Gear4music Holdings — Two years’ success and platform for expansion

Gear4music (G4M) is the largest dedicated UK-based online retailer of musical instruments and equipment. It is growing rapidly and has a strategy of continued penetration of its specialist market, led by geographical expansion into Europe but including a major product development element. It is committed to expanding its lead over a fragmented competitive market by providing a best-in-class online service.

Results were excellent, with 58% revenue growth resulting in 331% PBT growth to £2.7m and 272% growth in EPS to 11.6p. The 73% revenue boost in H117, partly on post-referendum competitiveness, was complemented by a strong operating margin increase in the second half. Net cash reduced from £2.6m at February 2016 to £0.4m, reflecting active stock investment to improve the customer proposition and utilise buying economies.

We have reduced our FY18 PBT forecast from £2.9m to £2.4m, mainly on additional depreciation on the new European and UK locations and interest costs on the freehold. The additional costs, combined with initial inefficiency in the German operation, compared with returns on those investments, are likely to result in greater weighting of pre-tax profit to the second half in FY18. We expect EPS growth to resume in FY19 at a forecast rate of 33%, increasing to 35% in FY20.

We use both peer comparison and DCF to derive our indicative value for G4M. We reference UK quoted online retailers, distinguishing between larger e-tail and smaller operations which are to some extent hybrid. We allow a 15% discount against ASOS and Boohoo for size, liquidity and their established growth record. Pricing the shares on a P/E basis reflecting that discount and averaged across FY18 and FY19 puts G4M’s shares at 591p. A similar approach based on EV/EBITDA multiples puts them on 653p, and hence an average of 622p. On a DCF basis we price the shares at 627p, assuming a 3% reduction in revenue growth each year from 2021 (25% growth), and a 10% terminal EBITDA margin. The new borrowings reduce the cost of capital. Blending our two approaches gives our valuation of 625p.

Gear4music (G4M) is the largest dedicated, UK-based online retailer of musical instruments and music equipment. It is growing rapidly, with 46% revenue growth in FY16 and 58% in FY17. Its strategy is continued growth, with an increasing emphasis on the mainland European market for musical instruments and equipment (management estimates the European market as a whole at £4.3bn compared with £0.75m for the UK). The company sells own-brand musical instruments and music equipment alongside premium third-party brands including Fender, Yamaha and Gibson, to customers ranging from beginners to enthusiasts and professionals.

Strategy

The operation effectively started in 2003 with a consignment of guitars placed on the website. Revenue accelerated from 2013 when the operation went international, and in June 2015 the company raised £10.3m gross at 139p in its AIM IPO.

G4M is the largest UK online retailer in its field with FY17 revenue of £56m. In FY17 there were 12.6m visitors to its website www.gear4music.com (and foreign language equivalents) with 488,000 orders, up 104%. At IPO a prominent objective was to develop its presence in European markets, and in the last year it has made considerable progressed against that objective. Another objective was to develop its online and fulfilment service to best-in-class standards, at a time when most retailers in its sector have less developed capabilities.

Mainland Europe is a strategic priority. The addressable market for the whole of Europe was estimated by management at the time of the IPO to be £4.3bn compared with £750m in the UK alone. G4M maintains 18 country websites to ensure that its offer is authentically represented in all markets: this includes not only language translation, but also other national conventions and a firm pricing offer in each currency, in contrast to competitors.

International sales grew by a remarkable 124% during FY17, over three times the substantial 34% growth in the UK, to become 38% of total sales, up from 27% in FY16.

In November 2016 G4M opened its first European mainland distribution centre, a 38,000 sq ft site near Stockholm, Sweden. The centre enables next day delivery across Scandinavia and has annual revenue capacity of £14-16m. Initial trading has been strong, with over 40% of Scandinavian orders routed through the centre, contributing to 186% Scandinavian sales growth in Q417.

The much larger German centre, a 72,000 site at Mulheim near Dusseldorf opened in February 2017. It has annual revenue capacity of £30-35m, acting as a platform for sales into Germany, France, the Netherlands, Belgium and Italy. It is at an early stage of trading and is likely to remain inefficient during the H118. Management plans to open a showroom and returns centre in H218.

Even though the bulk of G4M’s revenues are from the UK or the rest of Europe, it already has the capability set up to ship to 190 country destinations, and is already shipping to over 60. Management’s experience in the UK, applying state of the art retail technology to disrupt a sleepy industry, leads to the aspiration that this could be a significantly larger international company, not only in Europe, but further afield.

