Gear4music Holdings — Update 18 October 2016

Gross margin edged ahead to 26.6% and EBITDA margin demonstrated much better utilisation of the overhead and marketing structure, with a rise to 6.3% from 1.8% in H116.

Key performance indicators for the online sales platform are strongly ahead. Both the number of website visitors and, significantly, their conversion rate, are up by significant double digits, while material increases in active customers and email subscribers indicates a fast improving profile for G4M’s offer among potential customers.

Growth in visitor numbers and conversion rates show a bias towards Europe, although relatively low conversion rates also show the potential of further market share gains. Despite the first half traditionally being the quieter half, own-brand products grew much more strongly than in the full year FY16, at 63% against 30%. Although other brands also increased their already high growth rate from 57% to 76% in the same periods, this means that growth is now more closely matched between own and other brand categories.

G4M has a strategic objective of international expansion, in both existing and new geographical markets. Since IPO, the company has further developed its ecommerce platform, with multilingual, multi-currency and fully responsive design websites covering 18 countries.

European sales grew by 88% in FY15 and 73% in FY16. In H117 the rate of growth of European sales has accelerated materially to 169% and now represents 36% of total revenue, up from 23% a year ago. This dynamic growth results from the company’s strategic focus, and was also assisted by competitive pricing that was made possible by inventory purchase commitments, which effectively reflected the pre-vote exchange rate environment.

We analyse below revenue growth before and after the end of June. The 169% European growth in H1 was split between 137% to June and 239% for the final two months. At the same time UK revenue growth remained constant at 44%.

It is clear that G4M’s increased pricing competitiveness in European markets since the vote has allowed it to take share. The company benefited from significant stock orders for branded products at sterling prices that did not reflect the new exchange rate environment. To date, it has not seen a significant competitive response. However, this is a continuing risk.

G4M announced in May that it planned to open a distribution centre in Sweden in November 2016. A second European hub, to open by the end of the financial year, is now identified as being in Germany. The hubs are intended to transform the European customer proposition, reducing customer delivery times and opening up local buying and merchandising opportunities. The developing mainland European presence should remove a potential longer-term barrier to sales growth, increasing overall capacity to more than £100m in revenues. This increasing European exposure should de-risk the company from any potential UK consumer weakening in the medium term.

Stock range and depth has been steadily increased, with H1 stock value of £9.3m, up 16% and representing around 90 days’ cost of product sale based on our FY17 forecast. The number of SKUs available is up 17% y-o-y to 34,400. There was an emphasis on developing the own-brand range during the period, including the introduction of own-brand acoustic pianos, a broadening of the guitar and percussion ranges and an improved premium drum kit offer.

G4M rightly prioritises its e-commerce, in which it invested £0.6m in the period (H116: £0.4m), and progressed a number of projects including:

G4M is acquiring the software development team, which has been effectively a dedicated, but externally controlled resource. The consideration is not disclosed but we understand that there is a deferred structure, which should ensure the transaction is cash neutral in the medium term. We see this as a positive strategic move, which should allow management to prioritise projects and manage the resource more closely in line with its own perceived strategic objectives. It should also be cost-effective as development will now be priced at actual cost rather than a marked-up amount.

We are significantly upgrading our forecasts, as shown in Exhibit 4 below.

While European trading following the Brexit vote has been transformed by G4M’s competitive pricing position, we remain cautious about this factor. While we understand that some GBP supply prices have been held at lower levels for longer than we originally expected, they must inevitably at some point revert to levels that reflect the actual exchange rate environment. We described G4M’s exchange rate trading environment in our initiation note (Sensitivities – Exchange rates on page 7), and we assume that management will broadly act to maintain margins, and therefore that rising input prices would result in higher selling prices.

However, underlying factors mean that we can still safely increase our estimates:

We thus revise our overall FY17 revenue growth forecast from 37% to 58%, taking revenue from £49m to £56m. Gross margins are likely to be supported in the short term by the favourable purchase pricing regime. The cost environment is being controlled in line with management’s plans for the year and, with the additional costs of the European hubs affecting the last quarter, we reduce our EBITDA margin assumption from 5.2% to 5.0%. This results in an 11% increase in our EBITDA forecast, amplified to 16% at operating profit level by the gearing effect of depreciation and amortisation and by 21% at PBT after H1 exchange rate gains.

For FY18e, we are cautious on UK consumer demand in the face of expectations by forecasters of weaker fundamentals, such as lower GDP and consumer confidence, and growing price inflation. As a result, we use more cautious growth assumptions than for FY17. However, G4M is clearly accessing a demand niche and winning market share that is driving independent growth. Our forecasts indicate that G4M has European market share of only around 1% in our forecast period, leaving significant further share to go for.

