Dick Smith management discussed merits of buying stock 'cheaper rather than dearer'

Court hearings into the collapse of Dick Smith have begun. Photo / Nick Reed

"Retailer buy cheaper than dearer."

It was a simple handwritten annotation, scrawled on a pack of documents for a meeting of Dick Smith's finance and audit committee in May 2015, but the five words appear to have flummoxed the people left picking through the pieces of failed retailer to work out what went wrong.

That note, written by former non-executive director Lorna Raine, referred to a discussion between the committee and Dick Smith's management, chief executive Nick Abboud and chief financial officer Michael Potts, about the company's plans to deal with excess stock.

"I think that refers to a discussion that as a retailer it's better to buy stock at a cheaper price than a more expensive price," Raine told a Supreme Court hearing today, where she appeared to answer questions from receivers Ferrier Hodgson over the collapse of the company.

Barrister Jeremy Giles SC, acting for Ferrier Hodgson, appeared incredulous. "Surely there is an element of stating the obvious," he said. "What was the discussion about?"

Raine said she didn't "recall the specifics of the conversation".

"But Mr Abboud and Mr Potts were clearly in a conversation talking to the finance and audit committee about why the stock had gone up and how they were going to unwind it," she said.

That committee meeting took place around two months after a fellow board member said he first had an "orange light", when it emerged the retailer was holding nearly AU$100 million in excess stock.

Bill Wavish, who represented private equity firm Anchorage Capital Partners on the Dick Smith board until March 2015, said until around December 2014 the company's inventory was "surprisingly accurately managed" at around the AU$250 million mark.

Anchorage bought Dick Smith from Woolworths for AU$20 million in late 2012 and made AU$500 million after floating it on the stock exchange nine months later.

Under the policy developed by Wavish following Anchorage's purchase of the business, Dick Smith would hold around 90 days worth of inventory - roughly consistent with 80 days for the likes of JB Hi-Fi, Dixons in the UK and Best Buy in the US.

Ahead of the Christmas peak that would increase by AU$100 million to AU$350 million, before coming back down by the end of February.

"In the period I was there, that remained the case until in December 2014, the inventory was slightly higher than we would have expected," Wavish told the court.

"It was about $30 million too high. But by January and February, it was almost $100 million too high, which was the first orange light as far as I was concerned."

Pressed by Giles on why it wasn't a "red light", Wavish said such a build-up was "not unusual in retail".

"The issue is how does management respond," he said.

"If they'd had a bad past track record of managing things I would have been concerned. I basically asked [Abboud and Potts] what they were going to do about it.

"They had a plan to take it down to $248 million, and they had a good track record of doing it before, so I believed there was no reason why they wouldn't achieve it."

Dick Smith collapsed in January 2016 with around AU$400 million in debt, including $140 million to lenders HSBC and Westpac.

In its report into the company's failure, liquidator McGrathNicol was scathing of questionable purchasing decisions based on rebates the company could earn from suppliers rather than customer demand, leading to a build-up in unsaleable or overvalued inventory that ultimately had to be written off to the tune of $60 million.

On Monday, former company secretary David Cooke told the court he raised concerns with Abboud and Potts via email in October 2015 about a massive overstock in Dick Smith-branded batteries, to the tune of nearly 25 years supply.

In a separate email to the Dick Smith board discussing a presentation to Macquarie, independent non-executive director Jamie Tomlinson said he had a "red flag concern" about how the company would explain the spike in inventory and the $65-$75 million adverse cashflow.

"We're attributing this to a private-label inventory build up - seems like a lot of private label to me," Tomlinson wrote.

Raine told the hearing that "yes we were concerned" about the inventory spike, and it "formed part of ongoing board discussions" with the board seeking "plans from management in terms of how this was going to be unwound".

She said while she didn't "recall specifically" what those plans were, "management had comprehensive marketing activity plans [and] secondly management had adjusted their ordering profile".

Much of the questioning of Wavish, Raine and Cooke has concerned the Dick Smith board and management's policy towards "maximising" so-called "over-and-above" rebates, and their accounting treatment.

O&A rebates are payments the company could earn from suppliers by meeting certain criteria such as ordering or selling a certain number of units. Dick Smith breached accounting standards by reporting the increased profit from the rebates in the month of purchase, rather than when the associated product was ultimately sold.

Wavish defended the company's policy of "maximising" rebates from suppliers, which he said was a decision taken by himself, Abboud and Potts.

"There seems to be a view that rebates are bad," he said. "Rebates are good - retailers cannot survive without supplier rebates. For most companies, including Dick Smith and Woolworths, the total of supplier financial support during the year exceeds their profit. You avoid maximising rebates at your peril."

Wavish described it as a "whole of business strategy".

"Everybody knew to maximise," he said.

"The fundamental part of the acquisition of Dick Smith from Woolworths was that Dick Smith had previously been capable and should in future be capable of generating a lot more money out of suppliers.

"There is a whole skill in this area, and I regarded Abboud as being good at that skill. While you may send the buyer back to get additional rebate, a far more fertile ground is to go to other people in a supplier with their own budgets, not in the sales department.

"So for example in the marketing department, the supply chain department, maybe look for wage subsidies to sell more product in your stores, and maybe getting someone like Mr Abboud to go along to senior management to get a last bite.

"That was a whole of business strategy and was very successful. The issue was not [whether rebates] are a good thing. The issue is how are they accounted for - and the auditors were happy."

Ferrier Hodgson is questioning the group of 10 former directors and managers using powers under sections 586A and 597B of the Corporations Act. The Australian Securities and Investments Commission is also conducting its own investigation into the collapse.

Evidence obtained under oath during the hearings may be used to determine whether there is a case for criminal charges to be brought.

Tomlinson is due to appear on Wednesday, while Abboud will appear in early October.

Others summonsed include former chairman Rob Murray, who is also chairman of retail wholesaler Metcash, and Anchorage boss Phillip Cave.