We have watched from the sidelines, with interest, the commentary surrounding the collapse of Dick Smith (ASX:DSH).
Having eschewed the float for our investors we refrained from commenting before and immediately after the company’s very public downfall.
More recently, a public spat emerged between two commentators, both of whom we respect enormously. While it’s never a great idea to have an argument with someone who buys their ink in bulk, our friends Steve Johnson at Forager Funds and Tony Boyd at The Australian Financial Review (AFR) locked horns over who might have been at fault for the demise of Dick Smith.
And since, according to Tony, the collapse of Dick Smith will now be the subject of a Senate Inquiry, it is worth highlighting what we currently believe to be the three major issues that Dick Smith’s collapse raises for investors.
Pierpont, in the AFR on 5 February 2016, wrote:
“The DSH accounts showed inventory at November 25, 2012 at $370 million. On the following day, November 26, the inventory was written down $58 million to $312 million.
The writedown would have written down any premium on consolidation by the same amount, but on the flip side it gave Anchorage a $58 million start on the next profit and loss account. That write-down was not mentioned in the DSH prospectus although Pierpont would have thought it material information.
It was not even mentioned in the meagre report by Deloitte as investigating accountants. All Deloitte said was that they had read the previous annual reports of DSH and they seemed to have complied with the law.”
We believe Pierpont has a point. Deloitte fulfilled its obligations under the law, the prospectus fulfilled its obligations and Anchorage complied too. But what if complying with the law was not enough to properly inform investors? Could it be that the law is deficient?
The role of disclosure
The Australian Corporations Act contains a general disclosure test for prospectuses. It requires that a prospectus must contain all the information that investors and their professional advisers would reasonably require to make an informed assessment about the prospects of the share issuer.
Therefore, protection for investors is offered under the regime of disclosure. If everyone is fulfilling their obligations under the law and the law enshrines a regime of general disclosure, then clearly it is the regime that is the source of investor pain.
Fund managers frequently explain to their investors, sometimes in jest, that it is productive to read prospectuses from back to front. Any distasteful elements are obfuscated at the back. That professional fund managers must do this in order to properly assess a prospectus suggests the current regime of disclosure has been corrupted.
But because there are conflicts, it might be argued that change won’t happen for two reasons:
a) our government is sympathetic to big business and their role in employment generation, and
b) companies need a well-lubricated, liquid and efficient market through which to raise capital.
I forecast little tangible benefit for investors will come from a Senate Inquiry that does not examine the regime itself.
The role of the auditors
Retail investors believe that what they read in a prospectus is sacrosanct. Perhaps more shocking is that less sophisticated investors believe the mere issue of a prospectus renders the offer as ‘investment grade’. I suspect few retail investors read the auditor’s opinion that accompanies the financial information.
A hypothetical auditor is only required to state that the hypothetical prospectus complies with the law. However, this may coincide with a time (such as during the fund-raising period, when not all information about the historical performance of the ‘business’ is always available) which omits or obfuscates meaningful financial information. When this happens, both the auditor and the law are rendered useless by the regime itself.
The role of timing of information release
The final point that the DSH collapse raises for this investor is the timing of the release of historical information. Prospectuses are relatively selective about the information that is revealed about a company’s historical trading performance and balance sheet changes. It’s particularly irksome that historical revenue and EBITDA numbers are often provided in the table of historical financial performance but not the more granular numbers. If they are, they are heavily-modified, normalised and adjusted so as to bear no resemblance to the tax returns the then owner of the business (as opposed to the listing company) sent off to the Tax Office.
At the time investors were asked to invest in DSH, it is not clear whether it was possible to reach the conclusions about the company that other commentators and fund managers have subsequently made. The balance sheet data in the prospectus dated November 2013 only related to June 2013. It is important to note that this is all the disclosure required by ASIC in their regulatory guidance ‘Effective disclosure for retail investors’. Senate Inquiry anyone?
What did the prospectus really say about inventories?
Dick Smith’s $149 million inventory valuation as at June 2012, the subsequent jump to $370 million on 25 November 2012, the fall to $312 million on 26 November 2012, and the $168.5 million at June 30, 2013 (this latter figure was reported in historicals provided only on the day of the float, as is required) were not numbers disclosed obviously in the prospectus.
Although Dick Smith was founded in 1968, the prospectus states Dick Smith Holdings was incorporated on 25 October 2013. Changes to ownership and structure, in the few short years prior to listing, will always complicate disclosure, giving the issuers valid reasons for being unable to provide investors with the meaningful information they might argue they require, while simultaneously providing another reason any Senate Inquiry will probably fail in improving the lot of retail investors.
Note No.4 to Table 5.7.1.1 ‘FY2013 Pro Forma and Statutory Reconciliation’ on page 62 of the prospectus, under the heading ‘Acquisition and Restructuring Costs’ stated (in arguably microscopic font); “… and $2.5 million in costs related to achieving a significant reduction in the inventory balance.”
However, there was precious little evidence of the extent of the changes in inventory that have subsequently been cited by other commentators.
And page 53 of Prospectus also stated; “The unaudited income statements for the period from 1 July 2010 to 26 November 2012, which were derived from the unaudited accounting records of DSE, exclude certain items, such as inventory impairment … as these adjustments were not recorded in the DSE unaudited income statements. These items were charged to either the acquisition balance sheet or the impairment loss and restructuring provisions recorded by the previous owner.”
Importantly, it could be argued the information pertinent to inventory has now been ‘disclosed’, even though it is equally arguable that very little was really disclosed.
Disclosure regime needs overhaul
While the furore surrounding DSH’s demise may focus on inventory changes and private equity’s role, we believe any Senate Inquiry should broaden its scope to include the disclosure regime upon which all laws and regulatory guidances - designed to protect retail investors - are based.
Of course, we don’t expect anything will change.
In the meantime, for investors worried they might be duped when examining a prospectus in the future, simply take a look at the Statutory and Pro-Forma Historical Consolidated Balance Sheet. There you will find a business that would list with $33.5 million less cash than the $46 million it started with, $26.5 million of borrowings (where previously there were none), and $40 million less equity than the $156 million it had prior to the float. And all this despite investors ‘contributing’ equity of $337 million.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any individual.