Description

Note that this is a low quality [“sort of”] cigar butt Australian nanocap with <US$100k of liquidity without news flow so likely appropriate for only a tiny subset of the VIC readership.

Summary

SurfStitch Group (SRF) is an Australian 1P online retailer focused on the surfer niche but branching into snow/skate and eventually broader action sports.  SRF acquired online peers in the US and UK before a late CY14 IPO at A$1.00/shr or over a A$200mm valuation.  In CY15, SRF raised another A$90mm at A$1.50 and A$2.00 to pay for A$60mm of deals in media and hardware.  Everything was looking good until they abandoned FY16 (June YE) guidance during its 1H release in February.  The CEO suddenly resigned shortly thereafter, supposedly to pursue an MBO that never materialized.  SRF cut guidance twice more, in June installed a COO hired in May as its new CEO, saw the departure of its Chairman, and saw an accounting reversal connected with a now-unilaterally cancelled A$20mm cross-licensing deal that it is getting sued for.  SRF burned over A$30mm of cash in FY16 and has just A$21mm left.  The company’s sell-side coverage has evaporated, and the shares troughed at A$0.10 before a ‘vigorous’ recovery to the current A$0.175.  

I don’t blame anyone for whom reading that led to the disgorgement of some recently consumed foodstuffs.  But at the current price, the company is trading for 20% of FY16A revenue, which is too low.  SRF should be able to bridge its liquidity over the next 2-3 years, which is enough time to right the ship if that’s at all realistic.  Either way, I think the shares are worth at least trading for a bounce if the business shows any signs of life (base case), though if management actually stabilizes the operation, the blue sky scenario is a multi-bagger.  The terminal downside is a donut (the bad kind), but in the interim, the company still has a combination of cash, saleable media and hardware assets, and no financial debt.

The Business

• Largest (admittedly of few) global pure-play online retailer of surf-related apparel and products.  Operating from facilities in Australia, the UK, and the US.

• Legacy Australian website is surfstitch.com, but acquired swell.com (US) from Billabong and surfdome.com (UK) from Quiksilver.

• Historically competed on price, brand/SKU assortment, and delivery times (1-2 day local country deliveries in Australia and the UK) in the image of Amazon.

• >50% of the business is apparel/footwear a la Zumiez, Tilly’s, et al, with hard goods such as surfboards at ~20%.

• The table below breaks out reported revenues and gross profits, as well as my rough guess on contribution margins (I would not bank on these being right as they are purely directional and would love to compare figures if anyone else has taken a stab at them).

History

• Founded in Sydney by Justin Cameron (recently departed CEO) and Lex Pedersen in CY2007/08.  Justin was an ex-sell-side research guy and Lex had worked in operations for a surf retailer.  Bought were surfers and the business started out of Justin’s garage, selling products on eBay.

• Billabong bought 20% of SRF in 2009 when it was Australia-only, and took its stake up to 51% in 2012.  It was around the same time that Billabong also acquired swell.com.

• SRF bought itself as well as 100% of swell.com (now SRF USA) from Billabong in Aug 2014, in the midst of Billabong’s restructuring under Oaktree.  News reports suggest Billabong got proceeds of roughly US$35mm, which would very roughly place the implied value of Australia + US retail at A$70-90mm.

• Bought surfdome.com from Quiksilver in Nov 2014 for about A$45mm.  Surfdome was founded in 2005 by current SRF European head Justin Stone, who sold 51% of the business to Quiksilver in 2011.  SRF had worked with Billabong on a European business based out of France and focusing on continental Europe in 2012, but this was largely a failure.  Surfdome is now effectively SRF Europe, with the legacy French asset shut down.

IPO Hype

• SRF was pitched as a dominant online operator in surf rolling up the industry with a TAM within surf/snow/skate in its three key regions of A$15-20bn.  IPO bulls may also have been sold on SRF’s positioning to extend across additional action sports categories and into high growth geographies such as Asia and Latin America.

• Management claimed that growth would stay in the double digits with a revenue goal of A$1bn in FY20, with EBITDA margins that would mature at 7.5-10%.  At a peak price of A$2.13, SRF’s market cap at one point exceeded A$500mm, which admittedly is reasonable if A$1bn and a 10% margin were realistic.  It probably is not.

• In reality, the surf/action sports industry is mediocre.  While there is little dependable information around market size and growth, we know that there is fashion risk as the category skews young (age 15-30, albeit more male-oriented) and is heavy on the commoditized apparel products.  This matters because consumers of surf brands are not necessarily surfers.  Further, the branded and brick & mortar side of the industry has a history of aggressive growth followed by distress, including Billabong, Quiksilver, most recently PacSun.

