Electronics retailer Dick Smith has been our claim to fame over the past few months. Matt’s excellent exposé of the private equity shenanigans leading up to the float made Dick Smith is the Greatest Private Equity Heist of All Time the most popular Bristlemouth post of all time – by a factor of 10.
But the share price is down more than 80% since the time of the float and our job is (sorry Matt) making our clients money. Any stock that falls that far is worth a look, especially one that doesn’t have much debt.
The opportunity here is clear. At today’s price of $0.38, Dick Smith’s market capitalisation is $89m. Throw in $40m of net debt and you could buy the whole business for $129m (its “enterprise value”). The company generated revenue of more than $1.3bn last year. That ratio of enterprise value to sales – less than 10% – is extremely low for a retailer. JB Hi-Fi trades at 54% of revenue, Myer 34% and even Specialty Fashion trades at 20% of revenue.
It might sound like an absurdly simplistic metric, and it is. Obviously JB Hi-Fi makes more profit from every dollar of revenue, so is worthy of a higher ratio. But in retail it is a useful starting point. Flipping Dick Smith’s sub-10% ratio on its head, if the company can earn just 1% profit margins, the owners will earn in excess of 10% on today’s enterprise value. Eke out a 2% profit margin, and you are looking at 20% + returns.
So the question is, can this business make 2% margins?
It should. Two percent is still a very poor retailer. But I’m not sure Dick Smith has been making anything. Not when Woolworths owned it. Not when private equity owned it. And not since it has been listed.
The financial accounts will say different. According to the 2015 annual report, Dick Smith made $65m of Earnings Before Interest and Tax (EBIT) in the year ended 30 June 2015, and $62m in 2014. That $127m of cumulative profit quickly gets whittled away, though, if we factor in prior and subsequent events.
There has been roughly $50m of benefit from private equity write downs and provisions ($15m in annual depreciation and $10m in annual provision release). They may have been legitimate, but it’s a big chunk of the total profit.
Now we also know that inventory bought during that two years it has been listed is worth at least $60m less than it is on the books for.
All retailers have obsolescent inventory. Most of them clear it regularly and also put it through their cost of goods sold as a regular provision. I couldn’t find a “below the line” write off of inventory in JB Hi-Fi’s history, and I can assure you it’s not because they sell 100% of their purchases above cost.
The best case is that Dick Smith has made some poor purchasing decisions that won’t be repeated. It could also be that obsolescent stock is a regular cost of doing business that hasn’t been appropriately recognised in recent years. And if that’s the case, you could knock another $60m of the last two years’ EBIT, leaving you with next to nothing.
My guess is that that is a bit too extreme and that the true answer is somewhere in between, but it is genuinely difficult to ascertain whether this business is making any money or not. And private equity left it with such a working capital deficit that the cash flow has been even worse.
Nagging away at me is the feeling that we are getting too conservative on some of these “fallen angels”. We’ve taken a decent look at Metcash and Slater & Gordon in recent months and haven’t done anything. Perhaps the Forager of five years ago would have been more enthusiastic given the undoubted universal pessimism about them. For now, though, Dick Smith can be added to the list of stocks where we can’t quite get comfortable.
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