Chief Financial Officer's report

Management remains committed to driving volumes and market shares by driving further cost efficiencies, exploring synergistic opportunities to leverage its asset base and infrastructure, while growing its value-added product portfolio which is now the core business focus.

Shareholder value actively shaped our strategy behind revenue growth, operating efficiency and asset efficiency, but our growth strategy experienced a hurdle given the decline in headline earnings of 65.9% because of the recent drought the recent drought, cooler summer and economic headwinds that has become the new “normal”. Clover’s financial growth story may have stuttered recently, but prospects remain positive given the investment in key fundamentals to address the volume decline.

Clover’s board of directors and management believe the financial statements published in this integrated annual report present fairly, in all material respects, the financial position, financial performance and cash flows of Clover Industries Limited in accordance with International Financial Reporting Standards (IFRS), and without material misstatements. The significant accounting policies adopted in the preparation of the financial statements are appropriately described in the financial statements section of this integrated report. The board and senior management is confident that Clover’s internal control system is adequate for preparing accurate financial statements in accordance with IFRS and the requirements of the Companies Act of South Africa.

OVERVIEW

Although the “new normal” constrained economic environment undeniably impacted on the financial results for the year ended 30 June 2017, it was the loss of volumes as a result of higher input costs and a cooler summer that had the largest effect. Shareholders were advised during our interim results that Clover needed to contend with many complex challenges during the period. The prolonged drought and rand volatility resulted in above inflation input costs which were largely recovered through revenue price increases, but as consumer sentiment was subdued, and competitive pricing ever more aggressive, Clover’s volumes and market shares suffered. Clover’s price increases during April 2016 and a comparatively wetter and cooler summer negatively impacted sales volumes overall, except for the new yoghurt and custard categories.

The lower volumes increased our inventory levels marginally in the first six months of the year, and as the drought started to abate, it was time to protect our market shares. Clover began dealing in promotions during March 2017, and the regaining of market shares and increased volumes were evident up until the end of June 2017. Revenue from the sale of products increased 3,3% for the year as prices were relatively higher than the comparative period, but at the expense of volumes. While selling prices have improved since April 2016, prices remain stagnant or falling, and volumes also came under pressure limiting the overall revenue growth.

While certain of Clover’s brands did not trade in line with volume expectations, the results were further negatively impacted by a decrease in services rendered income. The liquidation of a recently signed principal, and the constrained economic environment contributed to the muted principal revenue. Clover’s growth intent to replace the Danone volumes through new partnerships, acquisitions and healthy sales of our new and existing products was stunted by the overall lower volumes, which needed to bring down unit costs. Declining principal revenue also means that Clover must look deeper to unlock additional cost savings whilst finding new revenue streams.

In addition, the drought had a major impact on the availability and increased cost of raw milk and fruit pulp. At the time of writing this report, the culling of herds due to the drought still negatively impacts the producers and there is a current challenge to supply the forecasted market with milk, however the milk flow during this spring and summer will determine market conditions for next winter.

Clover deliberately maintained its rejuvenated high-volume infrastructure as it was unclear if volumes would return, and fixed costs were therefore relatively stable compared to inflation, and in some instances were even lower and well maintained. Clover however invested significantly in its future through higher marketing costs, research and development costs. Many areas of the business were streamlined, which lead to non-recurring once-off restructuring costs of R 46,8 million for the year, considered to be essential investments for the future.

Following a thorough strategic review of the business environment, and Clover’s internal capacities, it was concluded that although the drought is largely over, save for the Eastern and Southern Cape, the muted environment will be extended for some time and structural changes in Clover's infrastructure have therefore been introduced to balance its supply and demand expectations in the short to medium-term.

ECONOMIC VIABILITY

Given the constrained economic environment, the burning question for Clover is how to grow sustainably whilst delivering a return to all stakeholders. In the immediate future Clover will be riding out South Africa’s limited growth economy and the after-effects of the southern African drought. We will use this time to recalibrate the supply chain to extract further cost saving efficiencies and examine our portfolio pricing to meet the demands of consumers and grow market shares, and restore growth.

