Group finance director’s report

It is pleasing to report a profit for the year of R451 million, up 678% on last year’s profit of R58 million. This is a return to a more normal level of earnings as well as the traditional pattern of higher second-half earnings over the first half.

We have pursued a strategy over many years to obtain a better balance in our Group between the divisions of chemicals, mining and agriculture and, within these divisions, a better geographical balance. The benefits of this strategy are reflected in our results in that the substantially higher profit of our Mining division has more than offset the lower profit of the Chemicals division which, together with a normalisation of profits in our Agriculture division, resulted in the 678% improvement in profit for the year.

In line with the move to an integrated annual report, I will discuss the macro opportunities that influence our financial results before commenting on this year’s results.

Macro environment

To properly appreciate our results and their meaning in terms of a return to a more normal pattern of earnings, it is helpful to recap the events of the prior two financial years. These periods were characterised by extreme volatility in the macro environment in which we operate.

In the first half of FY2009, there was a sharp rise in commodity prices which benefited our selling prices and margins. At the beginning of the second half of FY2009, the global financial crisis rocked the world economy, causing a sudden and sharp drop in commodity prices and pressure on our selling prices and margins. This was tempered by the rapid weakening of the rand against the US dollar, as well as a drop in volumes as global economic activity declined.

In the first half of FY2010, the rand strengthened against the US dollar. Combined with a continued but slower drop in commodity prices, this resulted in further pressure on our selling prices and margins, and a R350 million downward valuation of inventory in our Agriculture division. In the second half of FY2010, the rand continued to strengthen against the US dollar while commodity prices started to recover, although not sufficient to offset rand strength, resulting in selling prices and margins remaining under pressure.

It is a tribute to the inherent strength of our various businesses and the balance between our three divisions that we were able to weather a period of such extreme volatility and emerge in a strong condition.

The macro environment for this year was more stable. This was exceptionally good for our Mining division, extremely difficult for our Chemicals division and somewhat positive for our Agriculture division. At the beginning of the year, a patchy recovery in global economic activity started as economies began to respond to the substantial stimulus packages implemented by various governments which, in turn, resulted in mining and agricultural commodity prices rising. Demand for mining commodities in particular increased. The rand continued to strengthen against the US dollar, negatively impacting all our divisions’ selling prices and margins. This was most acutely felt in our Chemicals division which also suffered the effect of depressed demand from our customers in the South African manufacturing sector as they struggled with competition against cheap imports made possible by rand strength. Inflation remained well under control within the South African Reserve Bank target inflation band and interest rates remained at historical lows. Despite low interest rates, economic activity levels in the South African manufacturing sector remained depressed due, in part, to rand strength against the US dollar.

Key financial factors, risks and uncertainties

To assist with a better understanding of our Group, I discuss some of the key factors in generating profits and cash flow, how they affect us and what we do to manage these risks, where such management is possible.

The value of the rand

The value of the rand affects us in three key areas. Most sales prices of our products in South Africa are set by reference to the rand:US dollar exchange rate and thus the stronger the rand, the lower our selling prices. In turn, the cost price of most of our products and raw materials, whether produced locally or imported, are set by reference to the rand:US dollar exchange rate and again the stronger the rand, the lower our cost price.
A combination of these two factors – lower selling prices and lower cost prices – affects profits as it tends to lead to a lower rand margin but is positive for cash flow as it requires less working capital funding. The converse is true in that a weaker rand:US dollar exchange rate leads to higher selling prices, higher cost prices and a higher rand margin – which is positive for profits but initially requires increased working capital funding. We have no control over the long-term movement in the value of the rand and do not hedge against such movements, although we have a policy of managing and hedging short-term foreign exchange exposures which seeks to protect margins and cash flow by taking into account the Group net foreign exchange exposure, and the trading cycle and pattern of each of our three divisions.

Most of our operations outside South Africa set their product sales prices in US dollars and incur product costs in US dollars. Their earnings are mainly US dollardenominated and a strong rand negatively affects the translation of these profits into rand. The converse is true. We do not hedge the value of these US dollar-denominated profits.

