Is Dick Smith’s float one to watch?

Is Dick Smith’s float one to watch?

Last week’s Freelancer (FLN) IPO marked the 73rd ASX listing this calendar year. We have steadily grown more and more skeptical at the speed many businesses are being brought to market in the pre-Christmas rush.

Given a somewhat fully valued listed market, new IPOs have been labelled as the ‘only game left in town’ and we have witnessed incredible demand for what we would class as B or C grade businesses.

And with new valuation metrics such as EV/Sales (or anything else that can be quantified), not EV/Cash Flow or even EV/Earnings being marketed as reasons why companies should trade at lofty multiples, we certainly think that now is not the time investors should be throwing caution to the wind.

This goes for the upcoming float of Dick Smith Electronics (DSE), given:

• Anchorage Capital paid $94m for the business from Woolworths (WOW) just 12 months ago and is floating it for $520m.
• The well-published challenges WOW experienced with the business – and they are some of the best retailers in the country.
• After comparing some basic financial metrics to the number one Australian electronics retailer in JB Hi Fi and uncovering that it generates lower returns on capital, generates lower profit margins and materially lower revenues from a larger number of stores (smaller format).
This by itself is enough to put us off opening the prospectus and risk wasting our time undertaking hours of research. But not so fast.

Putting aside initial biases and instead digging further and talking with management, here are a few things to note:

• Whilst Anchorage capital is selling a meaningful portion of its stake, it will retain 20% with management and key staff, including the new CEO, also holding a further 5%. This provides comfort that they haven’t stripped the business completely bare for the IPO.
• Dick Smith’s new CEO spent 24 years at Myer and has built up a significant level of retailing and managerial experience. A history of long tenure and skin in the game generally results in corporate alignment, and hopefully, many years of sustainable growth.
• After trawling through a number of Woolworths’ past annual reports, we discovered that it had written off the carrying value of Dick Smiths by $420m just prior to it being sold.
• This carrying value was justified by the firm’s auditors given it was earning ~$17m NPAT, as shown below:

• Under Anchorage Capital control, the business has boosted NPAT from $7m in 2013 (an abnormal year given heavy restructuring) to a forecast NPAT of $40m. This suggests to us that a proposed $520m market cap upon listing is not overly aggressive, and compares with the $420m valuation write-down.

• Under WOW control, ~17m NPAT on ~$1,550b sales translated into NPAT margins of 1.1%.
• Assuming the $40m forecast NPAT is achieved by current management, this would mean a margin of 3.2% which compares to JB Hi Fi’s (JBH) 2013 NPAT margin of 3.5%.
• Given this margin is in-line with industry best practice, it appears sustainable and not necessarily dressed up for sale. Indeed, these numbers are indicative of the remarkable and major turnaround that has been achieved since acquisition from WOW in November 2012.
• In comparison, JBH margins since 2008 are as follows:

• We note that in 2012, WOW management aggressively sold down Dick Smith stock and raised cash prior to its sale. This ‘fire sale’ caused intense market dislocation, putting JB Hi Fi’s margins under pressure. Since then, JBH margins are back on the rise as companies including Dick Smith have operated more rationally.

• In terms of future growth, whilst Dick Smith’s store rollout program is not as exciting as other retailers, the business’s turnaround is still in its early stages and a new concept store is being rolled out. This is coupled with positive like for like (LFL) sales in the retailing industry at present and positive tailwinds for the business’s top-line. Indeed management is expecting 2% sales growth.

• And whilst an aggressive sharpening of the cost base has taken place, new efficiency measures are still planned, and we expect costs savings to continue over the next two years.
• We would therefore anticipate that if Dick Smith can again begin to grow its sales line while improving its business efficiency, margins should improve further. Hence, profitability in future years will rise. As we know, in the longer term, shares prices follow earnings.

In Dick Smith, what appeared at first glance to be something of on an ugly duckling is actually a solid, well-established business with an invigorated management team and a clear strategy for the future.

Sure, it’s unlikely the business will be able generate the scale benefits and profitability of JBH, but given the pricing of the float at 13x forecast earnings vs JBH at 17x, we believe that discount is supportive.

We are more comfortable with the business, its earnings and hence its upcoming IPO post our review. And this was only reinforced when we also met with management. Despite these positives however, a lack of value has prevented us from participating.