We not only need to consider the unique South African operational complexities, but also the global supply chain pressures. We believe, like many other FMCG businesses, that a step change is necessary in every respect of the current business for not only survival, but to also build solid platforms for when the economy starts to turn. Already we are seeing lower inflation and interest rates, which could free up money in the hands of consumers.

The unbundling of DFSA is the first step to creating a product portfolio that is not exposed to dairy price fluctuations. Clover remains focussed on fully utilising the capacities and asset base that was invested into heavily during the last five years, by encouraging growth in the DFSA products, as Clover will remain a significant service provider to DFSA. Our aim is to continue to tighten integration throughout the value chain to extract efficiencies to remain economically viable.

The combination of stagnant or falling selling prices and rising input costs is forcing Clover to make difficult decisions to sustain short-term operations, while still aligning these decisions with long-term growth objectives. Raw milk, fruit pulp, labour and energy costs have all exceeded inflation. The annual “strike season” is characterised by ever-increasing demands of existing and new unions who may not have a full appreciation of the challenging operating environment that we face. Above the requirements of workers, there are rising demands by government for compliance and an increase in the tax base in the form of sugar taxes.

Clover’s continuing economic viability is measurable through financial results and market share growth in various segments. In our quest to grow our range of branded and value-added products, we frequently identify and assess potential mergers, acquisitions or joint venture opportunities with the view of unlocking possible supply chain synergies. Clover only considers opportunities that will sustainably enhance margin and shareholder returns.

COMPREHENSIVE INCOME

Headline earnings

Headline earnings decreased by 65,9% or R235,0 million to R121,6 million. This decrease in headline earnings is primarily because of:

headline operating profit, which decreased by 52,3% or R298,4 million
net finance costs, which increased by 18,0% or R20,3 million
headline tax expense, which decreased by 63,9% or R72,9 million. The effective tax rate base decreased by 3,9% to 20,6% that is explained in more detail under “Profit for the year” later in this report
share of profit from a joint venture, which increased by 29,6% or R4,2 million
non-controlling interests, which decreased by 51,4% or R0,5 million.

Headline earnings per share decreased by 66,2% (125 cents), or 0,3% less than headline earnings, because of script dividends issued during the year.

Profit attributable to shareholders of Clover Industries Limited declined by R192,6 million less than the decrease in headline earnings of R 235,0 million. This was mainly due to profits of a capital nature of R42,7 million after tax (which is excluded from headline earnings).

Revenue

Revenue improved by 2,4% or R 239,9 million to R10 058,6 million.

Sale of products increased by 3,3% to R9 401,8 million, despite overall volume decreases of 3,5 %. This was primarily due to selling price increases necessitated by the drought to recover farm gate raw milk and ingredients price increases, and muted consumer sentiment. The full implementation of a major retailer’s distribution centralisation resulted in additional charges against sales in the form of an increased DC allowance. Retailers have generally also been more aggressive with volume rebates and co-operative advertising campaign requirements.

Services rendered to principals contributed R641,5 million to revenue, which was 6,3% lower than the previous year. The decrease was primarily because of the subdued market conditions of our principals, as well as the liquidation of a recently signed principal. The loss of a major principal in prior periods remains a major disruptor to Clovers’ overall revenue growth strategy since listing. The void in services rendered fees has been mitigated by recent acquisitions and new products listings, and the creation of DFSA will see services rendered revenue increase substantially on the back of a volume growth strategy.

Cost of sales

Cost of sales increased by 4,4 % or R307,5 million. Higher selling prices necessitated by rising input costs, required more vigorous advertising campaigns which was further compounded with new product launches, and trade support increased by R3,9 million or 1,9%.

The cost of raw materials and ingredients increased by 6,0% or R217,8 million, while the volumes decreased by 3,5%. Average raw milk prices were 13,0% higher than the previous year, as producers in the primarily industry required protection to stimulate milk flow because of the drought. The milk flow did not change from the prior year and additional milk is only expected during this spring. Ingredients costs increased by 18,0% (taking the volume decrease into account), mainly due to the lack of availability because of the drought. The 14,8% price and mix variance (excluding volumes) is primarily attributed to the fruit pulp concentrate increases, as well as substantial increases in sugar and artificial sweeteners.