Our Group has a substantial asset base outside South Africa, primarily denominated in US dollars. A strong rand negatively affects the translation of the value of such assets which affect the foreign currency translation reserve and hence the Group equity in the balance sheet. We do not hedge the value of these US dollar-denominated assets.

Commodity prices

Most of the selling prices of our products in South Africa are set by reference to the international commodity price and thus the higher the commodity prices, the higher our selling prices. In turn, most of the cost prices of our products and raw materials, whether produced locally or imported, are set by reference to the international commodity prices, and thus the higher the international commodity prices, the higher our product cost and raw material input costs. A combination of these two factors – lower selling prices and lower cost prices – is negative for profits as it tends to lead to lower rand margins but positive for cash flow as it requires lower working capital funding. The converse is true in that a weaker rand:US dollar exchange rate leads to higher selling prices, higher cost prices and a higher rand margin – which is positive for profits but initially requires increased working capital funding. We have no control over the movement in commodity prices. Our Mining division hedges against much of these movements in the contracts entered into with its customers. In our Chemicals and Agriculture divisions, there are limited opportunities to hedge against movements in prices of the commodities they trade in, but where such opportunities exist, our management hedging committee meets monthly to consider the management and hedging of short-term exposures that seek to protect and enhance margins and cash flow.

Differential in rate of growth in rand margin and South African inflation rate

The primary determinant of the rate of growth in our total rand margin is a combination of international commodity prices, the rand:US dollar exchange rate and sales volumes. The primary determinant of the rate of growth in our manufacturing and other overheads is the South Africa inflation rate. A low rate of increase or even a decrease in the selling prices of our products occurs when international commodity prices are low and/or the rand is strong, but the rate of increase in costs that have to be incurred in manufacturing and distributing our products continue to rise in line with the South African inflation rate. We have no control over such factors, but we can respond to an extent by vigorous cost management and reduction, as undertaken by the Chemicals division this year.

Urea:ammonia ratio

Nitrogen is the main ingredient of fertilizer, the primary product sold by our Agriculture division. The sales price of nitrogen is determined by the international price of urea, while the cost price of ammonia, the key raw material used to produce nitrogen, is based on the international price of ammonia. The ratio of the price of urea to the price of ammonia per ton of nitrogen sold is one of the primary profit drivers of our Agriculture division. Over the long term, the ratio tends to be favourable as urea is a downstream product of ammonia but, in the short term, there can be significant deviations caused by supply/demand conditions that can affect profit margins positively or negatively. We have no control over these factors but our management hedging committee actively monitors the position to take by implementing the limited hedging opportunities available or by suitably adjusting purchasing patterns and product mix.

Regions in which we invest

We have a physical presence in 26 countries, primarily in southern, eastern and West Africa, with the bulk of our operations based in South Africa. Operating in such a diverse number of countries brings numerous challenges and risks including political stability, currency, taxation (including customs and import duties), different ways of conducting business and the ability to externalise earnings. Over many years we have learned a number of lessons on how to manage our business in these complex and varied environments and have a number of policies and processes in place to monitor and, where possible, mitigate and manage these risks.

Credit market risks

Our intra-year funding requirements peak around September/October each year at levels significantly higher than debt levels in place at the beginning of any financial year. The reason for this is that our Agriculture division has a long supply chain cycle as it has to import a significant portion of the raw materials used to produce fertilizer, run its plants at close to 100% capacity for the entire year to build up fertilizer inventory and import some finished product, all required to meet demand for fertilizer in the summer planting season. As these are essentially intra-year seasonal funding requirements, they are funded by short-term facilities. Any significant deterioration in credit markets at the same time as peak funding needs could pose a risk. This risk has been considerably reduced as a result of the R1 billion of equity raised in September 2010, which has considerably strengthened our balance sheet.

Financial review

Group revenue rose 6% to R9 368 million (2010: R8 827 million) on the back of volume increases in the Mining and Agriculture divisions and overall commodity price increases, partially offset by rand strength. No carbon credit revenue (CER) was generated this year (2010: R50 million) due to a delay in the certification of CERs that were generated.

