Why Dick Smith was called 'the greatest private equity heist of all time'

Photo: Getty/Harry Todd

The business that made entrepreneur and philanthropist Dick Smith a multi-millionaire in the early 80s looks like it could well vanish from the Australian retail scene and as Business Insider’s Greg McKenna details, a lot of people with now worthless shares they bought just two years ago in the company’s IPO for $2.20 are now wondering who to point fingers at for the downfall.

Investors started out in an optimistic mood after the company floated for $520 million in December 2013 – the shares rose to $2.40 the following month, but a little over three months ago, as the writing on the wall in red ink grew more copious, Forager Funds Management’s Matt Ryan let rip in a celebrated blog post calling the IPO “one of the great heists of all time, using all the tricks in the book, to turn Dick Smith from a $10m piece of mutton into a $520m lamb”.

While Anchorage Capital paid Woolworths $115.208 million for Dick Smith Electronics, Ryan argued that the 2014 accounts showed only $20 million in cash was initially paid by the holding company set up by Anchorage, there was already $12.6m in cash in the business, so the investment was less than $10 million.

Ryan says the rest of the cash came from the balance sheet, with $58m in inventory written off, alongside $55m from plant and equipment, and $8m in provisions.

Why? Here’s Ryan’s explanation:

The inventory writedown is the most important step in the short term. 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).

The Dick Smith business had a huge clearance sale in 2013, with the inventory costs shedding $200m to just $171m between November 2012 and June 30, 2013, which also boosted operating cash flow by $140m in the process and Ryan argues $117m of that was used to finish paying Woolworths.

“Note that the pro-forma profit was only $7m during this period,” he said.

“The big clearance sale in financial year 2013 leaves them 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.”

He goes on to explain how the company tweaked the balance sheet until the forecast price earnings ratio looked plump ahead of the float, before Anchorage offloaded the last of its shares in September 2014 when they were still above the $2.20 float price.

But by the end of 2014, inventory was back up to $254m and suppliers were funding the expansion, with payables growing by $95m.

The 2015 financial year was crunch time.

Here’s Ryan’s explanation about what happened next:

Operating cash flow was negative $4m, as inventory increases further and suppliers demand payment, decreasing accounts payable.

The business is 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.

Ryan’s post was made the day after Dick Smith announced a profit downgrade and the shares dropped to 0.77 cents.

To Forager’s credit, they were sounding the alarm bells about Dick Smith from the start, writing in September 2013, before the float that:

The oldest trick in the retail-turnaround book is to write your inventory down to zero one year, sell it for 50 cents in the dollar the next and report yourself some handsome profits (the amazing thing about Billabong was that they got part 1 right and still couldn’t manage a profit).

Presumptuous of us, yes – we haven’t even seen a balance sheet – but our bet is that this is exactly what has happened with Dick Smith.

So who’s to blame for the demise of a once popular brand?

Today, Forager just pointed the finger on Twitter:

You can read the original Forager Funds post on Dick Smith here.

* An earlier version of this story was originally published on January 6, 2016, when the stores were first placed in administration.

NOW READ: DICK SMITH: Now the blame game begins

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