Chief executive officer's report

As the first outsider to lead Imperial, my lack of familiarity with the past is both an asset and a liability. Fresh perspectives and conclusions must constantly be tempered by an appreciation of the factors, decisions and context that shaped the status quo.

INTRODUCTION

In succeeding two leaders who played definitive but very different roles in the evolution of Imperial, I am determined to preserve and to build on the extraordinary entrepreneurial legacy of Bill Lynch, and the value-creating capital management policies established by Hubert Brody. Both of these are essential to the progress of Imperial in an environment increasingly different to that in which either of them operated.

My leadership role is therefore additive – identifying and marshalling those additional capabilities necessary to enhance the performance, progress and reputation of an extraordinary corporation in a challenging environment. This is a privilege afforded few and I am enthused by the prospect.

ENVIRONMENT

Without detracting from the progress of the last 20 years, it is an understatement to say that South African commerce and industry currently faces an unprecedented litany of external threats.

These include low and slowing economic growth; a volatile and steadily depreciating currency; high and rising unemployment; excessive consumer debt; violent social and labour unrest; an increasing regulatory burden; a scarcity of skills; high rates of crime and corruption; electricity shortages; and doubts around the government’s willingness or ability to institute growth stimulating reforms. With these impediments to the progress of business and the flow of direct foreign investment, it is unsurprising that consumer and business confidence is at 10- and 15-year lows and ratings agencies have downgraded our sovereign debt.

This was the environment in which 66% and 74% respectively of Imperial’s revenue and operating profit was generated during 2014.

The question at the heart of the most onerous choices facing South African business leaders over the next few years is whether our current experience is simply the nadir of a difficult cycle through which we must navigate carefully, or a structural socio-economic change that warrants a more fundamental review of our businesses.

The National Development Plan (NDP) represents the best chance of avoiding the latter. Imperial is committed firstly to aligning its strategies and plans in support of relevant NDP initiatives, and secondly to working directly with government and indirectly through business associations, in pursuit of the growth and development objectives of the NDP. Debates about whether or not growth will create jobs in the short term, cannot divert us from the primacy of growth as the foundation of long term progress for every citizen.

The non-South African operations of Imperial operate in varying environmental circumstances. In most sub-Saharan Africa countries improving gross domestic product, urbanisation and increasing consumption off a low base, are contributing to high predicted rates of growth relative to South Africa over the next five years. This potential is currently being dampened in Nigeria and Kenya by violent political activism and terrorism. Europe and the United Kingdom are recovering steadily, but at a lower rate than anticipated, while business-specific rather than environmental factors will for now determine the progress of our modest operations in South America, Australia and the United States.

GROUP FINANCIAL HIGHLIGHTS REVENUE GREW 12% TO R104 BILLION OPERATING PROFIT GREW 2% TO R6,2 BILLION CASH FLOW FROM OPERATIONS DECREASED 21% TO R5,7 BILLION

GROUP FINANCIAL HIGHLIGHTS

Despite a tightening of economic conditions in the second half, there were three laudable features of Imperial’s financial performance in 2014.

The first was revenue exceeding R100 billion for the first time, the second record operating profits, the third record revenue and operating profit from four of the group’s five divisions.

Detail and commentary on Imperial’s financial position and performance is contained in the Chief Financial Officer’s report on page 36.

DIVISIONAL HIGHLIGHTS

The Logistics Africa division delivered pleasing growth in revenue on the prior year, which was depressed by the industry-wide strike among transport union workers. Acquisitions contributed to revenue growth by 23% to
R22,1 billion and tight managerial controls further contributed to the 38% growth in operating profit to R1,3 billion.

The subdued 0,4% growth of the Logistics International division’s revenue to €1,4 billion was a reflection of the slow recovery and low volumes in the German markets we serve. Some operating leverage produced 5% operating profit growth to €69 million. Currency translations resulted in 24% and 27% growth in revenue and operating profit respectively to R19,2 billion and R1,0 billion.

