CFO review
13,12% cash flow return on investment (CFROI®) for South Africa (2005: 13,05%)
This review provides further insight into the
financial position, performance and recent
major developments of Netcare, and should
be read in conjunction with the annual financial
statements presented on pages 103 to 168.
A large number of corporate transactions were
concluded during the year under review. These
included the:
- acquisitions of General Healthcare Group
(“GHG”) and Prime Cure;
- unwinding of the Netpartner crossholding;
- issue of perpetual preference shares; and
- the sale of non-core assets and investments
to reduce debt.
The profitability of all operations was in line
with our expectations and capital expenditure
in the South African-based operations was at
all time high levels reflecting Netcare’s belief
in, and support for, the growth of the home
base. These expenditures include the capital
work in progress relating to the building of
new hospitals at Tableview (R99 million) and
Ballito (R43 million), the purchase of the
Umhlanga hospital (previously leased) for
R234 million and significant investments in
medical equipment R185 million and IT (SAP)
infrastructure R89 million.
On 25 April 2006 Netcare announced that it
had led a consortium to acquire a controlling
interest in GHG, the leading private hospital
operator in the United Kingdom. The
acquisition was concluded on 12 May 2006
with Netcare acquiring an effective holding
of 52,6%. As management of GHG take up
their allotted equity this holding is expected to
decline to 50,1%.
The UK healthcare market offers attractive
growth opportunities as public funded
healthcare is increasingly being privatised. This
together with medical technology advances
and aging populations across Europe and
England, is expected to drive increased
healthcare utilisation. The percentage of
private acute and psychiatric care beds (approximately 15 675) in the United Kingdom
as a percentage of total acute and psychiatric
beds (approximately 198 000) is one of the
lowest world wide at just under 8%.
Netcare acquired its shareholding through
a consortium with three leading UK-based
financial and property investors, namely Apax
Partners Worldwide LLP, London and Regional
Properties Limited and Brockton Capital LLP.
The Consortium acquired 100% of GHG for
a total consideration of £1 310 million. It also
assumed liability for debt in GHG amounting
to £735 million and incurred acquisition related
costs of £32 million.
For purposes of acquisition accounting in terms
of IFRS 3 (Business Combinations), assets
and liabilities were fairly valued at 12 May
2006 (the acquisition date). The property, plant
and equipment constituted the main assets
and were valued for accounting purposes at £1 632 million and made up as follows:
- £362 million relates to land which is not
depreciated;
- £111 million relates to short life assets which
will be depreciated over a period between
2 to 10 years;
- £1 052 million relates to long life assets which
will be depreciated over 50 to 75 years; and
- £107 million relates to equipment and other
assets.
Having regard for the above and the fair value
of liabilities and provisions, the goodwill arising
on acquisition was £1,120 million. Management
have completed the annual goodwill
impairment review and confirmed that the value
is supportable.
Netcare’s investment in GHG comprised an
equity contribution of £219 million as well
as the injection into GHG of Netcare UK
valued at £20 million. Financing for the equity
contribution was raised through offshore
loans and secured by Netcare. The balance
of the purchase consideration was settled by
the consortium partners and the raising of
additional debt financing in GHG.
The debt of GHG at acquisition consisted mainly of £646 million in publicly listed bonds
(Irish Stock Exchange). In terms of pre-agreed arrangements with the acquisition debt
financiers, these bonds were cancelled and repaid on 17 July 2006. Early settlement
penalties (“Spens”) and associated costs of £77,3 million were incurred and were accounted
for as a fair value liability within the acquisition balance sheet and form part of goodwill.
In September 2006, the process of transferring the properties of GHG to a series of
specialised property holding companies was finalised with the result that GHG now
consists of a clearly defined operational entity (“Opco”) and a series of property holding
companies (“Propcos”). All legalities with regard to these structures were finalised by year
end. Following the year end, the debt financing was replaced with long-term Propco debt
of £1 650 million and Opco debt of £215 million in October 2006. Notably the total debt
of GHG is secured by GHG and debt financers have no recourse to Netcare South Africa.
