Dick Smith disaster should make us questions all retail profit results

James Thomson
Jul 14 2016
Should investors trust the results of retailers this reporting season?
That might sound like a dramatic question, but the more we learn about the mess that is the collapse of Dick Smith, the more relevant the issue becomes.
As has been made clear by receiver Ferrier Hodgson and now by administrator McGrathNicol, an increasingly desperate Dick Smith management team saw sales going south and started making procurement decisions based on which product was going to earn them the biggest rebate – that is the “over and above” payments that a retailer could earn if it fulfilled a certain condition, such as ordering or selling a certain amount of units.
These rebates aren’t illegal – heck, they even have their own accounting standard.
But they also aren’t transparent. And as suggested by the Dick Smith example, in some circumstances they can be determinantal to the health of the business.
“Purchasing decisions increasingly based on rebates ultimately leads to a slowing of inventory turnover rates, as the products are generally less popular with customers,” the McGrathNicol report says.
“Eventually, in the case of DSG, heavy discounts were needed to sell the rebated stock, destroying the margin uplift that the rebate sought to achieve and, in some cases, the stock could not be sold at all and became obsolete.”
According to McGrathNicol, the “over and above” rebates did not just give a little boost to earnings, they transformed it.
In 2014-15, Dick Smith reported earnings before interest, tax, depreciation and amortisation of $72 million. Take out O&A rebates of up to $93 million, and some other rebates and advertising subsidies, and Dick Smith’s adjusted EBITDA loss would have been $119 million.
Inventory build-up
The rebate-driven buying led to a massive build up of crap stock and, eventually, a big writedown on that stock in late 2015. That write-down seems to have led suppliers to get worried about Dick Smith’s health. They tightened their credit terms and all of a sudden Dick Smith was in the death spiral.
The receivers want to see the directors and management answer some pointed questions in court about how and why this rebate strategy was pursued, and whether and why rebates that hadn’t been “earned” (that is, the conditions attached to them, such as hitting a certain level of sales, hadn’t been met) were included as profit.
What’s most scary about these rebate revelations is that we’ve only found out about the size and shape of the rebates after Dick Smith has collapsed.
The administrator’s report says the rebates were “regularly tested as part of its annual audit; with the auditors identifying that rebates were deal-by-deal and therefore needed regular review to ensure they were treated properly”.
But in the 2015 annual report of Dick Smith, I can find only one mention of the word “rebate” and that’s in an explanation of the accounting policy related to inventories.
There’s certainly no mention of the specific amount earned from rebates in the notes to the accounts, nor in auditors’ report.
Investors in the dark
Indeed, the results for that year showed profit and EBITDA gently rising from the previous year. It wasn’t a stellar result, but in the context of a tough retail sector, it wasn’t terrible either. An investor in the company may have walked away from the result relatively pleased with their shareholding. Had they known about the true picture of the rebates, they may have been running away to sell up.
So how on earth is an ordinary investor supposed to track rebates and their influence on a result? Indeed, how can an investor in the retail sector be sure, as they scan accounts this reporting season, that the earnings reported are as they seem? Where do you look?
Already this year we’ve seen Target forced to restate its earnings after discovering rebates had been booked as profit. That mistake cost several executives their jobs, and left chief executive Richard Goyder chastened.
But that example shows that it’s not just poor retail businesses – because that’s what the latter-day Dick Smith was – that can be caught up in rebate disasters.
Retailers might dismiss rebates as a normal part of doing business.
But the complete lack of transparency around them, and the way they appeared to have led Dick Smith management to run the business in a way contrary to the interest of shareholders, mean these rebates can become ticking time bombs.
It’s hard to expect mum and dad shareholders to ask management to explain the level and type of rebates used in a retail business. But lets hope there are some fund managers and analysts ready, willing and able to ask the tough questions.