From the Annual Report. Things look good. Make sure you have some tucked away.
REVIEW OF OPERATIONS Chairman's Report I t is with pleasure I present to you the 2003 Annual Report for Orbital Engine Corporation Limited. The past year has been significant in Orbital's history in that it has continued the program commenced in 2002, to address the company's operating costs and reduce them to a level that provides stability and neutralises excessive cash uses. The changes have resulted in substantial restructure of costs across all facets of the company which, for the first time ever, should enable Orbital to achieve financial stability that is supported by continuing profit growth from increased sales and positive cash flow. The Board is mindful of the substantial erosion of shareholder value which has occurred, particularly during this restructure period. We do, however, have confidence that development of several complementary revenue streams, including effective use of our installed R&D facilities to generate engineering services, will provide the profit and cash flow from which we can continue to promote the company's proprietary engine technologies. Orbital's technology has the potential to be more widely applied and with persistence we remain positive that it will be taken up by some of the major automotive manufacturers, but in reality to achieve these objectives will take time, particularly to achieve the full commercialisation of the OCP direct fuel injection system. That is why getting profit and positive cash flow from our engineering services is a major step in enabling us to allow this technology to realise its potential. The changes made have started to work through the system in the second half of 2003. This resulted in Orbital reporting $1 million profit in the second half. We were heartened by the investor support to the capital raisings which took place either side of the financial year end. Making definitive forecasts in the current economic environment is difficult but I can advise shareholders that the outlook for Orbital is significantly brighter than it has been for a number of years. On a personal note, I feel privileged to be invited to join your Board as a successor to the retiring Chairman, Mr Ross Kelly. Ross Kelly has shown strong commitment to your Company throughout the period since his appointment to the Board in 1995. He has presided over many changes, including the positive outcomes that you see reflected in the last six months. We wish Ross well in his retirement. Your Board will continue to focus on initiatives which are aimed at building on the stable financial basis that has now been developed for Orbital. We will be developing strategies which enable our profit and cash flow to continue to improve so that we have the run time available to enable our technology to penetrate the mass 4-stroke markets. We fully understand our obligations to shareholders to restore shareholder value. We thank you for your continued support. CEO's Report Overview The 2003 financial year was a turning point for Orbital Engine Corporation. A refined corporate strategy announced in May 2002 delivered lower costs and further commercialisation of Orbital's engine technology to the point where the Company was able to announce a $1 million second half profit. For the full year, Orbital continued with its trend toward profitability and cash flow improvement - a major turnaround from the previous two financial years where the Company reported successive losses of $26.8 million and high cash burn. The second six months were particularly encouraging with an operating profit of $1 million and an improvement in cash flow compared to the first half. Emerging from the restructure is a Company with multiple income streams that are expected to provide Orbital with a stable revenue base for the longer term. Our fee-for-service engineering business has been a major contributor to the improvement and is starting to emerge as a leading-edge service provider in its own right. This has been a crucial change. Significant also has been the use of the engineering services as an adjunct to the marketing of our OCP technology. Frequently, major automobile manufacturers contract Orbital's engineering services to adapt their development or research engines to OCP, offering an unrivalled showcase for the technology. Interest in Orbital technology in automobiles continues to be high. However, the Company is considerably less reliant on the adoption of OCP by the major automotive manufacturers for its short-term cashflow and financial well-being, than in the past. The restructure of Synerject announced during the year was also a major contributor to our improved results. Synerject's top line growth and improved profitability year on year has been significant. The restructure has also provided ongoing financing of Synerject until September 2006. Orbital's operating result is now derived from three clear segments - engineering services, technology income (licence fees and royalties) and the Company's share of its 50% ownership of Synerject - each of which is now a significant contributor to the consolidated financial result. Reorganisation A number of significant changes to the Company's organisation occurred during the year. At Board level, the Honourable Andrew Peacock resigned as a Non- Executive Director and Mr Ross Kelly, after many years of service as Chairman, retired. Both contributed substantially to the development and implementation of the Company's revised strategy. At a personal level I would like to acknowledge and thank Ross Kelly for his guidance, understanding and counsel as we effected the major changes necessary over the last eighteen months. Mr. Don Bourke joins the Board with a great depth of understanding of the needs of Orbital and I look forward to his period as Chairman. At executive level, a number of senior executive's roles have changed including Mr John Beech, Ms Deana Cesari and Mr Ramon Newmann whose roles have not continued