Earnings growth despite market headwinds

Focusrite 30 April 2019 Update
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Focusrite

Earnings growth despite market headwinds

Interim results

Consumer electricals

30 April 2019

Price

489p

Market cap

£284m

Net cash (£m) at 28 February 2019

26.2

Shares in issue

58.1m

Free float

60%

Code

TUNE

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

1.4

(2.2)

10.5

Rel (local)

(2.1)

(9.9)

10.8

52-week high/low

524p

364p

Business description

Focusrite is a global music and audio products group supplying hardware and software used by professional and amateur musicians, which enables the high-quality production of music.

Next events

Pre-close

September 2019

Final results

November 2019

Analysts

Kate Heseltine

+44 (0)20 3077 5700

Russell Pointon

+44 (0)20 3077 5757

Focusrite is a research client of Edison Investment Research Limited

Focusrite has delivered 23% H119 earnings growth, despite market headwinds, reflecting continued market share gains for its Focusrite ranges, a strong performance in Europe and 260bp gross margin improvement. The company is actively seeking opportunities to use its substantial £26m net cash balance, as reflected in the current valuation.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

P/E
(x)

Yield
(%)

08/17

66.1

9.5

14.8

2.7

33.0

0.6

08/18

75.1

11.3

17.5

3.3

27.9

0.7

08/19e

78.3

12.4

18.8

3.6

25.9

0.7

08/20e

82.1

12.7

19.1

3.7

25.6

0.8

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments. EPS based on diluted number of shares.

H119: Solid earnings growth; substantial net cash

Against a challenging macro backdrop and record prior year comparatives, Focusrite delivered a solid H119 performance. Revenue growth of 4.1% to £40.4m (slightly ahead of the £40m pre-close guidance) benefited from sterling weakness against the US dollar, while 0.5% constant currency growth contributed to an impressive two-year stacked growth rate of 26%. The 260bp increase in the gross margin to 44.3% helped to drive 11.4% EBITDA growth, while underlying PBT was up 22.6% to £7.2m. Net cash has increased by £3.4m from the year end to £26.2m.

A mixed regional and divisional performance

Europe delivered robust sales growth of 21%, while in the US the company’s decision to pass on the 10% import tariff in October protected gross profit while North American revenue declined by 11%. Divisionally, continued strong demand for Clarett and Scarlett led to 12% growth in the Focusrite division, more than offsetting a 14% decline in the Novation division. This was driven by weaker demand for Launchpad, following several years of robust growth, and is being addressed with a pipeline of new products over the next 18 months.

5% upgrade to PBT may prove too cautious

We leave our FY19 and FY20 revenue forecasts broadly unchanged while cautiously assuming a further 50bp uplift to the FY19e gross margin to 43.2%. This is below the margin achieved in H1 as a further increase in US tariffs to 25% is still a possibility.

Valuation: Assumes a return on net cash

On a DCF basis, the share price is slightly ahead of our updated valuation of 471p (vs 457p), which assumes 10% revenue growth for five years beyond our forecast, fading to 2% in perpetuity, a terminal EBITDA margin of 21% and an 8.4% cost of capital. However, it does not reflect the potential return on investment of Focusrite’s excess cash. We calculate that the market is factoring in utilisation of excess cash at an attractive 12% post-tax ROCE.

H119: Solid earnings growth; net cash for acquisitions

Focusrite has reported a solid first-half trading performance. Revenue increased by 4.1% to £40.4m, beating pre-close guidance of c £40m. On a constant currency basis, revenue grew by 0.5%, against record underlying growth of 26% in H118.

The company’s swift action to raise prices in the US following the introduction of a 10% import tariff contributed 100bp to the 260bp improvement in the group gross margin to 44.3% (H118: 41.7%). The additional uplift in margin reflects ongoing efforts to effectively manage discounts to dealers and distributors and a minor benefit due to the product mix benefit of Focusrite Pro.

