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Risks keeping executives awake at night

10 June 2010


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Margin pressures are the most significant risk factor that companies will encounter over the next 12 months. This, together with political uncertainty, is keeping executives awake at night. This is according to the findings of the second CFO survey announced recently by Deloitte.

The Deloitte 2010 CFO survey covered the full industry, turnover and experience spectrum of 200 of South Africa’s top organisations nationally, including listed and unlisted entities in the private sector as well as major state-owned enterprises. This enabled the firm to examine the economic outlook of South Africa’s corporate landscape through the eyes of CFOs.

In 2009, CFOs were predominantly focused on internal issues and preoccupied with those risks which could be controlled by the organisation during the downturn. Key risks that kept executives awake in 2008, namely political concerns and electricity supply, hardly featured on the radar screens of CFOs in 2009. External risks, e.g. volatility in key variables and weak demand, were considered harder to manage and created greater anxiety because they were regarded as less controllable.

Looking back, 88% of CFOs considered that their risk management frameworks were effective in identifying and assessing the key risks facing their organisations. 92% believed they met their objectives in reducing or managing their risks within acceptable levels. Financial services, mining and construction showed the most positivity in this regard.

“The 2010 CFO Survey highlighted the following significant risks: margin issues, including the impact of electricity supply and pricing; market share, competitiveness and competition; financial health of suppliers and customers; and political factors,” comments Hugh Harrison, CFO Leader at Deloitte.

As far as the political, margin and electricity risks are concerned, it is clear that in many instances, these issues are inter-related, making detailed analysis complex. In the main, they focus on the twin key performance drivers of profitability through margins, and market share through competitiveness.

Margin pressures were singled out by CFOs as being the most significant risk factor over the next 12 months. Although this is uniformly attributable to input cost pressures across all industries, construction, retail and TMT also noted significant pressure on the pricing/revenue side, with limited flexibility to maintain historic margins due to industry-wide increases in competition.

Key inflationary cost concerns relate to: administered prices, especially electricity and transport; the lagged effects of wage settlements and recent union demands of several multiples of inflation; commodity price inputs, especially oil; and currency fluctuations and hedging costs.

“Although the electricity increases finally approved by NERSA fell below initial expectations, the cost and reliability of electricity supply remain the second largest risk factor to South African business performance,” continues Harrison.

CFOs agree that national electricity pricing policy presents a significant constraint to future economic growth; disadvantages the competitiveness of South African businesses; onerously increases the costs of doing business whilst detracting from the country’s ability to attract essential investment. The inescapable fact is that the South African economy remains energy dependent for both existing industrial projects and for the proposed mega capital projects, resulting in domestic and commercial consumers continuing to subsidise key strategic industry investments.

During the recession, reduced consumption masked the seriousness of the situation, with little agreement or progress made towards increasing generating capacity and encouraging independent power production. Leadership battles at Eskom, together with only partial success in securing the necessary funding, forced several energy intensive industrial concerns to take power generating capacity into their own hands, at potentially uneconomic cost.

Business remains unconvinced and critical of the rigour and transparency of government’s consideration of the longer term strategic consequences of its electricity pricing policy. Absa economist Jeff Gable has gone on record stating that there is an apparent contradiction between the pursuit of an industrial policy that has growth aspirations in sectors that are power heavy in a country that’s going to be electricity light.

In 2009, weak demand was one of the top three risks facing CFOs, coupled with the impact of destocking inventories, which totalled R37 billion in 2009. Although this has decreased in the current year, demand remains a concern. Restocking inventories has seen a swing of R40 billion, which has contributed meaningfully to certain organisations’ performance.

“Together with increasing competition, the ability to protect market share has become more of a priority to CFOs, but is constrained by margin flexibility and capacity,” says Harrison. “Similarly, with inventories normalising, this is unlikely to contribute further to growth, particularly without a recovery in employment and related consumer spending.”

Competitiveness was rated as the single largest industry concern facing South African firms that have ventured beyond our borders. For those with mainly domestic operations, however, this moved down to third place, highlighting the fact that they are relatively more shielded from the effects of competition and have other more pressing concerns to worry about. The effects of the financial crisis have served to lay bare this historic reliance on a ‘tamer’ domestic market. Several restraints to competition have been exposed during the recession, as well as during the recent increase in Competition Commission enquiries, including: significant pricing power enjoyed by many of the dominant players across industries; potentially insulated South African market dynamics because of the regulatory and exchange control regimes; and advantageous strategic cost structures.

Taken together, these have significantly and artificially bolstered the apparent competitiveness of domestically focused South African organisations, at stark odds with those who have pursued strategies of growing offshore markets. The impact of exchange control and rigid structures around domiciles, has caused CFOs to question the impact of a South African domicile on their organisation’s ability to compete in the global markets and the impact of this on their local share price.

In regard to the threat of competition, locally focused operations did not appear to be particularly concerned about the risks posed by foreign competition or new entrants. For domestic companies with a footprint outside South Africa, this was rated as a significant risk factor, specifically by the manufacturing and TMT industries. Product substitution was only seen as a concern for those industries facing market saturation and traditionally high margins such as TMT and financial services.

For those industries subject to regulation, the increasing costs of compliance and potential political uncertainties have further contributed to a negative impact on margins and competitiveness. Because of the legislative and political frameworks impacting regulation in South Africa, although this is a significant concern, it surprisingly does not feature prominently at the top of CFOs’ agendas.

According to Harrison, a significant further impact on margins and competitiveness arose from concerns regarding infrastructure decay and the need to find alternative solutions in the face of erratic and costly government delivery. This was of most concern to those South African companies with international ambitions and foreign companies operating in South Africa because of the impact on their ability to scale from their domestic base as well as the effect on the efficiency and costs of doing business.

Prior to the financial crisis, credit assessment for the majority of non-financial institution organisations relied on well established ‘know your client’ procedures and long-standing relationships, and therefore received relatively little management attention. With the impact of the crisis on the financial viability of both customers and suppliers, this has been elevated as a significant concern. Particularly in the manufacturing industry, organisations have become more conscious of the potential risks to margins of having to identify alternative, often foreign sources of procurement in the event of default by key suppliers.

Contacts

Hugh  Harrison
CFO Leader
Tel: +27 (0)11 806 6248
hharrison@deloitte.co.za
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