Packaging costs increased by 4,9%, primarily because HDPE bottle prices increased 5,2%, and PET bottle prices increased by 5,5 %. Fortunately, the price of cartons only increased 3,3%, and suppliers offered discounts which offset the weakening in exchange rates.

Milk collection costs decreased by 3,0% or R 9,6 million, given the general volume decrease because of the drought. Total fluids volumes decreased by 1,7%, because of fresh milk volumes decreasing by 8,4% while UHT volumes increased 4,6%.

Manufacturing costs rose by 3,7 % year on year. Considering the volume decrease, this increase was primarily because of wage increases, increased outsourced production, and energy cost increases. The year started with higher inventory levels given the lower sales volumes, but from March 2017 the selling prices eased and production volumes started to increase. Due to the predominantly fixed nature of manufacturing costs and the new factories absorbed into the supply chain, unit manufacturing costs increased 6,7%.

Primary distribution costs decreased 1,9% or R 8,6 million on the back of lower volumes.

Gross profit

Cost of sales increased 4,4% or R307,5 million, in contrast to the 2,4% or R239,9 million growth in revenue. As a result, gross profit percentage decreased from 28,4% to 27,1% and gross profit decreased by 2,4% or R67,7 million. The gross profit margin was assisted during the year with recipe changes to accommodate the sugar tax, but the full impact will only be realised in future.

Other operating income

Other operating income of R60,0 million mainly constitutes:

R33,4 million profit on the sale of property, plant and equipment (PPE) and scrap;
R9,3 million on the sale of Lactolab;
Sundry income of R5,8 million, largely from the canteen.

Selling and distribution costs

Selling and distribution costs increased by 7,5% or R145,0 million primarily due to the roll-out of the bottom of the pyramid campaign through “Masakhane”. Clover’s staff structure was optimised and new positions were limited, except for the Masakhane roll-out. Inflationary costs were contained by negotiating more keenly priced contracts, for vehicle and fleet costs, while electricity and fuel costs increases were realised. Clover managed to stabilise and contain costs through an efficiency drive, and secondary distribution costs therefore only grew with 3,0% or R37,5 million, well below inflation.

In total, Clover spent 25,0% or R60,6 million more on advertising, marketing, research and development costs compared to the prior year. Clover leveraged various synergies using an approach focusing on the previous investments in the mother brand, however new product launches and higher selling prices necessitated an increase in spend.

Administrative expenses

Clover reduced administrative expenses by 5,2 % or R15,7 million.

Vacant staff positions were not filled, and top management took a 0% salary increase which helped limit the annual increase in personnel expenditure to just 4,6%.

Head office managed to avoid inflationary increases to overheads and reduced its overall spend by 9,6% or R25,0 million through:

providing for profit share and other financial linked performance bonuses
not filling vacant positions, particularly at executive level
reducing training spend through higher Skills Development Levy (SDL) grants received in this period
a moratorium placed on legal and consulting fees

Restructuring expenses

Approximately R46,8 million was spent on retrenchment costs, which are classified as restructuring expenses. This was predominantly for consolidating the City Deep distribution centres into Clayville as well as other manufacturing and distribution efficiency drives that will bode well for the future.

Operating profit

Operating profit decreased by 44,3% to R314,5million. Headline operating profit decreased by 52,3% to R298,4 million when excluding capital profits. Normalised operating profit also decreased by 44,7% to R319,9 million.

Our operating margin decreased to 3,1% from 5,7%. The normalised operating margin decreased to 3,2% from 5,9%.

Profit for the year

Profit for the year ended 54,9% or R193,2 million lower at R158,7 million. This result was the outcome of a R250,0 million decrease in operating profit, a R20,3 million increase in net finance charges, a R72,9 million decrease in the income tax expense, and a R4,5 million increase in the share of profits from the Clover Fonterra Ingredients (CFI) joint venture.