Acquisitions since the IPO

• SRF began acquiring extremely niche media assets in 2015.  The idea was that traffic from content assets would drive higher conversion while helping SRF reduce its reliance on search, which at the time represented ~2/3 of its traffic (of which ~2/3 organic and ~1/3 paid).  Somewhere along the way, SRF decided that it could look even more like Amazon by claiming the potential for a subscription to its content assets a la Amazon Prime.  The deals were:

• Magicseaweed (May 2015, A$8.5mm + deal cost and equity earn-out), which offers real-time and forecast surfing conditions and other media content via a website and a mobile app.  This was done at rough 2.5x sales and 20x EBT.

• Stab Magazine (May 2015, A$2.3mm+), a news website with a subscription magazine currently offered at A$50/year for quarterly issues.  The price was roughly 2x and 14x.

• Garage Entertainment (Nov 2015, A$14mm in shares and cash), a surf/action sports-related VOD operator (think Netflix) with a production operation doing documentaries and TV shows.  There’s also a small cable channel in New Zealand.  In full-year FY16, this business generated just A$1.5mm in revenue and lost -A$1.2mm.

• Against pro forma FY16 EBITDA guidance of A$18-22mm, SRF raised another A$50mm at A$2/share in November, in part to acquire Surf Hardware International (SHI) for A$24mm.  SHI makes physical attachments to surf boards, with strong positions in fins and plugs (the company claims competitive advantage via a fin design patent with significant remaining life).

• This deal clocked in at 0.6x sales and 13x PBT, and reflected ambitions towards further vertical integration and private label/owned brand penetration on its site.

Timeline of Recent Events

• February 25: SRF reported 1H16 in this February, showing strong topline performance but abandoning EBITDA guidance based on a desire to spend on content.  The shares dropped –34% from A$1.73 to A$1.14.

• March 10: SRF announces its CEO resigned via email and claimed he would pursue an MBO with a PE backer, which never happened.  Lex and Justin take over as Co-CEOs.

• May 3: SRF cuts pro forma EBITDA guidance cut to A$2-3mm v. prior consensus ~A$18mm.  Mike Sonand, who has previously served as a C-suite executive at various sub-A$300mm retail businesses in the past, is brought in from outside the company as COO.  The shares drop from A$1.04 to A$0.48 or –54%.

• June 9: SRF drops FY16 EBITDA guidance to –A$18mm due to the reversal of a A$20mm license agreement that the company was reneging on.  Management points to aggressive discounting used to drive historical growth, and guided to positive EBITDA and cash flow in FY17.

• June 20: SRF announces its US operations will cut 40 positions cut by end of October.  Sonand takes over as CEO, leaving Lex and Justin to focus solely on the US and UK businesses.  Sonand is quoted in the press release as saying “fundamentally it’s a great business, it just hasn’t been executed well and under my leadership it will do a lot better.”  The shares are now at A$0.22, but there is no major price reaction to the release.

• Aug 30: FY16 earnings is released, showing a –A$19mm non-GAAP EBITDA loss, the cash balance down in 2H16 from A$61mm to A$21mm.  Sonand guided to single digit growth and a –A$2-4mm EBITDA loss in FY17, with the statement: “[SRF] is fundamentally a great business, but … period of rapid expansion … had a major impact on … results… [my] number one priority … [is] to implement a stabilization plan with a key focus that the business has better control of its cash flow”.  The articulated stabilization plan is as follows:

• Cut European headcount by 25% from 100 to 75;

• Cut US headcount by 65%, leaving a barebones fulfillment operation;

• Rationalize the 700+ brands and 30k+ SKUs on offer to 350+ brands;

• Reduction in working capital and expenses to conserve cash;

• Hired Deloitte to shop SHI (designated as non-core asset);

• Pursue private label with goal of hitting 20% of sales

• As of August 2015, Morgan Stanley had FY16/17/18e revenue (June YE) pegged at A$257mm/319/390, and JP Morgan was at 282/350/421.  MS currently has FY17/18e at 288/300 with EBITDA and -4/2, while JP Morgan dropped coverage on Sept 2.

• SRF shares traded as low as A$0.10 after the August release, and now sit at A$0.175.

Investment case

In my mind, the investment case at this price revolves around two components: 1) that the company can realistically stay above water in the near term, and 2) that there’s some hope that the business has underlying value.

