The Rise And Fall Of Dick Smith Electronics

Background

According to the report produced by the administrator of Dick Smith Group, McGrathNicol, in July 2015 sales of DSG was 97.2 million dollars. Gross profit in the month was 17.1 million dollars. Net profit after tax was – 1.3 million dollars (net loss).In August 2015, sales of DSG were $ 93.9 million; gross profit was $ 17 million; and net profit after tax was – .3 million dollars (McGrathNicol, 2016).

In September 2015, sales of DSG were $ 131.1 million; gross profit was $ 37.2 million; and net profit after tax was $ 1.6 million.In October 2015, sales of DSG were $ 89 million; gross profit was $14.8 million; and net profit after tax was – $3.4 million (net loss).

In November 2015, sales of DSG were $85.2 million; gross profit was – 46.4 million; net profit after tax was – 42.8 million dollars.In December 2015, sales of DSG were $ 200.1 million dollars; gross profit was 13.8 million; net profit after tax was – 70.5 million dollars.

It can be seen that DSG posted net loss in each month in the six month period after June 2015. The month of November 2015 was particularly bad. In this month it was unable to post gross profit. This means that the cost of sales was more than the revenue from the sales. This happened because the company had to give huge discounts to clear its obsolete inventory. Heavy discounts were given in both November 2015 and December 2015 to clear the inventory.  Total loss reported by the company in the months of November and December, 2015 was $113 million.

EBITDA (Earnings before interest, taxes, Depreciation, and Amortization) losses in the six month period were $114 million.

Inventory of the company had become so obsolete that an impairment charge of $60 million had to be taken on the value of the inventory.

Net cash inflow in the six month period after June 2015 was $ 1.7 million. So the company was able to generate positive net cash inflows in the six month period even after the losses. 

Cash & cash equivalents of DSG on 31^st December 2015 stood at $31.2 million. Total debt that was due to mature over the next one year stood at $ 20.2 million.

Key factors that led to voluntary appointment of administrators on 4^th January 2016 were:

1. Very low cash flow generated by operations.
2. Insufficient cash balance to purchase new stock.
3. Delays in payment to operational suppliers.
4. Onerous lease obligations.
5. Obsolete inventory of stock.

End of answers to Question 1

Question 2      Analysis of strategic issues (30 marks | word limit: 1400 words)

(a)       Critically analyse the expansion strategy of DSG. (500 words)

(b)       Summarise the reasons why DSG failed. (900 words)

Criteria based marking guide for Question 2(a)–(b)

	Excellent	Satisfactory	Unsatisfactory
(a)	•  clear, accurate demonstrated knowledge of the expansion strategy •  thorough research into concept of best practice with accompanying sound analysis •  logical, convincing explanation of how actions compared to best practice •  adheres to word limit requirements	•  some demonstrated knowledge of the expansion strategy •  adequate research into concept of best practice with some analysis •  reasonable explanation of how actions compared to best practice	•  little or no demonstrated knowledge of the expansion strategy •  little or no research into concept of best practice with little or no analysis •  inadequate explanation of how actions compared to best practice ·   not attempted
(Range: 10 marks)	(Range: 7.5–10 marks)	(Range: 5–7 marks)	(Range: 0–4.5 marks)
(b)	•  logical and comprehensive discussion on why DSG failed with evidence of facts and figures •  adheres to word limit requirements	•  reasonable discussion on why DSG failed with evidence of facts and figures	•  inadequate discussion on why DSG failed with little evidence of facts and figures ·   not attempted
(Range: 20 marks)	(Range: 15–20 marks)	(Range: 10–14.5 marks)	(Range: 0–9.5 marks)

DSG’s core activity was operating consumer electronics retail stores in New Zealand and Australia. These brick-and-mortar stores were complemented by an online retail store. In 2013 DSG got listed at the Australian Securities Exchange (Anchorage Capital Partners, 2013). Post this IPO listing the company embarked on an expansion plan.  The expansion strategy was mainly organic in nature.  Organic means that it involves opening new stores of the company for expansion. Inorganic route is where a company acquires other companies for achieving expansion.

