Second-half trading as expected with higher cash

Focusrite 18 September 2018 Update
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Focusrite

Second-half trading as expected with higher cash

Full-year pre-close statement

Consumer electronics

 

18 September 2018

Price

447.50p

Market cap

£260m

Net cash at 31 August 2018 (£m)

22.8

Shares in issue

58.1m

Free float

59%

Code

TUNE

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(2.5)

(5.2)

55.7

Rel (local)

0.3

(1.1)

52.8

52-week high/low

504.0p

257.5p

Business description

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

Next events

Final results

20 November 2018

Analysts

Paul Hickman

+44 (0)20 3681 2501

Kate Heseltine

+44 (0)20 3077 5700

Focusrite is a research client of Edison Investment Research Limited

Focusrite ends the year with revenue as forecast, continued profit growth in the second half and revenue in line with our expected slower second-half growth. Cash of £22.8m is 10% higher than we forecast and is now over half the balance sheet. US tariffs will likely apply to Focusrite’s business there and management has been considering its response, while risks associated to Brexit appear relatively minor to us. It seems the share price continues to discount a significant acquisition.

Year end

Revenue (£m)

PBT* (£m)

EPS* (p)

DPS (p)

P/E (x)

EV/EBITDA (x)

Yield (%)

08/16

54.3

7.7

11.8

2.0

37.9

24.8

0.4

08/17

66.1

9.5

14.8

2.7

30.2

18.7

0.6

08/18e

75.4

10.8

16.3

3.0

27.4

16.2

0.7

08/19e

80.0

11.5

17.0

3.3

26.3

15.7

0.7

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

Revenue and trading in line, cash above forecast

Focusrite has indicated that H2 revenue, profits and cash have all continued in y-o-y growth in H2, consistent with our profit and loss forecast. Growth has been broadly based across core product areas and in all major regions. In addition, positive results reported from expansion into new markets indicate a return on recent investment in Asia and potentially Latin America.

Cash: Further strengthens balance sheet

Net cash of £22.8m at August is 10% above our forecast and a net £8.6m rise in the year. As profits are in line, the beat was effectively achieved by continued control over working capital. The added cash may heighten observers’ expectations of an acquisition, but the company continues the same stringent screening process.

Macro risks flagged: US and Europe

With some 40% of Focusrite’s sales in the US and production in China, the company expects that extended tariffs will be applied to its products in common with its competitors. Management has been planning for this and considering the natural choice between absorbing the impact or passing it on to customers. Depending on Brexit outcomes, sterling could strengthen if a deal is struck, which, subject to the company’s hedging arrangements would affect the sterling value of the company’s euro sales. In another scenario, customs hold-ups might affect distribution of Focusrite’s product, although this should be manageable.

Valuation: No change in our view

On a DCF basis, the share price remains equivalent to a medium-term organic growth rate of about 12%. On a peer group comparison, the picture is mixed: the shares trade at a 2% P/E discount for FY18e but a 30% premium for FY19e. On an EV/EBITDA basis the company trades at a premium of 21% for FY18e and 32% for FY19e. The missing element is the excess cash, where the market appears to be discounting investment of the net cash balance at a c 15% post-tax return.

Full year pre-close
Revenue and profit: H2 at least equal to our forecast

Focusrite has indicated that H2 revenue, profits and cash have all continued in y-o-y growth. That is consistent with our profit and loss forecast and better than our previously forecast year-end cash of £20.8m.

Exhibit 1: H1/H2 forecast

£000s

H117

H217

FY17

H118

H218e

FY18e

H1 y-o-y

H2 y-o-y

FY y-o-y

Revenue

32,020

34,035

66,055

38,819

36,593

75,412

21.2%

7.5%

14.2%

Gross profit

12,855

13,496

26,351

16,200

15,282

31,482

26.0%

13.2%

19.5%

Gross margin

40.1%

39.7%

39.9%

41.7%

41.8%

41.7%

3.9%

5.3%

4.6%

Adjusted EBITDA

6,131

6,978

13,109

7,969

7,159

15,128

30.0%

2.6%

15.4%

Adjusted EBITDA margin

19.1%

20.5%

19.8%

20.5%

19.6%

20.1%

7.2%

-4.6%

1.1%

Operating profit

4,571

4,899

9,470

6,230

4,994

11,224

36.3%

1.9%

18.5%

Pre-tax profit

4,599

4,913

9,512

5,833

5,004

10,837

26.8%

1.8%

13.9%

EPS (p)