On staying above water:

• Starting with A$21mm of YE16 cash, subtracting A$10mm of FY17 cash burn, and adding A$15mm of net proceeds from a potential ~YE17 sale of SHI (A$17mm of impaired book value less A$2mm of transaction costs, representing 8x FY16 PBT) gets us to a YE17 cash balance of A$26mm.  As inventories are now covered roughly 1:1 by payables, working capital should be approximately neutral.  This leaves significant room for me to be off on the FY17 cash burn, or conversely wrong about the SHI sale happening.

• Cash burn could possibly drop so quickly due to a combination of low hanging fruit and finite duration discretionary spending in the current budget.  The threat of distress and an operations-focused outsider with traditional retail experience and a drastically different attitude towards financial management all points towards better inventory management and lower cash burn.

• For one, SRF was previously operating at >100 days of inventory despite being an apparel-focused online retailer (though this was more an operating than financial issue, as the inventory was largely funded by smaller suppliers).  I estimate inventory days and payables / inventory closed FY16 at 81 and 100%, from 106/84% at YE15 and 125/97% at 1H16.

• A substantial portion of the FY16 EBITDA penalty was caused specifically by significant deterioration in US retail traffic and revenues.  However, despite Sonand’s very poor explanation of the dynamics here, the company appears to be taking the first steps towards a market exit by cutting local FTEs to just 14.

• SRF’s ramp in media investments is discretionary and can be shut down if needed.

• SRF has been working on realigning its global operations under the single SWELL brand.  This represented just A$3mm of incremental opex in FY16, but is coming to an end and previous management highlighted the program’s benefit as a potential A$12.5mm cash flow tailwind.  

On the underlying value:

• While consolidated performance has been poor, SRF has pockets of strength across its regions, with the Australia business profitable on a contribution basis and roughly breakeven on an allocated basis.  UK appears to be at or approaching breakeven on a contribution basis, and is the only geography that continues to grow at a solid clip.

• SRF Australia’s competition consists of local operators including Surf Dive n’ Skate and City Beach.  Each of the three have slightly different brand and product selections – SDS is more skate heavy, while City Beach appears to have a narrower apparel selection.  SRF offers the most customer-friendly shipping and returns program, and pricing is similar across the three.  SRF should continue to benefit from internet penetration, but is more mature than other markets given high share and a smaller target population.

• SRF UK’s headline European competitor is Blue Tomato in Austria (owned by Zumiez), which lists higher prices across the board v. surfdome.com.  Further, Blue Tomato’s distribution facilities are on the continent, giving SRF a major delivery advantage within the UK (free next day delivery for orders >GBP75 v. 2-5 day >EUR100).  That said, entry into the continent would be difficult and expensive for SRF, as already proven by its previous failed JV with Billabong.

• In the US, SRF has significant apparel competition in the form of retail chains such as Zumiez and Tilly’s, and skews heavily towards the much bigger skate market.  Retailers also continue to add brick and mortar capacity in addition to e-commerce fulfillment to build online sales (omnichannel) despite category weakness, though the former has slowed.  SRF’s key surf market is fragmented, but at A$26mm revenue in FY16, SRF is part of that fragmentation.  SRF US revenues are declining, with similarweb.com showing swell.com traffic on the decline.

• SRF has yet to fully integrate its media assets into its retail properties.  While clearly a risky and expensive endeavor ex-ante, much of the costs and lifting have been expended.  I actually err on the side of believing this effort highlights more the commodity nature of the core retail business than the meritless doings of prior management.  For an idea of how this might theoretically work, see http://blog.swell.com.

• For a point estimate of base case value, I apply 0.5x sales to the Australian and UK retail operations, 10x FY15 EBT to the two profitable media assets, and 1x impaired book to SHI to get to A$116mm or about A$0.42/share.  This assumes excess cash is burned and the other assets are worthless on a terminal basis.  

• Perhaps the US operation stays unprofitable and Sonand keeps it around longer than he should, in which case its real value is negative.  Perhaps you believe FY17 cash burn will require the liquidation of SHI just to stay solvent, in which case the implicit A$0.05/share built in for SHI is double-counting.  Either way, I believe there is enough headroom for good things to happen.

• Under this framework, a A$0.30/share value would require additional cash burn of A$0.12/share or -A$33mm beyond my -A$10mm FY17 assumption.

• On the upside, it is easy to sketch out the case for a multi-bagger if competitive influences in the industry prove transitory, and a leaner SRF returns to internet growth form with a pathway to ‘juicy’ positive single-digit margins.  For example, a A$400mm revenue SRF earning 4% non-GAAP on EBITDA in five years and trades at 20x EBITDA would be worth A$1.09, good for a +44% price CAGR.  In other words, if SRF lives to fight another day, the upside will take care of itself.