Propco debt is secured over the GHG property portfolio.
In March 2006 Netcare proposed a scheme of arrangement between Netpartner and
Netpartner shareholders to effect the unwind of their respective cross shareholding and
for Netcare to acquire 100% of Netpartner. Accordingly, Netcare issued 77,7 million new
Netcare shares to Netpartner shareholders in return for their shares in Netpartner, thus
making Netpartner a wholly owned subsidiary of Netcare. The proposal was supported
by all shareholder bodies, sanctioned by the High Court and became effective on
26 September 2006.
The result of the above transaction is that the 340,4 million shares in Netcare previously
held by Netpartner are now treasury shares and that Netcare now owns 100% of
Medicross (previously 20% held by Netpartner). The unwind also simplifies the accounting
and reporting structures and improves transparency. Negative goodwill of R819 million
has been reflected directly in equity, as the transaction related to the repurchase of
Netcare shares. The transaction is 9% earnings accretive on a like-for-like basis.
In February 2006, Medicross acquired 100% of Prime Cure Holdings, an integrated
South African healthcare services business primarily serving the emerging market for
a total consideration (including transaction costs) of R125,0 million. Prime Cure has
a network of 37 centres and approximately 2 400 contracted service providers and
complements Netcare’s footprint in primary care.
Netcare is exposed to a number of external risks which could significantly impact on
results. These risks are monitored on an ongoing basis and, where possible and in line
with our strategy, appropriate derivative instruments are entered into to mitigate risk.
Netcare does not enter into speculative trading positions.
During 2006, a web-based risk management application was rolled out at each
significant business unit. These risks are monitored by operational and executive management on a regular basis and the major risks are reviewed by the Group Risk
Committee on a bi-annual basis. In addition, the internal audit department includes
these risks in its internal reviews and audit monitoring.
Financial risks to which the Group is exposed
can be classified into the following major
categories:
Credit risk
Credit risk arises from customer nonperformance
or default. Considerable
resources, expertise and controls are in
place to ensure efficient and effective management of credit risk. Our credit risk
arises predominantly from settlement risk
which stems from transactions involving
the non-simultaneous exchange of values
where the Group honours its obligations to
deliver value, and the counterparty does not.
Currently the major area of concern relates
to amounts due from the Road Accident
Fund of R77 million, where the Company
experiences delays in excess of 180 days in
receipt of payment. This situation is monitored
closely and adequate provisions are held. The
Group also experiences concentration risk in
that a significant proportion of the accounts
receivable relate to one party. We believe
that we are exposed to concentration risk in
respect of both the Road Accident Fund and
the Compensation for Occupational Injuries
and Diseases (“COID”) of where the balance
due at year end was R127 million.
Liquidity risk
Liquidity risk arises should the Group
have insufficient funds or marketable
assets available to fulfil its future cash
flow obligations. The Group’s liquidity risk management framework is designed to
identify, measure and manage liquidity risk
such that sufficient liquid resources are always
available to fund operations and commitments.
To this end, a domestic note programme with
an authorised value of R2 500 million was
concluded during the year (see debt profile
below). In addition, convertible bonds due
2011 to the value of R1,7 billion were raised
after year end. These bonds are convertible
at the option of the bondholder into Netcare
shares at a price of R15,30 per Netcare
share at any time from 22 November 2006 to 30 September 2011. The conversion price
represents a premium of 25,4% over the
prevailing Netcare share price at the date
of issuing of the bonds. The bonds carry a
fixed coupon of 6% payable semi-annually in
arrears.
Operational risk
Operational risk arises from inadequate
or failed internal processes and controls.
Operational risk is inherent in all areas of our
business. The strategic focus is on preventing,
detecting, investigating and whistle blowing on
fraudulent activities. The Group’s internal audit
activities adopt a risk based approach and aim
to audit all business units at least every three
years and areas of greater risk more frequently.
The Group maintains a zero-tolerance
approach towards fraud and dishonesty.