in the new structure and Mr Mark Norman who has taken the appointment as President of Synerject. All had been long standing employees and I would like to thank them for the valuable contribution they each made to the Company. The changes that have been required at Orbital during the past eighteen months have been significant and have had a major personal impact on all staff and their families, whether directly through retrenchment, international or interstate transfer, reassignment or indirectly through ORBITAL ENGINE CORPORATION LIMITED AND ITS CONTROLLED ENTITIES DIRECTORS' REPORT FOR THE YEAR ENDED 30 JUNE 2003 6 general uncertainty. Throughout, all staff have maintained a commitment and professionalism to their work, sometimes under very difficult circumstances that I would like to acknowledge. FY03 HIGHLIGHTS Engineering Services Orbital has continued throughout FY03 with its strategy of building competent out-sourcing services in powertrain engineering for Original Equipment Manufacturers (OEMs) in all market segments, Tier 1 suppliers and others with an interest in combustion engineering, including regulators. This class of business is well developed in the US and Europe and has enjoyed considerable growth over the last few years. Historically an area of high cost for Orbital, it has operated at break even this fiscal year and seen growth in its revenue. During the year, Orbital won a number of major contracts including two within OEMs' advanced engineering programs. These involve Orbital working on a full payment basis with the OEMs on the application of OCP technology to their product(s). Such contracts are financially valuable to Orbital in their own right, but also provide the Company with an unrivalled showcase for the OCP technologies. Other major programs during the year included the very visible activities for the Australian Federal Government's Environment Australia on 20% ethanol/petrol blends and its impact on the Australian car fleet and emissions. Our strategy has also focused on improving our sales and marketing efforts in securing this class of work as well as the broadening of our product offering, as demonstrated by the ethanol project. Further OEM engineering contracts continue to be under discussion, some with possibly extended revenue streams. Penetrating the Indian market In February, Orbital signed a Technical Co-operation Agreement with Indian-based UCAL Fuel Systems, under which UCAL has the right to manufacture and supply components of the OCP system to the 2-stroke motorcycle market in India. Given the size of the Indian market - twice that of Europe with 4.2 million units manufactured each year - the UCAL agreement is very significant. While the Indian market remains protected, domestic manufacturers are facing a looming deadline for reducing emissions. New stringent emission standards come into force in 2005, with a further tightening of the rules in 2007/08. The UCAL agreement has the potential to open up a significant market and establish an Asian manufacturing cost base, for all markets. Synerject Synerject is Orbital's 50:50 US-based joint venture with Siemens-VDO Automotive Corporation. Synerject is a manufacturer of air assisted direct injectors, fuel rail assemblies and related componentry as well as a systems integrator and components supplier to the non- automotive market. Synerject also supplies prototype air assisted direct fuel injectors for automotive and other 4-stroke applications. The restructure and refinancing of Synerject during the 2003 financial year was important for the ongoing success of Orbital. Changes in the way Synerject is structured and managed have led the company to record a maiden profit, with sales and earnings growth forecast for FY04. The 2003 profit contribution of $1.4 million (on sales up 52% at US$39 million) compared with a loss of $3.1 million in FY02. In January, Orbital announced that agreement had been reached to put new financing arrangements in place for Synerject until 30 September 2006. Synerject was cashflow positive during the financial year and met all terms and conditions of the new financial arrangements. As part of the restructure, Synerject acquired the operations of Orbital's marine and recreation systems business (with substantial cost savings to Orbital) and Siemens-VDO's non-automotive systems business with effect from 1 April 2003. All systems sales previously reported in Orbital will now be reported within Synerject, so that in 2004 Orbital's system sales will be zero. Despite this loss of turnover, we expect minimal impact at EBIT level as we have been able to achieve cost reductions that will compensate, notably through the closure of our operations at Newport News in the US. At the same time, Orbital will share in the gains created by Synerject from the two businesses. With the restructure now bedded down, the outlook for Synerject through 2004 and beyond is favourable. Capital Raisings In June, Orbital moved to augment its capital reserves with an underwritten $6 million capital raising. The raising was split between a $2.8 million placement in June 2003 and a Share Purchase Plan ("SPP") that concluded in July 2003, which raised a further net $3.2 million. The issues were successfully completed, with solid demand from both institutional and retail investors. Orbital was gratified with the investor support it received for its strategy of strengthening the balance sheet through the raising of fresh capital to allow the Company the financial stability it needed to secure extended programs of work. New Products and Awards There are now more than 30 product models incorporating OCP in the market from five OEMs. Four new models were introduced or are planned for introduction during the 2003 calendar year in the marine and motorcycle markets. Most significant for Orbital was the move by marine engine manufacturer Mercury to produce 3 cylinder Optimax ™ engines alongside their high capacity, 6 cylinder models. The 115hp, 1.5 litre Optimax ™ 