Expansion Strategy of DSE

So DSG started a new chain of retail stores under the Move brand. It entered into a partnership with David Jones to run and operate retail stores under the David Jones brand. “Move by Dick Smith,” stores opened up in duty free locations at airports. It also showed some inorganic expansion, when it purchased the Mac 1 stores in September 2014. Mac 1 stores were resellers of Apple products (McGrathNicol, 2016).

To finance this expansion strategy, DSG used both internal cash reserves and also borrowed. Use of internal cash reserves ultimately led to decline in cash balances. Due to this decline in cash balances it was later on unable to pay its suppliers in a timely manner. It also found it difficult to pay back the obligations on its debt.

One of the objectives behind this expansion strategy was to enable DSG to target different market segments. This in turn would increase its sales.

2(b)

DSG failed because a number of reasons.  The main reasons were:

1. Market related factors: Market related factors played an important role in this failure. High competition in the consumer electronics retail industry in Australia and New Zealand resulted in erosion of profit margins of DSG(Blanchard, 2017).  It was unable to control its overhead expenses. Its overhead expenses were on average, 9% higher than those of its competitors.  Among the nine key competitors in the consumer electronics retail market DSG had maximal number of stores at 394 stores. But it was only the sixth largest player with just 9% of the market share. JB Hi-Fi, the market leader, had 26% market share with just 187 stores. DSG’s store network expansion strategy did not translate into proportionate increase in sales.

Competition also intensified because of the coming of online retailers. These retailers were able to sell products at lower prices to customers because of their lower cost base and more flexible inventory management capabilities. Increase in life cycle of personal computers (PCs) also contributed to the troubles of DSG. They lowered demands for PCs for office use. Office sales were important as they contributed to 40% of the total sales of DSG.

1. Failure of the expansion strategy: Another reason of failure was aggressive expansion using internal cash reserves and external debt. This resulted in deterioration of the financial health of the company. It continued to open new stores while same store sales continued to decline. This expansion strategy resulted in reduction of returns on invested capital of DSG. At the same time it considerably increased the debt burden or leverage of the company, thereby increasing its financial risk. The company’ total debt increased to $ 127 million from $ 71 million in the six month period between June 2015 and December 2015(McGrathNicol, 2016). These borrowings were raised as the company was unable to raise enough cash to pay its suppliers; meet its capital expenditure requirements. While it was facing this cash crunch it also paid dividends to its shareholders. This worsened its slide.

1. Purchasing decisions: The management of DSG bought stocks for the stores on the basis of rebates given by suppliers, and not on the basis of customer demand. This ultimately resulted in the company having items in its stock that did not have much customer demand.

1. Inventory management: The Company built huge inventory. Due to rapid technological innovation and changing customer preferences because of this innovation, the inventory of the company soon became obsolete. Ultimately it had to dispose a large part of this inventory at heavily discounted prices. It also had to take a $ 60 million write-down on its inventory(McGrathNicol, 2016). The obsolescence of items in the inventory of DSG can be assessed from the fact that even during the peak Christmas shopping season of 2014, the company was not able to reduce its inventory by a significant amount.

The private label strategy also was a cause of DSG’s failure. Private label strategy meant that DSG also had its own brand of consumer electronic products. This involved getting electronic products manufactured from contract manufacturers. This increased supplier commitment and inventory levels of DSG significantly. It had to later on take down significant write-down on this inventory.

1. Product Mix: DSG’s product mix deteriorated further because many of the suppliers had stopped supplying to it because of the large dues it owed to them. Some suppliers, such as Apple, had put it on cash-on-delivery terms. At the time it was put into administration, 16 of its major suppliers had either put it on stop delivery or cash on delivery or bank guarantee before delivery.

End of answers to Question 2(a)–(b)

Question 3      Value creation and M&A (50 marks | word limit 2400 words)

In a relatively short period of time, Dick Smith was subject to a series of significant corporate transactions.The sale of the business by Woolworths to the private equity fund Anchorage (November 2012); the sale of the restructured business by Anchorage to the public by way of an IPO (December 2013); and, the financial collapse of the business requiring the voluntary appointment of an administrator (January 2016).