As described in detail on page 74 of this report, the single most significant determinant of Imperial’s 2014 financial performance was the delayed impact on our Vehicle Import, Distribution and Dealerships division of the weakening Rand in 2013. As a South African importer, the 25 to 30% decrease in the value of the Rand against the relevant basket of currencies between January and December 2013 had a direct and dramatic impact on the cost of new vehicles ordered. However, existing inventories and forward cover on the currency delayed this impact on operating margins for approximately six to nine months. As new inventory flowed through to the point of sale, the required price increases sequentially depressed competitiveness, volumes, margins and profitability. These developments resulted in revenue growth of 6% to R27,1 billion and a 32% decline in operating profit to R1,5 billion.

This was not the case in the Vehicle Retail, Rental and Aftermarket Parts division, where the impact of the weaker currency on vehicle prices was offset to some extent by the export activities of most local original equipment manufacturers. Notwithstanding a decline in the South African new vehicle market and subdued growth in rentals, the
division produced a solid 7% growth in revenue to R34 billion, with operating profit growing 16% to R1,6 billion as a result of improved margins on sale of pre-owned vehicles, sound management and excellent retail dealership performance.

Due to the exit from certain non-performing classes of business, the Financial Services division revenue fell 2% to R4,1 billion, while operating profit grew 14% to R1,1 billion.

Further detail on the operating performance of Imperial’s divisions is contained in the segmental review on pages 162 to 163 and the divisional reports on pages 50 to 95.

STRATEGY

As the listed parent of various business units that compete in the marketplace for goods and services, Imperial Holdings must achieve two objectives. It must add value to its business units in excess of the tangible or intangible costs of doing so, and it must add value to shareholders by diversifying in a manner they could not.

The evolution of Imperial has proven this to be the case. The development of the group over decades has sought to enhance the scale, competitiveness and performance of existing businesses, while utilising established capabilities to found or acquire businesses in allied markets and lines of trade not easily accessed by the public markets.

The development of the Imperial group will always remain our primary strategic obligation as a parent: founding, acquiring, merging, integrating, driving the profitability, and disposing of, companies and assets to enhance and expand our leadership in mobility. Our expansion internationally will be dictated by our relative competitive advantage in a given market rather than a predisposition to specific geographies.

Imperial is not a conglomerate operating in disparate sectors or industries. The resources and capabilities that today enable Imperial subsidiaries to compete and mitigate risk can be traced back to the group’s genesis as a motor dealer. Although our embedded entrepreneurial ethos will cause us always to be vigilant and opportunistic in considering new developments, we intend to tighten our focus on three major lines of mobility: consumer and industrial logistics; vehicle import, distribution, dealerships, retail, rental and aftermarket parts; and vehicle-related financial services.

To this end we intend to sharpen executive attention and increase returns on capital and effort by: disposing of underperforming, sub-scale or strategically misaligned assets; improving productivity and reducing costs by eliminating complexity in organisation structures, reporting lines, legal structures, minorities, boards and accounting; and facilitating value-creating intra-group transactions and collaboration.

Imperial’s second strategic obligation as a parent will be to raise, allocate and control capital for sustainable value accretion. In this regard we aim to realise Imperial’s strategic and financial objectives by funding the group’s debt and equity requirements at competitive rates, allocating capital to those sectors and jurisdictions where maximum risk-adjusted returns are achieved and controlling working capital within planned limits.

With shareholder value creation ultimately determined by returns on capital, management throughout Imperial has become disciplined in pursuit of a targeted return on invested capital greater than the weighted average cost of capital. A general medium term return on invested capital in excess of the weighted average cost of capital plus 4% is used to measure the performance of existing businesses and to allocate capital for organic and acquisitive growth, with higher returns required in sectors and jurisdictions of higher risk.

Groups do not compete – only business units do. Imperial’s third strategic obligation as a parent is therefore to ensure the strategic clarity of its client-facing business units. This entails imposing disciplines and processes that will assist each client-facing business to define precisely how it intends to compete and win in its chosen market over the medium to long term.

