The big Dick Smith short

Click the NBR Radio box for on-demand special feature audio: Forsyth Barr's Rob Mercer discusses Dick Smith troubles with Duncan Bridgeman and Andrew Patterson

When shares in electronics retailer Dick Smith Holdings plummeted 58% on Monday, it would have come as no surprise to some.

An already big short position had been building all year and by late October more than 14% of the company’s shares had been sold short, up from 6.5% in January.

The first hit came on October 28 when Dick Smith warned margins were seriously affected by discounting and full year profit would be $A5-8m below previous guidance of $A45-48m.

That took shares from $A1.27 down to 84Ac.

The following day analyst Matt Ryan of Sydney-based boutique fund manager Forager published a blog post titled “Dick Smith is the greatest private equity heist of all time”.

It was a devastating takedown of the Dick Smith initial public offer in late 2013, when private equity firm Anchorage Capital Partners sold 80% of the company for $A344m ($378m) at $A2.20 a share.

It sold the remaining 20% in September last year for $A105m.

Many were sceptical of the float at the time because Anchorage had bought Dick Smith from retail giant Woolworths for $A115m in November 2012, just one year earlier.

How could the business have been turned around so quickly?

The prospectus claimed that: “Over the past year Dick Smith has undergone a significant transformation under the leadership of managing director and CEO Nick Abboud” and the improvements were expected “to deliver additional financial benefits in the coming years.”

According to Mr Ryan, not only did Anchorage stump up much less than $A115m for the business, its higher profit forecast for 2014 was generated mainly with accounting techniques, not operational improvements.

The first item was achieved through a $A58m write-down of inventories at the time of Dick Smith’s acquisition in 2012, reducing its book value to $A312m. The move enabled the retailer’s new owners to carry out a huge stock clearance without the discounts showing up as a big loss.

“And boy, did they liquidate,” Mr Ryan wrote.

By June 2013, according to financial statements, inventories were down to $A168.5m.

The sales generated $A117.6m in operating cashflow, of which $A78.6m was used to pay Woolworths. Just $A10m of equity was contributed by Anchorage.

The private equity edge
When it came to part two, dressing Dick Smith up for sale, the private equity firm had an advantage, said Mr Ryan, because “while private equity are focused on cashflow, equity market investors aren’t really focusing on how much cash has been ripped out of the business. All they seem to care about is profit.”

One of the profit-boosting techniques was the $A55m writedown in plant and equipment assets, which significantly reduced the depreciation charge and hiked profit accordingly.

Meanwhile inventory was built up again with the help of credit from suppliers – payables rose from $A153m in 2013 to $A228m in 2014.

However, eventually the chickens come home to roost and they returned to the coop in flocks this year – negative operating cashflow as suppliers are paid off, requiring new debt to fund working capital and a dividend.

“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,” wrote Mr Ryan.

However, it’s not that the accounting technqiues has anything to do with Dick Smith’s current struggles, it’s that the business wasn’t really changed from its days as a Woolworths subsidiary.

The second hit came on Monday when Dick Smith announced a $A60m write-down of inventory and a warning of a further profit downgrade.

“Significant market activity continues in an effort to stimulate consumer demand during the all-important Christmas period,” the company said, but “the benefits of this activity on inventory levels are, at this time, uncertain.”

The news drove Dick Smith shares down to just 28Ac, although they have since recovered to about 42Ac.

It’s a reasonable guess that some of the bounce is coming from short-sellers booking their profits.

Mr Ryan told NBR he was surprised by the size of the writedown.

“It’s got the look of a management team that are not totally in control of the situation,” he said.

“Our best call on this is probably that the company was in a lot of trouble before being sold by Woolworths, was never really fixed up, and the trouble is just showing up again. We think private equity has pulled a couple of tricks here to make it look good in the middle. But this is a business that has had issues the whole way through.”

Financial statements for Dick Smith’s New Zealand business are yet to be posted in full but those already available show a matching trend of inventory, cash and payables in the period of private equity ownership.

The effect on JB HiFi
As Dick Smith flounders, attention is turning to its impact on rival retailer JB HiFi.

A research note published by First NZ Capital today lowered its target price for JB HiFi from $A21.75 to $A19.05 but said that “the risk of DSH's closure has increased and that would be a positive valuation event for JBH.”

Kicking Dick Smith while it’s down, the note said the retailer’s closure was a “material enough probability” to consider some potential upside for JB HiFi of about $A6 a share.

The short sellers aren’t so sure.

The most recent short sales position report published by the Australian Securities & Investments Commission shows 15.8% of JB HiFi’s stock was sold short as of November 26.

In the short-term, it appears some investors see generic problems for electronics retailers affected by an industry which is introducing new products at a furious pace, quickly downgrading the value of stock.

With competition intense, profits will be hard won.  

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