How Dick Smith Got Itself Into One Big Fat Mess?
Inventory at the mass retailer is at an all-time high with the mass retailer resorting to massive discounting in an effort to generate cash flow.
This weekend Dick Smith is offering 20% off Toshiba notebooks, 40% off Swann Security products and 10% off Apple Macs.
Financial analysts claim the business is going to have to take on $71m in debt to fund a more sustainable amount of working capital.
Following last week’s shock announcement when directors revealed that 2016 net profits are now anticipated to be $5 million to $8 million lower than previous guidance of $45 million to $48 million.
The stock was down as much as 36% on Friday as institutional investors dumped $20M worth of stock.
According to Forager Funds Management Dick Smith is a lemon and shareholders have been “duped using all the tricks in the book, to turn Dick Smith from a $10m piece of mutton into a $520m lamb”.
They claim that Anchorage Capital. The private equity group who acquired Dick Smith from Woolworth has” pulled off one of the great heists of all time”.
This is what Forager claims happened.
Firstly, Anchorage set up a holding company called Dick Smith Sub-holdings that they used to acquire the Dick Smith business from Woolworths. They say they paid $115m, but the notes to the 2014 accounts show that only $20m in cash was initially paid by the holding company.
They also reveal that there was $12.6M already on hand at Dick Smith so their total outlay was only $10M.
So where did the rest of the cash come from?
An investigation of the Dick Smith balance sheet reveals that Anchorage Capital marked-down the assets of the business as much as possible as part of the acquisition.
This was easy enough to do due to the low purchase price that they paid for the business.
$58m was written-off from inventory, $55m from plant and equipment, and $8m in provisions were taken by the team being run by Nick Aboud the CEO of Dick Smith.
Forager Funds Management claim that the inventory write-down was the critical step taken initially.
Matt Ryan in a note to investors said “They are about to sell a huge chunk of inventory but they don’t want to do it at a loss, because these losses would show up in the financial statements and make it hard to float the business. The adjustments never touch the new Dick Smith’s profit and loss statement and, at the stroke of the pen, they have created (or avoided) $120m in future pre-tax profit (or avoided losses).
Now they can liquidate inventory without racking up losses. And boy did they liquidate”
They reveal that at 26 November 2012, Dick Smith had inventory that cost $371m but which had been written down to $312m. Yet by 30 June 2013, inventory has dropped to just $171m.
That points to a very big clearance sale.
If you read their prospectus it reveals that sales in the financial year 2013 were exaggerated.
The reduction in inventory has produced a monstrous $140m benefit to operating cash flow, basically from selling lots of inventory and then not restocking.
The cash flow statement shows that Anchorage then used the $117m operating cash flow of the business to fund the outstanding payments to Woolworths, rather than funding it from their own pockets.
Ryan concluded his note saying “And that, my friends, is a perfectly executed chapter 1: How to buy a business for $115m using only $10m of your own money”.
Then came the next stage, how to flog the business.
In December Anchorage Capital floated Dick Smith and this involved flogging a $115m business for $520m. The shares rose to $2.10, today those sale shares are only worth $0.695 with some senior Dick Smith executives now facing the real possibility that they will never see their investment money, again.
In an effort to make the business look good, the directors turn their attention to the profit and loss side of their business.
They need to make it look profitable and above all a Company that is in good shape to take on Harvey Norman and JB Hi Fi.
Forager Funds Management said that their big clearance sale in financial year 2013 left the business with almost no old stock to start the 2014 year. That’s a huge (unsustainable) benefit in a business like consumer electronics which has rapid product obsolescence they said.
They claim that a great deal of the discounted inventory was probably sold by 30 June 13 with benefits flowing through to the 2014 financial year.
This and the write down of plant and equipment reduced the annual depreciation charge by $15m.
“Throw in a few onerous lease provisions and the like, totalling roughly $10m, and you can fairly easily turn a $7m 2013 profit into a $40m forecast 2014 profit” FFM said.
“That allows Anchorage to confidently forecast a huge profit number and, on the back of this rosy forecast, the business is floated for a $520m market capitalisation, some 52 times the $10m they put in”.
Anchorage were able to sell the last of their shares in September 2014 at prices slightly higher than the $2.20 float price and walk away with a quiet half a billion.
2015 trading issues.
During the past two months several senior executives have quit the mass retailer including a General Manager, two senior merchandising executives and three senior buyers.
The problems the Company are now facing go back to what happened in late 2013 and throughout the 2014 trading year.
By the end of 2014, inventory had increased to $254m, with new shareholders footing the bill for repurchasing inventory. This should have resulted in poor operating cash flow, but most of this was funded by suppliers at year-end, with payables increasing by $95m.
At the same time Dick Smith management was asking suppliers to stump up millions in marketing dollars prior to goods going on sale. Some paid up while other rejected the overtures from Dick Smith buyers with some threatening Dick Smith that they would rather not trade with the mass retailers than have to pay out money.
The CEO of one CE vendor told ChannelNews back in June “Dick Smith were desperate to raise cash running into the end of their financial year which for them which finished on the 22nd of June 2015”.
By this stage operating cash flow was negative $4m, as inventory increases further and suppliers demand payment, decreasing accounts payable.
Forager Funds Management claim that the business is now required to take on $71m in debt to fund a more sustainable amount of working capital. As the benefit of prior accounting provisions taper-off, profit margins fall, and the company reports a toxic combination of falling same-store sales and shrinking gross margins in the recent trading update.
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