Administrators' report on collapsed chain reveals flaws in growth and a $64m mountain of unwanted stock.

Administrator McGrathNicol handed down its report into the collapse of the Dick Smith electronics chain last week. Here are three things we've learned:

1. Retail profits can be deceptive

When retailers buy stock from suppliers they often get a "rebate" from the supplier in exchange for buying a lot of stock.

For instance, a retailer might buy a laptop from a computer maker for $500 and receive a $50 rebate from the manufacturer. McGrathNicol notes this is a legitimate strategy that can help retailers increase profit margins.


But rebates also provide an immediate profit. Usually retailers can't record a profit until they've sold an item, but in our example of the $500 computer, the $50 rebate would have immediately added to the bottom line.

"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)," the administrators found.

The rebates led Dick Smith managers to buy products which came with rebates rather than those consumers might want to buy. This meant the retailer had to sell the products at heavy discounts (or in some cases throw them out) destroying any benefits from the rebates.

Ultimately Dick Smith managers built up A$60 million ($64m) worth of stock they couldn't sell.

2. Not all growth is good

It is an axiom in business that companies should try to increase their sales, but the collapse of Dick Smith shows not all sales are equal.

In the two years or so before it collapsed, Dick Smith opened about 60 new stores as it chased sales. Revenue growth was based on store growth and commercial sales at low margins, the administrators said.

That's fine if profits are increasing but, as the company continued its store expansions, sales in existing stores were falling and its outlets failed to compete in their local markets. However, investors didn't hear about this.


"The declining comparable same store sales were not highlighted in the financial results due to 'new revenue' from new stores and growth in the non-core business," said McGrathNicol.

The company spent A$83m opening new stores in the 18 months leading to its collapse. Much of this was funded by debt, and now forms part of the A$260m the company won't be able to pay to its creditors.

It is an axiom in business that companies should try to increase their sales, but the collapse of Dick Smith shows not all sales are equal.

McGrathNicol notes, as Dick Smith opened new stores to increase sales, the cost of those stores and their stock didn't immediately impact its profits, because they were treated as investments and so didn't appear on the profit and loss statement.

"In our view, there was insufficient analysis performed on comparable sales and the investment case to support continued store expansion. In our view, better and more focused analysis on comparable sales would have identified that the core retail business was experiencing declining sales and that the store expansion plan was eroding value by reducing the return on invested capital whilst at the same time increasing [Dick Smith's] debt burden," the administrators said.

Dick Smith had a 9 per cent share of the consumer electronics market in Australia and New Zealand in the year before it collapsed, yet it had nearly 400 stores, more than twice as many as JB Hi-Fi, which had a 26 per cent market share.

The administrators note this meant Dick Smith's funding and overhead to procure its sales "was considerably larger than its competitors, and almost twice as large as the next most significant player".

3. Watch out for private equity

The administrators haven't made any adverse findings against Anchorage Capital Partners, the private equity firm that floated Dick Smith on the share market, although its investigation continues.

It is clear there was a massive transfer of wealth from shareholders to Anchorage.

Anchorage Capital Partners bought Dick Smith from Woolworths in September 2012 for A$94m and floated it 15 months later for A$520m. Those shareholders are now left with nothing, while Anchorage's managers and investors have held on to their massive profits gained from flipping the company on the share market.

Aside from the new store openings masking the poor performance of existing stores, investors heard almost nothing about the rebates propping up the chain's profits. The Australian Financial Review noted the word "rebate" appeared only once in the company's 2015 annual report, and that was only a passing mention.

Yet rebates and advertising subsidies from retailers were responsible for turning what would have been a A$119m operating loss (earnings before interest, tax, depreciation and amortisation) into a A$79m profit.

None of this was illegal, nor is there any suggestion that Anchorage didn't comply with accounting standards, but it should give pause to investors next time a private equity firm wants to sell out of one of its investments via the share market.