3- cylinder engine was the first of three new Mercury models planned to be introduced this year. Peugeot also introduced a new model motorscooter using OCP in April 2003. It follows into the market four new scooter models using OCP direct injection released by Peugeot and Piaggio last financial year. Your company's contribution to "Environmental Sustainability through Product Design" was recognised by the receipt of the prestigious Banksia Award during the year. The Banksia Awards are actively supported by the Prime Minister and the Minister for the Environment and Heritage and cumulatively add weight to possible legislative changes that could favour the adoption of OCP. Outlook The changes introduced during FY03 have streamlined the organisation and improved accountability. These changes have produced a leaner, more value oriented organisation. Most importantly, Orbital has now diversified its risk and opportunities through the development of the multiple revenue streams. Each revenue segment has its own distinct growth path and commercial opportunities, easily identifiable and better understood by the market. Forecasts are difficult to make in the current environment. However, the restructure and re-focus of Orbital provides improved certainty of revenue streams and likelihood of commercial success. In the 2004 financial year, Orbital is seeking to consolidate its lower cost operational base and achieve income in line with budget and ahead of FY03 in each of its three areas of business activity. ORBITAL ENGINE CORPORATION LIMITED AND ITS CONTROLLED ENTITIES DIRECTORS' REPORT FOR THE YEAR ENDED 30 JUNE 2003 7 Commercial Review Engineering Services While continuing to develop its OCP technology for motorcycle, marine and recreation, and automotive applications, Orbital has sought to increase its revenue by widening the scope of its engineering services and testing. Orbital provides engineering solutions for all types of powertrains at its development centre in Western Australia. Customers in all fields of engineering are offered cost effective solutions utilising a wide range of skills and resources such as: • engine design and modelling (2D and 3D) • numerical analysis • computational fluid dynamics • combustion and fuel system development • calibration and control strategy development • rapid turn around prototyping • engine management systems development The Company utilises fully equipped engine emissions and performance dynamometers, engine durability cells, engine and vehicle environmental cells, vehicle emissions chassis dynamometers and mileage accumulation dynamometers. Orbital's capabilities and expertise in these areas have been recognised in various programs that the Company has undertaken in the 2003 financial year, including the following examples. An extensive program was commissioned in late 2002 by the Australian Government agency, Environment Australia, to assess the impact of running a range of vehicles on petrol containing 20% ethanol. The purpose of the program was to determine the impact on motor vehicles of this level of ethanol in petrol through extensive on-bench and vehicle testing. The results of the work were taken into account by Government in establishing policy on the maximum ethanol content of petrol. On-engine and vehicle production and proofing programs were also carried out to validate customers' engines and vehicles over extensive durability test cycles using robotically controlled mileage accumulation dynamometers and automatic engine test facilities. Orbital was also engaged during the year to modify a production outboard engine to enable it to operate on JP5 fuel. Traditional problems with the use of such heavy fuels include poor cold starts and difficulties in engine calibration. As a result of offering a wider range of services, Orbital's customer base has expanded significantly over the past 12 months, particularly in the Australasian market. Marine & Recreation In the marine and recreation market, the 2-stroke engine is used in a number of outboard, personal watercraft (PWC), snowmobile and other applications where high power to weight ratio performance is desirable. Emissions legislation for outboards and PWCs enacted in the US in fiscal year 1997 calls for a progressive and linear reduction in emissions. Each succeeding model year requires a greater number of engines capable of improved emissions or implementation of technology capable of larger emissions reductions. The State of California has introduced an accelerated emissions requirement, which called for 75% emission reduction in 2001 and further reductions in 2004. Orbital's customers publicise that they are able to meet these requirements by incorporating OCP technology into their engines, while at the same time improving fuel economy, reducing the tendency to stall, reducing smoke levels, providing better stability and improving starting, when compared to conventional (carburetted) two-stroke marine engines. The State of California has also introduced tighter emissions requirements for 2008. These requirements have been achieved by the Mercury Marine 135hp OptiMax™ outboard. Two of Orbital's three production customers, Mercury Marine and Bombardier-Rotax, expanded their product ranges utilising Orbital technology in the 2003 financial year, despite challenging market conditions. Mercury originally set the standard for clean 2-stroke outboards when it began producing Orbital-equipped models in 1996. In 2001 Mercury was recognised by the Bluewater Network, an environmental lobby group that has worked to ban conventional 2-stroke marine engines in many areas, with the first ever "Excellence in Environmental Engineering Award". The citation praised Mercury for "taking the lead in the development of ultra-low emissions engines" and for its commitment to protecting the environment. Mercury has stated that it will cease production of all conventional 2-stroke outboard engines by 2006. Mercury now produces nine engines in the OptiMax™ line, ranging from 115hp through to 250hp, with the addition in 2003 of the OptimMax™ 3-cylinder engine models including the 115hp model and the scheduled release in the third quarter of calendar 2003 of 75hp and 90hp models. Mercury also supplies OptiMax™ engines to Bombardier for their sport boats and to Polaris for their recently released Jetboat. Bombardier introduced a fourth OCP-powered PWC in their 2003 model year with the release of the Sea-Doo XPDI™ watercraft. Orbital has benefitted from a full year of sales of Tohatsu's four TLDI™ 3-cylinder outboard models generating record direct injection production volumes under the Tohatsu and Nissan brand names. Motorcycle Orbital's business development efforts in the motorcycle area have been concentrated on growing OCP technology market share for European applications and pursuing new business in Asia. During the 2003 financial year Orbital continued to work proactively with its European customers and Synerject to assist with the launch of new customer models and to win new business. Activities included marketing OCP technology for use on higher engine capacity platforms and increasing the penetration on 50cc applications. Peugeot's "Jetforce" scooter was released for sale for the European 2003 summer market, bringing to seven the number of motorcycle models on the market incorporating Orbital's direct injection technology. Orbital continues to offer engineering services to both regional motorcycle manufacturers and Tier 1 component suppliers to assist them in establishing local component supply infrastructure for Orbital's technology in major Asian markets. Business development activities in Asia focused on India and Taiwan where forthcoming emissions standards will be implemented and where there is an interest in exploiting the benefits of 2-stroke engines and extending the life of existing investment in 2-stroke engine production lines. In February 2003, Orbital entered into a Technical Cooperation Agreement with UCAL Fuel Systems Ltd, a manufacturer of carburettors and fuel injection system components for the Indian motorcycle and automotive markets. Under the agreement, UCAL has been granted the right to manufacture and supply components of Orbital's OCP direct injection fuel system to the 2-stroke motorcycle market in India. The agreement with UCAL is an important initial step for the adoption of Orbital technology by domestic Asian motorcycle manufacturers. UCAL and Orbital are working with leading Indian manufacturers to progress the adoption of the technology. Throughout the year, the range of products offered to motorcycle customers was expanded to include OCP direct injection 4-stroke products developed by Orbital's Automotive group and high value Engine Management Systems engineering consultancy services. OCP direct injection for 4-stroke technology has the potential to deliver fuel economy improvements of approximately 10% to 15% over existing 4-stroke carburetted engines, depending on the application and the baseline engine, whilst complying with increasingly stringent emissions standards. Initial interest in this product has been strong, particularly for developing countries, with high gasoline prices and low average wages. ORBITAL ENGINE CORPORATION LIMITED AND ITS CONTROLLED ENTITIES DIRECTORS' REPORT FOR THE YEAR ENDED 30 JUNE 2003 8 Motorcycle (Continued) Pocket Dash™, Orbital's diagnostic unit designed and manufactured to support the motorcycle air assist direct injection products, achieved further sales to dealers in Europe, together with the provision of upgrade kits which further enhance the functionality of existing Pocket Dash units in the field. Potential interest in this low cost diagnostic system is now being received from India and other countries that may require the implementation of Engine Management Systems in the near future in order to comply with the forthcoming local emission requirements. Automotive The worldwide emphasis on reduced vehicle fuel consumption together with the increasing availability of low sulphur fuels continue to be major drivers to the automotive producers' desire to reap the full potential of direct gasoline fuel injection. First generation, high pressure systems, have failed to deliver significant on-road fuel economy benefits. Manufacturers are now investing in improved cylinder designs that locate the injector in the centre of the combustion chamber and which, when combined with low sulphur fuel, deliver much improved fuel economy. This desire to adopt the next generation of direct injection (DI) technologies has created a renewed interest by original equipment manufacturers in considering Orbital's low pressure air assisted DI technology for production applications. A recently completed extensive development and application program by Orbital for a European customer has confirmed that the Orbital direct injection technology when applied to optimised designs of 4-stroke engines continues to deliver benefits ahead of competing technologies. This customer program involved designing a new 2-valve, 4-cylinder variant of an existing production engine featuring the close integration of Orbital's direct fuel injection technology in the preferred configuration of a centralised injector. In addition to the design and analysis of the new cylinder head and ancillary systems, Orbital was responsible for all engine test and development activities including engine dynamometer development of emissions and full load performance, verification of operation and vehicle chassis dynamometer calibration of emissions, drivability and catalyst system development. The resulting demonstrator vehicle delivered a fuel economy improvement over the standard production vehicle of approximately 17% using the European drive cycle together with emissions below Euro 4 levels. Orbital continues to work with a number of automotive customers on programs which, if successful, could lead to future serial production.
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