Lessons from Dick Smith's collapse and what to look for within an IPO prospectus
As the dust finally settles on the infamous collapse of electronics retailer Dick Smith Holdings (ASX: DSH), what's now surfacing are valuable lessons on how investors can avoid getting burned on future IPOs.
Admittedly, there is a senate inquiry into the collapse of Dick Smith, but it remains to be seen whether it will have the cerebral horsepower to correctly identify the issues or the political will to make any reforms that make bringing a company to market even more demanding than they appear to be.
Meantime, what resonates loudest over the Dick Smith debacle is the degree to which satisfying prospectus obligations (under the law) and the board's disclosure obligations to shareholders can become binary opposites.
The fancy footwork that's come back to haunt those who put their faith in Dick Smith's IPO prospectus was the decision to show inventory at November 25, 2012 at $370 million, only to write it down $58 million to $312 million one day later.
While any right minded person may have concluded that this was 'material information' that investors had the right to know, the write down did not find its way to the Dick Smith prospectus, nor did it make its way to the report by Deloitte as investigating accountants.
Don't shoot the company
If Dick Smith can 'hand on heart' claim to have met its disclosure obligations under the letter of the Australian Corporations Act, then the board has every right to point the finger at the lawmakers as the source of investor angst.
If the 'general disclosure' test for prospectuses, contained within the Australian Corporations Act, allows Dick Smith to omit information investors would reasonably require to make an informed assessment about the prospects of the share issuer – then the current regime of disclosure appears seriously corrupted.
Similarly, it's important to note that the balance sheet data in the prospectus dated November 2013 only related to June 2013, and ironically this still managed to meet the disclosure required by ASIC in its regulatory guidance 'Effective disclosure for retail investors'.
Ironically, the senate inquiry is likely to be more fixated on the role of private equity in Dick Smith's IPO than the disclosure regime upon which all laws and regulatory guidance – designed to protect retail investors – are based.
The lesson for investors trying to decipher an IPO prospectus is A) don't take the rhetoric at the front of the prospectus at face value, B) pressure-test the numbers and earnings projections by seeking professional input, and C) be doubly wary where the IPO is being brought to market – as Dick Smith was – by private equity.
Dick Smith's collapse also flags question marks over the timing of the release of historical data.
IPO Prospectuses are notorious for hand-picking only the choicest morsels of data around historical trading performance and balance sheet changes.
As a result, it's not uncommon for heavily-modified and normalised historical revenue and EBITDA contained with an IPO prospectus to be unrecognisable from the tax returns the former owners of the business filed to the ATO.
By glancing at the Statutory and Pro-Forma Historical Consolidated Balance Sheet, would-be investors would have found a business that would list with $33.5 million less cash than the $46 million it started with,$26.5 million of borrowings (where previously there were none), and $40 million less equity than the $156 million it had prior to the float – that's despite investors 'contributing' equity of $337 million.
What should be eminently obvious?
Would-be investors shouldn't have to be season share market analysts to piece together key IPO prospectus data that should be immediately apparent to anyone reading it.
However, the capacity for Dick Smith's IPO prospectus to blur key information with seeming impunity makes a mockery of the both the law and the auditor upholding the best interests of investors.
As a case in point, the $149 million inventory valuation as at June 2012, the subsequent jump to $370 million on 25 November 2012, the fall to $312 million on 26 November 2012, and the $168.5 million at June 30, 2013 (while reported in historicals provided on the day of the float, as is required) were not numbers disclosed with any obvious intent within the prospectus.
Also buried with the prospectus on page 62, in tiny font under the heading 'Acquisition and Restructuring Costs' stated… "and $2.5million in costs related to achieving a significant reduction in the inventory balance." But what remained a mystery was the extent of those changes in inventory.
Then on page 53 the Prospectus also stated; "The unaudited income statements for the period from 1 July 2010 to 26 November 2012, which were derived from the unaudited accounting records of DSE, exclude certain items, such as inventory impairment … as these adjustments were not recorded in the DSE unaudited income statements. These items were charged to either the acquisition balance sheet or the impairment loss and restructuring provisions recorded by the previous owner."
Clearly, further information relevant to inventory was subsequently disclosed, but it's reasonable to dispute that the company went out if its way to disclose precious little at a time when the information was most needed.
What value in the checks and balances?
While an IPO prospectus is first and foremost a marketing document, too many mum and dad investors' still tend to blindly assume they 'investment grade' when they're clearly not.
Given that an IPO prospectus is supposed to satisfy myriad checks and balances, this is hardly surprising. But despite those check and balances, the Australian Securities and Investment Commission (ASIC) previously found that around a third of float prospectuses misled investors.
Ironically, while an auditor's opinion is supposed to accompany the financial information contained within an IPO prospectus, it's typically limited to its compliance with what the law prescribes for, and little else.
However, it's not uncommon for an auditor's opinion to conveniently coincide with a time when not all information about the historical performance of the 'business' is always available – and during the fund-raising period is a classic example – hence making it easier for meaningful financial information to be conveniently omitted.
Useful IPO tips.
Given that it's tricky buying into IPOs at the best of times, the following tips should help you identify true value within the mixed bags of floats in 2016.
- Stick to your value investing principals: You should be attracted to the floats of companies with consistently above-average return on equity (ROE), with little debt and not too much goodwill on the balance sheet.On the flipside, steer clear of buying into floats where the net tangible assets (NTA) or net worth (pre-IPO) is negative.
- In whose best interests: If you're contemplating buying into a float where the people responsible for turning the company around are planning to exit relatively quickly – think again.
- Focus on the fundamentals: As a value investor, you should be more interested in investing in an IPO for the long term than"stagging" or selling immediately after the IPO for a quick profit. Given that a company's (IPO) glossy prospectus is also an advertising document, you need to see through the hype to the underlying quality of the business and its core earnings, and especially where future growth will come from.
- Do your homework: It's equally important to investigate previous financial statements of companies planning to float and find out whether the money raised is being earmarked to fund expansion or repay debt,and the amount to be paid to existing owners.
- Wise words from Warren Buffett: The world's most successful investor expressed his cynicism towards IPOs in the following quip."It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer."