Reference no: EM13489197

CatCon (Proprietary) Limited ('CatCon') manufactures ceramic catalytic converters for use in petrol- and diesel-powered passenger vehicles and light-duty commercial vehicles. Catalytic converters are able to destroy most harmful substances produced by vehicle engines, such as
carbon monoxide, unburnt hydrocarbons and nitrogen oxides, which are present in vehicle exhaust emissions.

Basically, catalytic converters consist of a ceramic structure coated with a metal catalyst which is attached to a vehicle's exhaust system. Metal catalysts generally consist of a combination of the platinum group metals (PGMs), namely platinum, palladium and rhodium.

CatCon is based in Port Elizabeth and sources the majority of the components required for the manufacture and assembly of catalytic converters from suppliers in close proximity to its operations. CatCon derives the vast majority of its revenue from exporting its converters to European-based automotive assemblers. Exports of catalytic converters are a significant revenue stream for South Africa, generating almost as much revenue as the export of passenger vehicles.

The South African government introduced the Motor Industry Development Programme (MIDP) in 1995 to stimulate the local manufacture and export of vehicles and automotive components.

The MIDP provided the springboard for the rapid expansion of the South African catalytic converter industry, as these components have a relatively high value. South Africa's rich platinum resources also assisted in developing the catalytic converter industry, for it provided an opportunity for local manufacturers to add value to this precious metal prior to it being exported. The local catalytic converter industry experienced significant growth in production volumes in the period from 2000 to the middle of 2008. The industry produced a record 17,3 million catalytic converters for export in the 2008 calendar year. However, the financial crisis which started in late 2008 had a significant adverse impact on passenger vehicle sales globally. Demand for catalytic converters decreased by approximately 40% in 2009. Although sales of new passenger vehicles recovered in 2010 and 2011, global volumes have still not equalled the peak levels reached in 2008.

CatCon spent R150 million in 2006 on the expansion of its manufacturing facilities to cater for an anticipated growth in demand. The company raised a foreign loan of US $60 million in 2006 to fund not only this capital expenditure but also expected future working capital requirements.

The foreign loan, which bears interest at a fixed rate of 7% per annum, is repayable in equal annual instalments, payable in arrears. The first instalment was paid on 1 July 2007 and the final instalment is due on 1 July 2013.

Manufacturing operations

CatCon manufactured 4,5 million catalytic converters in the financial year ended 30 June 2011. The production capacity is eight million units per annum, and hence the company is currently operating well below capacity. In the financial year ended 30 June 2008, CatCon manufactured 5,5 million catalytic converters and the decision to expand operations during 2006 appeared to be sound.

Despite the significant reduction in production and sales of catalytic converters in the 2009 financial year, CatCon was able to report earnings before interest and taxation (EBIT) of R555 million. Profitability has been declining since 2009 and management is concerned about this trend. There have been many challenges for CatCon management over the past three years including the following:


· Production was increased in 2010 to meet resurging demand. Inventory levels were low at the time and management was stretched to ensure that production and inventory levels rapidly increased to meet the higher demand;

· Platinum prices have been very volatile over the period from January 2008 to June 2011. In May 2008 the price of platinum was US $2 060 an ounce. This declined to approximately US $850 in December 2008 following fears that demand for this precious metal would decline as a result of the state of the global economy. Platinum prices slowly recovered during 2009 and 2010, and by June 2011 the prevailing platinum price was US $1 830 an ounce;

· PGMs used by CatCon in the manufacture of catalytic converters represent between 60% and 70% of total manufacturing costs; and

· CatCon retrenched 20% of its manufacturing work force in early 2009 in response to the declining demand for catalytic converters. Employee morale suffered following the retrenchments and relations between workers and management remain strained.

Revenues

Global passenger vehicle sales declined in 2009 following the economic crisis in late 2008. Lower demand was driven by limited access to vehicle finance and nervousness regarding economic conditions by consumers.

CatCon's sales volumes declined from a high of 5,2 million units in the 2008 financial year to 3,6 million units in 2009. Unit sales in the 2010 financial year were 3,9 million and 4,4 million in the 2011 financial year. Ongoing challenges facing CatCon include -

· pricing pressure from European customers who are reluctant to accept price increases in line with the increasing input costs (mainly PGM costs); and

· the strength of the rand against the US dollar. The prices of exported catalytic converters are quoted in US dollar and a strengthening rand has an adverse impact on CatCon's revenues.

Financial performance

Extracts from CatCon's recent annual financial statements and further details are set out below:
CATCON (PROPRIETARY) LIMITED
EXTRACTS FROM STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED 30 JUNE
Notes 2011 2010
R million R million
Revenue 1 5 852 5 039
Cost of sales 2 (5 389) (4 354)
Gross profit 463 685
Operating costs (350) (345)
Profit from operating activities 3 113 340
Finance costs 4 (39) (31)
Profit before taxation 74 309
Taxation (21) (89)
Profit attributable to shareholders 53 220

Notes
1 The average selling price per catalytic converter was US $170 in 2010 and US $190 in 2011. The average R : US $ exchange rate during 2011 was 7,00 : 1,00 (2010: 7,60 : 1,00).

2 Cost of sales comprised the following:
2011 2010
R million R million
Opening inventories (raw materials, work in progress and
finished goods)
839
406
PGM costs 3 812 3 288
Other manufacturing costs 1 726 1 479
Depreciation of manufacturing plant and equipment 25 20
Closing inventories (raw materials, work in progress and
finished goods)
(1 013)
(839)
Cost of sales 5 389 4 354

PGM costs are priced in US dollar. All other manufacturing costs are priced in rand. I nventories of finished goods and units manufactured:
2011 2010
Units Units
Opening inventories 700 000 400 000
Units manufactured 4 500 000 4 200 000
Units sold (4 400 000) (3 900 000)
Closing inventories 800 000 700 000
CatCon used a consistent quantity and mix of PGMs per unit in the manufacture of
catalytic converters in the 2010 and 2011 financial years.
CatCon uses the first-in-first-out (FIFO) basis to record inventories in its enterprise
management system and accounting records.
The R : US $ exchange rate at 30 June 2011 was 6,80 : 1,00 (2010: 7,65 : 1,00).
3 Profits from operating activities were arrived at after (crediting)/charging the following:
2011 2010
R million R million
Movement in provisions 5 10
Total depreciation (including manufacturing plant and equipment) 32 26
Foreign currency translation gain: Foreign loan (25) (13)

4 Finance charges comprise the following:
2011 2010
R million R million
Interest on foreign loan 14 20
Interest on bank overdraft 25 11
39 31
The bank overdraft bears interest at the prevailing prime overdraft interest rate (currently
9%).
CATCON (PROPRIETARY) LIMITED
EXTRACTS FROM STATEMENTS OF FINANCIAL POSITION
AS AT 30 JUNE
2011 2010
R million R million
Non-current assets 195 170
Property 15 15
Plant and equipment (manufacturing and non-manufacturing) 180 155
Current assets 1 895 1 667
Inventories 1 013 839
Trade receivables 882 828
Total assets 2 090 1 837
Issued ordinary share capital 100 100
Retained income 707 654
Equity attributable to shareholders 807 754
Non-current liabilities
Interest-bearing liabilities 52 123
Current liabilities 1 231 960
Trade payables 759 587
Provisions 45 40
Taxation 3 13
Current portion of interest-bearing liabilities 85 101
Bank overdraft 339 219
Total equity and liabilities 2 090 1 837

Raising of capital

AZN Bank has been CatCon's commercial bank since the latter's inception. On 31 July 2011 the account executive at AZN Bank responsible for the CatCon account, Ms Beezbubble, informed the directors of CatCon that the overdraft facility would be reduced to R50 million with effect from 31 December 2011. According to Ms Beezbubble, her credit committee was uncomfortable with various issues, including the following:

· The fact that AZN Bank financed the repayments of the foreign loan, as CatCon is not generating sufficient cash flows to service this themselves;
· The debt : equity ratio of CatCon is far too high in the current economic climate; and
· The declining gross profit margin of CatCon, which is placing the business at risk.

CatCon shareholders are currently the executive directors, who hold 74% of the shares in issue, and iBaai Holdings Limited (26%), a broad-based black economic empowerment group based in Johannesburg. CatCon presently has 100 million ordinary shares of no par value in issue.

Listed companies similar to CatCon are currently trading at historic price-earnings (PE) multiples of 12 and historic Enterprise Value to EBIT multiples of 8.

CatCon has been investigating two possible options to raise capital and has no other viable options for raising equity or debt at present.

Option 1

The Black Swan Trust ('BST'), a private equity fund based in Cape Town and incorporated as a business trust, has offered to subscribe for convertible preference shares in CatCon on the following terms and conditions:

· BST will subscribe for 90 million cumulative non-redeemable convertible preference shares to be issued by CatCon on 15 December 2011 for a total consideration of R315 million;
· The preference shares will have no par value;
· The preference shares will attract a dividend of 35 cents per share per annum;
· The preference shares will be convertible into ordinary shares at the election of the preference shareholder(s) at any time at a ratio of one ordinary share for every two preference shares held; and
· The preference shareholders will be entitled to sell their preference shares to any party without first having to offer these shares to CatCon or its ordinary shareholders.

Option 2
Wohlstand Investments ('Wohlstand'), a development finance company based in Germany, has offered to subscribe (through the issue of new shares) for a 40% shareholding in CatCon on or before 15 December 2011. Wohlstand has placed a value of R900 million on 100% of the equity of CatCon prior to its investment in the company. Wohlstand believes that the global catalytic converter market will return to pre-2008 levels and is bullish on the long-term global automotive market prospects.

REQUIRED

(a) Prepare a pro forma statement of cash flows for the financial year ended 30 June 2011 and state whether AZN Bank's contention that it is financing the repayment of the foreign loan is correct or not.

(b) Debate and conclude whether you believe CatCon's gearing levels were too high at 30 June 2011.

(c) Discuss possible reasons for the deterioration of CatCon's gross profit margin percentage during the financial year ended 30 June 2011.

You should perform detailed calculations to support your arguments including -

· an analysis of revenue and the components of cost of sales on a per unit basis for the 2010 and 2011 financial years; and

· an analysis of the components of cost of sales as a percentage of revenue on a per unit basis for the 2010 and 2011 financial years.
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(d) Identify and describe eight key risks facing CatCon. 16

(e) Analyse, discuss and conclude on the reasonability of the valuation placed on CatCon by Wohlstand.

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(f) Prepare a report to the Board of Directors of CatCon in which you recommend, with reasons, which of the capital-raising alternatives the company should pursue. Your report should include -

· an analysis of the debt : equity ratios of CatCon before and after the capital raising;

· the implied equity values placed on the company in each option; and

· key factors relevant to the decision as to which option to pursue.

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(g) Outline possible actions that CatCon could take to improve the company's financial performance and cash flow generation.
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Presentation marks: Arrangement and layout, clarity of explanation, logical argument and language usage.