Finally, Imperial’s fourth strategic obligation as a parent is to develop executive capability. While the human capital management of Imperial’s around 52 000 employees is dealt with on a decentralised basis, the impact of executive capability on the progress of the group demands a broader intra-divisional perspective. Imperial is therefore in the process of implementing practices and processes to identify, select, develop, compensate and retain executive leaders throughout Imperial, whose performance and potential positions them among the top quartile in their fields of expertise. This talent pool will be viewed as a group resource to be deployed wherever required in the interests of Imperial’s performance and sustainability.

The legitimacy of Imperial as a holding company and parent will be proven by its ability to create value through these four strategic initiatives over time, and more precisely by continuous verification that the value of any subsidiary would be less under different ownership or as an independent entity. Simply put, Imperial has no right to be invested in businesses or assets whose long term value is not enhanced by its ownership.

SOCIETAL RELEVANCE

As a supplier, employer, client, taxpayer and investment, Imperial ranks among South Africa’s larger companies, with a direct or indirect impact on tens of thousands of lives. We are mindful that the effects of our commercial activities on broader society are potentially significant and as fiduciaries we strive at all times to exercise due care in our dealings with stakeholders.

We do so in an era when the legitimacy of business is at an all-time low and the creation of shareholder value is a necessary but insufficient condition for sustainability. In a world of growing inequality, unfettered short term capitalism is a proven nonsense that will be regulated into extinction. We therefore subscribe to the view that corporate sustainability is founded on accountability for decisions that impact people, planet and profits in the long term, and we report on “Triple Bottom Line” issues separately in the 2014 Sustainable Development Report.

We know that the foundation of our performance and progress is the provision of competitively priced products and services of high quality, conducted within all laws and regulations, and to high ethical standards. But there are additional responsibilities attached to a corporation of Imperial’s size and reach. Among the most important of these is the demonstration of our societal relevance, not through redistribution as a charitable donor, but in the businesses we operate.

We are intrigued by the concept of shared value creation – creating concurrent economic and societal value by identifying viable new business activities that address societal needs: distributing essential foods to retailers and “last mile” traders throughout Africa; just in sequence logistics that reduce costs for the world’s leading motor manufacturers; maintaining temperature controlled warehousing of life saving pharmaceuticals; providing entry-level motor vehicle buyers with affordable solutions; and assuring or insuring them against unforeseen mishaps.

PROSPECTS

There is no reason to expect a material change in the market conditions facing Imperial’s businesses in the short term. The South African economy, heavily correlated with the activity of its major trading partners, will experience slow or no growth as low and middle income consumer markets buckle under unemployment and debt, and industrial markets experience lower demand exacerbated by protracted militant labour activity. The development of consumer markets in Africa will provide a higher growth rate off a low base with local political and socio-economic factors necessitating vigilance and country diversification. The United Kingdom will continue to experience a steady recovery, with that of Europe more tentative.

In this context Imperial’s progress and performance in the current year will rely on three factors: the competitive dynamics of the markets in which we operate; our relative competitive position in those markets; and the manner in which we deploy our resources, capabilities and capital. These factors differ for each of our divisions.

Logistics Africa

The demand for logistics solutions is growing throughout Africa. In South Africa, industrial and consumer companies are outsourcing various elements of their supply chain activities to focus on their core business. To the north the emergence of a middle class in many countries requires the distribution of branded consumer and pharmaceutical products to final marketers and small traders. Imperial’s infrastructure, network and expertise provides a strategic advantage and the development of integrated capabilities in transport, warehousing, demand-driven route to market fulfilment and consulting facilitates access to and relationships with clients across the entire supply chain. Over the last 18 months the competitiveness and cost efficiency of the division has been enhanced by a structural consolidation. Finally, this division has a demonstrable record of accretive acquisitive growth, 2014 acquisitions that will make a full-year contribution in 2015, and a promising pipeline of further acquisition opportunities.

We expect real growth of revenues from Logistics Africa with operating profit growing at a higher rate.

