Is there value in SurfStitch?

The SurfStich (ASX:SRF) debacle offers some good lessons for investors, and its shares may now be good value

After more than doubling from its December 2014 IPO at $1.00 per share, former market-darling SurfStitch (ASX:SRF) has since fallen more than 90%.

Management upheaval, corporate governance concerns, problems integrating acquisitions and aggressive accounting have all been contributing factors.

With a market capitalisation of $54m, it’s now selling for less than the net cash on its balance sheet at 31 Dec 15. This means investors now are getting the SurfStich business for free – although, after its latest update forecast losses for 2016, its cash balance is likely lower now. 

Lessons

There are some good lessons in this debacle.

Firstly, it's another example why retail investors should avoid most floats – especially those from private equity – with the main exceptions being government floats such as Medibank Private (ASX:MPL) or companies whose previous owners can't wait to be rid of them (for example, the sale of CYBG (ASX:CYB) by NAB (ASX: NAB).

Sellers know more about the business than you and get to choose when – and at what price – they sell shares to you. Moreover, your broker wants you to participate in IPOs because they make money regardless of whether you do. All this makes it unlikely that IPOs will make the best investments over the long term.

SurfStich also illustrates the problems that can arise with businesses that make constant acquisitions. Integrating businesses is difficult, due to the different cultures, systems and even languages involved, yet investors often just concentrate on the additional earnings promised by acquisitions without considering the risk that unforseen problems will dash their high expectations. 

It’s always worthwhile determining what investors’ expectations are for a stock as the market has a tendency to pay too much for stocks thought to have great growth prospects.

One quick, albeit crude, way is to look at the company's price-earnings ratio (PER): the higher the PER, the greater investors’ expectations and vice versa.

Expectations are important because if these high expectations are met, then investors usually make a nice profit but this pales in comparison to the double-digit percentage losses that can occur if these expectations aren't realised.

Moreover, management may react to investors' high growth expectations with aggressive accounting and/or acquiring more businesses solely to keep growth going and investors' appetites satisfied.

By contrast, stocks with low expectations are unpopular (for some examples, check out our Buy list) so usually suffer minor falls if these already low expectations aren’t met. By contrast, the gains are much higher if their future turns out to be better than the market expected. 

That is, all things equal, the odds favour stocks with low expectations. 

Value now?

Which brings me back to SurfStitch. Its ugly past means investors’ expectations are about as low as they can get. Assuming its liabilities and cash are real but its receivables aren't, there’s probably some value in inventory, its websites and brands. 

Along with a cheap price and new management, perhaps there’s an opportunity here if the company can stem its losses and move to breakeven soon. It’s not a stock that we officially cover but it could be of interest for those willing to do their own research.

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