As a result, EBITDA grew by 11.4% and operating profit by 16.4%. The operating margin improved by 190bp, driving 22.6% growth in pre-tax profit to £7.2m. Consistent with the prior year, there were no exceptional items. Net cash has increased by £3.4m since the year end, to £26.2m.

Exhibit 1: Summary of results

£000s

H118

H218

FY18

H119

H1 growth
y-o-y

H1 ccy growth y-o-y

Revenue by product type

Focusrite

23,434

23,997

47,431

26,308

12.3%

Focusrite Pro

2,259

2,503

4,762

2,594

14.8%

Novation

11,419

8,647

20,066

9,827

-13.9%

Distribution

1,707

1,155

2,862

1,696

-0.6%

Total

38,819

36,302

75,121

40,425

4.1%

0.5%

Revenue by geography

North America

16,852

15,868

32,720

14,963

-11.2%

-15.8%

Europe and Middle East

15,997

13,709

29,706

19,315

20.7%

18.4%

Rest of World

5,970

6,725

12,695

6,147

3.0%

-1.2%

Total

38,819

36,302

75,121

40,425

4.1%

0.5%

Gross profit

16,200

15,474

31,674

17,921

10.6%

Gross margin (%)

41.7%

42.6%

42.2%

44.3%

6.2%

Adjusted EBITDA

7,969

7,516

15,485

8,881

11.4%

Adjusted EBITDA margin (%)

20.6%

20.7%

20.6%

22.0%

6.6%

Operating profit

6,230

5,383

11,613

7,251

16.4%

Operating margin (%)

16.0%

14.8%

15.5%

17.9%

11.8%

Pre-tax profit

5,833

5,510

11,343

7,150

22.6%

EPS (p)

8.9

8.7

17.6

11.0

23.6%

Net cash

19,734

22,811

22,811

26,172

32.6%

Source: Focusrite, Edison Investment Research

Revenue growth boosted by currency

Focusrite has a large international market, with c 85% of revenue generated outside the UK, and is therefore exposed to short-term currency fluctuations. In H1, the currency impact of euro-denominated sales (c 30% of revenue) was relatively muted, while sterling weakness against the US dollar (c 50% of revenue) benefited reported sales growth, as highlighted in the above table.

Divergence in regional sales performance

Sales growth in most countries in Europe, the Middle East and Africa (EMEA) was robust, with particularly strong demand for Focusrite products. Regional demand in Europe was further boosted by additional stock orders of c £0.5m by distributors in February amid Brexit uncertainty. This contributed to impressive EMEA sales growth of 20.7% (constant currency 18.4%) in H1.

Overall, North America regional sales declined by 11.2% (constant currency -15.8%). This is in marked contrast to both H118 and FY18 when constant currency sales grew by 34% and 17%, respectively, driven in part by strong demand for the Launchpad range. In this period, the Launchpad range, which is now four years old, has declined. Also, the US market has been affected by the trade dispute with China. Focusrite dealt with this issue decisively by raising prices to protect the profitability of the group. Moving forward the management team is confident that its forthcoming new products will restore growth to this market.

Elsewhere, ROW sales increased by 3.0% (constant currency -1.2%). This was aided by growth in Asia of c 10%, despite the ongoing trade war between China and the US, offsetting challenging conditions in Latin America. The group is making the changes needed in this region to provide the foundation for growth in the future.

Product categories: Focusrite divisions powering ahead

By division, Focusrite and Focusrite Pro delivered robust revenue growth of 12.3% and 14.8%, respectively, while Novation declined by 13.9%:

Focusrite: Demand for the second-generation Scarlett range, which accounts for approximately three-quarters of divisional revenue and was launched in 2016, has continued to be robust and it remains the number one audio interface in the world. Scarlett delivered sales growth of c 12% and made further market share gains. The Focusrite Pro division, which includes the more expensive RedNet and Red ranges, was the fastest-growing segment with growth of 14.8%.