This is clearly a potentially large future opportunity: the world market for musical instruments and equipment has been estimated at US$17bn by Music Trades magazine and G4M management. The company is already shipping product to the US and now plans to launch a US website in the next year.

Key performance indicators give evidence of the growing effectiveness of G4M’s online platform, with 25% increases in the number of unique visitors in each of the last two years.

Conversion rates have also risen strongly both in the UK and Europe, and we understand that momentum continues through Easter 2017, although the proportion of repeat customers has been affected by the welcome swing towards larger ticket items (which are necessarily less frequent) rather than smaller accessories, a trend seen in average order values.

Mobile is lagging PC penetration. although mobile visitors were up 55%, with 32% of visitors from mobile sources (FY16: 26%). Social media is an area where the company aims to increase its focus in FY18. We understand that Black Friday in 2016 produced a good result but one that management felt demonstrated further opportunity, and relevant new staff hires have been made specifically in support of this objective.

Returns rates are less than 5%, and revenue per £1 of marketing spend grew 3% to £11.90.

Despite marked growth in product listings there is still enormous headroom to management's medium-term target of 80,000 SKUs.

The product range extends over all categories and features top brands such as Fender, Gibson and Yamaha, as well as in-house brands. G4M’s span over the complete range is becoming a point of differentiation, although Thomann offers comparable breadth in Europe. G4M also faces competition from aggregators like Amazon, but these cannot provide the specialist focus that G4M does, including product advice, video illustration and returns. Amazon is also a sales channel for G4M’s own-brand products.

The company has continued to develop its own brands, which have kept pace with demand for other brands that include well-known brand names. Own-brand products, at £14.4m, represented 27% of FY17 product revenue and achieved growth of 58% (FY15: 33%). G4M’s brands include gear4music (the generic value brand) and playLITE (plastic versions of brass instruments for students). SubZero (guitars and amplification equipment), RedSub (bass guitars and amplification equipment), Minster (digital pianos), WHD (drums), Archer (strings), Rosedale (woodwind), and Coppergate (brass) represent step-up concepts in each product area. Own brands bring higher margin, though generally a larger stock investment, as the company takes possession of such products by the container load (Exhibit 5).

G4M’s value range is very wide, from a kazoo priced at £0.99 to a grand piano costing £32,000. Fulfilment operations cater for the entire range and the company retains six courier firms, as well as Royal Mail. As the online market becomes more sophisticated, in part led by majors such as Amazon and Argos, delivery times are becoming critical to competitiveness. G4M’s systems ensure that the customer is offered up to eight delivery options and only c 25% of its sales are on standard delivery terms, with some 75% on premium terms such as next-day, named day or 10.30am delivery.

G4M purchases its products from a large range of UK and international suppliers including a number of global brand owners. Having traded since 2003, it has built up long-established and positive relationships. COO Gareth Bevan, who has 16 years’ experience in the musical instrument and equipment industry, has longstanding relationships with key individuals. The company operates with its major branded suppliers on annual dealership agreements. Supply agreements include settlement discounts and retrospective rebates linked to volume targets. The company is a top tier customer for all the major players.

We commented a year ago that the existing leasehold 135,000 sq ft York warehouse and office, and 9,000 sq ft showroom had capacity for revenues of c £50m. G4M’s rapid growth has brought forward the need for more space, and the board has made the strategic decision to acquire a 50,000 sq ft freehold office building in York. The £5.3m acquisition is entirely debt funded.

We think this is a sound strategic move. The company is investing in its own infrastructure, which is probably its greatest area of exposure over the next few years; it is investing in its own organic growth potential which though difficult to quantify, fundamentally increases the assurance of its own high investment returns; it avoids the downside risk of external acquisitions; it is using its balance sheet (while we forecast double-digit interest cover), and is acquiring an asset of long-term value, while reducing its cost of capital.

The physical transition will be in two stages. Following expected completion in July 2017, around half the space will be leased to the existing occupier until June 2020, and the existing G4M UK management team will relocate to the other half. This will include customer services, distribution and returns, and all administrative functions. The warehouse will remain in the current 135,000 sq ft leasehold building, phasing out ahead of lease expiry in June 2020. Vacant possession of the additional office space should match G4M’s further expansion at that time. G4M is to build a new showroom adjoining the new property, probably in FY19, and following preliminary discussions with planners, management does not expect approval to be a problem.