We now assume UK revenue growth of 25%, below our 38% for FY17e, but higher than our previous 12%. In Europe we assume 70%, well under our FY17e growth of 111% but still above our previous 48%. We anticipate that the two European hubs will contribute to this growth. We therefore expect European revenue to reach 43% of the total by FY18 (and 45% in FY19). Combined, we upgrade expected growth from 24% to 41%, taking our revenue forecast from £60m to £79m.

While we expect the company to maintain gross margin levels, two factors are likely to substantially absorb the operational gearing benefits of the higher volumes. Firstly, in FY18 the European hubs will reflect a full year of costs, mainly in property costs and people (there will clearly be an investment in working capital as well). Secondly, G4M is moving to expand its operating management structure in preparation for higher volumes of business. For example, the new position of head of European operations has been instrumental in generating the rapid growth in European business.

As a result, we expect the EBITDA margin to grow only slightly to 5.1%. We now forecast PBT growing 45% to £2.9m and EPS growing 48% to 11.4p.

The same trends continue in our FY19 forecast with a more modest revenue growth of 24%, taking revenue to £98m and thus close to management’s £100m target, and driving 27% earnings growth.

Whereas we originally forecast net positive cash flow effective from FY18, we now anticipate small outflows continuing until FY19. These reflect higher trading volumes leading to higher working capital investment in these years, and a small amount of additional capex in FY17e. We forecast year-end net cash to bottom out at £2.2m in FY18e (previously £2.5m in FY17e). The company has c £4m of largely unutilised bank facilities in place (trade loans were £0.7m at August 2016).

Management is to revisit its dividend policy at the end of the financial year. In view of the company’s growth potential, we do not expect any dividend to be material in yield terms and we await the actual decision before including it in our forecasts.

We use both a peer comparison method and a DCF to derive indicative value for G4M. In addition, given G4M’s significant growth potential and in the light of our forecast upgrades, we have now also included a growth-adjusted peer comparison method using PEG ratios.

We compare the valuation with quoted online retailers. We previously allowed a 30% discount against ASOS and Boohoo for size, liquidity and their established growth record. Given G4M’s improved record and profile, we reduce this to 20%.

On an EV/Sales basis, G4M stands at a discount to the peer group. In terms of P/E ratios, it is at a calendarised P/E discount of 5% for 2017 increasing to 22% in 2018 (in that year the peer multiple increases as a result of the forecast profitability of AO World). On EV/EBITDA, G4M is on a 16% premium to the group for calendar 2017: however, this reflects the low multiples of N Brown and Findel, which do not enjoy the same growth profiles as ASOS and Boohoo. By calendar 2018, this premium has disappeared. Taking an average of calendar 2017 and 2018 P/E and EV/EBITDA ratios implies a valuation of 332p.

While G4M’s share price has moved ahead strongly since we initiated in May, we do not think the market fully reflects the company’s enhanced growth profile, and we therefore explore this aspect by reference to PEG ratios. Leaving out the extremely high early-stage earnings growth in FY17, when we forecast EPS to more than double, our forecast earnings growth over the following two years to FY19 is a compound average 37%, which we adopt for the purpose of the PEG ratio. On the basis of this medium-term growth, against its CY17 P/E of 27.0x, G4M has a PEG of 0.7. ASOS, Boohoo and Findel have an average PEG (after discounting as above) of 1.3.

Putting G4M on the 1.3 PEG implies a CY17e P/E of 49.5x, resulting in a price of 382p.

G4M is rapidly growing its share of a substantial market through its disruptive competitive position but is still at an early stage. We therefore believe a DCF approach is a relevant valuation metric.

Our DCF model is based on our three-year forecast, extended for a further seven and to a terminal year. We fade revenue growth from 2019e (+24%) by c 3% pa to terminal growth of +2%. We assume that EBITDA margin grows gradually from 5.2% at 2019e, on economies of scale, to a terminal 9%. We use an equity-only cost of capital of 9% (vs 10% previously), reflecting the current very low interest environment with a 1% risk-free rate but including a small company premium of 8%. We assume capex at a constant proportion of revenue on the assumption that the company will continue to invest in its platform and expand significantly in Europe. These assumptions, reflecting the longer-term growth potential, result in a valuation of 392p, with terminal value accounting for 76% of EV.

Exhibit 7 shows the effect on this valuation of differing assumptions for cost of capital and terminal growth. As shown, a 10% WACC would bring the valuation to 329p.

We also test scenarios for differing medium-term growth rates and terminal margin.

This indicates that the current price would be equivalent to a step-down of c 3% in the 2020 growth rate (declining then to our terminal 2%) and a terminal margin of c 8%.

All our metrics are above the current share price, with a valuation range of 332-392p. By averaging the three metrics: peer comparison of 332p, PEG ratio 382p and DCF 392p, we derive a blended valuation of 369p.