Following our earlier blog on the heist at Dick Smith, we received an email from Alan Kohler’s Eureka Report (subscription required) with some interesting commentary from an analyst who had actually spoken with the Dick Smith management team. Here’s the piece in full:
A subscriber sent me [Kohler] this link during the week, to an article about Dick Smith headed: “Dick Smith is the greatest private equity heist of all time”.
Given some of the private equity heists that have taken place, this is quite a big claim. The article is very detailed, and pretty devastating, so I asked our analyst, James Samson, to look at it and get the company’s response as well.
This is what he wrote:
“Essentially when asked what the points DSH would like to convey about this Forager piece, DSH suggested two main points:
“Firstly, the acquisition by Anchorage was three years ago, and the write downs that ensued are not able to materially impact trading three years later. Stock has turned over many times since then so any inventory impacts are lost in the wash.
“Secondly, the acquisition was made, and a gain on acquisition of $145m was made. If they (Anchorage) were trying to low ball the asset base to pump profitability, then they could have written things down significantly. This was not done, suggesting the absence of the intention to low ball any figures, and lift accounting profits.
“My view is that this is a fair counter argument. The end of the day, this was a few years ago. The current issues in my mind are more about competition and poor retailing (bad advertising strategy and stock mix). The market should be more concerned with this, than a scare campaign on the well-known function of PE firms dumping things on the market.
“So, they are both right, but it doesn’t matter – that is not what went wrong at DSH… it is an operating issue, not an accounting issue, and it will take a strong cash flow result and profits hitting the guidance range for the market to start to trust DSH again.”
The fact that we haven’t heard anything from Anchorage ourselves suggests we were mostly on the money. And nothing in the above addresses the crux of the argument that they turned $10m into $520m in less than two years, largely by raiding the balance sheet.
There is nothing wrong with doing yourself a good deal, of course, especially when the counterparty is a supposedly sophisticated corporate like Woolworths. But is it true that, having floated the business in 2013, it has been too long for Dick Smith’s current problems to be a result of the Anchroage ownership period?
Only partly. It’s true there’s not likely any remaining benefit from selling written down stock, but then we didn’t say there was. It is the expiration of some of this assistance, of course, that’s helping bring problems to light. And some of the benefit could easily have run into the start of the 2015 financial year. One of the big advantages of a massive clearance sale is that, having sold everything, you start with a clean slate and have no obsolescent stock. And the thing about obsolescent stock is that you don’t know it’s obsolescent until you haven’t sold it for a period of time. Then you start getting commentary like this from the recent profit downgrade:
Heightened promotional activity and unfavourable product and channels mix intensified to adversely impact gross margin in October, as we undertook promotional activity to stimulate sales and protect market share.
There’s no way of proving this, but my guess is that the obsolescent stock charges would have been low in 2014 and lower than usual in 2015. Now, as we roll into 2016, there is no escaping the fact that some of the stock isn’t worth carrying value.
Other provisions, though, can clearly carry over for a number of years. Let’s take the property, plant and equipment write downs, for example. The depreciation expense is still blatantly undercooked and that continues to help report higher-than-real profitability. This table tells the story (bottom totals don’t quite add up due to a few adjusting items I haven’t included):
|Year ended 30 June||2013 (10 months)||2014||2015|
Look how the net purchases of property, plant and equipment (PPE), low under private equity ownership in 2013, is drastically higher than the depreciation expense in 2014 and 2015. The net PPE asset is inexorably trending back to where it was prior to the write-downs ($120m) and the depreciation expense is heading right back to where it was, north of $20m per annum. The “real” depreciation expense is probably $10m higher than it was in 2014 and still $5-8m higher than last year. Remember this a business that made $53m of pre-tax last year, so we’re talking more than 10% of profit.
In the 2015 financial year, the company was still getting benefits from onerous lease provisions, too. They may well have been legitimate provisions and, as they roll off, the new leases they sign could be in line with the assumptions made when the provisions were taken. But it is simply not true that you can only dress something up for a year.
The last point, that the business has some serious operating problems, is right on the money. But this business had serious problems when Woolworths sold it. Private equity owned it for less than a year, pulled cash out, spun the accounts and said they had turned the business around. After the spin washes through, the same old problems are revealed, and Anchorage have walked away with $520m. That’s why this was a heist and Dick Smith shareholders have that sinking feeling.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.