Gross profit increased 41% to R1 965 million (2010: R1 389 million) and rose to 21% of revenue (2010: 15,7%) due to improved gross margins in the Mining division and the avoidance of a repeat of the previous year’s R350 million abnormal downward valuation of inventory in the Agriculture division. Adjusting the previous year’s gross profit for the R350 million abnormal downward valuation of inventory, this year’s gross profit margin of 21% is a credible improvement of 1,3% on last year’s pre-downward valuation of inventory adjustment gross profit margin of 19,7%.

Other operating income of R85 million (2010: R77 million) included an insurance claim receipt of R44 million (2010: R32 million), while other operating income of the previous year included a profit of R20 million on the transfer of businesses to our Nalco associate.

Administration overheads increased by 3% to R532 million. Included in administration expenses are share-based payment charges of R15 million (2010: R42 million) and higher provisions for incentive bonuses. Taking these into account, administration costs were well controlled. Distribution overheads increased by 15% to R790 million primarily due to higher volumes in the Mining and Agriculture divisions. Other operating expenses comprise mainly foreign exchange profits and losses on trading – a loss of R30 million (2010: R44 million profit) was incurred due to the continued strength of the rand.

Operating profit increased 146% to R687 million (2010: R279 million). After adjusting last year’s operating profit for the R350 million abnormal downward valuation of inventory, operating profit of R687 million increased 9,2% on a 6,1% rise in revenue. This was due to a substantial improvement in the operating margin of our Mining division as operating leverage kicked in, a small improvement in operating margin in our Agriculture division on the back of higher volumes and higher commodity prices, partially offset by a reduced operating margin in our Chemicals division due to a decline in gross profit while overheads were similar to the previous year. There was no contribution this year to operating profit from sale of CERs, whereas sale of CERs contributed a net R43 million last year.

Finance cost of R122 million comprises interest paid and foreign exchange gains or losses on conversion of foreign bank balances. Finance cost reduced from R217 million to R122 million due to a reduction in debt following receipt of the net proceeds of R971 million from the rights offer received on 14 September 2010, lower overall cost of debt due to lower interest rates, a reduction of R29 million in the loss on conversion of foreign bank balances, partially offset by higher average working capital requirements as a result of higher commodity prices and the very late agriculture summer sales season due to the unusually late start to summer rains in South Africa. Taxation increased to R151 million (2010: R51 million), incurring an effective tax rate of 25% (2010: 47%).

Total assets increased by 21,5% from R5 187 million to R6 304 million due to increased capex spend on the new nitric acid complex and higher levels of working capital.

Property, plant and equipment increased by R643 million to R1 938 million mainly as a result of R546 million spent on the new nitric acid complex. Included in property, plant and equipment is R621 million cumulative spend on the new complex, including capitalised interest of R25 million.

Inventory increased 13% from R1 315 million to R1 488 million due to higher unit costs on higher commodity prices in our Agriculture division and a degree of restocking in this division off the unusually low physical stockholding at the end of the previous year. Trade and other receivables increased 26% from R1 365 million to R1 722 million due to the very late agriculture summer sales season that resulted in a higher-than-normal level of Agriculture division trade debtors, late receipt of USD12 million receivable for the 2010 season (payment received after year-end) and an earlier-than-normal advance payment of USD22,5 million made to a supplier to secure supply for a tender.

Equity increased by 69% from R1 973 million to R3 338 million as a result of the net proceeds of R971 million from the rights offer received on 14 September 2010, retained current-year earnings of R448 million, partially offset by a R67 million reduction in foreign currency translation reserve due to the impact of the strong rand on our
US dollar-denominated equity.