These corporate transactions received significant attention from the media and other parties, often with the benefit of hindsight.

Please refer to the following source documents:

• Dick Smith prospectus 21 November 2013 (available on MorningStar DatAnalysis database in KapLearn under ‘Library’)
• Article by Matt Ryan of investment fund Forager ‘Dick Smith is the greatest private equity heist of all time’ 29 October 2015, 
• Submission to Senate Inquiry by Anchorage Capital Partners in conjunction with the Parliament of Australia 18 March 2016(download submission 12

• Extract from Chanticleer article AFR 11 February 2016 (Schedule 6 in Anchorage submission – see web address above)
• Extract from Chairman’s Statement Dick Smith AGM 28 October 2015 (reproduced below) (available on MorningStar DatAnalysis database in KapLearn under ‘Library’)

Cashflowduringtheyearwasimpacted bythe decisiontoavailourselvesof beneficial inventorybuyingopportunities. This involvedtheCompanybuyinginventoryearlierin theyear thannormal to take advantageoffavourable exchangeratesandproductpricesandresulted inthe paymentof this inventorybeforetheendof theyear.YourDirectors anticipateimprovedcashconversionin 2016, despitethechallengingretail environment.

Notwithstanding the cash flow impact,the Company’sbalancesheet remains strong.Your Directors are pleased to declare a 5 cent per share fully franked dividend, which was paid on 30 September 2015.

(a)       ‘The price Woolworths received for the sale of Dick Smith was ridiculously low.’

             Reflect on this statement made by a disgruntled Woolworths’ shareholder shortly after Anchorage announced the Dick Smith IPO. Based upon information available at the time of the IPO, including the prospectus, and given the prevailing circumstances when Woolworths sold Dick Smith, comment on the validity of the opinion expressed in this statement.

Organic Expansion with Inorganic elements

(b)       List the major issues of concern raised in the article by Forager and comment on the validity of these issues.Include in your answer, as appropriate, statements made by Anchorage in its submission to the Senate Inquiry.

(c)       Within the context of value creation, assess the sustainability and efficacy of the transformation strategy and initiatives undertaken by Anchorage.

(d)       Reflect on the statement (made by a retail analyst when the Dick Smith share price collapsed): ‘Only a fool would buy shares in an IPO where a private equity fund is the exiting vendor.’ Why might such a view be misguided and potentially result in poor investment decisions?

(e)       Review the post IPO share register (refer to the IPO top 20 shareholding notice) and the post IPO share price performance of Dick Smith.  What inferences (if any) can be made on the market view of the veracity of projected performance for the company as set out in the prospectus.

(f)        Reflect on the statement made by a fund manager when Dick Smith went into voluntary administration: ‘The market gets it right nearly all of the time.But it was wrong on Dick Smith.’ Discuss whether you think the market ‘got it wrong’

Criteria based marking guide for Question 3(a)–(f)