• The real downside is zero, but for a more academic figure, net tangible assets at YE16 are A$0.12 per share, and about A$0.07-$0.08 at my YE17 estimate.

Management and Compensation

• Using a case study in Sonand’s resume, I believe that while he may not be an e-commerce visionary, he is the hard-nosed retail restructuring expert that SRF needs to right its ship.

• Globe International is a skate-oriented Australian apparel and hardgoods manufacturer.  In early 2002, the company brought Sonand on board as CFO in the midst of an industry downturn.  The company did a poorly timed skate acquisition, saw its earnings begin to vanish, and appointed Sonand CEO in early 2003.  From the first half of 2003 to the second, Mike drove Globe’s adj. EBITDA margin up 6% (roughly 4% to 10%; bear with me as Australian GAAP was a little funky) and adj. PBT back into the black on flat sequential revenues.  In doing this, Globe generated more EBITDA in its 2H03 than it did in 2H02, despite revenues being -22% lower.  Globe’s shares peaked at A$2.40 in early 2002, sat at A$0.30 when Mike took over as CEO, and reached A$0.54 when he was moved down to COO in late 2004 after the business had fully stabilized, in favor of a more visionary leader (whose brothers just happened to have founded the company).

• At SRF, Mike has very clearly articulated his view that SRF was caught up in a deal-making ‘frenzy’ and that the business needed to be cleaned up.  For better or worse, he has also cast humility aside and expressed confidence in his ability to tackle this job.  

• Sonand is getting a base salary of about A$0.5mm/yr, and received his first tranche of 1mm SRF shares in June.  If he can return SRF to its prior glory, he stands to make an extra A$2mm+ over the next two years, which is likely considerable for his PA (he earned ~A$0.5mm/yr while at Globe).

• Lex and Justin Stone currently own 9mm and 11mm shares, with Lex having sold down from 16mm a year ago and Justin having kept all his shares.  Justin Cameron, the CEO who jumped ship, had cut his holdings from 17mm to 8mm over the same period, in parallel to Lex.

• SRF’s general executive compensation structure has been a combination of annual cash bonus based on hitting non-GAAP revenue and EBITDA targets, as well as an annual long-term restricted stock program that vests over three year windows based on 3-year TSR relative to v. Australian small cap industry peers.

Concerns / issues

• Competitive pressures understated in my assessment beyond what Sonand can handle, leading to continued losses and eventual bankruptcy (ie. the thesis is wrong).

• Accounting: SRF reported in 2H16 that it had booked a A$20mm license deal in 1H16 that it was reversing.  Details around this issue have been light, though this may be due to the threat of a lawsuit.  This said, any accounting changes made are already fully reflected in the company’s FY16 report (one must either ignore or adjust 1H16 figures), and I don’t have reason to view this as a major near-term use of cash for the company.

• SRF signed a 1H16 deal with Three Crown Investments (TCI), the owner of a collection of surf/action media assets similar to Magicseaweed and Stab, to effectively cross-license content access and distribution between the two group’s properties with offsetting cash consideration.

• This revelation implied to investors that the strong interim report was inflated, and revealed something troubling about the company as the deal was not specifically disclosed, and Justin Cameron severely downplayed the magnitude of these ‘content revenues’ on the 1H call – content revenues which were effectively zero margin.

• For those desiring detail, the arrangement post-changes as disclosed in the FY16 report were as follows: TCI pays SRF A$20.3mm over 10 years for perpetual access to SRF’s media and gets a 10-year right to advertise and distribute on SRF properties for a 15% commission; in return, SRF pays TCI A$2mm for two years of branding on TCI apps, A$0.5mm for premium content, A$8mm for TCI to link to SRF on its key surf website for 10 years, and A$9.7mm for ten years of access to TCI’s database with surf condition data.  

• SRF decided to unilaterally terminate the agreement in July, and TCI sued in Queensland in August.

• Take-under: Even if the core business turns out to be any good, the issue is thinly traded and now poorly-covered.  A strategic may come in and capture the valuation discount for itself.

• Inventory: SurfStitch currently operates with a significant amount of inventory, which for now is funded by suppliers.  The company has not broadly disclosed details around the sustainability of its consignment and rebate-based inventories, and there are few details around its Billabong and Quiksilver supply agreements expiring over the next year.

Catalyst

Cash burn comes down.

SHI sale announced/closed.