Disappointingly, payroll fraud was identified
in May 2006 and confirmed by internal and
external forensic auditors. The fraud took place
over an eight-year period and amounted to
over R28 million. The employee in question has
appeared in court and has been found guilty
of fraud. There was minimal impact on the
2006 earnings.
Interest rate cash flow risk
Interest rate cash flow risk arises from
movements in market rates relative to the
agreed lending rates on contractual debt instruments. The Group enters into derivative
interest rate swap instruments in order to
mitigate this risk and applies hedge accounting
where the effectiveness criteria can be met.
In the United Kingdom, the indebtedness
of GHG has been converted to fixed rates
through long term floating-to-fixed interest
rate swaps covering a notional amount of £1,650 million relating to property mortgage
loan finance, with a further £200 million relating
to operating company debt.
In South Africa, swaps were entered into to
cover interest on the equity investment of £219 million made by Netcare to acquire GHG.
This hedging position will be unwound as the debt is repaid. In addition, local interest
rate swaps have also been entered into on a funds pool approach as the Group seeks
to fix between 50% and 75% of local debt at any given time. The convertible bonds
of R1,7 billion issued after year end carries a fixed coupon rate for five years and is an
integral part of the above policy.
Exchange rate risk
Exchange rate risk arises from adverse movements in the exchange rate with reference
to major currencies.
The United Kingdom debt of GHG provides a natural hedge against the assets of that
subsidiary and, in addition, Netcare has hedged the foreign currency exposure with
regard to its £219 million equity investment at a rate of R12,17: £1. This position will be
unwound as and when Netcare settles its indebtedness.
Due to the acquisition of GHG on 12 May 2006, the operations of the Group are
not comparable on a year-on-year basis. The operating results set out hereunder accordingly exclude the results of GHG and Netcare UK, which are set out separately
within this review.
Comparisons between the 2005 and 2006 financial years reflect strong organic growth
and further improved operational efficiencies.
The key financial performance indicators for the year ended 30 September 2006 are as
follows:
| |
2006
Rm |
2005
Rm |
%
change |
| Revenue |
8 184 |
7 353 |
11,3 |
| EBITDA |
1 617 |
1 438 |
12,4 |
| Operating profit |
1 350 |
1 194 |
13,1 |
| Net finance costs |
163 |
127 |
28,3 |
| Earnings attributable to ordinary shareholders |
960 |
800 |
20,0 |
| Contribution to basic headline earnings (cents) |
61 |
59 |
3,4 |
| Shareholders’ funds |
1 995 |
3 418 |
(41,6) |
| Net debt |
5 444 |
1 109 |
390,9 |
| Net debt: equity (%) |
273 |
32 |
|
Revenue increased by 11,3% to R8 184 million
(2005: R7 353 million), with increased admissions
of 5,3%. All core divisions reflected positive
growth. EBITDA grew from R1 438 million to
R1 617 million with all operational divisions again
reflecting solid growth.
EBITDA margins improved from 19,6% to
19,8%, while EBIT margins improved from
16,2% to 16,5%. EBITDA includes the
following abnormal items:
- R85 million release to income of the deferred
lease provision relating to the Umhlanga
Hospital which was purchased during the
year;
- R65 million relating to the IFRS 2 (Sharebased
payments) cost of the Health Partners
for Life (BEE) trust; and
- R38 million of impairment costs relating
to certain properties, intangible assets,
goodwill and investments.
The Debt : EBITDA ratio has increased from
77% to 337% reflecting the higher level of
debt following the acquisition of Netpartner
and GHG. The Net Debt : Equity ratio has
similarly increased from 32% to 273% for the
same reason, but is compounded by the fact
that the Netcare shares held by Netpartner
are now accounted for as treasury shares. The
R650 million worth of perpetual preference
shares issued are regarded as equity by virtue
of the fact that they are non-convertible, nonredeemable
and non-cumulative.
South African net financing costs increased
to R163 million (2005: R127 million) due
to interest incurred on the financing of the
investment in GHG, expensing of interest rate
hedges and ongoing capital expenditure. Local
net interest cover remains at a satisfactory
5.7 times (2005: 9.6 times).