7.0

7.8

14.8

16.3

17.0

17.6

133.2%

117.5%

18.8%

Net cash

9,391

14,174

14,174

19,734

22,881

22,881

110.1%

61.4%

61.4%

Source: Focusrite, Edison Investment Research

Focusrite confirms revenue for the year is c £75m, in line with our expectation of £75.4m. This implies second half sterling-reported growth of 7.5% compared with 21% in H1 to give 14% for the full year. On a constant currency basis, full-year revenue growth of over 15% compared with 26% in H1 implies H2 growth of 4–5%. That is a good level of increase, especially as management indicates it was broadly based across core product areas and in all major regions. In addition, positive results reported from expansion into new markets indicates a return on the recent investment made into the sales regions of Asia and, to a lesser extent, Latin America.

The company does not quantify the level of H2 profit growth, but our pre-tax forecast of 1.8% was deliberately cautious so there could be a further step up to the actual result when reported in November 2018.

The statement also refers to moves, set out at the full year, to structure sales programmes to enhance the lifetime value of customers, which should bring benefits over the medium term.

Cash: Adding further strength to the balance sheet

Focusrite has increased net cash to £22.8m, an £8.6m rise in the year. That is 10% higher than our previous forecast of £20.8m. This was achieved mainly by the value added by increased profits, as well as prudent working capital management. We understand that there is unlikely to be a material reversal of the working capital position post year end. As a result, the balance sheet is even stronger than we previously recognised, with 56% of shareholders’ equity in cash.

Potential acquisition activity

Management has made no secret of the fact that it considers acquisitions as a growth vehicle, and we understand that the process of reviewing possible acquisitions remains active. Some candidates offer themselves because the company has excess cash and has expressed an inclination to seek acquisition assets. Others are identified by management as part of a screening process for likely targets that meet its strategic criteria.

Macro factors present potential risk

Management references macroeconomic risks in its statement. These are in two separate areas, the US and Europe:

Macro factors: US

Focusrite’s products are sourced from China and c 41% of its sales are into the US. Management expects these to become subject to the latest round of tariffs imposed on imports into the US from China. News reports have suggested an initial 10% level for the tariffs. As the breadth of applicable products has widened, Focusrite has been planning for this and considering the natural choice between absorbing the impact or passing it on to customers. Its competitors in both its main product areas will need to make the same choice.

That said, it is becoming clear that Trump’s negotiating style is to create a major threat as a show of power, leading to a strong base that can then be used to make discussions more productive. If this represents such a tactic and it works as intended, the risk could be reduced.

Macro factors: Europe

The major risk factor in Europe is clearly Brexit. It is therefore uncertain precisely how such risks could play out in practice, but the main areas we would focus on are:

Exchange rate fluctuations: markets to some extent reflect a no-deal scenario and sterling could strengthen if a deal is struck. If this happened, it could impact sterling value of the company’s euro sales (c 25% of revenue). We understand the company has hedged c 70% of its FY19 and c 25% of its FY20 exposure.

Product distribution: the principal risk is that customs hold-ups following some versions of a Brexit deal, or no deal, might affect distribution of Focusrite’s product. On the plus side, the company sends its product to distributors, who supply end retailers, so that fine timing is not a major issue. Also, Focusrite uses internationally established freight forwarders who are likely to have the best systems and strategies for avoiding unnecessary delays.

Forecast: No change to profit or earnings

We make no changes to our forecast profit and loss for FY18 or FY19. We reflect year-end net cash of £22.8m as confirmed in the statement. Looking forward, we cautiously assume that £1m of the £2m uplift in that figure rolls forward to FY19.

Valuation: No change in our view

With no change in our earnings forecast, we make no major alterations to our valuation metrics. We value the shares using DCF techniques to evaluate the longer-term income stream available to investors. As a secondary metric, we consider valuation in relation to a peer group of smaller companies on near-term earnings expectations, although few of these are close peers. However, as discussed below, neither metric fully reflects the potential of the company’s cash of £22.8m.

DCF valuation: Market is discounting substantial growth

Our DCF projection extends our forecasts out to 10 years with revenue growth fading in the last three years to a terminal rate of 2%. We assume a terminal EBITDA margin of 21% (as 19.8% was already achieved in 2017, this may be conservative) and capex investment at 7% of revenue, reducing to 5% in the terminal period. We assume an equity-only cost of capital of 8.4%.

