Focusrite — Strong delivery with further potential

Focusrite has reported strong interim results, on a number of dimensions:

Novation products have benefited in all geographies from a recent marked improvement in interest and adoption of grid controllers, seen particularly among younger customers. Launchpad is Novation’s brand in the grid controller format, although the upturn has also been noted by competitors.

The rise in demand reflects the greater adoption of these products by high-profile DJs and musicians, who feature the products on their YouTube performances (Launchpad is also widely used to create tribute versions of dance numbers). This combines with the fact that Launchpad is now readily available on Amazon, which is a much wider market than in the past. The upturn in demand is brought into higher relief by comparison with a quieter year in FY16, without so many new products as the year before.

Linked to the boost in Launchpad sales, management also notes an increase in its Midi keyboard, Launchkey, which helps musicians to digitise their performance in an intuitive way. Meanwhile, although the Circuit grid-based groove box continues to grow revenue, management is considering a repositioning to improve performance. Circuit was first launched in October 2015 and is now being updated partly in response to the suggestions made in the active online forums.

The number of downloads of the Launchpad and BlocsWave apps have now surpassed 6m, growing at around 100,000 per month. The investment in this team and the associated income are both increasing.

Focusrite’s revenue growth, at 23.1%, is comparable to that of the company as a whole, of which it makes up two-thirds. It continues to build market share following the renewal of the Scarlett range in June 2016. The second-generation Scarlett range is continuing to gain market share, which is significant as it is already market leader in most of its key markets. The continuation of share gains, from 40% to 49% over the last year, gives assurance that the benefits of the second-generation launch are not just short term, although clearly in FY18 it will be lapping post-launch sales.

Six new products have been launched in the first half: Red 8Pre, Clarett OctoPre, Scarlett OctoPre, Scarlett OctoPre Dynamic, iTrack One Pre and Launch Control XL MK2, as well as a Circuit Components Update. Spanning different price segments and target customer groups, these are aimed at increasing penetration and reach. Feedback from customers, retailers and distributors has been positive to date.

Foreign exchange nearly doubled revenue growth to a remarkable 46%, but even before the dollar effect, constant currency growth of 25% is impressive. It emphasises the fact that the company’s largest market (41% of total revenue) is also its fastest growing, and this is in a consumer economy that is better placed than the UK and most of Europe. Renewed growth from Novation, against a weaker comparative, was one factor fuelling growth, and accelerating demand for commercial and professional-level products in the RedNet range was another. This technology enables simultaneous distribution of multiple signals at high quality, and is significant because it represents increased penetration of a major new market, the live sound and broadcast business-to-business market, which offers further growth opportunities ahead. In addition, the second-generation Scarlett USB range continued to generate good demand, as elsewhere.

Here headline growth of 7% was equivalent to 5% on a constant currency basis, and the picture was more mixed. Growth in the UK was strong at 16%. Clearly, there were declines elsewhere, although this is probably the result in channel changes, and specifically the move online. The adoption of Amazon directly by the company as a sales channel (it was previously used by distributors) is significant and within the last year has risen to represent 13% of EMEA revenue, or around £1.7m in the half. All the incremental sales via Amazon are classified as UK sales, although in practice part of them will have been ordered by customers abroad. So the development of the Amazon channel may be diverting other European sales to the UK category.

As with the US, underlying constant currency growth was below the headline at 8% against 22%, but was still significant. The result was the net of some contrasts. Growth in revenue in China reflects early achievement for the new sales office in Hong Kong, and is very promising in view of the size of the market there. Indications are that the fast expanding middle class is developing a strong taste for western popular music, and Focusrite’s principle of making music easy to make is closely aligned with this need. However, declines in Japan and South Korea resulted from issues with the distributor there, which the company is working to resolve. Asia has already been highlighted as a strategic focus area and management intends to continue building its presence with expansion of the sales team, albeit from a low base. Latin America remains a potential growth area, and although it has not received specific growth focus to date, there is a suggestion that it may do so in future, although this is more likely to be through an online presence than a physical establishment.

The e-commerce initiative, launched softly in March 2016, has grown its penetration to over 1% of revenue and clearly has much further to go. In its initial phase it was focused on refurbished products, but management has now started to expand its application to a wider range of products and this is leading to a growth in demand in both the e-commerce channel and the existing dealer network. The strength of Amazon sales is a good indicator of a level of demand through e-commerce channels, and we think it is likely that the company will continue to grow its own e-commerce store, while at the same time recognising the continuing importance of distributor and dealer channels with the important service element that they provide.

We are upgrading our pre-tax profit and earnings forecasts for FY17 by 5.4%.

We assume lower underlying revenue growth of 8% in the second half year compared with 12% in the first, as a result of our overall caution on consumer demand, notwithstanding the independent growth demonstrated in H1 and the company’s 40%+ revenue exposure to the strong US market. It is also inevitable that the boost from the launch of the second-generation Scarlett range in June 2016 will start to fade, and will begin to lap itself by the end of the year. On the other hand, the current demand for Novation’s Launchpad, particularly through the Amazon channel, is encouraging. We expect gross margin of 40.9% in H1 to flatten to 38.0% in the full year as the euro currency advantage from H1 reduces. Conversely, we expect the 25% growth in operating costs in H1, which was driven by timing, to flatten in the full year to 23%.

Similarly we are cautious on revenue growth for FY18 and assuming revenue growth of 9%. We upgrade pre-tax profit and earnings per share by 4%.

We expect working capital to remain well controlled and as a result year-end net cash to increase to £10.8m.

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 value the shares using 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.

To create a DCF projection we extend 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 19.3% (2019e: 17.5%) 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 2%, risk premium 7%, beta 0.9), resulting in a valuation of 249p/share (of which 142p is in the terminal value). All assumptions are unchanged except that we have increased our terminal margin assumption by 30bp reflecting our higher forecast. Our previous valuation was 214p. This would put the shares on an FY17e P/E of 19.5x and EV/EBITDA of 11.5x. 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 small-cap market is the most appropriate context for Focusrite. As there is no close 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.

For calendar 2017, Focusrite trades at an average 13.1% P/E discount and an average 2.6% EV/EBITDA premium to the group, which 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. EV/Sales at 1.6x is close to peers. Adjusting to average peer multiples values Focusrite shares at 257p on a P/E basis and 231p on an EV/EBITDA basis, a blend of 244p, which is close to our DCF valuation.