Novation: Having enjoyed several years of exceptional demand since launch in mid-2015, sales of the signature Launchpad model declined, leading to the Novation segment declining by 13.9% in H1. Consistent with the company’s ongoing focus on product development and innovation, management has flagged a healthy pipeline of updated and new product launches over the next 18 months.

It also continues to strengthen its software products, including the app-based music creation tools (the Ampify brand), which support easy use of the Novation ranges and therefore make the products more accessible to novices. There are three app products that now have a combined total of more than 10.5m downloads, increasing at a rate of 120k downloads per month.

Balance sheet strength

Net cash increased by £3.4m to £26.2m compared with the year end (and by £6.5m y-o-y). This increase is a result of H1 EBITDA of £8.9m offsetting working capital outflows of £2.1m, capex of £2.3m, dividend payments of £1.3m and smaller items. Free cash flow as a percentage of revenue was 12%, compared with an average of 10% since the company listed in 2014.

The working capital outflow was mainly attributable to prompt payments to suppliers in H1 leading to a £2.3m reduction in payables, while a £0.9m increase in stock almost fully offset a £1.1m reduction in receivables. Stock levels in H2 are expected to increase further in advance of new product launches (two major launches have been flagged for the summer and autumn of 2019).

The company has employed a full-time business development officer and is actively assessing acquisition opportunities to invest surplus cash.


Forecast changes

We upgrade our PBT forecasts by 4.7% in FY19e and 5.2% in FY20e.

Exhibit 2: Changes to forecasts

£m

FY19e

FY19e

% change

FY20e

FY20e

% change

Old

New

Old

New

Revenues

78.0

78.3

0.4%

81.7

82.1

0.5%

Gross profit

33.3

33.8

1.6%

34.9

35.4

1.5%

Gross margin (%)

42.7%

43.2%

0.5%

42.7%

43.2%

0.4%

Adjusted EBITDA

15.9

16.1

1.0%

16.5

16.6

0.8%

Adjusted EBITDA margin (%)

20.4%

20.5%

0.1%

20.2%

20.3%

0.1%

Normalised operating profit

11.8

12.3

4.7%

12.0

12.6

5.2%

Normalised PBT

11.8

12.4

4.7%

12.0

12.7

5.2%

Normalised EPS (p)

17.9

18.8

5.1%

18.0

19.1

5.6%

Net cash

27.9

28.5

2.3%

33.8

35.2

4.0%

Source: Edison Investment Research

We leave our FY19e and FY20e revenue forecasts broadly unchanged, given trends seen in the US in H1, ongoing uncertainty regarding Brexit and the likelihood that the company will want to clear stock from the channels ahead of two major product launches, expected later this year.

We cautiously assume a further 50bp uplift to the gross margin in FY19e to 43.2%, below that achieved in H1 (44.3%). While this reflects the company’s ongoing focus on managing margins and the positive mix effect of Focusrite Pro, a further increase in US tariffs to 25% is still a possibility. Should tariffs be raised, we would expect management to take actions to mitigate the margin impact over the medium term.

We have also adjusted our forecast tax rate down from 12% to 11%, consistent with H1 and prior years. While the majority of profits are taxed in the UK, the effective rate is lower than 19% due to enhanced tax relief on R&D.

We forecast net cash of £28.5m at the end of FY19, rising to £35.2m at the end of FY20.

Valuation: Market assumes cash utilisation

Focusrite is market leader in its specialist field. Its rating is dependent on the market’s confidence in its ability to remain at the forefront of a competitive field of technical developments and to service a demanding user group. We believe the company is well placed to sustain this reputation over the medium term and, for this reason, we use DCF techniques to place a value on the longer-term income stream available to investors. As discussed below, we do not believe that this metric fully reflects the potential of the company’s excess cash.

DCF: Long-term value reflected in sensitivity analysis

Over our 10-year horizon we assume revenue growth in years four to eight of 10%, fading to a terminal rate of 2%. We assume a terminal EBITDA margin of 21% (FY18: 20.6%), capex of c 7%, reducing to 5% by the terminal year, and an equity-only cost of capital of 8.4% (risk-free rate 3%, risk premium 6%, beta 0.9).