The muted results, compounded by higher inventory levels required additional interest bearing debt to fund working capital and capital expenditure on tangible assets.

Clover’s effective tax rate was calculated at 20,6%, which is well below the 28% normal corporate tax rate. The effective tax rate was decreased primarily as a result of :

Non-taxable income -7,6 %
Non-deductible expenses 2,7%
Special deductions -1,0%
Botswana lower tax -1,7%
Foreign withholding tax -2,4%
Joint Venture Equity accounted -2,6%

Return on equity

Operating in a constrained economic environment with variable costs increasing ahead of inflation, resulted in Clover’s return on equity decreasing from 12,9% to 5,5%.

DIVIDENDS

The Company declared and paid an interim dividend of 24,21 cents per share during April 2017. No final dividend was declared by the board, which will bring the total dividend for the current financial year to 24,21 cents.

The board previously stated that it will during the medium term progressively reduce the dividend cover to lower levels. The total dividends for 2016/17 represent a dividend cover of 2,6 times compared to the 2015/16 dividend cover of 2,9 times. The board’s policy to as a minimum maintain dividends in the event that HEPS are less than the previous year, but given the unique circumstances in the economy, and the effective reduction in the dividend cover, no final dividend has been declared as additional working capital is required to restore growth

FINANCIAL POSITION

Non-current assets

Since listing in 2010, Clover has invested heavily in acquisitions and rejuvenating our factories and distribution assets for continual and sustainable growth. This level of investment was needed to maintain Clover’s outstanding reputation for quality products. New acquisitions or the internal development of brands and products must support the further build out of this premium status. Our brand reputation is underpinned by Clover’s chilled distribution network, which is universally regarded as South Africa’s finest. This invaluable asset also required a significant investment to maintain its hard-earned reputation.

Additions and maintenance to assets need to be funded, while also maintaining an optimal debt to equity ratio.

Clover invested capital of R316,9 million into tangible assets. This amounted to a R322,6 million increase in property, plant, equipment and intangibles for the financial year, which excludes the effect of depreciation, disposals and scrapping.

Major capital projects during the year were:

	R’m
Clayville – Various projects (including visitor centre and distribution cold room expansion)	40,7
Estcourt – Aspen IMF contract	23,7
Lichtenburg – General capital expenditure	14,7
Clover Waters – Move from Inhle to Doornkloof	22,5
RBC – Yoghurt capacity expansion	69,2
Queensburgh – Merging of lines	24,9
Port Elizabeth – General capex and UHT optimisationß	17,9
All Production branches – Backup power	17,5

Current assets

Clover stated in our interim results that selling prices were significantly higher to combat the effects of a prolonged drought primarily in the Highveld, Kwazulu-Natal, and the Western and Eastern Cape. The drought in the Highveld and Kwazulu-Natal was subdued with great summer rainfall, while the sub-optimal conditions in the Western and Eastern Cape prevailed. The countries milk flow was relatively stable when compared to the prior year, but the cooler and wetter summer in December 2016, and the higher selling prices, resulted in volumes decreasing, particularly in the beverage segment. This resulted in Inventory levels increasing by 5,2% or R47,7 million in comparison to the previous corresponding reporting period.

Trade and other receivables were relatively stable and only marginally increased because of the overall increase in revenue of 2,4%.

Trade receivable days outstanding and bad debts remained at minimal levels when compared to the combined sales of Clover and those principals for which we provide credit management. (Analysts should note that trade receivable days outstanding cannot be deduced from the financial statements as the full receivables of certain distribution principals are included in trade receivables while the revenue of such principals is not included in the Statement of Comprehensive Income. Only fees earned from providing the services involved are included in revenue).

Equity

The share premium account increased by R 9,9 million over the prior financial year due to the issue of new ordinary shares to settle the elected script dividends from retained earnings.

Non-current liabilities

The lower operating profit, an increased investment in working capital, and capital expenditure was the primary contributor to a R207,5 million net increase in interest bearing debt (both current and non-current).

Apart from interest bearing debt, non-current liabilities were similar to the previous year, with the exception of the deferred tax liability that increased by R28,7 million. The increase is primarily driven by accelerated depreciation allowances claimed for tax purposes, employee related expenses that are only deductible when paid (which reversed in the current year) and deferred tax arising from the Clover Pride business combination

Current liabilities

Clover’s lower volumes, accounted for R88,6 million or 6,5% reduction in trade and other payables.

There was a reduction in other current financial liabilities of R19,5 million which is mainly as a result of the diesel hedges coming to an end.

Employee related obligations reduced by 41,4% or R6,9 million which is largely equal to the opposite movement of employee related obligations under non-current liabilities. Overall the obligation increased by 2,5%.

GEARING

Group gearing increased from 44,1% to 51,4 % at 30 June 2017. The increased gearing was primarily because of the lower profits and increased working capital requirements. Clover’s gearing is well within our ability to service interest and repayments, but we have limited capacity to fund new growth opportunities. We will focus our gearing to provide working capital for the anticipated restored growth, that will largely be self-funded.

CASH FLOW

Clover’s net current assets ratio decreased from 1,6 to 1,4. Excluding inventory, the position deteriorated from 1.1 to 1,0, given the lower operating profit performance.

Cash generated from operations, before working capital changes, totalled R439,2 million compared to R709,7 million reported in the prior year. Lower cash generation was primarily due to the lower profit recorded. In this year, working capital absorbed R162,2 million of cash compared to the R36,2 million of the prior year. Lower volumes because of the higher selling prices given the cooler and wetter summer, Clover spent R 67,8 million more on inventory in comparison to the previous corresponding period. Trade and other receivable slightly increased compared to last year given the marginal improvement in revenue.

Investment activities consumed R277,7 million in cash compared to R332,6 million in the previous year, following the sale of the Bellville and Stikland properties. Clover also spent R49,8 million less capital on tangible assets.

Under financing activities, R260,9 million was paid for finance costs and dividends, compared to R231,7 million in the previous year. Clover utilised R211,3 million of additional debt at the end of the year when compared to the previous year to fund working capital expenditure and capital expenditure on tangible assets.

Clover reported a net decrease in its cash position for the year of R58,7 million.

SEGMENTAL PERFORMANCE

Segmental information is only disclosed to Margin on Materials (MOM) level as Clover’s assets and operations are largely integrated between segments, which makes the allocation of overhead costs to the different segments impractical. Overheads are managed at Group level. With the introduction of DFSA, the group needed to implement controls to allocate these cost to an operating profit level. As this will be the first year of operation for DFSA, an agreement has been reached to pilot the allocation and provision was made in the contracts to effect necessary adjustments. Once the DFSA allocations and reports have been completely finalised and tested, it is anticipated that these allocations will be applied to the rest of the segments.

MOM refers to revenue, less raw material, ingredients and packaging costs. Clover’s entry into the yoghurt and custard under our own brands necessitated the establishment of a dedicated fermented products and desserts division to manage our yoghurt, custard, and maas. We also established a division for Olives and Soy products, and given the low volumes, this has been disclosed under the “other” segment.

Dairy fluids

The dairy fluids segment is still made up of fresh milk, UHT milk, steri milk, ultra-pasteurised milk and cream. In future, dairy fluids will only contain value added milk, as fresh, UHT, and ultra-pasteurised will be transferred to DFSA. Botswana and Milkyway will however remain in Clover under this segment.

Revenue for this segment was up 4,9%, but given the average farmgate milk price increase, MOM was down 2,6% to 38,0%.

Average selling price increases of 6,5% materialised, however dairy fluids volumes decreased by 1,7% for the period. Clover’s UHT volumes (including DOBs) increased by 4,6%, whilst fresh and ultra-pasteurised milk volumes decreased by 8,4%. Cream volumes decreased by 6,2% given the lack of growth in milk flow because of the drought.

