Focusrite — Update 22 November 2016

Two significant points stand out from the full-year results. Firstly, they demonstrate very strong growth coming through in the second half around the key second-generation Scarlett launch, which represented eight of the 16 launches in an active programme in FY16 (see Exhibit 2).

Secondly, second half growth was particularly strong in the Rest of the World and the US, at 27% and 23% respectively (Exhibit 2). Focusrite has a strategic focus on the Far East, opening a Hong Kong sales and marketing office to help grow the region during the year. Regional sales increased 2% to 19% of the company’s total. The US saw a strong take-up of the Scarlett second-generation launch.

Margins remain firm after allowing for the effect of currency. A stronger US$ against sterling is negative to the margin percentage, but only slightly so on the cash margin. The stronger euro is positive to both. Net, there is a marginal benefit from a weaker pound.

Pre-tax profit of £7.7m beat our forecast by 7% and EPS of 11.8p by 10%. Revenue growth of 13.1% to £54.3m was in line with pre-close guidance. Gross margin, although declining as expected year-on-year due to the stronger US$, was better than our forecast because of the late boost in the euro. This fed through to a similar beat on the EBITDA margin which, after depreciation and amortisation that was slightly below forecast, drove the better pre-tax result.

Revenue growth of 13.1% was led by the Focusrite brand group in the second half, reflecting the success of the launch of the second-generation Scarlett range, the company’s largest brand family. The year also saw launches of the Clarett and Red ranges ($500-4,000), which we discussed in our initiation note, together with launches of products in the RedNet professional range, where customers include Microsoft and Disney.

The Novation group saw a revenue decline in H2 against 36% growth in H215, when the Launchpad Pro was launched and in contrast to H1, which saw the launch of the innovative Circuit instrument. However, Novation product registrations continued to increase, suggesting that the decline was the result of stock management by dealers rather than lack of customer demand. Distribution revenue strengthened markedly in H2 as more dealers bought KRK monitors, which the company distributes in the UK, reinforcing an overall stronger rate of growth later in the year.

The 40bp decline in gross margin can be attributed to the weakness of sterling against the US$ in the second half. The company’s revenue is c 50% and cost of sale is c 100% in US$, creating a good natural hedge; however, the resulting increase in sales and cost of sale produce a lower percentage margin despite the fact that there is little cash exposure.

The net effect of these factors was a boost to EBITDA growth in H2, to 17% against 3% in H1 (which had been affected by weakness in Q1 and also the fact that the company stopped shipping the older generation of the Scarlett range a few months ahead of the June second-generation launch, so that the channel was ready to accept the new product). The same effect is seen at operating profit level (18% against 1%). However, at PBT and EPS level, this was distorted between the two halves by the fair valuation process in relation to FX hedging instruments but, as expected, this had little effect in the year as a whole.

Focusrite has no borrowings, and cash declined over the year by £0.4m to £5.6m. This was mainly as a result of decisions to increase stock holdings on new products, but also reflected an agreed change in payment terms to a large customer. Both of these are likely to be one-time effects.

The strong performance in the second half supports our confidence in the company’s strategy, which we set out in our September initiation note. Developments of the strategy already included the launch of the Blocs Wave app in H1 and the launch of the company’s first webstore.

Our upgrades to forecasts effectively represent a roll-forward of the FY16 over-performance.

We are upgrading our FY17 EBITDA forecast by 2% and our EPS forecast by 5%. Although we assume 8% underlying revenue growth, the effect of weakening sterling against the company’s predominantly international markets is to amplify that to total revenue growth of 15%. However, to the extent the c 50% of revenue that is in US$ is matched against close to 100% of product cost, that currency effect is reduced at gross profit level. A small increase in gross margin carries through from FY16, and this drives the upgrades to PBT and cash. We do not forecast a geared effect from the increase at PBT and earnings level as we anticipate slightly higher central cost inflation, including the Asia office and eCommerce inititative.

For FY18 we upgrade PBT and EPS by 4% and 5% respectively. Again, we cautiously assume 8% underlying revenue growth, but with less fluctuation in currencies than in FY17, the total revenue increase is 9%. The increase in gross margin that we anticipate is largely the result of the 2017 euro hedging at £/€1.28 on 75% of European revenue reverting to spot, which we assume at £/€1.21. Once more, we assume higher cost inflation, which limits the assumed flow-through of higher margins to pre-tax profit and earnings.

We believe Focusrite is well placed to achieve sustained earnings and dividend growth based on its ability to remain at the forefront of its competitive and technical market. We use a DCF projection to place a value on the longer-term income stream available to investors. Although there are few close peers, we also consider valuation relative to a group of smaller companies on near-term earnings expectations.

Our DCF projection extends our forecast using similar revenue growth and margin assumptions for two years, and out to 10 years on growth, fading in the last three years to a terminal rate of 2%. We assume terminal EBITDA margin of 19.0% (2019e: 16.9%) and capex investment at 7% of revenue, reducing to 6% in the terminal period. We assume an equity-only cost of capital of 8.4% (risk-free rate 3%, risk premium 6%, beta 0.9), resulting in a valuation of 214p/share (of which 129p is in the terminal value). Our previous valuation was 202p. This would put the shares on an FY17e P/E of 17.7x and EV/EBITDA of 10.7x. Varying the cost of capital and the terminal growth assumption would give the following ranges:

Varying our assumed sales growth and margin assumptions affects the valuation as follows:

In addition, our valuation would change by c ±40p for every 1pp change in our discount rate.

In our view the London small-cap market is the most appropriate context for Focusrite. As there is no close peer here, we define the relevant group as other UK smaller tech, electronics and consumer companies in relevant subsectors, as well as relevant companies in US and European markets. Although far from exact, this gives some context in terms of market valuations in adjacent sectors.

Focusrite trades at an average 15% P/E discount and an average c 7% EV/EBITDA premium to the group, which is slightly inconclusive, but suggests that the lower P/E rating reflects its favourable cash-rich capital structure and low tax rate resulting from its ongoing investment in R&D. Adjusting to the group in both calendar years on average values Focusrite shares at 197p on a P/E basis and 166p on an EV/EBITDA basis, an average of 181p. EV/Sales at around 1.5x is in line with peers.