It remains the case that the current share price is equivalent to a medium-term revenue growth rate of about 12%, well within previously achieved growth rates. Exhibit 2 below shows the share price implication of alternative sales growth rates, as well as terminal margin assumptions.

Exhibit 2: Sensitivity to medium-term growth rate and terminal margin

Sales growth FY21-25

8%

10%

12%

14%

16%

Terminal margin

23.0%

428

461

497

536

577

22.0%

408

439

473

509

548

21.0%

387

417

449

483

520

20.0%

367

395

425

457

491

19.0%

347

373

401

431

463

Source: Edison Investment Research

Peer group reference: Mixed picture

Focusrite does not have a direct peer, but we compare it with UK smaller-cap tech, electronics and consumer companies in relevant subsectors, as well as relevant companies in US and European markets. This is far from an exact comparison but does give some context in terms of market valuations in adjacent sectors.

Exhibit 3: Peer valuations

P/E (x)

EV/EBITDA (x)

EV/Sales (x)

Yr1e

Yr2e

Yr1e

Yr2e

Yr1e

Yr2e

Universal Electronics

19.5

12.8

9.3

7.1

0.6

Tivo

11.7

11.8

10.4

3.3

3.3

Morgan Advanced Materials

11.2

12.2

6.9

7.2

1.4

1.3

Photo-Me International

13.6

13.1

6.4

6.2

2.4

2.3

Oxford Instruments

17.3

15.9

10.8

10.2

2.8

2.8

Bang & Olufsen

62.8

23.1

12.2

9.8

0.4

0.4

XP Power

18.4

15.4

13.7

11.7

3.5

3.4

Avid Technology

29.9

10.7

8.8

0.5

Gooch & Housego

30.1

26.1

17.8

15.6

4.0

3.8

Dialight

24.3

13.6

11.2

7.4

1.1

1.0

Quixant

27.1

24.5

19.7

17.8

3.2

2.8

Judges Scientific

22.0

18.7

13.4

13.3

2.7

2.6

B&C Speakers

16.9

12.2

2.7

2.5

Trakm8 Holdings

8.2

5.1

0.9

Gear4music Holdings

61.9

42.2

28.3

20.8

1.9

1.4

Average

27.6

20.0

13.2

11.7

2.4

2.6

Focusrite

27.0

25.9

16.0

15.4

3.2

3.0

Premium/(discount)

-2.3%

29.6%

21.2%

32.1%

35.5%

17.2%

Source: Bloomberg. Note: Based on market prices at 17 September 2018.

Focusrite trades on a 2% P/E discount for FY18e but a 30% premium for FY19e. On an EV/EBITDA basis, it trades at a premium of 21% for FY18e and 32% for FY19e. On an EV/sales basis the company also trades at a premium to the peer group.

The cash valuation gap got bigger

While on the face of it our metrics do not point to valuation at or above current market levels, what is left out of the equation is how Focusrite’s increased excess cash of £22.8m may be used. Here we consider the likely effect of using it to make an accretive acquisition.

As we analysed in our April note, Focusrite generates high average taxed ROCE rates of 45–51%. It is not likely that 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 value impact of excess cash (£m/p per share)

ROCE

10%

15%

20%

Excess cash

22.8

22.8

22.8

Post-tax earnings

2.3

3.4

4.6

Incremental EPS

3.9

5.9

7.8

Pro forma FY19 EPS

20.9

22.8

24.8

Peer P/E

20

20

20

Implied share valuation (p)

417

456

495

Source: Edison Investment Research

Hence, it would seem the market appears to be discounting investment of the net cash balance at a c 15% post-tax return.

Exhibit 5: Financial summary

£000s

2016

2017

2018e

2019e

2020e

31-August

IFRS

IFRS

IFRS

IFRS

IFRS

INCOME STATEMENT

Revenue

 

 

54,301

66,055

75,412

80,022

86,023

Cost of Sales

(33,439)

(39,704)

(43,930)

(46,615)

(50,111)

Gross Profit

20,862

26,351

31,482

33,406

35,912

EBITDA

 

 

10,249

13,109

15,128

15,662

16,660

Operating profit (before amort. and except).

