income 45 40
Profit before taxation 340 350
Taxation (110) (113)
Profit for the year 230 237
Earnings per share (cents) 153,3 158,0
Dividend per share (cents) 120,0 100,0
Number of ordinary shares in issue (million) 150,0 150,0
Zapphire has not issued any ordinary shares nor has it repurchased any shares through a share buyback or on the general market during the past two financial years. The shareholders of Zapphire at 30 September 2011 can be categorised as follows:
The Ian Williams Family Trust 40,0%
Institutional investors 20,0%
Management 12,5%
Other shareholders 27,5%
100,0%
Hardrock Mining (Proprietary) Limited (‘Hardrock’)
As the nature of contract mining is closely related to some of Zapphire’s construction activities and the company has a strong mining client base, the company has for some time considered entering the contract mining industry.
Hardrock was a contract mining company with a large fleet of graders, excavators and dump trucks which were used in open pit mining. Unfortunately, Hardrock was overly reliant on one client in the diamond mining sector and when this particular client dramatically scaled down its open-cast diamond mining activities in 2009 and 2010, Hardrock found itself in severe cash flow difficulties, with the result that it has been placed in liquidation.
The liquidator of Hardrock is seeking to dispose of the company’s plant and equipment, part of which consists of a fleet of graders, excavators and dump trucks. The current replacement cost of the fleet is estimated to be R1,8 billion and the estimated fair market value of plant and equipment of equivalent age and usage is R1,4 billion.
The liquidator has invited all interested parties to submit bids for the Hardrock fleet and the deadline is at 12:00 on 30 November 2011. Zapphire plans to submit an offer to acquire this plant and equipment for R700 million.
If Zapphire is able to acquire the Hardrock fleet, it intends to offer contract mining services to existing clients in the coal, platinum and gold mining sectors. In addition, Zapphire is exploring the provision of services to mining groups based in Angola, the Democratic Republic of Congo (DRC) and Ghana. Services rendered in these territories will be invoiced in US dollar. Financing of the acquisition of the Hardrock plant and equipment Zapphire has acquired 100% of a shelf company (‘Newco’) for a nominal consideration and intends to use Newco to acquire the Hardrock fleet. In the event that Newco is successful in acquiring the Hardrock fleet, Zapphire will advance a non-interest-bearing shareholder’s loan of R200 million to Newco to fund working capital requirements.
Zapphire has been in discussions with various parties regarding the financing of the Hardrock plant and equipment. The company has received the following three proposals but has not yet made a final decision on which option to pursue:
1 AZN Bank Limited (‘AZN’), who has been Zapphire’s commercial bankers for the past ten years, is prepared to advance a loan of R700 million to Newco. The loan is to bear interest at 2,75% above the prevailing three-month Johannesburg Interbank Agreed Rate (‘JIBAR’), which is currently 5,575%. Interest will be payable annually in arrears. The loan principal of R700 million will be repayable in a single payment at the end of four years.
AZN requires Newco to undertake to meet certain annual loan covenants throughout the term of the loan. These loan covenants will include certain minimum financial ratios and an undertaking not to repay any portion of the shareholder’s loan to Zapphire until such time as the AZN loan has been repaid in full. In the event that Newco breaches any of the loan covenants, AZN will be entitled to increase the interest rate on the loan to JIBAR plus 8% until such time as Newco again fully complies with the loan covenant provisions. AZN also requires that its loan advance be secured by a notarial bond over the Hardrock fleet to be acquired by Newco.
2 Hacienda Hedge Fund (‘Hacienda’) has offered to advance a R700 million loan to Newco subject to certain conditions. The loan will bear interest at a fixed rate of 4,85% per annum and interest will be repayable quarterly in arrears. The loan principal will be repayable in five equal annual instalments of R140 million each. Throughout the period of the loan, Newco will be required to deposit R11 666 667 at the end of every month into a bank account, called a debt service reserve account, which Newco will cede to Hacienda. At the end of each year, R140 million will be transferred from the debt service reserve account to Hacienda to effect the annual loan principal repayment obligations.
