The Sugar Hit of Balance Sheet Funding – Dick Smith and the Macroeconomic Implications for Australia

“Come the end of 2015 financial year, however, it really comes home to roost. Operating cash flow was negative $4m, as inventory increases further and suppliers demand payment, decreasing accounts payable. The business is required to take on $71m in debt to fund a more sustainable amount of working capital. As the benefit of prior accounting provisions taper-off, profit margins fall, and the company reports a toxic combination of falling same-store sales and shrinking gross margins in the recent trading update.”

Dick Smith is the Greatest Private Equity Heist of All Time

Background

As per the above quote Forager Funds Management recently published a scathing critique of the private equity alchemists at Anchorage Capital and their handling of the purchase (and subsequent IPO) of Dick Smith Electronics.

The analysis is a timely reminder that while balance sheet funding can provide a sugar hit to dress up P&L outcomes in the short term, when reality bites the transition back to a more sustainable model (where day-to-day activity is funded from recurrent income) can get very ugly, very quickly.

Introduction

I was reminded of the Dick Smith story while catching up with an old mate in Sydney who has two boys in private school. Over dinner he mentioned that some 25% of private school fees are actually paid by grandparents.

(I could only find a quote that mentioned a figure of 15-20%, but either way that’s still a lot of money).

As the parent of two boys myself I have often wondered how on earth people could find $50K+ each year (in after tax dollars for two students) to pay those fees.

Turns out a significant proportion don’t.

Borrowing From The Past

You would need approximately $1m in capital to generate $50K in after tax income to pay those fees, and while no doubt some grandparents have that much wealth (in excess of their own requirements), it is reasonable to hypothesise that a significant proportion of private school fees are now being funded from our (historical) balance sheet, rather than the (current) P&L.

This is a process which cannot continue indefinately, and – as the capital is slowly consumed – will show up in declining rates of enrolment (and consequently income and employment amongst private school teachers, administrators, etc).

Borrowing From The Future (Part A)

The Federal Government currently borrows nearly $1 billion per week to fund its P&L (for the purpose of this analysis I will ignore deficits at the state and local government levels).

It is important to note that debt is simply future consumption brought forward in to the current period, so the Federal Government is effectively borrowing against the future to fund its budget.

That means that more than 2.5% of Australia’s GDP is being funded from the public balance sheet. (Total debt is on its way to half a trillion dollars, and there is no prospect of a balanced budget in the forward estimates).

But in terms of our borrowing from the future the actual figure is actually much higher than that.

Borrowing From The Future (Part B)

In terms of both nominal $$ and percentage of GDP construction activity is at an all time high.

More than 1 million Australians (approximately 9% of the workforce) are employed in residential, commercial and engineering construction, which is not surprising given that:

  • Construction is relatively labour-intensive
  • As anyone in Sydney and Melbourne will attest, we are going through a residential construction boom of historic proportions

Most of the funding for residential construction comes from an expansion of the balance sheet of the major banks.

In effect the salaries of a significant proportion of the Australian workforce is being funded from an expansion of our collective (household) balance sheet.

This is simply not sustainable, and begs the question of what those hundreds of thousands of people will be doing when the balance sheet funding eventually (and inevitably) dries up.

(The interplay of unsustainable fiscal and monetary policies has actually created systemic risk in the Australian banking system, but that’s a conversation for another day…)

Borrowing From The Future (Part C)

But is is not just the tradies who are benefiting from this balance sheet funding.

When I went to law school back in the 80’s, tertiary education was paid for by the government out of its P&L.

While the train wreck that is vocational education has far more to do with flawed public policy and poor governance, the whole tertiary sector is an example of how poorly the government is using its funding.

As a recent article confirmed, law schools around Australia turn out 12,000 graduates each and every year, in to a sector of the economy that only has 60,000 professionals.

So in fact part of the government’s $1 billion per week is being used to fund the salaries of university lecturers and other staff who are being paid to train people for jobs that simply don’t (or won’t) exist.

While again employment in the tertiary sector adds significantly to the national P&L, it is simply not sustainable, and as the student loan book grows and grows (now approximately $30 billion), the government will eventually be forced to transition back to a model where education is provided only:

  • Out of recurrent income
  • Otherwise where the investment can confidently generate a return to cover the government’s weighted average cost of capital (as well as repay the capital itself)

Conclusion

While no doubt this blog post could benefit from a more thorough statistical analysis, nonetheless my hypothesis is that in excess of 10% of Australia’s current P&L (ie GDP) is a macro-economic fiction conjured up from our collective balance sheet, and if the recent experience of DSE shareholders is anything to go by Australia is headed for a painful adjustment that has no precedent in modern economic history.

All that is required to trigger that process is for the balance sheet funding to start to dry up.

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