Logistics International

Inland shipping, terminal operations and contract logistics will experience growth in concert with the recovery of the European economy and German exports, both burdened currently by the Ukraine crisis. Our businesses operate in attractive niches where we hold leadership positions by virtue of the highly specialised technical expertise demanded by clients who are worldwide leaders in their industries. Our entry into South American inland shipping presents an opportunity to scale and expand our operations in that region. We will continue to follow our clients who are entering new markets and to seek meaningful acquisitions that will enhance our strategic defensibility and financial performance.

We expect real growth of revenues from Imperial International in Euros, with operating profit growing at a similar rate as a consequence of planned capital investment.

Vehicle Import, Distribution and Dealerships

We predict that 2015 new vehicle sales will decline slightly in response to higher new vehicle prices, inflation-induced lower disposable incomes, high consumer indebtedness, interest rate increases, a weak currency and the high base created by strong volume growth over the last four years. Substitution is expected to increase sales of pre-owned vehicles. In this context our Vehicle Import, Distribution and Dealerships division enjoys a defensible competitive position, founded on our exclusivity as an importer of various vehicle brands, deep involvement in the entire vehicle supply chain, ownership of most of the property in which we operate, and rising aftersales parts and service revenues resulting from a growing installed base of vehicles. Regrettably, as a direct importer this advantage and the division’s profitability are undermined by rapid weakening of the Rand.

Absent a further deterioration of the Rand above levels at year-end and including the full-year effect of acquisitions, we therefore anticipate good revenue growth for the Vehicle Import, Distribution and Dealerships division in 2015. However, a modest growth of operating profit for the year will result from two distinctly different halves. In the first half to December 2014 we expect a continued decline of margins and operating profits as the delayed effect of prior currency weakening flows through, with a recovery in the second half to June 2015 as this normalises off a low base.

Vehicle Retail, Rental and Aftermarket Parts

The economic fundamentals, other than the currency impact described for Vehicle Import, Distribution and Dealerships, pertain equally to this division where we expect unit passenger vehicle sales to decline, commercial vehicle units in South Africa and the United Kingdom to increase moderately, rental to remain competitive and pre-owned unit sales to increase. In this environment, scale, property ownership and established relationships with 14 leading original equipment manufacturers whose export initiatives ameliorate currency movements, positions our Vehicle Retail, Rental and Aftermarket Parts division to outperform on a relative basis in the long term. We expect the new motor vehicle, rental and leisure vehicle markets to be more competitive with pre-owned unit sales and margins improving. Aftermarket Parts will perform in response to an expansion of its product range and geographic footprint. We therefore expect low single-digit revenue and operating profit growth for the year.

Financial Services

The growth of new revenues from financial products and services will be dampened by the current economic climate, while those specifically associated with the motor trade will mirror the performance of the industry. By virtue of its partnerships with leading vehicle credit providers, access to the group’s distribution platform, a proven record of product and channel innovation and development, strong annuity revenue streams flowing from the installed base of business generated in the last few years, and capabilities in short term and life insurance, our Financial Services division is well equipped to compete in this environment. Growth of profitability is however highly dependent on claims, lapses and equity performance. If in line with 2014, we expect single-digit revenue and operating profit growth.

The near term outlook is daunting. We expect earnings in the first half of the 2015 financial year to decline on the prior period as the currency impact on the Vehicle Import, Distribution and Dealerships division flows through. In the absence of any softening of the Rand below year-end levels, this should right itself in the second half to produce earnings for the full year in line with 2014.

CONCLUSION

In many respects Imperial is entering a new era.

The economic, socio-political, regulatory, technological and competitive environment over the next decade will create new challenges and opportunities for Imperial. Concurrently, our size and market leadership in many markets will require a new approach to organic and acquisitive growth, while the dual imperatives of development beyond South Africa and our vehicle business will alter the capital and earnings characteristics of the group. Additional management will be required and the transition of a number of directors and senior executives will introduce new perspectives and alter Imperial’s leadership agenda and style. These factors will shape Imperial’s strategic obligations as a holding company and test its role as a parent.

Through these developments, we will ensure that the group’s major divisions are strategically and operationally focused, optimally structured with financial and human capital, and governed and led in a manner that imbues confidence in stakeholders.

MARK J LAMBERTI
CHIEF EXECUTIVE OFFICER