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OPERATIONAL REPORT

SPOORNET

• Turnover up 4% to R14,4 billion • Expansion of iron ore and coal lines commenced • 110 new locomotives purchased

“Spoornet focuses on the transportation of bulk coal, iron ore and general freight by rail.”   BUSINESS OVERVIEW Spoornet manages most of South Africa’s rail infrastructure. With a staff complement of more than 31 000 employees, Spoornet is positioned to become a profitable and sustainable freight railway business that contributes to lowering the cost of doing business in South Africa and to a more competitive economy. Spoornet’s freight operations are composed of a general freight business, a heavy haul export coal line and a heavy haul iron ore export line. Spoornet has a 22 000 km rail network, of which about 1 500 km is heavy haul lines. The network connects the ports and hinterland of South Africa and the rail networks of the sub-Saharan region.

Spoornet continues to operate long-distance passenger transport service Shosholoza Meyl and the luxury Blue Train. Strategic consultations are under way to reposition Shosholoza Meyl outside of Spoornet, while concessioning opportunities are being sought for the Blue Train. Divestment of these assets will enable Spoornet to focus on its freight operations and infrastructure.

STRATEGIC OBJECTIVES

Spoornet’s strategic objectives include:

• Enhancing Spoornet’s market leadership position as a safe, efficient and reputable provider of national freight transportation, and strengthening its stewardship of the rail system. Strategic imperatives in reaching this objective include:
  – Improving delivery efficiency and rail transportation reliability;
  – Providing sufficient and reliable capacity through accelerated backlog and scheduled maintenance; and
• Improving business profitability – now and in the future – through increased rail volumes and freight traffic, while reducing the associated costs. This will facilitate the broader structural transformation of the transport industry and ultimately reduce the cost of doing business in South Africa. Strategic imperatives in this regard include:
  – Divesting non-core businesses and focusing on Spoornet’s core business;
  – Ensuring systematic and targeted investment in rail infrastructure in the medium to long term to improve structural    efficiency;
  – Improving capacity and modernising equipment to accommodate anticipated growth in freight traffic; and
  – Achieving economies of scale and operational efficiencies by integrating Spoornet’s and Transwerk’s maintenance    facilities.

PERFORMANCE HIGHLIGHTS AND OPERATIONAL ACHIEVEMENTS

During the year, Spoornet’s newly appointed senior management team focused on the key challenges facing the organisation. The central challenge is that historic underinvestment in human capital and physical capacity (including maintenance) has resulted in a railway that does not meet acceptable safety and reliability standards, and which does not have appropriate processes and systems in place.

Operational achievements during the year included the following:

• Addressing the reliability and availability of rolling stock. All major maintenance programmes are being incorporated into Transwerk, which will be responsible for rolling stock availability and reliability in future;
• The Transnet Board approved an additional maintenance budget of R1,6 billion for the coming year to begin addressing the maintenance backlog for locomotives, wagons and rail infrastructure. This is in addition to the R5,7 billion capital programme for the coming year, which includes the capitalisation of major maintenance in terms of International Financial Reporting Standards;
• The Vulindlela coal line programme, has freed up dynamic capacity, resulting in the attainment of record daily volumes. However, a number of factors – including broken rails, problems with the supply of locomotives and wagon wheel sets and late summer rains that reduced mining output – had a negative impact on performance;
• The focus on the iron ore line raised daily volumes at the port of Saldanha to record levels. A total of 29,6 mt were moved compared to 28,2 mt in the previous year. A target of 32,7 mt has been set for next year;
• Spoornet has rationalised many of the cross-border arrangements (including concessioning) entered into over the past decade. These contractual obligations were difficult to administer and were often agreed on onerous commercial terms and at rates that anticipated a continued weakening of the rand;
• Spoornet awarded a contract for the purchase of 110 dual voltage electric locomotives. These are Spoornet’s first new locomotives in 16 years and will be used on the coal line;
• The new capital expenditure programme was initiated and R3,8 billion was expended on capital projects, which included expenditure now qualifying for capitalisation in terms of IFRS;
• Variations in energy costs, particularly the oil price, had a direct negative impact on Spoornet’s operational costs. The current year budget was based on an average oil price of $45/barrel, but the closing price for the year was $58/barrel. This resulted in the average price of diesel being R5,13/litre, compared to the projected price of R4,50/litre; and
• The remuneration base grew by 2% as a result of a historic wage agreement. There was no impact of back-pay on operating costs.

