Focusrite — Results exceed, strategy evolves

Focusrite is a global music and audio products group supplying hardware and software products used by professional and amateur musicians. Its products fall into two main brand groups, Focusrite and Novation. The Focusrite brand group (around two-thirds of the business) produces audio interfaces. The Novation brand (around one-third of the business) focuses on hardware and software for creating and playing electronic music. The strategy is to pursue growth through innovation, disruption and expansion, with three core processes: growing the core customer base, increasing the lifetime value of customers, and expanding into new and high potential markets.

FY17 earnings per share were 14.8p, up by 29.8%, and beat our 13.9p forecast by 6%. Revenue grew 21.6% (13.5% at constant currency) to £66.1m, with growth across both brands and in all regions. Adjusted EBITDA was up 27.9% at £13.1m and pre-tax profit before was up by 33.5% to £9.5m. The main Focusrite ranges all grew market share. Novation grew by 37.8%, led by a significant strengthening of Launchpad demand. Currency helped margins to strengthen 1.5ppts up on the year to 39.9%. Net cash finished at £14.2m, up from £5.6m at August 2016. We are upgrading our forecast FY18 EPS by 5.1% and FY19 by 6.3%.

Focusrite has leadership share in a specialist market. Its success in growing its earnings and dividend stream depends on its ability to remain at the forefront of a competitive technical field, marketing its products successfully to a demanding user group. We see the current strategy as helpful in expanding the company’s product offering to new market segments and developing its international markets. We use a DCF projection to place a value of 363p (previously 344p) on the longer-term income stream available to investors. That would put the shares on an FY18e P/E of 23.7x and EV/EBITDA of 14.2x. We also consider valuation in relation to a peer group of smaller companies on near-term earnings expectations, albeit there are few close peers. Focusrite trades at an average P/E and EV/EBITDA discount to the group. We now adjust the P/E measure to take account of 24p of excess cash, suggesting a slightly lower level of 338p.

Sensitivities include the cyclicality of consumer demand in Focusrite’s ultimate markets and the continued technical execution of excellent new products. Our forecasts assume that the company will continue to identify and exploit new technological and product opportunities that build its share of the market and monetise its substantial investment in R&D. Focusrite has a currency risk on its c 25% euro-denominated revenue although it has a substantial natural hedge to the US dollar; however, potential effects of Brexit on currency and movement of goods are unknown. Focusrite has dependence on a small number of suppliers, key resellers and distributors, so that the interruption of such relationships could be damaging. The achievement of the company’s plans also depends on the knowledge, judgments and experience of a small management team, so that continuity is important and unexpected change could bring risks (we note the transition to the new CEO has been executed smoothly).

Focusrite is a global music and audio products group supplying hardware and software products used by professional and amateur musicians. Its products, which fall into two main brand groups, enable and facilitate the high-quality production of music. The strategy relates to growth through innovation, disruption and expansion. It has been more specifically defined by the incoming CEO Tim Carroll as three processes:

The company has two main divisions: the Focusrite brand group (67% of FY17 revenue) covers audio recording equipment; and the Novation brand group (28% of FY17 revenue) focuses on hardware and software for creating and playing electronic dance music (EDM) and other types of music. Focusrite also has a smaller Distribution division, which acts as UK distributor for third-party brands.

What the brands have in common is an objective to serve musicians at all levels, and in particular help musicians who may not have been professionally trained to realise their creative potential by creating high-quality music with a minimum of technical complication.

Focusrite aims to provide the best quality product at each price point. Its products range from those designed for budget personal spend levels to the highest professional specifications, with consistent high standards throughout. Product ranges are continuously refreshed to remain at the forefront of the market. Its markets are fully international, with FY17 revenue split 42% US, 38% EMEA and 20% RoW.

Focusrite’s origins can be traced to the iconic ISA 110 pre and EQ module designed by legendary sound engineer Rupert Neve for Sir George Martin in 1985, which formed the basis of a family of state-of-the-art studio consoles in the 1980s and 1990s, used by Frank Sinatra, The Mamas and The Papas, Quincy Jones and Nat King Cole. Phil Dudderidge, originally a sound engineer with Led Zeppelin, having sold his own audio business, acquired the Focusrite business in 1989. The early history is documented on YouTube. The Novation business was acquired in 2004. The 2014 IPO was by way of a vendor placing of 17.8m shares at 126p: its main effect was to bring in institutional investors and reduce Phil Dudderidge’s holding from 77% to 52%. No new funds were raised.

