Focusrite — The song remains the same

Focusrite is a global music and audio products group supplying hardware and software used by professional and amateur musicians. Its products fall into two main brand groups, Focusrite and Novation. The Focusrite product sector (around two-thirds of revenue) produces audio interfaces under the Focusrite and Focusrite Pro brands. The Novation product sector (around one-third of revenue) focuses on hardware and software for creating and playing electronic music and includes Ampify, a newly created division for music-making apps. The strategy is to pursue growth through innovation, disruption and expansion, with three core goals: growing the customer base, increasing the lifetime value of customers, and expanding into new and high potential market segments.

FY18 results beat our expectations with pre-tax profit of £11.3m, growth of 19.2% and 5% above our forecast. Both product groups performed well with Focusrite growing revenue by 17.2% and Novation by 6.4% against an extraordinary 37.8% in FY17: overall revenue growth of 13.7%. North American sales grew 17% in constant currency, though performance was held back by Canada. EMEA sales, up 11% in constant currency, benefited from an 11% strengthening in hedged euro rates, translating to 18% sterling growth and contributing strongly to margin. In the RoW (up 21% in constant currency) Asian sales were strong although smaller Latin American markets were weak. Operating costs were controlled, contributing to operating profit growth of 23% to £11.6m with a 1.2ppt margin rise to 15.5%. Net cash at £22.8m was up by £8.6m. Our FY19 and FY20 forecasts are affected by the US tariffs on goods sourced from China, although we assume some strength from market leadership of both product groups. We upgrade our EPS forecast by 5.4% in FY19 to 17.9p, close to the FY18 beat, and by 2.6% in FY20e to 18.0p. We introduce our FY21e forecast with 3.4% earnings growth to 18.6p.

Sensitivities include the cyclicality of consumer demand in Focusrite’s ultimate markets and the continued technical execution of excellent new products. Our forecasts assume 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’s products are sourced from China and c 41% of sales are to the US and therefore exposed to tariffs, which have been reflected in our forecasts but may change for better or worse. It has a currency risk on its c 25% euro-denominated revenue although it hedges the majority of this euro exposure one year ahead. There is a natural hedge in relation to the US dollar. Potential effects of Brexit on currency and movement of goods are unknowable. Focusrite depends on a small number of suppliers, key resellers and distributors, so 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 continuity is important and unexpected change could bring risks.

We value the shares on a DCF basis to evaluate the longer-term income stream with reference to a peer group of smaller companies. Our long-term view of Focusrite’s value is not substantially affected by the Trump tariffs and we value the shares at 457p. Against peers, Focusrite’s P/E and EV/EBITDA valuations are above the wider peer group though closer to music specialists. However, we believe the market is discounting use of Focusrite’s cash at a post-tax return of c 10%.

Focusrite is an international music and audio products group supplying hardware and software products for professional and amateur musicians. It has two main product groups centred on different aspects of facilitating music production. Company strategy relates to growth through innovation, disruption and expansion, specifically defined as three goals:

The company has two main divisions: the Focusrite product group (69% of FY18 revenue) produces audio interface equipment used in recording; and the Novation product group (27% of FY18) focuses on sound-generating hardware and software that creates electronic music and other types of music. In 2017 the company created two new sub-groups: Focusrite Pro (part of the Focusrite segment), focused on the higher-priced B2B space, and Ampify (part of the Novation segment), dedicated to app development based on Novation sound-generation technology. The small Distribution division (4% of FY18) is UK distributor for third-party brands.

The common focus is to serve musicians at all levels to realise their potential by creating high-quality audio without technical complication.

Focusrite aims to provide the best-quality product at each price point. Products range from those at personal budget levels to sophisticated professional specifications, with consistently high standards throughout. Product ranges are continuously refreshed to remain at the forefront of the market. The company’s markets are widely spread internationally, with FY18 revenue split 43% North America, 40% EMEA and 17% RoW.

Focusrite was developed over 25 years before its IPO by its chairman Phil Dudderidge, originally a sound engineer with Led Zeppelin. He acquired the Focusrite business in 1989 after selling his own audio business, Soundcraft. Focusrite was originally formed by the celebrated British sound engineer Rupert Neve to create a console of ultimate quality based on the ISA 110 and ISA 130 mic pre module designed for Sir George Martin in 1985. The Focusrite studios became legendary in the sound recording world, although only 10 were ever built. During the 1980s and 1990s they were used by Frank Sinatra, the Mamas and the Papas, Quincy Jones and Nat King Cole among others. The early history is documented in Exhibit 1.

Having acquired the assets, Phil Dudderidge’s team began to broaden the range of products to serve a wider customer base of professional, commercial and hobbyist musicians. Focusrite’s first audio interface, the M Box, was launched in 2002.