FINANCIAL OVERVIEW

	Year ended	Year ended
	31 March	31 March
	2006	2005	%
	R million	R million	change
Salient features
Turnover	14 384	13 768*	4
Operating profit	1 695	767*	121
Profit/(loss) before taxation	808	(96)*	942
Net asset value	9 194	9 276	(1)
Profitability measures
Operating margin	11,8%	5,6%*	111
Return on net assets	8,8%	(1,0%)*	980
Capital expenditure
Total	3 809	1 328	187
Employees
Number of employees	31 398	32 516	(3)
Turnover per employee	0,46	0,42	10

*	Excluding fair value adjustments arising from the reversal of embedded derivatives:
	–	Turnover amounting to R403 million
	–	Profit before tax amounting to R3 473 million

FINANCIAL PERFORMANCE

Spoornet achieved a turnover of R14 384 million, an increase of 4% compared to the previous financial year.

The operating profit of R1 695 million (before fair value adjustments) is significantly higher than the R767 million reported in the previous year. This increase resulted mainly from the capitalisation of R681 million to property, plant and equipment in 2006, which was previously expensed. In 2005 the capitalisation was limited to R26 million as a consequence of the annual impairment review. The improvement in operating profit, compared to the previous year, is mainly due to volume increases on the export lines and cost-containment initiatives (despite write-offs such as the cost of exiting the Zambian operations, amounting to R170 million).

Finance charges increased from R863 million in the previous year to R930 million in the current year. The previous year’s reported results included the reversal of the embedded derivative gain of R3 473 million resulting from the renegotiated iron ore transport contract. Adjusting for this, Spoornet’s net profit before taxation improved significantly from a loss of R96 million last year to a profit of R808 million this year.

The total freight transported of 182 mt was marginally higher than the previous year’s volumes. However, as the volume growth was achieved primarily on the export lines, as reflected in the table below, a deliberate strategy was followed to move productive rolling stock resources to the export lines.

The table below illustrates total volume growth:

	Year ended	Year ended
	31 March	31 March
	2006	2005
Export coal (mt)	68,7	66,9
Export iron ore (mt)	29,6	28,2
General freight (mt)	83,8	86,1
Total volumes (mt)	182,1	181,2

The frequency of derailments, coupled with other safety related incidents, as well as the poor reliability of the rolling stock and infrastructure, reduced capacity.

In the passenger segment, revenue resulting from Shosholoza Meyl was lower than the previous year’s due to continued competition from alternative transport modes. No revenue growth was achieved at Luxrail.

The return on net assets increased from -1% (excluding fair value gains) last year to 8,8% in the current year. Returns should further improve as progress is made in addressing the unreliability of rolling stock and infrastructure.

CAPITAL INVESTMENT

Capital spending for the year amounted to R3 809 million, compared to R1 328 million in the previous year. The following capital projects were initiated during the year and will continue into the following year:

• Fleet renewal and modernisation;
• Expansion of iron ore line capacity;
• Expansion of coal line capacity; and

This year saw a significant increase in capital allocated to address the necessary investments in rolling stock and infrastructure compared to the previous year. These investments will improve safety, availability and reliability of rolling stock and infrastructure and will create capacity for projected volume growth. Future capital projects will also focus on the infrastructural areas of the business and are reflected in the planned capital expenditure for next year.

The capital expenditure for the next year includes:

Projects	R million
Coal line: capital required to increase capacity and
to purchase 110 new dual voltage locomotives
and build 400 jumbo wagons	667
Wagon fleet renewal and modernisation programme	900
Upgrade of 200 additional Class 18E1 locomotives	330
Iron ore line: capacity expansion up to 41 mtpa,
upgrade of locomotives and incab signalling	899
Capitalisation of maintenance costs	2 682
Eskom Majuba power station medium term coal supply	150
Asset tracking system	111
Increase component floats for locomotives	458
Other projects with spending less than R50 million	1 056
Total	7 253

Spoornet has planned for the following major capital expenditure (greater than R50 million) over the next five years:

Projects	R million
Capitalised maintenance	8 124
Coal export line	7 956
Ore export line	2 743
General freight	10 827
Other projects	1 822
Total	31 472

OPERATIONAL PERFORMANCE

During the year Spoornet’s main operational thrust was to run a scheduled railway. Spoornet has successfully integrated all unscheduled trains into a national integrated train plan. However, improving on-time departure and arrival remains a challenge. This is being addressed through an increased focus on locomotive availability and reliability, and improved operational planning.