The main brand categories are:

Novation’s products are instruments and software for making electronic music, the fastest-growing music creation segment.

There are four categories:

Focusrite is setting up two brands targeting opportunities in the high-end interface and app segments:

The main product ranges falling under the new brand are:

Ampify marks the formalisation of the company’s initiatives in app development based on its Novation sound generation technology. There are three app products that now have over 7.5m downloads and 550k active users. They are all structured as a freemium model that is free to load and has priced add-on features.

The company has seen an acceleration in the rate of downloads with 2.8m in the year, including a marked pick-up in interest from China. Margins are higher than for physical products, although third-party origination costs have been incurred. However, as the venture gains scale these can be increasingly brought in-house. The music creation app space is intensely competitive and barriers to entry are relatively low; however, the products hold their position in the top 10 Apple music creation apps.

The company is the UK distributor for the leading brands KRK (studio monitors) and sE Electronics (microphones). These are adjacent areas technically but are not currently growing.

The global music instrument and pro audio wholesale market was £2.7bn in 2013, according to Music Trades magazine (source: admission document), growing at c 2% pa. However, that market is disparate and fragmented, including conventional instruments and traditional technology, as well as electronic technologies relevant to Focusrite. At the time of the IPO, management estimated the addressable market for its portfolio was c £450m, being £250m in the recording segment, £100m in the EDM segment and £100m in the commercial segment. Against this, and allowing for market growth, FY17 revenue represents a c 15% share. In addition, Focusrite’s five-year revenue CAGR of 21% is considerably higher than estimated growth in the market as a whole.

Significant competitor brands for the Focusrite division are PreSonus and Apogee (vs Scarlett), Avid Pro Tools and Universal Audio Apollo (vs Clarett), and Avid HD and Apogee Symphony (vs RedNet). Launchpad competes against Ableton Push and Akai APC Mini ranges. Management estimates a c 50% share of the mass interface market, 17% of the semi-professional Thunderbolt market and 2-3% of the commercial market. According to management’s US market analysis, the company is number one in the overall interface market, and management believes the company is in the top three across Novation’s markets.

It is difficult to define market share in the app market, with its lower barriers to entry. However, the Launchpad app has generated over 7.5m downloads to date, helped by, and helping, the strength of the Novation brand. We believe Novation’s ability to add advanced features to the Blocs Wave app will be key in this fast developing market.

The board is headed by Executive Chairman Phil Dudderidge, who has a lifetime of sound engineering experience. Tim Carroll was appointed CEO effective January 2017; his substantial career was with Avid Technology Inc. where he was most recently vice president with responsibility for audio products. Jeremy Wilson, CFO, formerly of Regenersis, DHL and Electrocomponents, was appointed in 2014. Biographies are on page 12.

The senior management team has experience in all relevant product and market areas. Most managers are musicians as well as being qualified technically for their roles, and are passionate supporters of the strategy. The culture is entrepreneurial and opportunistic.

Although the chairman is a 52% shareholder, he remains actively engaged with other shareholders, and the board is also advised by two experienced non-executive directors: David Bezem, an investment banker formerly at Altium Corporate Finance, and Paul Dean, formerly group finance director of Ultra Electronics.

Product quality: Focusrite’s market leadership is based on the technical quality of its products, including updates to its ranges over time. It has well-developed testing and product review capabilities; nevertheless, a product issue requiring a major recall, for example, would be a negative event. We believe that product excellence will continue to be a positive for the company.

Technological opportunities: our forecasts assume the company will continue to identify, exploit and market new product opportunities that build its share of market, and continue to monetise the investment in R&D. If instead the initiative were grasped by competitors, growth could be affected. We note that the company is actively expanding its product areas with new brand groups Focusrite Pro and Ampify.

Consumer demand: the company is subject to cyclicality of demand in its consumer markets. Even for products aimed at the B2B market, demand is also ultimately driven by consumers. However, exposure to a range of international markets provides a measure of protection.

Currency risk and Brexit: c 60% of Focusrite’s revenue and c 100% of its cost of sales are denominated in US dollars (or related currencies), which gives the company an effective natural hedge against the currency. However, around 25% of its revenue is in euros. Focusrite uses forward contracts to lock in budget certainty against 75% of euro exposures; however, since it reports in sterling it has exposure to the euro, and to the extent the natural hedge is approximate, to the US dollar. On this basis, a 10% change in the value of US dollar would have little profit effect. However, a 10% movement in the euro would affect revenue by £1.6m. In addition, the effects of Brexit, both on currency and on the movement of goods into and out of the UK, are currently being assessed within Focusrite.