As a condition of the loan advance to Newco, Hacienda requires a call option on 7,5 million Zapphire shares at a strike price of R9,20 per share. Hacienda will be entitled to exercise the option at any stage during the loan period.
Like AZN, Hacienda also requires that its loan advance be secured by a notarial bond over the Hardrock fleet to be acquired by Newco.
3 The third alternative is that Newco issue a €70 million high-yield Eurobond. The current R : € exchange rate is 10,00 : 1,00. The Eurobond will be secured by means of a notarial bond over the Hardrock fleet acquired by Newco and a guarantee from Zapphire for 4
€70 million. The bond will have a fixed coupon of 5,65% per annum payable semiannually in arrears. The Eurobond will be listed on various European bond exchanges. The bond will be redeemable six years after issue at the par value of €70 million. The other key conditions of the Eurobond issue are as follows:
· Newco may not incur any further debt obligations, repay any portion of the Zapphire shareholder’s loan or pay any dividends to shareholders without the prior approval of the majority of bondholders; and
· The Eurobond is redeemable at an earlier date provided it is redeemed in full and Newco pays a premium of 2,4% of the par value of the Eurobond for each 12-month period or part thereof that the bond is redeemed earlier than the scheduled date.
Hedging of interest rates
Should Newco wish to hedge its exposure to interest rate movements, AZN is prepared to enter into an interest rate swap (to convert the three-month JIBAR into a fixed rate) with Newco to cover R350 million of the loan principal at the following annual rates:
Term Fixed rate
2 years 6,66%
3 years 7,25%
4 years 7,63%
Alternatively, AZN has offered an interest rate cap for a four-year period to hedge interest rate movements (three-month JIBAR) on R350 million of the loan amount at the following premiums:
Cap strike rate Premium payable
7,63% R8 228 122
8,13% R6 876 216
8,63% R5 767 727
Actions to secure the Hardrock acquisition
Mr Williams believes the acquisition of the Hardrock fleet will provide Zapphire with the opportunity not only to diversify but also to boost its revenue and profits. Given the strategic importance of the potential acquisition opportunity, Mr Williams has taken the following steps to improve Newco’s prospects to win the bid for the Hardrock fleet:
1 Mr Williams met with the former management team of Hardrock and offered them a signon bonus of R2 million each if they enter into three-year service agreements with Newco and agree not to be part of any opposing bid for the Hardrock fleet. These offers were made subject to Newco’s successful acquisition of the Hardrock fleet within the next six months.
2 Mr Williams has played golf regularly with key employees of the liquidator of Hardrock. After one of these social interactions, Mr Williams offered non-executive directorship positions to two key individuals employed by the liquidator. Mr Williams added that these appointments would only be made in two years’ time to avoid any controversy or conflicts of interest.
3 Mr Williams met with the Chief Executive Officer (CEO) of BJL Civils (Proprietary) Limited (‘BJL’) to discuss their interest in bidding for the Hardrock fleet. Mr Williams had heard from reliable sources that BJL was the only other serious bidder for the Hardrock fleet. Mr 5
Williams intimated to the CEO of BJL that Zapphire would agree to submit inflated bids for selected road tenders in the Free State during the next 12 months to ensure that BJL secured such work on favourable terms, on condition that BJL submitted a bid of R400 million for the Hardrock fleet. Zapphire and BJL are the two largest contractors in the road building and rehabilitation sector in the Free State.
4 Mr Williams met with various journalists ‘off the record’ recently and made it clear that Zapphire was nervous about bidding for the Hardrock fleet, as the initial technical due diligence reports about the condition and value of the fleet were very negative. Mr Williams further stated that the demise of Hardrock was no accident as the South African contract mining market is highly competitive and mining groups have too much negotiating power.
Strategy session: Hardrock
The executive directors and key management of Zapphire recently spent three days at a private game lodge in the Kruger National Park. The former management team of Hardrock was also present at the strategy session, which focused on various issues relating to the possible acquisition of the Hardrock fleet. No expense was spared during the weekend, from the hiring of a private jet to transport all executives to the game lodge to the ordering of the most expensive French champagne available.