Spoornet prepared a five-year business plan that defines restructuring strategies. It incorporates plans for divesting non-core, non-freight businesses. A longer term strategy is also in place to facilitate volume growth. The process for the development of an integrated Rail Master Plan was also initiated during 2005 and is being finalised in conjunction with the South African Port Operations, the National Ports Authority and the Departments of Transport and Public Enterprises.

SAFETY, HEALTH AND ENVIRONMENT

Spoornet contracted advisory firm DuPont International to assess and assist in addressing safety fundamentals. This initiative continues to focus on the safety transformation of operating systems and management of, as well as, changing cultural mindsets and behaviours, with the goal of improved safety. These initiatives are expected to result in a major improvement in Spoornet’s safety performance in the next year.

In addition, Spoornet has developed strategies, systems and programmes to create integrated occupational safety, health and hygiene management practices, minimising risks and ensuring compliance. A safety, health and environmental legal register was compiled to monitor operational activities that may impact the safety and health of employees and the public, as well as the organisation’s assets and the natural environment.

The past year has seen a number of safety incidents, including derailments, resulting in operational disruptions. The cost of major incidents is estimated at R400 million to date, excluding the opportunity cost of lost revenue due to reduced capacity.

Spoornet has developed and implemented a policy that commits the business to sound environmental practices. The policy promotes the minimisation of environmental pollution and supports compliance with applicable environmental legislation, regulations and standards. No environmental prohibition notices or penalty threats were issued to Spoornet during the year.

An integrated environmental management system is used in the assessment of business projects. Environmental impact assessments (EIAs) are conducted for Spoornet projects that fall within the scope of activities covered by the Environment Conservation Act, 73 of 1989. Extensive studies were completed during the year relating to the iron ore line upgrade, the coal line upgrade and various EIAs for loop lengthening and facility upgrades.

  

HUMAN CAPITAL MANAGEMENT

Employee numbers declined by 3%, mainly as a result of natural attrition.

As at 31 March 2006, black employees constituted 69% of the Spoornet staff. The focus during the year was on leadership development, change management and the enhancement of workforce skills – all essential components of Spoornet’s turnaround strategy.

MANAGEMENT CHALLENGES

All major capital projects were on track during the year. The benefits of this should begin to reflect in the improved availability of capacity and increased reliability of rolling stock in coming years, as the backlog maintenance programme and the current capital expenditure programmes are executed.

These programmes will address the challenges that Spoornet faces in the coming year, including:

• Addressing the historical underinvestment in rail infrastructure and rolling stock maintenance;
• Improving the safety record;
• Restoring customer confidence in Spoornet’s service levels;
• Developing human resource capacity and restoring employee confidence, pride and productivity;
• Improving rolling stock and infrastructure reliability; and
• Achieving the industry-benchmarked key performance indicators (KPIs).

These challenges are also being addressed through the Vulindlela programme, which aims to yield significant improvements in all areas of performance over the next three years.

PROSPECTS

The operation of a scheduled railway remains a key objective for the coming year. This should be achieved through an integrated plan addressing efficiencies in rolling stock and infrastructure, scheduling, human capital requirements and other operational factors.

Maintenance optimisation through the integration of Spoornet’s and Transwerk’s maintenance facilities will remain a priority.

Transnet-wide initiatives affecting Spoornet include procurement optimisation, coordinated capital expenditure implementation planning and integrated infrastructure funding planning.

Spoornet is committed to the transformation of the South African transportation industry and the effective turnaround of the freight rail business.

During the year management focused mainly on stabilising the business and improving performance through improved operational efficiency, customer service and profitability. The new strategic direction will ensure that the business increases volume and market share. This, in turn, will enable Spoornet to strengthen its position as a key player in the country’s continued economic growth.