I have been following the saga of Dick Smith’s receivership with great interest, not because anything illegal happened (at least, not as far as I can tell), but for the illustration of corporate raiders at work.
There is a very interesting blog piece written by the people at Forager Funds Management in October of last year on exactly how Dick Smith was purchased by private equity for $115M with only either $10 or $20 million down, the balance paid by selling written down stock and not replacing it, thereby stripping cash from the company, generated future profit through more stock sales without replacement and plant writedowns (reducing depreciation expense), and floated Dick Smith just over a year later for $520 million in a state of low inventory that arguably caused it substantial cashflow problems as it tried to restock.
This is the article concerned. I strongly recommend that everyone reads it. A layperson should be able to follow it reasonably easily.
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.
So if Woolworths got paid $115m and Anchorage only forked out $10m, where did the rest of the cash come from?
The answer is the Dick Smith balance sheet, and this is always the first chapter in the private equity playbook: pull out the maximum amount of cash as quickly as you can.
In this case, first they had to mark-down the assets of the business as much as possible as part of the acquisition. This was easy enough to do with a low purchase price. You can see in the table below, that $58m was written-off from inventory, $55m from plant and equipment, and $8m in provisions were taken.
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).
Now they can liquidate inventory without racking up losses. And boy did they liquidate.
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.
A salient point to note is that investors in the Dick Smith IPO would not have had access to all the accounts on the blog at the time of purchase. They wouldn’t have seen the massive inventory and plant writedowns because these happened when the private equity purchaser took over Dick Smith. They would, however, have seen the inventory figure. Should they have known that this was way too low and there wasn’t enough cash to bring stock up without substantial debt? Too hard for the vast majority, I would think. There is also the possibility that it wasn’t too low…a low stock figure can mean an efficient and well-performing business.
That points to a very big clearance sale, and the prospectus confirms that sales in financial year 2013 were exaggerated by this. 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 (note that the pro-forma profit was only $7m during this period).
So, business paid for. The next task is to produce profit for the purposes of marketing a float to investors.
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.
Remember that marked down inventory? Most of it was probably sold by 30 June 13 but there would still be some benefit flowing through to the 2014 financial year.
Remember the plant and equipment writedowns? That reduces the annual depreciation charge by $15m. Throw in a few onerous lease provisions and the like, totaling roughly $10m, and you can fairly easily turn a $7m 2013 profit into a $40m forecast 2014 profit. 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. Private equity are renowned for pulling off deals, but if there’s a better one than this I haven’t heard about it.
They wouldn’t have made half a billion mind you, unless brokerage etc was all paid by the company, which it may have been. I would expect that Anchorage got less than half a billion. But even if it were “only” $400M that is still an astounding profit. In less than two years, on $10M down.
And the result for Dick Smith Investors?
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.
Come the end of 2015 financial year, however, it really comes home to roost. 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.
Let us not ignore the possibility that the board and management of Dick Smith post-float loaded up on millions of dollars inventory that people didn’t want to buy when they could get similar or better at JB Hi-fi or others. There is plenty of potential blame to go around. Also, the people at Achorage Capital brought in new systems to help modernise Dick Smith and make it more efficient. But the benefits of those systems are insignicant compared to the downstream effects from short term profit maximisation and the cash-stripping to pay for the acquisition of the business.
I really cannot over-emphasise the need for caution in all commercial dealings where people are either selling you something without full historical disclosure or having a vested interest in you buying something whether or not its a good deal. Personally, I won’t invest in any IPO offered by a Private Equity firm. It isn’t that there aren’t any sucessful private equity IPOs. There are. It’s just that they are too vulnerable to the type of strategy set out above.