The tale of Dick Smith and Anchorage Capital:
Turning $10m into $500m in 2 years

You may recently have heard, Dick Smith has closed all it’s stores and fired close to 3000 staff. The backdrop to this involves Anchorage Capital and a $520m pay-day. The outcome has raised red-hot debate over the private equity industry, which may have important implications in the future.

So how did Anchorage Capital pull off such a remarkable feat, buying Dick Smith for $10m, and turning it into $520m, returning over 5200% in 2 years?

Part 1: Buying a $115m business for $10m

They set up a holding company called Dick Smith sub-holdings, which they used to acquire Dick Smith for $115m. Notes to the accounts show that only $20m was initially paid by the holding company, though Dick Smith already had $12.6m in cash. Digging further into the financial statements, Dick Smith sub-holdings was only created with $10m of capital. It seems likely that this was the initial contribution upfront.

So if Anchorage Capital only contributed $10m, where did the other $105m come from? This is where the magic happens. The answer is from Dick Smith’s balance sheet. First, they marked down the assets of the business as much as possible as part of the acquisition process. $58m was written off from inventory, $55m from PP&E and $8m in provisions were taken. This is an important short-term step because they want to sell off a large part of the inventory without racking up losses, as this would show up in financial statements and make the business hard to float. Now they can liquidate inventory quickly without racking up losses (i.e. have a big clearance sale). Inventory worth $371m, written down to $312m, within the space of 6 months, dropped to just $171m.

The reduction in inventory produced a gigantic operating cash flow, which essentially was from selling off all the inventory and then not buying any to restock. They used this cashflow from the Dick Smith business to fund the outstanding payments for the acquisition.

Voila, buy a business for $115m using only $10m of money from your own pocket.

Part 2: Selling a $115m business for $520m

Equity markets investors don’t care how much cash has been ripped out of the business, they care more about profit.

Now Anchorage Capital has to turn its focus to profit, hence the income statement, to make the business look as profitable as possible. The big clearance sale in the earlier year means there is essentially no old stock to start 2014, that’s extremely beneficial in consumer electronics where products have rapid obsolescence. The marked down inventory will still have some benefit flowing into the year. The PP&E write-downs means there is less depreciation flowing into into the income statement. These things combined can turn a profit of $7m in 2013, to $40m forecast profit in 2014. This allows Anchorage Capital to forecast huge profit numbers and on the back of this, float the business for $520m. Anchorage Capital quietly sold their shares later in 2014 and walked away with a cool half billion dollars.

Part 3: The aftermath

All the ‘financial engineering’ above has consequences. By the end of 2014, inventory increased back up to $254m and doing so meant payables to suppliers increased by $95m. However, end of FY2015 is when things went off the hook. Operating cash flows go into the negative and as suppliers demand payment, Dick Smith has to take out $71m in debt to maintain a more sustainable working capital. The positive effects of the inventory write-downs and other provisions have worn off by now and profit margins plummet.

Eventually the situation worsened and recently, Dick Smith made the decision to fire-sale all of it’s stock, close all it’s stores and make around 3000 employees redundant.

This buyout and float has raised many questions about the morality and legality of the private equity industry.

Financial markets experienced an awful start to the week, with no asset classes spared. The S&P 500 plunged 5% at open, finishing 11% below the May high. European stocks fell by 5%, the most since 2008. Commodities sharply slid to a 16-year low with Brent crude trading below $45 USD.

Most selling has been attributed to the slowdown of growth in China which is seen in the devaluation of the Yuan and the continued decline of Chinese equities. It remains to be seen how poor upcoming Chinese economic data is and how far the market will fall.

Read the full article here

Last week Apple (APPL: NASDAQ) was officially added to the Dow Jones Industrial Index. The Dow is an average indexed to the stock market performance of thirty large American companies. The average was first calculated in 1896 and has fallen out of favour with market watchers. Detractors say companies are chosen arbitrarily, for example Google and Facebook are omitted at the expense of older, smaller companies (as measured by market cap) such a P&G and General Electric.

The Dow is weighted to changes in a company’s share price, rather than overall changes in market capitalisation. Effectively, this means expensive stocks have a disproportionate effect on the index. Historically, Apple’s stock could not be included in the Dow for this reason– its 7:1 stock split in June 2014 brought the share price of the company down to ~$US120 from US$700, much closer to the price of other stocks in the average.

You can hear more about the Dow Jones Industrial Average on this week's Planet Money podcast here

With 2014 being one of the biggest years for M&A since the Global Financial Crisis, it seems likely that deal making will stay strong throughout 2015.

While economic growth is spluttering, credit remains cheap, asset prices are somewhat depressed and overseas raiders will benefit from the lower Australian ­dollar.

The AFR has identified some of the biggest deals to watch out for in 2015:
1. BHP Billiton’s great demerger
2. Foxtel’s potential purchase of Ten
3. US firm, Iron Mountain’s bid for Recall
4. Programmed Maintenance Services’ bid for Skilled Group
5. GE Capital selloff 

To read about the deals in detail, follow the link below.

http://www.afr.com/p/business/companies/ten_deals_to_watch_in_7par6TBMSnaRDZ6U7jPmCL

Wall Street banks have failed to keep up with the stock market during its more than five-year boom, falling behind industries such as technology and health care. There were just 32 U.S. financial firms among the world’s largest 500 companies by market value when trading closed on Dec. 18 in New York. That compares with 41 at the end of 2006, the last full year before the credit crisis. Some companies that remain on the list, such as Citigroup (C) and American International Group (AIG), have shrunk to a fraction of the size of tech giants like Apple (AAPL) and Google (GOOG).

Please refer to http://www.businessweek.com/articles/2014-12-23/wall-street-loses-ground-as-the-market-booms for the full story.