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Santa bypassed Dick Smith shareholders

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Santa doesn't appear to have been kind to the management and shareholders of Dick Smith as trading in its shares were halted on Monday until an update is provided on its funding position and debt covenants. What was revealed as an earnings and inventory rout at the end of last year seems now to have infected the company's balance sheet.

The major event that would have affected Dick Smith's financial fortunes since December is how it fared in the all important pre-Christmas trading period and the post Christmas store sales period.

The decision by Dick Smith to request a trading halt immediately after this period does not augur well.

The company' announced on November 30 that it could not affirm the (downgraded) profit guidance provided only a month earlier and that it would be taking a $60 million impairment to inventory.

But Dick Smith's financials appear to have further deteriorated and investors and suppliers will be anxiously waiting to see whether the company can renegotiate terms with its bankers, whether it will seek to raise equity or – worst case scenario – whether it may fall into the hands of administrators.

At the November announcement Dick Smith's chief executive, Nick Abboud, softened expectations that any near term improvement was in sight saying, "We are cautious on the outlook for the Christmas trading period … we will continue to drive sales, maintaining flexibility on gross margin to reduce inventory and improve our net debt position".


In plain speak this meant the company was going to engage in heavy discounting to get rid of excess inventory and bring in some cash.

But while the electronics group undertook a massive pre-Christmas sale it appears to have been insufficient to have the desired effect on its net debt position.

In early December, Fairfax Media quoted a Dick Smith spokesman who it said angrily denied the company was in danger of collapse or breaching its debt covenants, saying it would have updated the market if that were the case.

It now seems the market will get that update on Tuesday or Wednesday.

The company doesn't say which particular covenants may have been breached, but if the cash flow and earnings have been sufficiently ravaged or if asset values are set to fall again if inventory is further written down there are a number of possibilities.

One retail expert commented that the maintenance of a particular fixed charges ratio could have been a covenant that was susceptible if cash flow was under pressure over Christmas. This is one that can affect many retailers due to the lumpy nature of sales revenue and working capital and lease commitments.

In its 2015 annual report Dick Smith disclosed that at June 28, 2015, it had $70.5 million in loans and borrowings, while in 2014 it had nil. It said the utilisation of loan facilities reflected increased working capital requirements and that on June 22 that year it entered into a syndicated loan facility with the National Australia Bank, the Bank of New Zealand and HSBC Bank Australia which made available $135 million which is secured by property.

When Dick Smith reported its full year 2015 earnings it told investors that the big deterioration in  working capital was the result of timing of inventory purchases, creditor payments, new store openings and supplier terms

It said the higher inventory reflected a conscious decision to benefit from advantageous trading terms and a favourable exchange rate.

But such a strategy relies on being able to move the stock. And the subsequent issues that have emerged about Dick Smith's excess inventory suggests it was a disastrous call.

The potential to have breached loan covenants does not necessarily mean the company is experiencing an existential moment. However a breach in covenants may provide the opportunity for lenders to re-negotiate the cost of Dick Smith's debt or prohibit the company from drawing down more from the bank facility – and at the very least it will give the banks a bigger say in board decisions.

But it will put additional pressure on the future of its chief executive and raise new questions about how this company was able to undertake an IPO at $2.20 a share only two years ago. It will also shine a spotlight on whether investors that took part in that float were taken for a ride by the private equity interests that sold it.

Dick Smith last traded at 35.5¢ having reached lows of around 20¢ at the end of last year.

Woolworths was roundly criticised when it sold Dick Smith for $115 million in November 2012 to private equity group Anchorage and was further pilloried when less than two years later it was floated for $520 million.

While this doesn't provide Woolworths management with "I told you so moment" because it was poorly managed under its ownership as well, the events of the past six months demonstrate that Dick Smith's turnaround under private equity ownership was more about the application of financial  lip gloss than a genuine change.