The Novation business, originally a manufacturer of keyboard controllers and synthesisers, was acquired in 2004. The 2014 IPO was by way of a vendor placing of 17.8m shares at 126p. No new funds were raised and its main effect was to bring in institutional investors and reduce Phil Dudderidge’s holding from 77% to 52% (it is now 38%).

Under CEO Tim Carroll, appointed in FY17, the business continues to expand, innovate and develop its markets. Its products are sold in c 160 territories and countries. Routes to market are a mix: distributors in select areas, a hybrid model in North America utilising a distributor with Focusrite’s own sales backup, and direct B2C via direct e-commerce and in-app software purchases. Product teams keep in close touch with customers, and customers have responded by awarding high net promoter scores averaging +50 to +70 reflecting the quality of product and perceived high service levels. The company’s recent investment focus has been in developing its customer-facing websites, greater local marketing intensity in markets such as Japan, Mexico and Germany, and social media demand generation.

The main brand categories are:

Novation’s products are instruments and software for making electronic music, in four categories:

Supported by industry-standard software Ableton, Launchpad has been extended to a family including Launchpad Pro and Launchpad Mini. Price points are US$99–299.

Focusrite has set up two brand sub-groups targeting opportunities in the high-end interface and app segments:

The main product ranges falling under the new brand are:

Ampify is part of the Novation product group and 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 9.5m downloads and c 500,000 active users. They are all structured as a freemium model with priced add-on features.

The company has seen an accelerating rate of downloads with 2.0m in the year. Margins are higher than for physical products, despite third-party origination costs. These are initially high and should reduce as the venture gains scale and they can be 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 of 2% as above, FY18 revenue represents a c 15% share. In addition, Focusrite’s five-year revenue CAGR of 24% 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, c 15–20% 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 it is in the top three across Novation’s markets.

It is difficult to define share in the app market, with its lower barriers to entry. However, the Launchpad app has generated over 9.5m 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.

From H118 there has been a broadening of the market that is probably attributable to two factors:

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 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 18.

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

Although the chairman is a 38% 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, as well as their direct and intuitive user feel and lack of complication. 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 product excellence will continue to be a strength.

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

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.

US sanctions, Brexit and currency risk: Focusrite’s products are sourced from China and c 40% of sales are to the US and are therefore, in many cases, subject to tariffs. Although this is reflected in our forecasts, the US/China relationship is inherently unstable and could get better or worse, with consequent effects on the company. We believe it is most likely that a normalisation of trade relationships will lead to an improvement in prospects for the North American business, but the timing is uncertain. The main physical risk from Brexit is that customs hold-ups following a no-deal conclusion might affect distribution of Focusrite’s product. On the plus side, the company supplies distributors, who in turn supply end retailers, so fine timing is not a major issue. Also, Focusrite uses internationally established freight forwarders who are likely to have the best systems and strategies for avoiding unnecessary delays.

Around 60% of Focusrite’s revenue and c 100% of cost of sales (since all production is in the Far East) are in US dollars or related currencies, which provides a natural hedge. However, c 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 an element of exposure to the euro, and to the extent that the natural hedge is approximate, to the US dollar. On this basis, a 10% change in the US dollar against sterling would have little profit effect. However, a 10% movement in the euro would affect revenue by £1.6m (before hedging protection).

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.

Dependence on trade relationships: Focusrite depends on a small number of suppliers, key resellers and distributors, so 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, prospectively reduces its absolute dependence on third parties.

Acquisition risk: with a significant part of its balance sheet in cash and a strategy that includes potential acquisitions, it is likely Focusrite will make an acquisition at some point. An acquisition would bring a different set of risks, such as the price, fit, management transition, and execution of the related strategy.

Results for the year were better than we expected. Revenue of £75.1m was slightly lower than our forecast of £75.4m but still showed 13.7% year-on-year growth. It came at stronger margin however, with EBITDA margin of 20.6% against our forecast 20.1%, so pre-tax profit of £11.3m was 5% above our £10.8m forecast with growth of 19.2%. EPS increased by 18% and the dividend for the year was raised 22% to 3.3p.

Both product groups performed well during the year but Focusrite continued to grow strongly in the second half, contributing to 17.2% revenue growth in the year. The Scarlett, Clarett and RedNet ranges all participated in that performance, which was therefore spread across the price range. Scarlett forms around three-quarters of revenue and its second-generation USB audio interface range, which is the world’s number one selling audio interface, further strengthened its market share with 15% growth based on extended functionality.

The mid-price Clarett range has disrupted the market with superior price to performance relationship and has now widened the gap with a new USB range.

Focusrite’s commercial range, led by RedNet, has received additional impetus from the formation of the Focusrite Pro organisation. This has helped to drive growing applications in post-production, education, installed sound and broadcast markets. Markets in original content production, live sound events and live on-air productions are growing rapidly. New customers include NBC, and Formosa Group, a Hollywood post-production house.