Earnings from associates have decreased
substantially due to the significant once-off
restructuring costs expensed by Netpartner
relating to the unwind on respective Netcare
and Netpartner crossholdings. Earnings from
associates will in future be primarily driven by
Netcare’s participation in Healthshare Health Solutions and Community Hospital Group.
South African property, plant and equipment
increased from R3 134 million to R3 601 million
due to ongoing capital expenditure in the
Group (refer to cash flow note below). South
African net asset value per share is R1,69
(2005: R2,36). If the properties are included
at their market value, of R4 998 million
(2005: R4 675 million) the South African net
asset value per share at 30 September 2006
increases to R3,40 (2005: R3,94). Group
net asset value per share is R1,89 (R4,16 if South African properties are included at their
revalued amounts).
| |
20061
Rm |
20052
Rm |
20061
£m |
20052
£m |
| Revenue |
3 432 |
181 |
263,1 |
16,1 |
| EBITDA |
505 |
23 |
38,7 |
2,1 |
| Operating profit |
218 |
16 |
16,7 |
1,4 |
| Net finance costs |
679 |
3 |
52,2 |
0,2 |
| (Losses)/profits attributable to
ordinary shareholders |
(231) |
18 |
(17,7) |
1,6 |
| Contribution to basic headline
earnings (cents) |
(5) |
|
(0,4) |
|
| Shareholders’ funds |
4 241 |
23 |
292,0 |
2,1 |
| Net debt |
25 724 |
4 |
1 770,9 |
0,4 |
1 Includes the results of GHG for the period 12 May 2006 to 30 September 2006
2 Netcare UK only
Revenue contribution
(Rm)
|
The results from the UK business include GHG for the period from 12 May 2006 to
30 September 2006 and Netcare UK for the full year. Revenue from the UK business
was R3 432 million and operating profit was R218 million for the year. It should be noted
that the months under review are not traditionally the best months from a seasonal
perspective, as elective surgery is usually lower over the summer months. Operating
profit and EBITDA were negatively impacted by the following items:
- R280 million legal costs and stamp duties relating to the once-off restructuring of
GHG; and
- R39 million (2005: R12 million) NHS bid costs.
The operating profit margin adjusted for these costs is 15,7%, whilst the EBITDA margin
is 24,0%. Net finance costs arising primarily from the Opco and Propco debt amounted
to R748 million. The impact of the GHG acquisition on the Group resulted in a dilution in
headline earnings per share of 5,0 cents. |
|
| For the year ended 30 September |
2006
R:£ |
2005
R:£ |
| Closing rate at 30 September |
14,53 |
11,42 |
| Exchange rate at 12 May 2006 (GHG acquisition date) |
11,73 |
|
| Average exchange rate (12 May 2006 – 30 September
2006) |
13,04 |
|
Earnings attributable to ordinary shareholders decreased by 10,4% to R729 million
(2005: R814 million).
Net financing costs amount to R842 which incorporates the higher level of interest
following the acquisition of GHG.
A number of capital items were accounted for during the year which impacted on
headline earnings per share. Impairments of investments, loans, goodwill and property
amounted to R37 million. Included in capital restructuring costs of R172 million were
costs directly related to the acquisition of GHG of R161 million. Net capital profit on the
sale of investments and subsidiaries includes realised profit on the sale of Netcare UK of
R111 million.
Headline earnings per share before taking into account the effect of the BEE transaction
remained relatively flat at 60,7 cents per share (2005: 60,2 cents per share). Return on
ordinary shareholders’ equity (“ROE”) of 29,2%, is ahead of last year’s figure of 28,3%. |
|
|
| The Group’s capital structure as at 30 September is as follows: |
| |
2006
Rm |
2005
Rm |
| Total equity |
6 236 |
3 418 |
| Total liabilities |
44 265 |
2 864 |
| |
50 501 |
6 282 |
A domestic note programme with authorised
facilities of up to R2 500 million was initiated
during the year. In terms of this programme,
commercial paper to the value of R1,550 million
was raised at rates between JIBAR plus 0,35%
and a fixed rate of 7,97% on the two-year
paper. The proceeds were used to replace more
expensive debt, as well as to fund ongoing
capital expenditure on both new projects and
within our existing hospitals.
