If it sounds too good to be true, it probably is – How an Australian Public Company failed this week

The collapse into Administration and Receivership of Dick Smith Holdings Limited, and several associated entities on Tuesday 5th January, is a repeat of a story of failed retailers in Consumer Electronics around the world. We have heard it many times before. But as is the case in many corporate failures, the warning signs were there for anyone who cared to ask even basic questions, or read the public documents. They were there in the Prospectus. They were there in the Annual Report in August 2015. They were there in October and November, just a few weeks ago.

The November 2013 prospectus, underwritten by no lesser corporate luminaries than Goldman Sachs and Macquarie, detailed how the business, acquired from Woolworths for effectively $94M by Anchorage Capital Partners, was now worth $2.20 a share for a total market capitalisation of $520.3M.

Many are blaming Anchorage Capital. Private Equity makes its money by buying cheap, trimming hard, and selling at the top. In the case of Dick Smith, ‘Mission Accomplished.’ Yes not pretty, but having re-read the prospectus, nothing really misleading there. Just very carefully worded! The promoters (Anchorage Capital and directors of the DS Holdings Ltd entity) duly identified multiple risks of consumer preference changes, supply chain, currency and much more, as any prospectus is obligated to do. By the letter of the Corporations law, their texts are faultless. Society will decide if it was morally transparent. The most accurate and prescient risk identified was this, found in Section 6.2.4 on Page 79 of the 160-page document from November 2013.

“If Dick Smith misjudges customer preferences or fails to convert market trends into appealing product offerings on a timely basis, these may result in lower revenue and margins and could adversely impact Dick Smith’s future financial performance. In addition, any change in customer preferences may lead to increased obsolete inventory risk.”

So the promoters clearly understood the issues, specifically stating at the start of that section 6.2.4: “Dick Smith’s revenues are almost entirely generated from consumer electronics related products…” The shareholders who bought, if they had read this and understood its weighted importance, might have thought twice.

But once the business was away, trading as a Publicly-held business, Anchorage became just shareholders. Big ones, mind you. That understanding led, as it now appears, to a clear decision once the August 2014 Annual Report was out. Confidence in the continued value of their shareholdings after the float had clearly waned. Those risks had become clearer from actual operational results. Remember the company was floated after just a few weeks actual trading under the new structure. All the forecasts were pro-forma. There was no history of actual comparable results offered.

Anchorage took until just September 16th 2014, (9.5 months since launch, 30 days after that first ‘Annual’ Report,) to unload their remaining 47 million shares at $2.23 a share, just $0.3 cents above float price. A debate as to whether promoters should be forced to hold shares longer is a separate matter. So, despite Statutory EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation) of $43.9M, the effective negative cash flow had been around $16M in just 7.5 months. Payables in that first year had increased $119M, or over 80%, as the company started to rebuild stocks. But much of that was on new extended trading terms.

Whispers started around the local industry-supplier corridors. In meetings with Dick Smith in which I was either directly or indirectly involved, (and a minor supplier at best) significant increases were demanded in both discounts and payment terms. That on top of Woolworths major intensification of pressure the prior year. In my own company’s case most of this was rejected, and promised orders didn’t come as a result. However other suppliers acceded. This was gradually reflected in public documents showing extended payment and improved GP. The die was cast.

These improved trading terms, it now appears, were then used, to significantly fund Private label stock. – funded by the very suppliers’ money with which this Dick Smith private label stock would now compete. As is often the case, higher GP rates for retailers seem instantly attractive. But it’s the appeal of the product to the consumer that counts. And it didn’t. Or not enough.

In the Annual Report for Fiscal 2015 stock holdings were reported at $293M as of June 30th. COGS (Cost of Goods Sold) were $993M. So, stock turns were down to just 3.38 turns. That’s a terrible figure for any retail business. But in Consumer Electronics it’s death. The annual accounts suggested to anyone who runs a retail or wholesale CE business that stock was some $70M to $90M in trouble at June balance date. That assumes stock turns of a modest 4.25 turns a year would have been acceptable. For most retailers I know in this game, 6+ is their goal. And it wasn’t just timing. But the Directors took until November 30th 2015 before they took a stock write-down of 20%, or some $60M.

