Four key reasons.
Inventory continued to grow, new stores were being opened, despite same store sales experiencing a decline year-on-year, and purchasing decisions were based on rebates instead of customer demand. McGrathNicol has attributed the above action to the demise of Dick Smith. The administrators provided an in-depth report to creditors and Appliance Retailer has identified the report’s key points.
- Inventory management
A build-up of inventory appears to have occurred in advance of the 2013 Christmas holiday period, following which there was a $75 million reduction in inventory between 15 December 2013 and 15 January 2014.
- During the 2014 Christmas holiday period, the company only achieved a $10 million net reduction in inventory over the same time period and higher inventory levels were carried through the early months of 2015
- Stock mix became increasingly aged throughout 2015 and there was steady growth in ‘inventory days’
- By October 2015, management had exceeded its FY16 stock purchasing budget
- An independent consultant had been engaged to review the company’s inventory, identifying $180 million of inventory that was ‘inactive’, and of that recommending $60 million be written off
McGrathNicol believes a well-managed and timely clearance sale earlier in 2015 may have been beneficial to clear inventory levels to sustainable levels. “However, such a clearance sale would have likely reduced reported profitability in FY15,” the report stated.
- Rapid expansion
In October 2013, Dick Smith launched its multi-banner strategy and took over the operation of 30 ‘David Jones Electronics Powered by Dick Smith’ stores, and opened the first ‘Move’ concept store, despite same store sales suffering from declines across its core business.
However, declining comparable same store sales were not highlighted in the financial results due to ‘new revenue’ from new stores and growth in the non-core business.
McGrathNicol believes there was insufficient analysis performed on comparable sales and the investment case to support continued store expansion.
“In our view, better and more focused analysis on comparable sales would have identified that the core retail business was experiencing declining sales and that the store expansion plan was eroding value by reducing the return on invested capital whilst at the same time increasing Dick Smith’s debt burden,” the report stated.
- Purchasing decisions
Poor and declining performance may have led management to make decisions on what stock to buy based on the rebate attached to the stock, rather than customer demand.
- This contributed to a build-up in inventory and encouraged poor product mix decisions
- Some rebates provided a short-term incentive which enabled a profit increase in the month of purchase, rather than at the time of sale
- Heavy discounts were required to sell rebated stock, which damaged margin
- Supplier agreements
Throughout the calendar year 2015, Dick Smith was failing to pay suppliers on time, and more than 20 major suppliers had placed some form of trade restrictions, such as cash on demand payment terms, reduced credit limits and stop supply.
Fifteen of these suppliers received more in payments from the company during the six months prior to the appointment of McGrathNicol, than the value of goods supplied.
“These suppliers may have received unfair preference payments in circumstances where they were aware that Dick Smith was not paying accounts as and when they fell due,” the report stated.
McGrathNicol has noted that successful action for unfair preference payments includes establishing the date of insolvency, and the costs of pursuing an unfair preference payment can sometimes outweigh the potential returns. Creditors have defences available to them under Section 588FA(3) of the Act (and Section 296(3) of the NZ Act), and the recoverability of payments may be uncertain.
Insolvency
On 4 January 2016, the board resolved that Dick Smith was likely to become insolvent (unable to pay debts) at some future time and responded by appointing voluntary administrators.
McGrathNicol believes the retailer may have been insolvent before 23 December 2015, when it entered into an agreement with the banks that prevented it from drawing funds from its overdraft facility to repay the Macquarie trade finance facility. The company had no available cash or other source of funding.
Some of the relevant considerations in forming a view on this issue will include:
- Dick Smith breached its lending covenants on 30 November 2015, when it announced a material impairment of inventory, which was likely to have been impaired earlier in the calendar year
- Net operating cash loss of $71.2 million from 1 July to 30 November 2015 reduced to $22.1 million as a result of the clearance sale in December 2015
- Net debt increased by $122.7 million from 1 January 2015 to 30 November 2015 (refer sections 4.2 and 5.2);
- Positive net assets and current assets were always reported (except in the draft management accounts for December 2015)