The following issues elicited the most debate:
· Whether Newco should be a ‘plant hire’ company which hires out its plant (together with skilled operators) on an hourly basis or whether it should become a mining contractor and charge for tonnages of ore extracted;
· Whether Newco should undercut existing plant hire companies and / or mining contractors in South Africa by offering plant and equipment charge-out rates at lower than the market rates; and
· What actions Newco could take to rapidly secure contract mining work in Angola, the DRC and Ghana.
The Chief Financial Officer (CFO) of Zapphire made a presentation to the executives which covered various financial issues. He explained that industry practice was to depreciate plant and equipment on the following basis:
‘The useful lives of plant and equipment are determined based on the estimated number of productive hours to be worked by the plant and equipment. The rates at which plant and equipment are depreciated are based on the estimated number of productive hours to be worked which will reduce the cost of plant and equipment to their estimated residual values over their expected useful lives.’
The former Hardrock management team provided useful insights into the industry, including various costing and pricing issues. They stated that the major contracting cost relates to the hourly charge-out rates for plant and equipment. Other costs, such as employee costs, fuel expenses and repairs and maintenance of equipment, were important but insignificant compared to plant and equipment charge-out rates. To illustrate their point, they used an example of the charge-out rates for an excavator in the current Hardrock fleet which was used in contract mining operations:
The former Hardrock management team explained that Hardrock had always acquired new plant and equipment only and that it would then perform the exercise as outlined in the table above. They explained that with regard to Excavator FA1013 (and other acquired equipment) Newco would need to decide whether to charge the standard hourly rate of R133,64 or a lower rate, given that the specific excavator was to be acquired at a discounted value to replacement cost and current fair market value.
Hardrock and Zapphire have not previously operated in Angola, the DRC or Ghana, and the strategy of how to penetrate these markets sparked much debate. During a discussion on the rumour that bribes needed to be paid to secure work in these territories, Mr Williams stated explicitly that the Zapphire group would never pay a bribe but was not averse to paying commissions to external parties for introducing the group to potential mining clients in new markets.
Share price performance of Zapphire
The shares of Zapphire have traded between R9,20 and R9,60 per share over the past 12 months. The price-earnings ratios of listed competitors are currently between 8 and 12 times their historic earnings. According to the CFO, investment analysts have indicated that Zapphire’s shares have traded at a discount to those of competitors due to the company’s smaller size and the perception that it is over-exposed to the mining sector.
Excavator FA1013 Cost of new
excavator
Current fair
market
value
Newco
potential
acquisition
cost
‘Cost’ of excavator R1 600 000 R1 280 000 R640 000
Estimated remaining useful life (productive
hours)
12 500
10 000
10 000
Residual value at end of useful life R315 000 R315 000 R315 000
Plant cost per productive hour R102,80 R96,50 R32,50
Mark-up of plant cost 30% To be decided To be decided
Charge-out rate to client for each productive
hour of excavator use
R133,64
To be decided
To be decided
7
REQUIRED
(a) Critically evaluate the terms and conditions of the three financing proposals and discuss the factors that Zapphire and Newco should consider in evaluating which one of the proposals they should pursue. Where necessary, you should also list additional information that may be required to clarify the terms and conditions of the financing proposals.
You are not required to perform any calculations (such as the effective interest rates, net present values or internal rates of return) for any of the financing proposals.
(b) With regard to the interest rate swap and the interest rate cap instruments offered by AZN –
(i) explain how each of the instruments works and indicate how they could be used to hedge against interest rate movements; and
(ii) list the factors that Newco should consider in selecting one of the two instruments in order to hedge its interest rate exposure.
In your answer you should make use of the quoted rates and premiums.
(c) Describe the key factors that the Board of Directors of Zapphire should consider in deciding whether or not the group should acquire the Hardrock fleet and enter the contract mining industry.
(d) Assuming that Newco acquires the Hardrock fleet for R700 million, discuss the factors and issues it should consider in determining the charge-out rate, and accordingly the pricing policy, to be followed by Newco with regard to this plant and equipment.
(e) Discuss the behaviour and actions of the directors of Zapphire from an ethical and corporate governance perspective, and in particular –
· the actions of Mr Williams to secure the Hardrock acquisition; and · the events leading up to and during the Hardrock strategy session.