By then more Dick Smith Private Label stock was on its way. And it would most likely have been paid for before it was shipped from Asia. This further impacted cash flow. Those payments to local suppliers were now becoming due, or overdue. Because sales were not there, payments to local suppliers were not all paid on time. So supplies started getting held back. More whispers. The right stuff was not in store any more. It became the death spiral of retail. Sales were falling short of plan.

The cash drain of $60M use of funds from investment costs, tax payments and dividends of 65% of earnings, plus the catch-up of now having to pay for goods deferred earlier through one-time trading terms advantages, forced a rapid draw-down on bank facilities. That drawdown rate appears to have been $75M in the year to June 2015, and a further $50M in just six months, from the figures available in the public domain.

By Christmas two weeks ago, it was clear sales promises from management had not been achieved. A week later on New Year’s Eve Management’s focus on growth and private label had failed. At this point non-bank creditors might be as high as $250M, up from the $230M at balance Date in June. With the banks refusing to add to their unsecured exposure, it was time for some phone calls by directors to accounting firms. The rise and fall of Dick Smith Holdings was at hand. It was over.

The equity at June 30 was reported to be $160M. Combining the $60M stock write-down and the effect of slower sales on reduced profitability, even earnings had flipped from $46M positive for a year to some $70M+ negative for six months. After writing down stock by $60M in November and failing to move anything like enough of the $230M of existing June 30th stock, they simply ran out of bandwidth, even while making a trading profit. As the old saying goes you can go broke very easily making a profit if you have negative cash flow. And that’s what happened.

The broader issue of dressing up the balance sheet for the float will no doubt be subject to legal investigation by ASIC and possibly other bodies. So I won’t add to the conjecture. The rest of the media has had a field day already in a feeding frenzy of wise-after-the-event scribes.

But the facts are these. Woolworths had failed to make a trade sale after 15 months of trying during 2011 and 2012. The Dick Smith division was eventually sold to private equity, after over $420M of impairment in Woolworths 2011-2012 accounts for just $15M. A later performance payment of a further $79M or so made that $94M. It stretches credulity that a turnaround of such a claimed fundamental nature had enhanced its value by a factor of 5 in just 15 months.

You, the reader, would know that the CE category has been subject to price decline throughout all this time of about 15% a year. So if inventory had grown, as it appears, by more than half in the first 14 months as a public entity, then annual impairments or reserves should have been set aside and recorded of at least $15-18M annually since the float. Nowhere do any of the accounts show that. Over three years there was therefore most likely $45M of unrecorded degradation of value that the November “non-cash” impairment appears not to have covered. This was a miss by management, and by the Board.

The Directors, only some of who had retail experience, started catching up. They acted appropriately in October and again in November and in calling in Administrators. But they believed their Management for too long. And now, as Receivers try to work out the full list of creditors and real liabilities, let alone the worth of the inventory and lease exposures and the like, it would be hard to see the business having any continuing viability. Their costs of doing business are some 450 basis points higher than JB HiFi, the industry leader. The business has none of the diversity of Harvey Norman, or its resilience from over $2 Billion in Property holdings, as well as a solid if as some perceive, old-fashioned management. But Harvey Norman is a management that has weathered multiple storms as well as some of its own major inopportune investments and come out remaining strong viable and most important, relevant.

It would seem there are few potential buyers; Dick Smith and their hapless 3,300 employees will most likely be gone. Some hard-working suppliers may be taken down by this, or at least massively weakened. Dick Smith will be added to the list of Australian CE brands now departed: Palings, Brashs, Clive Peeters, Clive Anthony’s, Digital City, Megamart, Wow Sight & Sound, – to name but a few. The long-anticipated arrival of Amazon, which has disrupted the European and US retail CE businesses, has yet to occur. It will only get tougher.

A $420 Million impairment charge for Woolworths in 2012, a $515M loss of equity to current shareholders, and an estimated $380M profit for Anchorage Capital, is the wash-up. It’s not pretty, but it’s the reality. Manage cash and your offer to the public, and everything else will fall into place as a retailer. Dick Smith managed neither well: Anchorage did – brilliantly, much as one hates to admit it.

 

This article was prepared exclusively for PhotoCounter, Australia, based on publicly available data from Investor documents published by Dick Smith Holdings, Anchorage Capital and Woolworths Ltd.

 © Copyright John Swainston, 2016. All rights reserved.