The rights offer was implemented by way of a renounceable rights offer of 20 million new Omnia ordinary shares at R50. In terms of the offer, each shareholder was entitled to subscribe for 42,3282 offer shares at R50 per offer share for every 100 Omnia ordinary shares held. Subscriptions totalling R2 024 million were received in terms of the offer, resulting in an oversubscription of 102%. The equity was raised to part fund the construction of the new nitric acid complex. The total estimated cost of the complex (excluding finance costs) is some R1,4 billion, funded through a combination of the new equity raised, internally generated funds and, if required, project finance to be raised.

Cash flow utilised by operations was R109 million compared to cash generated from operations of R1 045 million in the previous year, primarily due to the cash flow attributable to working capital, partially offset by better cash generated through operating profits. In the previous year, working capital reduced by R805 million, mainly in inventory reduction, due to lower unit costs caused by lower commodity prices and the reduction in the physical inventory of the Agriculture division from the high levels carried over from the 2009 financial year to below-normal levels at the end of the 2010 financial year. This year, working capital rose by R755 million due to higher inventory and receivables and lower payables. Cash outflow from investing activities increased by R317 million to R783 million (2010: R466 million) due primarily to capex on the nitric acid complex. After taking into account the cash inflow from finance activities of R852 million (2010: R180 million) to which the rights offer contributed R971 million, there was a net cash outflow of R40 million (2010: R719 million inflow).

The year ended with a very strong balance sheet, net debt of R342 million (2010: R404 million) and a debt:equity ratio of 10% (2010: 20%). In looking at net debt of
R342 million, it should be noted that we have to date expended capex on the nitric acid complex of R621 million from the R971 million equity raised for that purpose. The balance of R350 million has been temporarily used to reduce short-term debt and will be utilised to fund capital expenditure on the nitric acid complex in 2012.

Chemicals

Revenue reduced by 3% to R3 596 million (2010: R3 714 million) as volumes were stagnant and there was a small decline in selling prices as international commodity price increases were insufficient to offset rand strength. Gross profit declined year on year, and with overheads being contained at the prior year’s level due to costreduction measures, operating profit declined 58% to R64 million (2010: R152 million). The operating margin decreased to an unacceptably low 1,8% (2010: 4,1%). Net working capital decreased marginally to R252 million (2010: R264 million).

Mining

Revenue increased 18% to R2 092 million (2010: R1 776 million) on the back of strong volume growth and a rise in commodity prices. The South African operation in particular demonstrated strong growth. Costs in the division were tightly managed so that operational leverage kicked in, resulting in a 47% increase in operating profit to R311 million (2010: R212 million) and the operating margin rising from 11,9% to 14,9%. Net working capital increased to R376 million (2010: R261 million).

Agriculture

Revenue increased 10% to R3 680 million (2010: R3 337 million) on the back of higher commodity prices and higher volumes. Operating profit was R312 million
(2010: R85 million loss). Adjusting last year’s operating loss for the abnormal R350 million downward valuation of inventory, this year’s operating profit of R312 million still reflects an 18% increase on last year’s adjusted operating profit of R265 million. This was achieved through the combination of higher commodity prices, higher volumes and strong overhead control, offset by some margin compression. Net working capital increased to R629 million (2010: –R11 million).

Prospects

The macro environment for next year appears more promising but it will be strongly influenced by the direction of the rand. Interest rates are expected to remain at current levels for most of next year while inflation is expected to start rising, which will affect our overheads. The increase in the fuel price is of particular concern, given our substantial expenditure on transport.

Our Chemicals division is expecting to improve its performance in the year ahead by a renewed focus on growing revenue through volume growth and the expected increase in manufacturing activity in South Africa. The division will also benefit from the overhead restructuring undertaken last year and which will continue next year. Our Mining division is expected to continue to benefit from buoyant global demand for mining commodities, with further volume growth anticipated across the division’s entire product range. Our Agriculture division anticipates favourable conditions as agriculture product price rises will probably lead to increased plantings which, combined with rising commodity prices and changed dynamics in the fertilizer supply landscape in southern Africa, bode well for next year. Our cash flow is likely to remain strong provided there is no sharp rise in commodity prices and/or a significant decline in the rand which would necessitate an increase in working capital funding.

NKH Fitz-Gibbon
Group finance director