Surfstitch wires global growth to digital content

A rebound in the share price of recently listed online retailer Surfstitch (ASX: SRF) has more to do with the market recognising that it was seriously sold-off – following an overreaction by the market to its decision to abandon its full year profit guidance – than any excitement over manoeuvres by the recently-resigned CEO Justin Cameron to take over the company with the support of private equity backers.

The stock's share price nosedived by a third overnight (25 February) to $1.14 following a decision by Cameron not to reaffirm Surfstitch's full-year EBITDA guidance, which was between $15 million and $18 million compared with $7.7 million in 2015.

Given that analysts had been forecasting EBITDA of $21 million, revised earnings took the market by surprise.

Following a string of surf content acquisitions – Surfstitch, which floated in December 2014 – managed to boost sales by 40% in the six months ending December, and this saw the company deliver a maiden profit of $5.7 million.

But while double-digit revenue growth was expected to continue in the June half and gross margins were expected to remain strong after rising 140 basis points to 48.3% in the December half, full-year earnings forecasts were slashed due to heavy investments in digital content.

However, when the dust settled, and the market got over the absolute horror of a recently-listed stock doing the unmentionable, and failing to meet prospectus forecasts, the bargain hunters piled back in on the back of the stock's potential for strong profitable growth and margin expansion.

Due to the popularity of its youth market brands, Surfstitch currently generates more than half of its revenues overseas in Europe and North America, and as an online retailer enjoys impressive bottom-line profit margins of around a whopping 48%.

Having found some comfort in the decision by the Surfstitch board to focus growth on its investment around the global content strategy, rather than focus on a defined EBITDA range, the share price has since rebounded by around 22% to $140, which remains well above the $1 issue price in December 2014.

Market confusion over Surfstitch's interim result has a lot to with keeping the market abreast of the pace at which the company is evolving. After all, the original investors in Surfstitch's $214 million float were buying into a totally different company that was once part owned by fallen 'old-school' surf-wear retailer Billabong International Ltd.

But given that online consumers are buying based on content and engagement rather than just on product and price, Surfstitch's ongoing foray into content appears to be a very smart move, and has the potential to create a sustainable competitive advantage over time.

For example, it's estimated that Shoppers who travel to Surfstitch's online store through its content sites spend around 50% more than other shoppers, and tend to buy higher-margin hardware such as surfboards and wetsuits.

Equally noteworthy, conversion rates are 700 points higher and purchase frequency is 50% higher.

Five months after the float, Surfstitch outlaid $21 million for Stab, a leading online surf content platform, and Magicseaweed, a user-generated surf forecasting network, funding the deal by raising $37.5 million in new capital at $1.50 a share.

Last November, the company paid $15 million for Garage Entertainment and Production, which makes videos such as The Bra Boys and The Crew and has a library of more than 3000 action sports titles which it distributes through its own video-on-demand platform and dedicated TV channels.

A week after the Garage deal, Surfstitch raised another $50 million at $2 a share to buy leading surfboard and accessories manufacturer Surf Hardware International.

The board plans to emulate Streaming services provider, Amazon Prime by accelerating its investment in content, – like movies and action sports videos – to attract new customers, boost customer conversion rates and drive sales and margins.

Like Amazon Prime, Surfstitch plans to monetise the content program by charging subscribers an annual subscription.

In efforts to reassure analysts and investors, Surfstitch has ruled out further acquisitions in the short term and expects new investments in content to deliver a return on equity (ROE) above 25%.

Meantime, investors are left to make sense of revelations that former CEO Justin Cameron has sided with private equity consortium in an attempt to take over the business.

Shareholders may benefit from an attractive premium, should the bid proceed, but it's not the main game, and investors who like the stock should buy based on fundamentals rather than the strength of any future takeover.

While Surfstitch's long term cash flow relative to reported profit has been weak, EPS is forecast to improve from $0.03 in 2016 to $0.10 in 2018, while net debt-to-equity is expected to improve.

ROE is also expected to improve from 4.70% in 2016 to 11.93% in 2018.

As a growth stock trading on a price to equity (P/E) of 44 times, and a 91% premium to its intrinsic value, the stock isn't cheap. However, it's still trading on a 33% discount to its 12 month high of $2.09 and does look well positioned for future re-ratings based on its global content strategy.

The stock looks attractively priced based on some 12 month forecasts as high as $2.40.