Management team: in its technical product area, the achievement of the company’s plans depends on the knowledge, judgments and actions of the management team. The team has a uniquely relevant blend of experience and any unexpected changes could affect the realisation of its plans. We note the transition to the new CEO has been executed smoothly.

Dependence on trade relationships: Focusrite has dependence on a small number of suppliers, key resellers and distributors, so that an interruption of such relationships could be damaging. We note that the company has started to distribute via Amazon and directly online, which, while still small in scale, potentially reduces its absolute dependence on third parties.

Earnings per share were 14.8p, up by 25.5%, and beat our 13.9p forecast by 6%. Revenue grew 21.6% (13.5% at constant currency) to £66.1m, with growth across both brands and in all regions. Adjusted EBITDA was up 27.9% at £13.1m and pre-tax profit was up by 24.1% to £9.5m

The main ranges Scarlett, Clarett and Red all grew in absolute and market share terms. Following its launch in June 2016, Scarlett 2nd generation traded particularly strongly, and consolidated its number one world position with market share now around 50%. Five new branded products were launched in the year.

The Novation division grew by 37.8%, led by a significant strengthening of Launchpad demand, and with strong growth from Launchkey and synthesisers. Larger penetration from online distribution channels such as Amazon helped Launchpad volumes to grow 39%. These channels are making the product available to customers who are not habitual music equipment purchasers, for example parents buying a Christmas or birthday gift for their children. Three new products were launched including a new flagship synthesiser, Peak. This retails at $1,299 compared with prices of $400-600 for the existing synthesiser range, opening up access to the market of professional musicians, where it is achieving widespread adoption.

Given that euro sales are around 25% of the total, and US and Far Eastern sales total 62%, some 85% of total revenue is in currencies other than pounds sterling. As a result, revenue was enhanced by sterling’s weakness, although constant currency growth was also strong:

The US is the company’s largest market with 42% of total sales. It remains a key sales focus and the Los Angeles marketing office team is being further expanded, with a team of c 30. Europe has been affected by strong competition between major resellers. That competition resulted in growth that was lower than other regions though still ahead of industry averages. In the rest of the world, strong Asia-Pacific sales were boosted by China, especially for Novation products, and the Hong Kong office has been fully established with five heads. Latin America and Canada both grew and are likely to be a focus for growth. Currency was also the main factor in gross margins that ended 1.5ppts up on the year at 39.9%.

Net cash finished at £14.2m, up from £5.6m at August 2016 and £9.4m at February 2017. Net cash inflow of £8.6m compares with an outflow of £0.6m in FY16, and is identical to profit after tax. This is largely the result of better working capital management, and specifically inventory management assisted by strong demand, with stock holdings reduced from 124 days to 77.

We are upgrading our forecast FY18 EPS by 5.1%. We upgrade revenue, based on underlying blended year-on-year increases of 8%, by 1.3%, and currency benefits increase our gross margin expectation by 2.4ppts to increase gross profit by 7.7%. Despite increases in expected organisational costs, particularly around the two new brands and the international marketing effort, that still results in a 4.8% upgrade to EBITDA and a 3.1% upgrade to PBT.

In FY19 we expect similar effects to result in upgrades of 2.8% to PBT and 6.3% to EPS.

We also introduce our FY20 forecasts with an EBITDA growth forecast of 5.7% to £15.6m.

Though smaller than many other household electronics companies, Focusrite is market leader in its specialist technical 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 a DCF projection to place a value on 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.

Our DCF projection extends our forecasts out to 10 years on growth fading in the last three years to a terminal rate of 2%. We assume a terminal EBITDA margin of 21% (2017 actual: 19.8%) 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), resulting in a valuation of 363p/share (of which 227p is in the terminal value). That would put the shares on an FY18 P/E of 23.7x and EV/EBITDA of 14.2x. 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:

As there is no close small-cap peer, we define the relevant group as 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.

For the year to August 2018, Focusrite trades at an average 6.8% P/E discount and a 1.5% EV/EBITDA discount to the group. For FY19e it trades at a 4.6% and 7.7% discount, respectively. However, we note the now significant excess cash of £14.8m, for which the P/E measure gives no credit (the EV/EBITDA valuation does). Adjusting to average peer multiples and allowing for that cash in the P/E comparison values Focusrite shares at 352p on a P/E basis and 323p on an EV/EBITDA basis, a blend of 338p, slightly below our DCF valuation.