How fast is Surfstitch really growing?

It’s been a very eventful 18 months for Surfstitch shareholders since IPO – four acquisitions, two capital raising, an earnings upgrade, an earnings downgrade, a CEO resignation and a rumoured privatisation. In turn, Surfstich’s share price has gyrated between $0.99 and $2.13.

Fluid environments present opportunities for mis-pricings as investors scramble to “vote” on a new valuations for the company in light of new information.

In this context, I decided to take a closer look.

The headline summary shows a profitable company on a 40% revenue trajectory:

Despite these stellar results, Surfstitch’s share price plummeted almost 40% presumably because Surfstitch decided that:

Given the pace of change and long term opportunities presented to the business, Management and the Board believes it is no longer prudent to focus on a defined EBITDA range. Instead EBITDA growth will be flexed based on investment around the Global content strategy.

So the questions becomes – is this simply the case of a fundamentally profitable and fast growing business making a prudent and opportunistic decision in re-investing its profits back into the business against the backdrop of an unforgiving capital market that’s simply concerned with short-term profitability?

As always, we need to inspect under the hood to find the answer. Let’s start by dissecting Surfstitch’s 1H FY2016 revenue growth.

Contribution from 1H FY2016 acquisitions

We know that c.$6.2m of revenue growth came from the SHI and Digital Garage acquisitions.

Note that the accounting of the Garage Entertainment acquisition warrants some attention:

In other words, Garage Entertainment generated $3.9m of EBIT from $4.0m of revenue within 51 days of Surfstitch ownership but only generated $0.4m of revenue and -$0.2m of EBIT over the preceding 4.5 months prior to the acquisition. Strange.

Contribution from 2H FY2015 acquisitions

We estimate that Magicseaweed and Stab, acquired during the previous half, contributed c.$3.5m of revenue during 1H FY2016.

But isn’t the headline growth rate already normalised for these acquisitions? Footnotes in the 1H FY2016 results presentation explicitly states the following:

[1H FY2015 comparatives] “represents reported pro forma 1H FY2015 results. Assumes Surfstitch, Surfome, SWELL , Magicseaweed, Stab acquired as at 1 July 2014 and are included in all periods shown.”

Well strangely, comparative proforma 1H FY2015 revenue was $103.6m, exactly the same number as that reported before the Magicseaweed & Stab acquisition:

So clearly Magicseaweed and Stab were not included in its pro forma comparative revenue number resulting in a higher headline growth rate that is misleading at best.

Currency tailwinds

This is the big one. US and UK together comprise a majority of Surfstitch’s revenue and AUD had depreciated against the USD and GBP by 19% and 13% respectively.

My estimate is that $8m-$9m of Surfstitch’s growth came directly as a result of AUD depreciation.

Surfstitch’s organic growth rate

So based on what we know, my back-of-the-envelope estimate of Surfstitch’s true organic growth for the half is 22% versus its 40% headline number:

The unknowns

There remains a number of unknowns.

Receivables have skyrocketed from c.$2m to $27m. For an online retailing business where customers pay upon order, such a large upswing in receivables is certainly strange. Surfstitch provided no clear explanation as to the nature of these Receivables.

Additionally, Surfstitch booked an unusually high gross profit margin for North America (up a whopping 1,444 bps). The inference being that this was the result of North America spearheading their content and syndication strategy – which supposedly boosts conversion rates as illustrated in its Stab/MSW example below:

However, this is unsupported by a 31% drop-off in conversion rates for North America during the half.

I really don’t know what to make of this, but I suspect if we can breakdown Surfstitch’s revenue between retail revenue (i.e. e-commerce) and non-retail revenue (i.e. syndication / content revenue) then we will have the answers to these questions.

However, for now, these are the unknowns.

Why Surfstitch abandoned its EBITDA guidance

Surfstitch provided a pre-capital raising guidance in November 2015 that revenue grew at 40%+ for the first 4 months of 1H FY2016. For Surfstitch to then barely make its 40% revenue growth guidance after incorporating revenue from the 2 acquisitions, the final 2 months of 2015 must have really slowed down.

I believe this is behind Surfstitch’s determination that it is “no longer prudent to focus on a defined EBITDA range”. Growth has slowed and significantly higher sales and marketing spend is required going forward to restore its growth trajectory.

The problem is that, amidst its frenzy of capital raisings over the past 18 months, Surfstitch sold itself to the capital markets as a post profit company on a 40%+ revenue growth trajectory. When it had trouble meeting these expectations, non-organic growth levers (as per above) had to be pulled.

Ultimately though, it’s not hard for investors to work out what is going on underneath the headline numbers. So now instead of the question being “ok, so growth is slowing and there are some headwinds emerging, let’s see if their content investment strategy works”, the questions then becomes “ok so growth is slowing and there are some headwinds emerging, but what else are they not telling us?”.

In other words, if the “known” adjustments gets us down to 22% revenue growth, then factor in a bit of discounting for the “unknowns” – then a scenario with organic growth rate in the teens is not inconceivable. A 10%-20% growth rate is certainly still decent but not the type of growth trajectory that supports Surfstitch’s current valuation.

Takeover of Surfstitch?

The spanner in the works is obviously the shadow of a potential privatisation bid led by its former CEO which has underwritten its share price over the past month or so.

I do not specialise in merger arbitrage however here are a few valuation reference points – Surfstitch’s original IPO was at a forward revenue multiple of 0.9x. A takeover offer at say $1.50 a share would equate to a revenue multiple of c.1.3x, so the question then becomes whether you believe an informed acquirer would be happy to pay this premium for Surfstitch today?

Update (3rd May 2016): This happened.

Update (9th June 2016): So it turns out the “Unknowns” above (i.e. the $25m jump in Receivables and the 1,444 bps margin expansion in North America) was pretty much what I thought it was – reverse this out and there is no growth for 1H FY2016:

Update (8th November 2016): I was asked today by Surfstitch’s SEO team to provide a link back to their site. So I will comply -> www.surfstitch.com 🙂

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.