Focusrite — Outstanding first half

H1 results show consistent and substantial organic growth across the business. Revenue grew by 21.2% y-o-y, EBITDA by 30.0% and operating profit by 36.3%. Operating margin improved from 14.3% to 16.0%, driving a 27% growth in pre-tax profit. There were no exceptional items in either year. Net cash has grown since year end by £5.6m to £19.7m.

Like many much larger companies Focusrite has a largely international market, with c 85% of revenues sourced outside the UK. The medium-term advantage of access to more buoyant consumer economies is arguably counterbalanced by short-term exchange rate risk, but in this period at least, relative sterling strength only serves to highlight that constant currency sales grew even faster than reported revenue, at 26% against the reported 21%.

Constant currency against reported revenue growth now shows an inverse trend compared with FY17. Then, constant currency sales grew by 13% (US: 18%, EMEA: 7% ROW 13%) which, translated to sterling, became 21.6%. In H118, similar sterling growth of 21.1% masks constant currency growth accelerating twice as fast as in FY17, at 26% as shown above.

Regionally, it is impressive that constant currency growth is well into double figures across the board, with the lowest being 19% in Europe, Africa and the Middle East. Here, management reports that all the major territories (UK, Germany and mainland Europe) were in solid growth.

The company noted an especially strong Christmas holiday season for the more consumer-priced products. It is possible that this strength may have altered the seasonal shape of sales.

By division, there has also been consistent growth across the business, with Focusrite division growing revenue at 23% and Novation by 19%. This represents a narrowing of the growth profiles, where for FY17 the growth was 19% and 38% respectively.

Focusrite is seeing continued sales growth in the second generation of its keynote Scarlett range, but also reports 28% growth for the more sophisticated Clarett brand (for product group descriptions see our Outlook note published in November 2017). The Focusrite Professional division formed this year, which targets the very different requirements of major corporate customers of the Red and RedNet brands, is starting to succeed in winning sales, including a major contract in China, albeit its activities only account for c 6% of revenue at the moment.

Novation’s signature Launchpad model grew revenue by 26% y-o-y. The company has seen these instruments coming into wider demand from a broader and younger consumer group, who are not necessarily hardcore music hobbyists. For example, their accessibility on Amazon seems to have corresponded with a move by parents buying the product for their teenage children ahead of Christmas. Similarly, the company’s own website and others such as Gear4music create a sales platform that faces customers who would not necessarily know a physical music equipment dealer. Novation has also seen synthesizer sales up 90% y-o-y as its newly launched PEAK 8-voice model has gained rapid acceptance following launch in April 2017.

The AMPIFY brand’s music apps have reached 8.5m downloads compared with 7.5m in FY17, and they are growing at c 0.2m per month. Management believes that app sales are a supportive driver of hardware sales in both the Focusrite and Novation brands.

Net cash has increased by £5.6m since year end to £19.7m. This net cash inflow is the product of H1 EBITDA of £8.0m and working capital inflows of £1.0m, less capex of £2.0m, dividend payments of £1.0m, and smaller items. The inflow from working capital is likely to reverse to some extent in the full year. A stock increase of 7% to £10.9m is well below the 21% increase in revenue as a result of close management, but if continued could jeopardise stock availability. An increase in creditors of £2m was phased near the end of the period and will probably equalise in the second half.

We upgrade our PBT forecasts by 4.5% in FY18e and 3.5% in FY19e.

Essentially, we carry forward the H1 revenue beat of £0.8m at H1 (£30.8m compared with £30.0m expected at pre-close), resulting in a £0.4m improvement at PBT level. We cautiously leave our expectation for H2 unchanged since it is still possible that the trading strength experienced in H1 was a change in the seasonal shape of sales, and that the strong level of demand may not be sustained to the same extent in H2. If it is, there should be further upside to our FY18 forecast.

For FY19e we see a slightly stronger outlook for the € against sterling, resulting in marginally higher revenue and margin, despite any continuing weakness of the US$ in view of the company’s natural hedge. Combined with a slight reduction in our operating cost forecast, this results in a £0.4m or 3.5% upgrade in our PBT forecast.

The company has stated its intention to reduce dividend cover over time to between four and five times (FY17: 5.5 times). Our dividend forecast of 3.00p rising to 3.65p by FY20 is equivalent to cover of 5.4 times falling to 4.8 times over the same period.

We increase our year-end net cash forecast from £20.4m to £20.8m, which reflects our profit upgrade. It also assumes that working capital will absorb £0.5m in the full year, much less than the 20% of revenue increase that management would consider normal, which would be approximately £2m.

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 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 excess cash of c £20m.

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% (risk-free rate 3%, risk premium 6%, beta 0.9).

The key assumption is the medium-term sustainable revenue growth rate. Here, the current share price is equivalent to a medium-term growth rate of about 12%. In the past three years revenue has grown at 17%, 13% and 22% respectively, which makes such an assumption eminently reasonable; however, whether that level of growth can be sustained for up to seven years ahead is the key question. Exhibit 4 below shows the share price implication of alternative sales growth rates, as well as terminal margin assumptions.

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.

Focusrite trades on a 1% P/E discount for FY18e but a 31% premium for FY19e. On an EV/EBITDA basis the company trades at a premium of 23% for FY18e and 34% for FY19e. On an EV/Sales basis the company also trades at a premium to the peer group.

While our metrics on the face of it do not point to valuation at or above current market levels, what is left out of the equation is how Focusrite’s excess cash of £19.7m may be utilised.

Focusrite generated high average ROCE rates of 44.7% in FY17 and we forecast 51.0% in FY18. On an untaxed basis those rates would be 49.7% and 58.0% respectively.

It is not likely that the company could generate returns from an acquisition equivalent to those of the business it has grown itself. However, using a range of lower ROCE rates, the excess cash would imply additional value as follows:

Similarly, the effect on our DCF of adding £3.3m (the pre-tax equivalent of the £3.0m in the 15% column above) to our EBITDA, and removing net cash, would be to value the shares at 452p, assuming only annual revenue growth of 8% between FY21 and FY25.

Rather than an assumption of higher organic growth over time, we suggest it is likely that the market is discounting a valuation that assumes utilisation of the cash balance along these lines.