The price and mix variance for raw materials incudes an average farmgate milk price increase of 13,0%. The cost of packaging materials increased 5,9% on average, and the price and mix variance for this segment on packaging and material increased 11,04% on average.

The milk collection costs increased by 6,3% net of the volume impact, and this primarily relates to increased labour and energy prices of 8,0%.

Concentrated products

The concentrated dairy products division consists of cheese, butter, and condensed milk.

Revenue in concentrated products remained relatively flat and was assisted with higher selling prices of 9,4%, but given the lower volumes of 12,9%, MOM was rather flat at 30,0%.

Given the global increased demand for butter, and the limited availability of cream, butter and spreads volumes were down 20,0%.

Natural pre-packed cheese volumes were down 25,0% as Clover exited the bulk cheese market, and some bulk products were still sold to other processors in the prior year.

Feta volumes were down 5,3% primarily because of higher pricing, and condensed milk volumes were up 3,5%.

The milk collection costs decreased based on volume decreases.

Ingredients

Although Clover does not at present participate actively in the international dairy ingredients market, we balance seasonal milk and cheese production by annually selling excess skimmed milk and whey powder into the local ingredients market.

Revenue for this segment was down 18,9% because of volume losses, but given the selling price increases, MOM increased 17,9% to 32,9%.

Average selling price increases of 14,0% materialised, however ingredients volumes decreased by 33,0% for the period.

The improvement in the cost of material and packaging is directly attributed to the volume decrease, and milk collection costs also improved as a result.

Non-alcoholic beverages

Non-alcoholic beverages consist of pure juices, dairy fruit mix (Tropika), nectar, ice-tea, water, flavoured milk, and the recently launched long life juices.

Revenue for this segment was flat as the prices made up for the volume losses.

Average selling price increases of 7,9% materialised, however the segment’s volumes also decreased by 7,9% for the period. Given the constrained consumer sentiment that was further compounded by the wetter and cooler summer, volumes for pure juice was down 4,8%, dairy fruit mix down 3,8%, nectar up 4,9%, ice-tea down 24,6%, water down 28,4%, and flavoured milk down 6,6%. Clover recently entered the long-life juice segment and gained 6,6% market share.

The price and mix variance for raw materials and packaging of 12,6% incudes an average sugar and fruit pulp price increase of 13,0%. The cost of packaging materials increased 5,9% on average, but other ingredients including artificial sweeteners experienced sharp increases.

The milk collection costs improved as volumes decreased.

Fermented products and desserts

This product Group houses the Group’s yoghurt, maas, and custard.

Given selling price and volume increases, revenue for this segment was up 16,9%, but given the raw milk and ingredient price increases, MOM was down 1,1% to 27,7%.

Average selling price increases of 9,0% materialised, and fermented products volumes increased by 8,0% for the period. Maas volumes increases 6,0%, yoghurt 5,3%, and custard 32,0%

The price and mix variance for raw materials and packaging of 10,0% incudes the average farmgate milk price increase of 13,0%, as well as the cost of packaging materials increase of 5,9% on average. The milk collection costs improved because of efficiency savings.

CONCLUSION

The environment for growth continues to be muted owing to lower than expected domestic GDP estimates and threats of further downgrades. Consumer confidence remains lacklustre with discretionary spend under pressure. The improved outlook for inflation and recent reduction in interest rates should provide some relief although the prospect of future interest rate cuts is uncertain.

While the after effects of the prolonged drought will be felt for some time, a gradual recovery in milk and fruit production volumes together with the strengthening of the rand to the dollar should result in a reduction in input cost inflation.

Despite the challenging economic and operating environment, management is optimistic about the company’s future as it looks through the cycle, and focuses on restoring profitability, and is confident that the actions taken to date should benefit the business in the longer term.

Management remains committed to driving volumes and market shares by driving further cost efficiencies, exploring synergistic opportunities to leverage its asset base and infrastructure while growing its value-added product portfolio which is now the core business focus.

Elton Bosch

Chief Financial Officer

11 September 2017

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