Based on these assumptions, which may prove conservative, our DCF values the shares at 471p (vs 457p before). In the table below we set out the share price implications for varying terminal sales growth rates and margin assumptions.

Exhibit 3: Sensitivity to terminal margin and sales growth rates (p/share)

Sales growth FY21–27

8%

10%

12%

14%

16%

Terminal margin

23.0%

479

515

553

594

638

22.0%

459

493

529

568

610

21.0%

439

471

505

542

581

20.0%

419

449

481

516

553

19.0%

399

427

457

490

524

Source: Edison Investment Research

Share price assumes utilisation of cash at 12% return

While our DCF on the face of it does not point to value at or above the current share price, what we believe to be missing from the equation is the utilisation of Focusrite’s net cash of £26.2m.

Focusrite generates high average taxed ROCE rates of 45–51%. It is not likely the company could generate such returns from an acquisition. However, using a range of lower ROCE rates, the cash would imply additional value as follows:

Exhibit 4: Potential returns on excess cash

ROCE

10%

15%

20%

Excess cash (£m)

26.2

26.2

26.2

Post-tax earnings (£m)

2.6

3.9

5.2

Incremental EPS (p)

4.5

6.7

9.0

Peer P/E (x)

15

15

15

Value per share (p)

67

101

134

Less cash per share (p)

(45)

(45)

(45)

Incremental valuation per share (p)

22

56

89

Implied share valuation (p)

493

527

560

Source: Edison Investment Research

The current share price would imply that the market is factoring utilisation of excess cash at a return on capital of c12%.

Exhibit 5: Financial summary

£000s

2016

2017

2018

2019e

2020e

2021e

Year end 31 August

IFRS

IFRS

IFRS

IFRS

IFRS

IFRS

INCOME STATEMENT

 

Revenue

 

 

54,301

66,055

75,121

78,292

82,098

86,203

Cost of Sales

(33,439)

(39,704)

(43,447)

(44,498)

(46,661)

(48,994)

Gross Profit

20,862

26,351

31,674

33,794

35,437

37,209

EBITDA

 

 

10,249

13,109

15,485

16,067

16,646

17,291

Operating profit (before amort. and except).

 

7,677

9,470

11,613

12,347

12,596

12,845

Amortisation of acquired intangibles

0

0

0

0

0

0

Exceptionals

(537)

0

329

0

0

0

Share-based payments

0

0

0

0

0

0

Reported operating profit

7,140

9,470

11,942

12,347

12,596

12,845

Net Interest

(14)

42

(270)

20

60

70

Joint ventures & associates (post tax)

0

0

0

0

0

0

Exceptionals

0

0

0

0

0

0

Profit Before Tax (norm)

 

 

7,663

9,512

11,343

12,367

12,656

12,915

Profit Before Tax (reported)

 

 

7,126

9,512

11,672

12,367

12,656

12,915

Reported tax

(870)

(959)

(1,199)

(1,360)

(1,392)

(1,421)

Profit After Tax (norm)

6,793

8,553

10,144

11,006

11,264

11,494

Profit After Tax (reported)

6,256

8,553

10,473

11,006

11,264

11,494

Minority interests

0

0

0

0

0

0

Discontinued operations

0

0

0

0

0

0

Net income (normalised)

6,900

8,553

10,144

11,006

11,264

11,494

Net income (reported)

6,256

8,553

10,473

11,006

11,264

11,494

Average number of Shares Outstanding (m)

53.2

55.4

56.8

56.8

56.8

56.8

EPS – normalised diluted (p)

 

 

11.8

14.8

17.5

18.8

19.1

19.4

EPS - basic reported (p)

 

 

11.8

15.4

18.4

19.4

19.8

20.2

Dividend per share (p)

2.0

2.7

3.3

3.6

3.7

3.9

Revenue growth (%)