 

7,677

9,470

11,224

11,465

12,183

Amortisation of acquired intangibles

0

0

0

0

0

Exceptionals

(537)

0

0

0

0

Share-based payments

0

0

0

0

0

Reported operating profit

7,140

9,470

11,224

11,465

12,183

Net Interest

(14)

42

(387)

50

50

Joint ventures & associates (post tax)

0

0

0

0

0

Exceptionals

0

0

0

0

0

Profit Before Tax (norm)

 

 

7,663

9,512

10,837

11,515

12,233

Profit Before Tax (reported)

 

 

7,126

9,512

10,837

11,515

12,233

Reported tax

(870)

(959)

(1,300)

(1,555)

(1,835)

Profit After Tax (norm)

6,793

8,553

9,536

9,961

10,398

Profit After Tax (reported)

6,256

8,553

9,536

9,961

10,398

Minority interests

0

0

0

0

0

Discontinued operations

0

0

0

0

0

Net income (normalised)

6,900

8,553

9,536

9,961

10,398

Net income (reported)

6,256

8,553

9,536

9,961

10,398

Basic average number of shares outstanding (m)

53.2

55.4

56.7

56.7

56.7

EPS - basic normalised (p)

 

 

13.0

15.4

16.8

17.6

18.3

EPS - normalised (p)

 

 

11.8

14.8

16.3

17.0

17.6

EPS - basic reported (p)

 

 

11.8

15.4

16.8

17.6

18.3

Dividend per share (p)

2.0

2.7

3.0

3.3

3.7

Revenue growth (%)

13.1

21.6

14.2

6.1

7.5

Gross Margin (%)

38.4

39.9

41.7

41.7

41.7

EBITDA Margin (%)

18.9

19.8

20.1

19.6

19.4

Normalised Operating Margin

14.1

14.3

14.9

14.3

14.2

BALANCE SHEET

13,748

11,520

14,625

17,321

Fixed Assets

 

 

6,367

6,332

6,940

8,138

9,462

Intangible Assets

4,792

4,963

5,737

7,107

8,579

Tangible Assets

1,575

1,369

1,203

1,031

883

Investments & other

0

0

0

0

0

Current Assets

 

 

28,191

36,126

44,080

51,129

58,282

Stocks

11,361

9,000

9,629

11,047

12,494

Debtors

11,224

12,952

11,570

13,593

15,319

Cash & cash equivalents

5,606

14,174

22,881

26,489

30,470

Other

0

0

0

0

0

Current Liabilities

 

 

(9,256)

(8,663)

(9,936)

(10,322)

(10,854)

Creditors

(8,612)

(8,204)

(9,679)

(10,015)

(10,492)

Tax and social security

(644)

(459)

(257)

(307)

(363)

Short term borrowings

0

0

0

0

0

Other

0

0

0

0

0

Long Term Liabilities

 

 

(282)

(245)

(287)

(361)

(440)

Long term borrowings

0

0

0

0

0

Other long term liabilities

(282)

(245)

(287)

(361)

(440)

Net Assets

 

 

25,020

33,550

40,797

48,585

56,449

Minority interests

0

0

0

0

0

Shareholders' equity

 

 

25,020

33,550

40,797

48,585

56,449

CASH FLOW

Op Cash Flow before WC and tax

10,249

13,109

15,128

15,662

16,660

Working capital

(6,009)

407

1,562

(3,105)

(2,696)

Exceptional & other

(417)

137

(0)

(0)

(0)

Tax

(165)

(633)

(1,300)

(1,555)

(1,835)

Net operating cash flow

 

 

3,658

13,020

15,390

11,003

12,128

Capex

(3,675)

(3,614)

(4,594)

(5,557)

(6,095)

Acquisitions/disposals

0

0

0

0

0

Net interest

(111)

(42)

(387)

50

50

Equity financing

172

258

0

0

0

Dividends

(976)

(1,138)

(1,702)

(1,888)

(2,103)

Other

365

84

0

0

0

Net Cash Flow

(567)

8,568

8,707

3,608

3,980

Opening net debt/(cash)

 

 

(6,173)

(5,606)

(14,174)

(22,881)

(26,489)

FX

0

0

0

0

0

Other non-cash movements

0

0

0

0

0

Closing net debt/(cash)

 

 

(5,606)

(14,174)

(22,881)

(26,489)

(30,470)

Source: Focusrite, Edison Investment Research

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