Novation grew revenue by a more modest 6.4% to £20.1m, but that was against the backdrop of an extraordinary 37.8% expansion in FY17, when escalating Launchpad demand combined with wider distribution reach including Amazon. In FY18 the synthesiser range took the lead with 46% growth led by the top-of range $1,399 Peak model, which has captured a market swing back to more sophisticated products, leaving the larger Launchpad (c 50% of Novation) and Launchkey to grow more slowly.

Constant currency growth was strong across all regions:

Given that euro sales are around 25% of the total, and US and ROW sales total c 60%, some 85% of total revenue is in currencies other than pounds sterling. A natural hedge against the US dollar protected the company from a 6% strengthening of sterling against the currency. However, after reflecting its 75% euro hedging policy, sales in Europe benefited from an 11% weakening, making EMEA the highest growth region in sterling terms and contributing strongly to margin.

The US is the company’s largest market with c 41% of total sales. Here growth was 11% (in £) with a weighting to the first half. North American performance as a whole was held back by flat sales in Canada, around 2% of sales. Canada is an area of marketing focus, utilising among other things the US marketing team (c 30 heads based in Los Angeles), and management expects to see growth developing here.

EMEA delivered constant currency growth of 11%, up from 6% in FY17. Continental Europe developed strong performance, although sales growth in the UK was relatively weak. In the rest of the world, Asian sales were very strong, following the strengthening of the Hong Kong office with c 5 heads, while Latin American markets were weak. Currency was an important factor in a gross margin rise of 2.3pp to 42.2%, contributing to operating profit growth of 23% to £11.6m with a 1.2pp margin rise to 15.5%.

Net cash at £22.8m was up from £14.2m at August 2017. Net inflow of £8.6m matched FY17 and is 85% of profit after tax. It is after a £0.4m recovery in working capital, which in FY17 approached constraining levels. Nonetheless, net working capital reduced from 72 to 68 days’ sales.

We cautiously assume FY19 underlying revenue growth of c 6%, below half of that in FY18 and a little lower than our previous assumptions, which have been surpassed. However, we have to recognise the reality that Focusrite’s product, which is all manufactured is China, is now subject to tariffs when exported to the US. The tariffs were introduced in late September at a 10% rate, with the potential to be increased to 25% from January 2019.

Tariff assumptions

As a result and including the £0.5m pre-tax beat in FY18, as well as a lower tax assumption, we are upgrading our forecast FY19 EBITDA, PBT and EPS by 1.5%, 2.6% and 5.3% respectively. In FY20e our assumptions of annualisation and a softening of the impact effectively cancel each other out and changes are smaller, with a 1.6% decline in normalised PBT. However, we now assume that Focusrite’s low tax rate, which results from allowances on its R&D investment, continues at 12% from FY19 (FY18: 10%). We previously assumed it rose to 15% by FY20. As a result, we upgrade our FY20e EPS by 2.6%.

The effect of alternative assumptions on price elasticity is as follows:

The zero case FY19e PBT projection is 23% higher than our last published forecast mainly because of the margin benefit above, combined with the FY18 forecast beat. Note that the scenarios analysed above only reflect differing elasticity, not the situation in which the tariffs were suspended.

We also introduce our FY21 forecasts with an EPS growth forecast of 3% to 18.6p.

We value the shares using 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 cash of £22.8m.

It is important to stress that the short-term downgrade to our forecasts as a result of the Trump tariffs has no substantial effect on our long-term valuation of Focusrite. The business retains its potential to expand its markets and products and as we assume the tariffs are essentially a negotiating tactic by President Trump, we do not believe they will have a lasting effect on the business.

Within our 10-year projection we assume annual revenue growth years 4–8 of 10% (against CAGR of 16.2% in the last three reported years), then fading our terminal growth rate of 2%.

We assume a terminal EBITDA margin of 21% (19.8% was already achieved in FY17) and capex at 7% of revenue, reducing to 5% by the terminal year. We assume equity-only cost of capital of 8.4%.

As a result, we value the shares at 457p. Exhibit 15 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 the 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. While Focusrite’s Yr1e P/E of 24.2x is above the wider group, it is comparable with companies having more direct product relevance such as Avid Technology, Gear4music and Bang & Olufsen.

On an EV/EBITDA basis, however, it trades at a substantial premium to most of the group, as also on an EV/sales basis. We believe this is a function of the market anticipating the use of Focusrite’s excess cash in terms of an acquisition.

Here we consider the likely effect of using it to make an accretive acquisition.

As we analysed in our April 2018 note, Focusrite generates high average taxed ROCE rates of 45–51%. It is not likely the company could generate such returns from an acquisition. However, using a range of lower ROCE rates, the cash would imply additional value as follows:

Hence, it would seem the market appears to be discounting investment of the net cash balance at a c 10% post-tax return.