Why the Dick Smith IPO will be a dud

Warren Buffett warns that IPOs are almost always bad investments

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Private Equity firm Anchorage Capital Partners is pushing ahead with initial public offering plans for consumer electronics chain Dick Smith Electronics (DSE). The IPO is expected to list on the ASX before Christmas, as a swathe of companies seek to list on the ASX, and take advantage of rising consumer confidence, as well as a rising stock market and demand for new equity offerings.

Some of the IPOs will turn out to be duds, while some will offer shareholders the opportunity to make substantial gains. Virtus Health's (ASX: VRT) initial offer price was $5.68, and was last trading at $8.65, a healthy rise of more than 40% for shareholders, while on the other hand, iSelect (ASX: ISU) has seen its share drop from $1.85 offer price to $1.37 as of close of business on Monday October 14.

Getting back to Dick Smith. Anchorage Capital bought DSE from Woolworths for just $20 million in September 2012, then paid the retail giant another $74 million to buy them out of an agreement if Dick Smith was sold. Now Anchorage hopes to attract around $600 million by selling DSE to the market.

Since taking over DSE, Anchorage has done an impressive job doubling earnings before interest, tax, depreciation and amortisation (EBITDA) from $36m under Woolworths in 2012, to $80 million in the year to June 2013. Anchorage says that it plans to open an additional 77 stores over three years to take the DSE network to more than 400 stores, including DSE departments in 29 David Jones stores.

Bu here's the rub. Investors should ask themselves why the owners have decided now is the best time to sell out. If the future looked very bright, surely Anchorage would continue to hold DSE and benefit from increasing earnings. But most of the easy gains may have already been made, through the closure of non-performing stores, selling off redundant stock and reducing costs. That may mean future growth is very unlikely to match 2013's doubling of EBITDA.

Additionally, DSE will have to compete with JB Hi-Fi (ASX: JBH), which has a much lower cost of doing business, Harvey Norman Holdings (ASX: HVN) as well as a host of overseas and local online consumer electronics retailers. It also seems highly unlikely that consumers will suddenly start flocking to David Jones stores to buy electronics.

Investors have been burnt by companies sold off by private equity in the past, with the most notable being Myer Holdings (ASX: MYR) and Collins Foods (ASX: CKF). Myer listed at $4.10 in 2009, is currently trading at $2.52, a 38% discount to its offer price, while Collins Foods listed at $2.50 and is currently trading at around $1.69.

Former Myer executive Nick Abboud is now the chief executive of DSE, and while Anchorage plans to sell its whole stake, Mr Abboud is expected to retain some or all of his equity in DSE post the IPO. Former Myer executive chairman Bill Wavish also has a small stake in DSE.

Foolish takeaway

Warren Buffett recently told Berkshire Hathaway shareholders that IPOs are almost always bad investments. He says there is so much hype involved that IPOs won't be the most attractive value. Investors should remember his words, "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 (company insiders) to a less-knowledgeable buyer (investors)."

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Motley Fool writer/analyst Mike King owns shares in Woolworths.

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