13.1

21.6

13.7

4.2

4.9

5.0

Gross Margin (%)

38.4

39.9

42.2

43.2

43.2

43.2

EBITDA Margin (%)

18.9

19.8

20.6

20.5

20.3

20.1

Normalised Operating Margin

14.1

14.3

15.5

15.8

15.3

14.9

BALANCE SHEET

Fixed Assets

 

 

6,367

6,332

7,314

9,543

11,514

13,391

Intangible Assets

4,792

4,963

6,039

7,997

9,902

11,809

Tangible Assets

1,575

1,369

1,275

1,545

1,612

1,582

Investments & other

0

0

0

0

0

0

Current Assets

 

 

28,191

36,126

47,612

54,424

61,829

68,652

Stocks

11,361

9,000

11,391

12,923

13,040

13,960

Debtors

11,224

12,952

13,310

12,870

13,496

14,407

Cash & cash equivalents

5,606

14,174

22,811

28,530

35,190

40,179

Other

0

0

100

102

104

106

Current Liabilities

 

 

(9,256)

(8,663)

(11,136)

(11,091)

(11,362)

(10,842)

Creditors

(8,612)

(8,204)

(10,709)

(10,606)

(10,866)

(10,336)

Tax and social security

(644)

(459)

(427)

(484)

(496)

(506)

Short term borrowings

0

0

0

0

0

0

Other

0

0

0

0

0

0

Long Term Liabilities

 

 

(282)

(245)

(300)

(405)

(506)

(608)

Long term borrowings

0

0

0

0

0

0

Other long term liabilities

(282)

(245)

(300)

(405)

(506)

(608)

Net Assets

 

 

25,020

33,550

43,490

52,472

61,475

70,593

Minority interests

0

0

0

0

0

0

Shareholders' equity

 

 

25,020

33,550

43,490

52,472

61,475

70,593

CASH FLOW

Op Cash Flow before WC and tax

10,249

13,109

15,485

16,067

16,646

17,291

Working capital

(6,009)

407

(427)

(1,194)

(483)

(2,362)

Exceptional & other

(417)

137

203

(0)

(0)

(0)

Tax

(165)

(633)

(478)

(1,360)

(1,392)

(1,421)

Net operating cash flow

 

 

3,658

13,020

14,783

13,512

14,771

13,508

Capex

(3,675)

(3,614)

(4,507)

(5,742)

(6,022)

(6,323)

Acquisitions/disposals

0

0

0

0

0

0

Net interest

(111)

(42)

(36)

20

60

70

Equity financing

172

258

306

0

0

0

Dividends

(976)

(1,138)

(1,679)

(2,071)

(2,150)

(2,266)

Other

365

84

(230)

0

0

0

Net Cash Flow

(567)

8,568

8,637

5,719

6,660

4,989

Opening net debt/(cash)

 

 

(6,173)

(5,606)

(14,174)

(22,811)

(28,530)

(35,190)

FX

0

0

0

0

0

0

Other non-cash movements

0

0

0

0

0

0

Closing net debt/(cash)

 

 

(5,606)

(14,174)

(22,811)

(28,530)

(35,190)

(40,179)

Source: Focusrite accounts, Edison Investment Research


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This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

The Investment Research is a publication distributed in the United States by Edison Investment Research, Inc. Edison Investment Research, Inc. is registered as an investment adviser with the Securities and Exchange Commission. Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a) (11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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New Zealand

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United Kingdom

Neither this document and associated email (together, the "Communication") constitutes or form part of any offer for sale or subscription of, or solicitation of any offer to buy or subscribe for, any securities, nor shall it or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. Any decision to purchase shares in the Company in the proposed placing should be made solely on the basis of the information to be contained in the admission document to be published in connection therewith.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document (nor will such persons be able to purchase shares in the placing).

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

The Investment Research is a publication distributed in the United States by Edison Investment Research, Inc. Edison Investment Research, Inc. is registered as an investment adviser with the Securities and Exchange Commission. Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a) (11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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