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Managing Working Capital Is Key to Growth and Survival: Hard & Costly Lessons

September 1st, 2016

In this post I want to share a story with you. It arises from a chance conversation with a member who is working with a client who has an inventory management challenge which came on the back of an article another friend of mine sent me about a report on the failure of the Dick Smith retail group in Australia.

I want to start with Dick Smith. This is (soon to be was) a company founded by, yes you guessed right, Dick Smith in 1968 with capital $610. I bought a car radio from him in 1969 from a small shop under a car park. He was an amazing entrepreneur- a unique character who wrote the book on customer service and the use of PR as a marketing tool before these things became popular. He sold the business to Woolworths (a major Australian retail group) in 1982 for $25m when $25m was a lot of money and he has since gone on to do many great things in, and for, Australia. But that’s not the story I want to share.

Dick Smith (the company) went through a series of phases and ended up as a $1.3 billion publicly listed company (listed in 2013) specializing in consumer electronics. It had steady gross margins around the 24% and operating costs of around 20% to yield a net margin of about 4-5% in a typical year. This is not what you’d call a stellar result but, for the intensely competitive consumer electronics industry, it was okay…. although it seems the most recent published accounts appear to deviate from the truth.

Suddenly this 48 year old company seems to have come off the rails. Under what appears to be new greedy, and as it turns out, incompetent and perhaps dishonest management, the company grew far too fast for the resources it had available to fund its growth with the result being in a few years (1-2 to be exact) it has incurred significant trading losses arising from excessive capex, deep discounting, and very bad customer service and has accumulated debts of at least $260 million which is way in excess of the $170 million that its most recent 2015 balance sheet showed.

The company was listed in 2013 by its new owners (a private equity group) at a valuation of $520 million after being acquired for $115 million in 2012. WHAT! How can a company in a mature, relatively stable, and highly competitive industry all of a sudden become that much more valuable?

If you run the numbers, the value growth from when Dick sold to Woolworths in 1982 to 2012, the year Woolworths sold the business, was 5.2% per year. Then somehow that value increased by 352% in one year … go figure. Today, of course, it’s worth nothing.

I have not taken a close look at the financials for the company from the IPO to now so I don’t know how much of the $520 million valuation went back to the private equity group that acquired the business as cash or was retained as equity. $95 million presumably went back to Woolworths (via the new owners) because the initial down payment on the $115 million acquisition was $20 million. That leaves $425 million in cash or equity but whatever the split my guess is there should have been sufficient funds available to fund a growth plan.

However, the fact that the company failed tells me not enough cash was left in the business, and/or growth was excessive given the availability of funds, the market situation, and/or there was a simple, but devastating, failure to manage working capital which seems to have happened.

For example, I understand that the cash conversion cycle (receivables days + inventory days – payables days) increased from 13 days in 2013 to 38 days in 2015. This required an additional $80 million to fund the working capital growth.

Had management use GamePlan’s Fundable Growth Rate Module that would never have happened. Or if it did happen it would be because management simply does not understand basic principles of financial management.

Dick Smith—the founding entrepreneur—does understand financial management principles. When asked to comment on the failure of the business Dick Smith himself said:

…most people would know Anchorage Capital Partners’ sale of the company for $520 million after picking it up from Woolworths for $94 million was impossible – you can’t have that type of gain in a short time … there’s no such thing as sustainable growth and cited the Dick Smith bubble burst as a classic case of people going for quick growth and getting into very quick problems.

There are a bunch of lessons in this story:

  1. Dick Smith (the person) did not need a huge pot of funds to build a great business – $610 was all he had.
  2. He has a great business idea centered on car radios, speakers, and parts for electronics enthusiasts (bit like Radio Shack here in the US)
  3. His genius was in guerilla marketing through PR and outstanding customer service which included, as I personally experienced when I bought a radio from him, a really noisy, happy, loud, store in which everyone was having a ball working with each other and their customers. The entire team was genuinely passionate about what they were doing and that was led by Dick’s boisterous exuberance. It was the sort of buying experience you talked about and I did!
  4. Dick grew his business within the funding constraints available to him presumably a combination of debt and equity. I have no idea how it was structured but we do know he opened 20 stores by 1982 and did not fail in the meantime so he must have managed his growth prudently.
  5. You can make an awful lot of money as an entrepreneur when you get it right. Dick parlayed $610 into $25 million over 14 years. This beats working for wages and way out-performs what you could reasonably expect to get from any traditional investment. And what’s particularly interesting about entrepreneurship is because you can control so many of the success variables it offers outrageous gambling casino returns without gambling casino risks.
  6. When “corporate” types i.e. Woolworths’ management get involved in an entrepreneurial company, the flair and excitement wanes and a successful business model often gets derailed – in this case Woolworths shifted focus from Dick’s enthusiast electronics and car radios into broader consumer electronics that had some other big players in a highly competitive, hard-to-differentiate market. This might have been necessary given the market at the time but if that’s so it shows that Dick had superb timing and got out before his model was one its way out. But the growth in the value of the business grew from the time he sold to just 5.2% per year.
  7. When “money people” get involved in businesses beware. Based on the performance of the company at the time of the acquisition from Woolworths the business couldn’t possibly have been worth $520 million. But let’s suppose it was. Clearly, the people who were in the management seat were not able to manage to that value. Specifically, they did not know how to manage working capital and they did not understand that growth will be constrained by the availability of funds—grow to fast you die, grow too slowly you miss opportunities. The key to sound financial management is the find the sweet spot.

Four working capital lessons to take away and share with your clients from this corporate disaster are well summarized by Michael Stapleton in an article published in Smart Company (July 18, 2016):

  • Pay attention to your balance sheet, as well as your profit and loss statement.
  • Learn how to construct and read a funds flow statement. It will tell you where your money is coming from and going to. It will help you understand why you sometimes feel like you are going broke whilst making a profit. This is a key GamePlan report that every one of your clients should get every year – the Annual Business Performance Review (ABPR).
  • Pay attention to your working capital. Regularly measure the length of time it takes to sell stock, collect debtors and pay creditors – see ABPR
  • Your working capital is often the largest investment in your balance sheet. Managing it well usually has a bigger impact on your cash flow than the earnings of your business – GamePlan Fundable Growth Rate Module deals with this important issue.
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