	Excellent	Satisfactory	Unsatisfactory
(a)	•  Comprehensiveunderstandingof the issues related to price and value within the context of a sale process •  Comprehensive understandingof the specific issues related to the sale of Dick Smith by Woolworths	•  Basic understanding of the issues related to price and value within the context of a sale process •  Basic understanding of the specific issues related to the sale of Dick Smith by Woolworths	•  Weak understanding of the issues related to price and value within the context of a sale process or not attempted •  Weak understanding of the specific issues related to the sale of Dick Smith by Woolworths or not attempted
(Range: 5 marks)	(Range: 4–5 marks)	(Range: 2.5–3.5 marks)	(Range: 0–2 marks)
(b)	•  Rigorous analysis of claims made by Forager •  Evidence of comprehensive understanding of broader issues relating to the involvement of Anchorage	•  Reasonable analysis of claims made by Forager •  Evidence of basic understanding of broader issues relating to the involvement of Anchorage	•  Inadequate analysis of claims made by Forager •  Not attempted
(Range: 12 marks)	(Range: 9-12 marks)	(Range: 6–8 marks)	(Range: 0–5 marks)
(c)	•  Rigorous analysis of value creation by Anchorage •  Evidence of comprehensive understanding of efficacy and sustainability of the transformation initiatives	•  Reasonable analysis of value creation by Anchorage •  Evidence of basic understanding of efficacy and sustainability of the transformation initiatives	•  Inadequate analysis of value creation by Anchorage •  Not attempted
(Range: 12 marks)	(Range: 9-12 marks)	(Range: 6–8 marks)	(Range: 0–5 marks)
(d)	•  Comprehensiveunderstandingof the issues related to the appraisal of potential investment in an IPO and whether or not the involvement of a private equity fund is a material factor	•  Basicunderstandingof the issues related to the appraisal of potential investment in an IPO and whether or not the involvement of a private equity fund is a material factor	•  Weakunderstandingof the issues related to the appraisal of potential investment in an IPO or not attempted
(Range: 8 marks)	(Range: 6.5–8 marks)	(Range: 4.5–6 marks)	(Range: 0–4 marks)
(e)	•  Comprehensiveunderstandingof the issues related to interpreting share register information and investment decisions	•  Basicunderstandingof the issues related to interpreting share register information and investment decisions	•  Weakunderstandingof the issues related to interpreting share register information and investment decisions or not attempted
(Range: 8 marks)	(Range: 6.5–8 marks)	(Range: 4.5–6 marks)	(Range: 0–4 marks)
(f)	•  Comprehensiveunderstandingof the issues related to equity market trading in conjunction with a thorough commentary on the share price performance of Dick Smith	•  Basicunderstandingof the issues related to equity market trading in conjunction with a basic commentary on the share price performance of Dick Smith	•  Weakunderstandingof the issues related to equity market trading or not attempted
(Range: 5 marks)	(Range: 4–5 marks)	(Range: 2.5–3.5 marks)	(Range: 0–2 marks)

Insert your answers to Question 3(a)–(f) below this line

3 (a )

The opinion that the price Woolworths received for the sale of Dick Smith was ridiculously low is not valid. Total payment that Woolworth’s received for selling its stake in Dick Smith was $ 115 million (Greenbalt, 2013). $20 million of this was received at the time of the sale and the remaining $95 million was received just before the IPO. At the time when Woolworths sold Dick Smith to Anchorage capital, net profit of Dick Smith was just $ 7 million. This implies a Price – to – Earnings (P/E) ratio of 16.42 times ( $  million / $ 7 million) at the price at which Woolworths sold it to Anchorage. This is not a P/E ratio at which the price paid can be considered to be ridiculously low.  Average P/E ratio at which All Ordinaries Index of ASX has traded in the long run is 10 (Chandra, 2017).

 The IPO after its listing valued Dick Smith at $ 520.3 million. But this valuation was on the basis of the projected turnaround that the management of Anchorage Capital said that it had achieved after acquiring Dick Smith from Woolworths. In 2013, a year after the purchase from Woolworths, the management of Anchorage had forecasted profit for next year of $ 40 million.

The situation in which Woolworths sold Dick Smith to Anchorage also needs to be kept in mind. Dick Smith contributed just 1% to the revenues of Woolworths (Greenbalt, 2013). It acted as a distraction for the management of Woolworths. The management was then busy in a tough competitive battle with Coles.

3 (b)

The issues raised in the article , “Dick Smith is the greatest private equity heist of all time,” by Myatt Ryan of investment fund Forager are highly relevant and valid (Ryan, 2015). It shows how the private equity fund Anchorage capital manipulated to create huge profits for itself at the cost of shareholders who bought shares in the IPO of DSG. The article lists the following main points:

• It says that Anchorage first created Dick Smith Sub-holdings to acquire Dick Smith from Woolworths. This holding company was created by issuing $10 million of equity capital to Anchorage. So Anchorage invested $10 million in this business. Dick Smith had $12.1 million in cash holdings at the time of acquisition. With the $10 million it had invested and with $12 million it got after the acquisition, Anchorage made the initial payment of $20 million to Woolworths.
• After the acquisition the first thing that Anchorage did was to take a write-down of $ 58 million on the inventory of Dick Smith; $ 55 million write-down on the plant and equipment of Dick Smith; and $ 8 million in provisions. Anchorage wanted to generate cash by selling the inventory at a discount. But without a write-down this sale of inventory would have appeared as a loss on its financial statements. So it first made the write-down on the inventory so that it could show a profit from the sale of inventory even after selling it at a discount. After this write-down in inventory, a big clearance sale of the inventory of Dick Smith was done. Heavy discounts were offered in this clearance sale. The clearance sale generated $140 million in operating cash flows. From this $140 million, Anchorage made the remaining payment of $ 95 million to Woolworths. So effectively Anchorage bought a $115 million business by paying just $10 million from its own side.
• According to Forager, the next step for Anchorage was to plan for an initial public offering (IPO) for Dick Smith. By doing a write-down on property, plant and equipment, it reduced its depreciation charge by $15 million annually(Ryan, 2015). Lower depreciation means positive impact on profits. It entered some onerous lease provisions to keep the depreciating related to its newly opened stores out of its profit & loss statement. On the basis of sales generated in the discounted clearance sales and the sales generated from new stores, the management of Dick Smith was able to forecast a net profit of $ 40 million for 2014. On the basis of this higher projected net profit, it was able to get Dick Smith a market capitalization of $520 million in the IPO. Anchorage capital sold its entire stake in Dick Smith by September 2014.

• Inventory costs increased to $ 254 million by the end of 2014 as a larger amount of inventory had to be bought because the old inventory was sold at heavily discounted prices in the clearance sale. Cash flows were still kept positive by delaying payments of a large number of suppliers. By the end of 2014, accounts payable to suppliers stood at $ 95 million.

Financing Expansion

The points raised in the article of Forage are valid. If the inventory that came with the acquisition of Anchorage was so obsolete that Anchorage had to take a write-down immediately after acquiring the business from Woolworths, then how was it able to sell this inventory so fast at above the written-down value?

In its submission to the Senate Enquiry, Anchorage has mentioned that when it acquired Dick Smith from Woolworths it was in very bad shape (Senate Inquiry Submission, 2016).  Woolworth had reduced the network of Dick Smith’s stores by 23% and profits were declining by several years. Anchorage also acquired huge amount of obsolete inventory, given the write-down that it took on the inventory immediately after the acquisition. It also took a write- down on plant, property and equipment. The question arises in one’s mind that if the situation was so bad, why did Dick Smith pay the price of $115 million to Woolworths for the acquisition? Also why did it immediately begin an expansion spree for Dick Smith?

 In its submission to the Senate, Anchorage has stated that it owned and managed the company from the time of acquisition in 2012 to September 2014. In the IPO in 2013, Anchorage gave up management control by selling 80% of its stake in the company. In September 2014, Anchorage completely exited Dick Smith by selling its last remaining shares. The question again comes to mind is that, did Anchorage expect to enable the turnaround that Dick Smith required in just 1 year! In its submission to the Senate Enquiry it said that it is a turnaround expert that buys struggling companies, turns them around, and then sells them at a profit.

In the essence of its submission to the Senate Inquiry, Anchorage has put the blame on the troubles of Dick Smith and its subsequent placement in the hands of administrators on the management that was there, after it exited the company. Nowhere in its submission, Anchorage addressed the issue of negative cash flows from operations or the huge accounts payable that was due to suppliers

3(c )

The transformation and strategy initiatives taken by Anchorage Capital to turn around Dick Smith were not effective and not sustainable. The strategy to open new stores to increase sales, in a scenario where same store sales were declining, was a fallacious one (Jonathan & Peter, 2013). The right strategy would have been to first identify the existing same stores that were bleeding heavy losses and decline in revenues and shut them down. The next step would have been to focus on stores that were doing relatively well. The third step should have been to control overhead expenses. The turnaround strategy did not focus on cutting down overhead expenses of Dick Smith to the level of its competitors. Dick Smith had the highest level of operating expenses in the consumer electronics retail industry.

