Gear4music Holdings — Ready to rock

After a first half focused on expected investment and positioning for the next stage of expansion, G4M has reported interim results with strong revenue growth of 44% y-o-y to £31.2m and pre- and post-tax profit at break-even levels.

Underlying momentum was strong both in the core UK market, up 30%, and particularly in the strategic focus market of Europe, up 70%, including maiden full trading periods at the two new distribution centres in Sweden and Germany. The company’s own branded products grew by 61%, faster than other branded products (41%), to reach a level of 24% of total sales.

Gross margin eased 1.6 percentage points to 25.0% as the company managed cost increases. Its own-brand products are purchased in US dollars, against which the GB pound was 8% weaker in the period. Purchases of other brand products, although mainly negotiated in GB pounds, are also inevitably affected by sterling weakness. These pressures were mitigated in part through investment in the customer proposition and in part by the higher margin associated with relatively stronger growth of its own products.

Operating costs totalling £7.8m rose from £4.9m at H117, an increase from 22.5% to 24.9% of revenue. That overall increase was largely accounted for by the two European hubs, at 2.2 percentage points of the total 2.4 point increase.

As flagged in the full-year results and at pre-close, the first half, which included the £4.2m fund-raise in May 2017, was a period of investment into the proposition and infrastructure that increased operational costs. During the period, needed hires were made, particularly in the sales and buying functions, and the half also bore the full-period costs of senior hires in the second half of FY17. Marketing costs continued at 8.1% of revenue, and depreciation and amortisation rose as a result of continued investment into the software platform.

Customer KPIs demonstrate underlying progression across the board:

Unique visitors to the website continue to grow at a substantial and consistent rate, reflecting the bias to new users, also apparent in the reduced proportion of repeat customers. G4M achieves payback on customer acquisition costs from the first transaction, on average.

Conversion rates continue to move upwards, as they have in every half-year reporting period over the past two years. They grew particularly strongly in Europe, and the convergence of European with UK rates represents a sizeable opportunity. Similarly, average order value continues to increase year-on-year, and at £132 indicates that customers are using the website for purchases of serious value. G4M maintains its high-quality Trustpilot score of 9.6, achieved for FY17. And the email database continues to grow significantly at 21%, on top of the transformative 84% a year ago.

The Swedish hub near Stockholm opened in November 2016 and the German one near Dusseldorf in February 2017. It is therefore nearly a year since the physical move to continental Europe was launched. In May, we noted that the German centre was at an early stage of trading and was likely to remain inefficient during H118. However, by August 2017 both the centres were making positive contributions to central costs, a promising position to be in ahead of the busier second half. With half-year costs of £0.7m and assuming similar gross margin to the rest of the business, it could be inferred that run-rate annual revenue from the centres is currently £5-6m, or some 7% of revenue.

This profitable position is significant in that it indicates that the process of setting up the international centres has been successfully executed. This is no small achievement for a business that was previously purely UK-based. It is an important result for a business that targets international markets. It has been a significant learning phase for management that reduces the risks associated with further international expansion. It puts the international operation in a strong position ahead of the busy second-half trading period.

Having raised £4.2m net cash in May 2017, G4M has invested in stock as planned, supporting continuing revenue growth. Stock increased from £9.3m at August 2016 to £13.0m at 31 August 2017, although the 39% increase is lower than the rate of increase in revenue, and we forecast a further increase to £15.5m by year-end. This should be partly mitigated by a reduction in receivables, which was inflated at August by prepaid stock on water, cash-in-transit and funds lodged with payment providers, as well as property-related prepayments. We forecast receivables reducing from £2.3m at interim to £2.0m at year-end.

The company also invested £5.6m in its UK Head Office freehold in York, although this was debt-financed via term loans of £5.5m. As a result, net debt was £3.7m against net cash of £0.9m at August 2016.

From its origins in the UK G4M has progressively developed strategies to penetrate wider markets, and currently has delivery available to over 190 countries. At IPO, management identified the UK and continental European as the major strategic growth areas and identified their market sizes. With FY17 results, the equivalent markets in the US and Asia were also identified:

The company’s successful incursion into Europe is the result of a consistent strategy of investing in the European market opportunity, including 18 individual native language websites that look and feel local to European nationals, the local distribution hubs in Sweden and Germany, and the functional support for a much larger marketing and distribution operation.

These actions have resulted in international revenue (largely European to this point) taking the lead in terms of rate of growth, while UK growth remains substantial.

G4M’s development to date has been marked by phases in which fundraising rounds for investment have preceded step changes in revenue growth.

Although it would be simplistic to assume a causal relationship, what has been apparent in the company’s record is a measured use of investment to prepare for phases of expansion, driven by market share. With this perspective, it would be logical to regard the company as being at the front end of further phases of expansion, where over time it could develop a share of a much larger market.

Given the strong customer KPIs, we expect second-half revenue to grow by similar rates to the first, both in the UK and internationally. We also expect foreign exchange pressures on margins to reduce in the second half, taking into account the lead times between contracting for stock and its impact on cost of sales. This should add to the characteristically stronger underlying second-half gross margin trend to lift it to 25.8% in the full year from 25.0% in H1. As sales accelerate and the European hubs become more efficient, administrative costs (excluding depreciation and amortisation) should settle from 24.8% in H1 to 22.6% for the full year, more in keeping with the 22.3% achieved in FY17. As a result, we leave our profit forecast unchanged. Our net debt forecast of £3.9m is also unchanged.

The shares reflect the strong growth expectations associated with significant market share gains both in the UK and newer geographies where G4M trades. Short-term P/E and EV/EBITDA multiples are top of the range of pure-play online retailers that are currently profitable (AO World and Koovs are not):

We believe this reflects the fact that peers such as Boohoo and ASOS are more established in terms of their penetration of international markets beyond Europe, and that G4M therefore has a greater market opportunity.

The investment case for G4M is based on its ability to continue to win market share in a fragmented market sector both in the UK and internationally.

Our DCF projection indicates, under consistent assumptions, the current share price implies that, from its current year level of 1%, G4M takes seven years to reach a market share of 6% in mainland Europe, equivalent to that which we forecast in the UK for the full year FY18 (the current market share for the 12 months to August 2017 is 5.2%). It will have taken six years to build this level of market share in the UK, from insignificant levels. If G4M takes less than seven years to develop the same market share in Europe (at constant profitability ratios), then there is a share price opportunity. For example, if it achieves it one year earlier, that would be equivalent to a share price valuation of 1110p on our current analysis.

The prospect of faster European share growth is supported by G4M’s adoption of European expansion as a major strategic focus. The company is specifically organised around this strategy, and is better resourced and experienced than it was eight years ago. In addition, it has the benefit of the May 2017 fund-raise, which secured £4.2m of additional growth capital specifically aimed at accelerating expansion. We therefore believe it is reasonable to expect that G4M will develop its market share over this time frame.

However, this scenario is not without risk. There is more organised online competition in mainland Europe, and management has the additional task of setting up operations in different geographies, although with the successful set-up of the Swedish and German hubs now confirmed, much of this learning is already behind it.

With the launch of the US$ website, the dimensions of the longer term market prospects potentially expand, producing an overlay to the scenario. If, instead of faster share gains in Europe, G4M develops a share of the US musical instrument and equipment market rising to, say, 1% over the next 10 years, this would be equivalent to a share price of 967p. In a more positive scenario in which G4M is able to achieve both the faster European growth described above and also a 1% US market share over 10 years, that would be equivalent to a share price of 1274p.