I still think is a reasonable risk-reward proposition at current...

I still think is a reasonable risk-reward proposition at current prices and here's why:

https://alphainvesting.net/2016/08/13/surfstitch-group-limited-asxsrf/


Situation:

• poorly managed business with string of bad news has led to a 89% share price decline in 2016 ($54m market cap as at time of writing)
• business is of average quality with limited competitive advantages
• not yet profitable

What we like:

• essentially buying this business almost for free at current market prices given cash balance
• new CEO committed to focusing on bringing the retail business into profitability and positive cash flow
• sells over $200m of merchandise annually so it has some level of scale
• cash hoard of $61m as at 31 Dec 15 (will monitor 30 June 2016 accounts results for cash burn rate)

Online retailer of surf apparel and accessories, Surfstitch Group Limited (ASX:SRF) has been severely beat down over the past 6 months due to a continuous string of bad news after bad news. Two profit downgrades (May 2016, June 2016) and departure of CEO and Co-Founder Justin Cameron has sent this once small-cap darling out of favor, with its share price falling from its highs of $2.09 last November to around just 20c per share today.

The overall assessment is that this is an average quality business that has been exceptionally mismanaged. We don’t believe that Surfstitch has a strong competitive advantage at this stage given that barriers to entry are low, nascent brand recognition and fairly vanilla customer interface of its platforms. However, that’s not to say that Surfstitch won’t be able to carve out a nice niche in the Surf, Skate and lifestyle segment over the medium term.

But why are we looking at this business now? Well, because, in our view, the selling has been overdone and many investors who bought into the parabolic growth story have experienced quite a wipe-out! The business now trades below its cash balance of $61m (as at 31 December 2015). We do note that there will be cash burn which we estimate will bring the cash balance down close to its market value today. But essentially the current market price allows us to own this business almost for free.
However, a free asset that burns a whole in your pocket doesn’t make a good investment. We believe that under Mike Sonand’s new leadership, and a renewed focus on running a profitable retail business, Surfstitch can at least earn a measly 1% EBIT margin. On their existing $200M revenue base, we would earn $2M of EBIT, and even without any growth, would easily justify the undemanding valuation. Mr. Sonand has a reasonable track record with extensive retail and apparel experience. A private equity take-over would also not be unsurprising as there are major operational improvements that could be made. Overall, there’s a fair degree of risk in this turn-around story, but we believe that due to the market’s overreaction, the risk-to-reward equation is favorable.