The biggest flaw in the turnaround strategy of Anchorage Capital was that it failed to notice that rivals were generating much higher revenues with lesser number of stores than Dick Smith. So the right strategy would have been to focus on increasing the sales of existing stores instead of opening new stores or entering in partnership with David Jones to manage its own stores or starting the new Move brand of stores. The strategy of building up huge inventory to support the expansion was unsustainable as enough cash was not being generated to pay back suppliers in time.

Reasons Behind the Failure of DSE

3 (d ) 

The statement, ‘Only a fool would buy shares in an IPO where a private equity fund is the exiting vendor, ‘is misguided and will potentially result in poor investment decisions.  Private Equity funds often exit investments to create positive value on their investments. One of the common elements of business models of private equity companies is to invest in companies for some time and then to exit their investments by taking the company public by getting it listed (Pandey, 2017). If the company in which the private equity firm is exiting the investment has good financial and operating and fundamentals then an investor investing in the stock of the company would generate good returns. Take for instance the case of Alibaba.

Private equity firms such as Silver Lake exited significant portions of their investments at the time of Alibaba’s IPO. Investors who bought shares of Alibaba at the time of its IPO, still made significant returns (Merced, 2014). Actually many private equity firms are great turnaround experts. Many of them are good at identifying businesses with good business models and then investing in them. The criterion of not buying shares in an IPO where a private equity fund is the exiting vendor is a highly fallacious one. It will definitely result in poor investment decisions.

3(e)

Looking at the shareholders register of Dick Smith it can be seen that a large number of shareholders were institutional investors. These investors have the resources to do adequate due diligence before taking the decision to invest in a share or not (Chandra, 2017). The IPO was oversubscribed. This means that the bids received were more than the total number of shares that were offered in the IPO. The IPO got listed at $2.20 per share and market capitalization of $ 520 million. The stock price of Dick Smith hovered around $ 2.20 per share – the IPO listing price – till as late as 31^st July, 2015. All these factors clearly show that the market believed in the veracity of projected performance in the IPO prospectus of Dick Smith, for long.

3 (f)

‘The market gets it right nearly all of the time. But it was wrong on Dick Smith.’ Yes the market got it absolutely wrong on Dick Smith. Sophisticated institutional investors failed in doing adequate due diligence before investing in the stock of the company at the time of its IPO. They made the investment on the basis of net profit posted by the company in the first quarter of 2013 and its projected profits in 2014. They didn’t look at the cash flow situation of the company. A simple look at the cash flow statements of the company and its balance sheet would have revealed that Dick Smith was generating positive cash flows from its operations only by delaying payments to its major suppliers.

  Cash and cash equivalents of the company steadily declined between 2013 and 2015. The price at which shares were subscribed in the IPO was around 11 times its projected earnings for the next one year. This was a high price to pay for the shares of a company that was struggling in a highly competitive market. The lesson from the case of Dick Smith is that investors should look at profit & loss statement, balance sheet and cash flow , and not just the profit & loss statement, before making the final decision of whether or not to invest in the shares of a company.

References

Anchorage Capital Partners. (2013). Dick Smith Lists on ASX. Anchorage Capital Partners , 

Blanchard, O. (2017). Macroeconomics. New York: Pearson.

Chandra, P. (2017). Investment Analysis and Portfolio Management. New York : Pearson.

Greenbalt, E. (2013). From $20m to $344m: Dick Smith for sale. Sydney Morning Herald 

Jonathan, B., & Peter, D. (2013). Corporate Finance (3rd Edition). Pearson.

Mason, M. (2013). Dick Smith’s flat ASX debut. Sydney Morning Herald 

McGrathNicol. (2016). The Dick Smith Group: Report to Creditors pursuant to section 439 A of the Corporations Act 2001. 

Merced, M. (2014). Silver Lake Reaps a Golden Return on Its Alibaba Stake After the I.P.O. DealBook/.

Pandey, I. (2017). Financial Management. New Delhi : Vikas.

Ryan, M. (2015). Dick Smith is the greatest private equity Heist of all time. 

Senate Inquiry Submission. (2016). Anchorage Capital Partners. Senate Inquiry Submission.