During the year additional unsecured finance to
the value of R207 million was raised to fund the
purchase of the Umhlanga Hospital (previously
leasehold). All other forms of asset-based
finance were repaid from the proceeds of the
domestic note programme noted above.
As a result of the elimination of the cross holding
between Netcare and Netpartner (which was previously equity accounted), debt previously
accounted for within Netpartner to the value of
R1 457 million was fully consolidated into the
Group.
As a result of the revaluation of fixed property
within GHG amounting to £1,15 billion
(R16,7 billion), a deferred tax liability of £345 million (R5,0 billion) was raised. This will
be released to income over the useful lives of
the properties (50 to 75 years) as the assets are
used in the production of income. An amount
of £7,1 million (R9,3 million) was released to
income since acquisition.
| Our net debt comprises the following: |
| |
2006
Rm |
Less: Non
recourse
debt within
GHG |
Debt with
recourse to
Netcare |
2005
Rm |
| Long-term debt |
29 224 |
26 464 |
2 760 |
493 |
| Short-term debt |
2 953 |
96 |
2 857 |
913 |
| Total debt |
32 177 |
26 560 |
5 617 |
1 406 |
| Less: Cash |
(1 009) |
(836) |
(173) |
(293) |
| Net debt |
31 168 |
25 724 |
5 444 |
1 113 |
The elimination of the Netpartner crossholding resulted in a fresh issue of 77,7 million
shares, while 116,1 million shares were de-listed and revert to authorised. A further
340,4 million Netcare shares previously held by Netpartner were also acquired and are
now treated as treasury shares as part of the consolidation of Netpartner.
An additional five million shares were also repurchased during the year.
Material cash outflows during the period include: investment in the Group’s capital
expenditure programme amounting to R1 014 million (2005: R469 million); share
buybacks of R683 million (2005: R32 million) and capital distributions of R391 million
(2005: R308 million). Major capital expenditure items comprise loans to various
business associates and ongoing capital maintenance expenditure at the hospitals.
Significant capital expenditure included amounts spent on the construction of new
facilities in Tableview and Ballito, the acquisition of the Umhlanga Hospital (previously
leasehold), as well as further investment in our SAP implementation project. The
ongoing investments reflect Netcare’s commitment to delivering high quality healthcare
to its patients through continued investments in healthcare technology and hospital infrastructure.
The Group continues to monitor performance, and evaluate potential investments using
the Holt method of CFROI© as the dominant measure. The market derived cost of
capital (minimum hurdle) in South Africa has increased from 7,2% to 7,5% during the
year. Our South African CFROI© of 13,12% represents a 0,5% improvement over that
achieved in 2005 of 13,05%. We expect this to improve in coming years as the benefits
from capital investments begin to bear results. A group CFROI© has not been included
due to the reporting period for GHG being less than 12 months. CFROI© is a registered
trademark in the United States of Credit Suisse First Boston or its subsidiaries or
affiliates.
As the South African Institute of Chartered
Accountants (“SAICA”) had embarked on a
convergence process with the standards as set
out by the International Accounting Standards
Board (“IASB”) in the late 1990s, the effect
of the transition to IFRS is not as dramatic in
South Africa as has been experienced in other
countries making the transition.
The financial statements are prepared in
accordance with and comply with IFRS. As a
result of the similarity between South African
Statements of Generally Accepted Accounting
Practice, as previously applied, and IFRS, the
principal accounting policies as set out in the
2005 annual report have been consistently
applied, except for the policies stated below:
The effect of adopting this statement is a
total charge of R78 million for the current
year. R5 million relates to options issued in
2004, while R13,1 million and R65 million
relate to the current year option issue and
the HPFL transaction (BBBEE scheme),
respectively. It should be noted that the current
expense in respect of the HPFL transaction is
considerably lower than the original forecast of
R93 million due to less unit trusts being issued
than was originally planned. These unit trusts
are likely to be issued in coming years and will be expensed at such time.
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