How a private equity investor made $500m

The receivers have been called in to Dick Smith Electronics (DSE), which operates 331 stores in Australia and 62 in New Zealand.

Another retailer getting into trouble is not earth shattering news, but the history behind the company is an interesting one; in particular how  a private equity firm was able to extract half a billion dollars from their short-term investment in the company.

The business was started by Dick Smith in 1968, initially to install and service car radios. It soon branched out into wholesaling electronic products, which was one of the most popular hobbies of the time. By 1980 the company had grown to 20 stores and Dick Smith sold 60% of the company to Woolworths, and the remaining 40% two years later. As the electronics hobby boom faded in the late 80s and 90s the company changed its emphasis to retailing electronic consumer products.

By 2012 the company was struggling in a tough retail environment.  In November 2012 Woolworths restructured and sold the business for $115m to Anchorage Capital Partners, an Australian based private equity company. On its website Anchorage says it paid $20m for the company, which was the initial cash payment made to Woolworths. The balance of the purchase price is likely to have come out of DSE from cash on hand and the sale of assets sitting within the company.

Anchorage put in place what it calls a “turnaround program” and a year later sold the business in an Initial Public Offering (IPO) on the Australian Stock Exchange for $520m. Anchorage retained 20% but sold out totally in September 2014. It was in and out within two years, and clipped $500m in the process.

This is how Anchorage describes the turnaround program: “Following the acquisition Anchorage introduced a new CEO…and further strengthened the existing management team…In partnership with Anchorage, this management team immediately began implementing a highly successful program of operational, strategic, customer and cultural initiatives across all areas of the value chain.”

Those major initiatives included:

  • Introducing sales incentives for staff and staff training (presumably sales training).
  • Renegotiating supply agreements (presumably negotiating better buying discounts), and opening up an office in Hong Kong to source unbranded products (to lower purchasing costs).
  • A new marketing program in collaboration with suppliers (presumably offering deals where the suppliers provided consignment stock and/or paid for some of the marketing costs).
  • “Significant clearance of old and obsolete stock; improved stock management and ordering practices; optimised freight movement including closure of two distribution centres.” Indeed the sale of stock was massive, reducing from $312m in November 2012 to $171m by June 2013, just before the IPO.
  • Adding 10-15 stores using a couple of new store formats.
  • Entering into an agreement with David Jones to take over the consumer electronics counters within their department stores.

They go on to say, as a result of these initiatives earnings before interest and tax increased from $23.4m in 2013 to $71.8m in 2014.

This is a very good case study of how private equity companies operate. They essentially go into deals with two broad objectives.

The first is to extract as much cash out of the business as possible. In this case they achieved that by substantially reducing stock levels. By realising assets from the company they acquired, their net outlay was not $155m but $20m (if that).

The second objective is to make the next year’s earnings number as big as possible, wrap it up with a growth story, and sell those future earnings to the public  – which in this case was at a multiple of 7.4x earnings.

That’s how it turned $20m into $520m.

Things appeared to be going well for the listed company until October last year, when they reported a dramatic turnaround in sales and problems converting inventory into cash.

Despite heavy discounting through to Christmas, the inventory position worsened, and last week the company was placed into receivership after failing to secure short-term bank funding.

Of course, out of pocket investors are looking for someone to blame, and Anchorage is in the firing line. The question being asked is whether their turnaround program was sustainable in the long-term, or is it simply a case of the current management not having the skills too manage the business. Some are questioning the “flick-it-on” approach by private equity investors generally.

In any case, Anchorage is $500m better off and DSE’s shareholders have nothing. For some the lesson is simple – don’t buy an IPO when the seller is a private equity investor.

 

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