Dick Smith's 12 years a slave to private label

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

Twelve years worth of batteries.

On 15 October 2015, nearly three months before Dick Smith collapsed with $400 million in debt, company secretary David Cooke sent an email to chief executive Nick Abboud and chief financial officer Michael Potts querying why the company was holding so much private label stock.

"Dick Smith AA Battery 40-pack, 141 months' cover in Australia," the email read. "Dick Smith AAA Battery 30-pack, 131 months' cover."

That meant, based on sales in the preceding four weeks, the electronics retailer was holding enough AA batteries to last nearly 12 years, and enough AAA batteries to last just under 11 years.

"It had been brought to my attention that we had potential overstocks in these products," Cooke told a Supreme Court hearing on Monday, where he appeared to answer questions from receivers Ferrier Hodgson over the collapse of the company.

Quizzed by barrister Jeremy Giles SC, acting for Ferrier Hodgson, Cooke said he separately queried Mr Abboud, Mr Potts and Dick Smith's head of private label, George Papacosta, on the anomaly.

"[Abboud said] that he would look into it," Cooke told the hearing. "He then came back to me and indicated that the higher levels of stock [were] in relation to proposed marketing activities in the lead-up to Christmas.

"[Potts said] something along the lines of, he would look into it. [Papacosta said] something along the lines of, the company was in the process of agreeing to sell private label through a new channel, which I wasn't aware of at the time of writing the email."

It was around this time that Cooke was responsible for co-ordinating "Project Jerry", described as a "company-wide project to drive improved cash flows through the Christmas trading period".

In a separate email to the Dick Smith board ahead of a presentation to Macquarie, independent non-executive director Jamie Tomlinson wrote: "I have a red flag concern about how we 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."

In response, Cooke wrote there were two reasons for the impact on cash.

"First, increased private label reflecting increased wait in-store and desire to drive margin expansion and timing of buying before the Australian dollar depreciated too far," he wrote. "Second, timing of buying of branded product."

Cooke told the hearing that explanation came from conversations with Mr Abboud and Mr Potts "that the company was able to take advantage of opportunities to buy product at attractive prices, either from a currency perspective or from a pricing perspective".

In its report into the collapse of the ASX-listed company, liquidators McGrathNicol said Dick Smith's post-float expansion plans "went unchecked" and major inventory purchasing decisions meant by early to mid-2015 the company was "carrying too much stock that was not saleable and was overvalued".

In a letter to former directors and officers of the company, lawyers for Ferrier Hodgson alleged a number of "wrongful acts" that led to the company's demise, including inflating earnings by deliberately buying too much stock and booking rebates from suppliers as profits.

Ferrier Hodgson alleges the directors and officers breached their duties by failing to have proper reporting systems in place to track and manage stock purchases, The Australian Financial Review reported.

In his questioning, Giles pressed Cooke on his recollection of senior management's discussions about sales performance, new store openings, stock levels, the decision to increase Dick Smith's credit line with lenders Westpac and HSBC, and the policy of "maximising" so-called "over-and-above" rebates.

These "O&A" rebates - effectively payments the company could earn by meeting certain criteria such as ordering or selling a certain number of units - mostly came back in the form of "promotional support".

This would then be accounted for as a reduction in marketing expenses, with and excess then booked as a reduction in cost of sales for the month the rebates were negotiated.

This was in violation of accounting standards, as it was "potentially prior to both the sale of inventory and any receipt of the agreed support".

McGrathNicol's report highlighted how the company's management team responded to falling sales by making purchasing decisions based on rebates.

"Poor and declining performance appear to have led to management making decisions on what stock to buy (and at what volumes) based on the rebate attached to the stock, rather than customer demand," the report said.

"In periods of low profitability, some rebates provided a short-term incentive for management to prefer a certain supplier and product, because the rebate increased profit in the month of purchase, rather than when the product was sold (as ordinarily would be the case).

"Purchasing decisions increasingly based on rebates ultimately lead to a slowing of inventory turnover rates, as the products are generally less popular with customers."

Cooke told the hearing he was "not aware of the company having such a policy" to maximise rebates between July 2014 and December 2014, and details on how O&A rebates were accounted for were "not part of my remit", nor were there discussions at board level "regarding the accounting treatment" of the rebates.

Asked whether there were any "controls" in place regarding inventory purchases, Cooke said purchasing of inventory "was not part of my remit so I do not have a view".

In a bizarre exchange, Giles referred to a document produced by Cooke for the receivers, which the former company secretary described as "a calculation to look at the cash conversion".

"There is a sentence that runs across the bottom," Giles said.

"It says, 'Sell private label product bought at 98 cents, back to the supplier at 78 cents, and rebuy it at 78 cents or even 77 cents, with a 'risk' related adjustment ... reflecting a commercial arms-length trade would get it into stock at the new rates, generate cash and make a profit.'" What was that about?"

"I don't know," Cooke said. "I don't know whether I wrote that line."

"Do you have any understanding about why selling private label product bought at 98 cents back to a supplier at 78 or even 77 cents would generate cash and make a profit?" Giles asked.

"No," Cooke said.

Referring to notes of a senior management meeting on 13 October 2014, which warned of a seven per cent decline in same-store sales, Mr Giles quizzed Mr Cooke if there was "any discussion about whether it was a good idea to continue opening new stores when comparable sales were down". Cooke said he did "not recollect".

"[The new stores were] being opened in areas where there were no Dick Smith stores and in attractive catchment areas," he said.

"The decision was made by the property team and the CEO."

Ferrier Hodgson is questioning the group 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.

Other former Dick Smith staff summonsed include former chief executive Nick Abboud, who is due to appear in early October, and chairman Rob Murray, who is also chairman of retail wholesaler Metcash.

Anchorage Capital Partners' Phillip Cave and Bill Wavish, who represented the private equity firm on the Dick Smith board until early last year, would be grilled on their roles.

Cave, who had previously strenuously denied allegations that Anchorage had pulled off a so-called "private equity heist", said he would co-operate fully with the receivers.

Anchorage bought Dick Smith from Woolworths for $20 million and made $500 million after floating it on the stock exchange nine months later. Dick Smith collapsed in January with debts of around $400 million, including about $140 million to Westpac and HSBC.

The last stores closed at the end of April, with all of the more than 3300 staff paid their employee entitlements in full.

Online retailer Kogan purchased Dick Smith's online business from the receivers earlier this year, with the website relaunching in May.

The hearings continue.