Online retailing remains the top determinant of success in retail and is changing the face of the retail industry. In the ONS retail sales numbers for Q117, UK online sales grew year-on-year by 19.5%, against 4.8% for all retail, and it represents c 15.5% of all retail spending. Traditional retailers continue to face challenges, with input cost pressures now adding to structural changes in demand to make investment returns increasingly difficult to achieve from terrestrial retailing. In the January 2017 edition of Edison Insight (Consumer sector focus), we wrote: “Relentless share gains in online will likely continue, riding long-term social trends. We expect further consolidation of physical store numbers as productivity pressures drive more retailers towards the ‘fewer, larger’ paradigm. And it is likely that the list of retail failures will lengthen.” Jaeger, Jones the Bootmaker and Agent Provocateur are among recent failures. Physical store numbers are set to decline 22% in the five years to 2018, according to forecasts by the Centre for Retail Research. Yet online retail is forecast to grow 14% by value, according to the MRG Capgemini eRetail Sales Index.

An e-tailer is defined as an online retailer without physical stores. Of the top 50 online retailers listed by IMRG for 2016, only 19 were e-tailers, and of those only ten (Amazon, Apple, ASOS, EE, Telefonica O2, Three, Very, DIY, Littlewoods, Vodafone) sell physical products, four of which are phone companies (the rest are mainly travel companies like EasyJet). Nonetheless, as Amazon, ASOS and Boohoo demonstrate, e-tailers selling physical product are positioned to take share and are actively doing so.

The UK musical instrument and equipment market is worth approximately £750m in the UK at retail value, according to management estimates based on research by consultants for management in 2012 and quoted at IPO. Of this, G4M management estimates that around £180m is online. The European market (as a whole) is estimated on the same basis to be worth £4.3bn. Different sources have different definitions, particularly since, although the definition of instruments is fairly clear, there is no firm definition as to what is included in musical equipment. However, on these estimates, G4M has a UK market share of c 5% but only 0.5% in Europe. The musical instrument (only) market is forecast to grow by a compound 1.7% over the next five years, according to ibisworld.co.uk.

The UK market is highly fragmented: the UK Music Industries Association lists c 250 members, mainly independents. Other sources identify up to 1,800 businesses on wider definitions. G4M’s two largest UK competitors, S&T and GuitarGuitar, had 2016 revenue of £31m and £26m, respectively.

European markets are attractive because of their greater size (Exhibit 6).

Hence G4M’s market opportunity is substantial. There is more established competition in Europe, particularly from thomann.de; however only three other companies are ranked higher than G4M by Music Trades:

The management team is headed by Andrew Wass, CEO. Andrew has over 20 years’ business management experience, having founded Gear4music (then called Soundpro) in 1995. In 1998 he began selling IT systems for the audio recording market before launching Gear4music in 2003. Between 1992 and 1998, Andrew set up and ran his own recording studio business, having studied Popular Music and Sound Recording at the University of Salford.

Chris Scott, CFO, joined G4M in October 2012. He was previously finance director at Officers Club, overseeing the sale of the business to Blue Inc. Chris joined the audit team of KPMG in Leeds in 1997, qualified as a chartered accountant in 2000 and spent nine further years in KPMG’s advisory practice, including a year on secondment at Barclays Bank. He holds an Executive MBA.

Gareth Bevan, chief commercial officer, joined Gear4music in July 2012. He was previously at DV247, a £36m turnover musical equipment retailer, where he was responsible for purchasing, sales and marketing. He has 16 years’ experience in musical equipment retail.

Other than commercial risk, we regard the main for issues to which valuation may be sensitive as:

Growth and market share gains: Key to the investment case will be the sustainability of market share gains on the back of the strategies of improved online and fulfilment service and European expansion, which may be viewed as higher risk than the UK. Growth could be different from our forecast assumptions: we explore in the Valuation section below the effects of varying growth rates.

Exchange rates: Currently, c 25% of products are sourced outside the UK from the Far East, priced in US$. European sales are likely to increase from their current 38% of sales. Both factors make margins sensitive to exchange rate fluctuations. The company does not hedge currency flows.

Technological: As a pure-play internet retailer, G4M is dependent on the normal working of the world-wide web for its website and associated functions such as payment and delivery. In the event of any disruption, there is little in the way of physical presence to fall back on. Similarly, revenue would be sensitive to any change in rates by net-based suppliers such as Google AdWords.

Inventory: Inventory is the largest asset on the balance sheet, with approximately 110 days of sales in stock. Management believes that availability of stock for next-day delivery is a major competitive advantage and that excess cash is well invested in stock that can produce a higher return than cash. Management of stock, including its physical security, is a significant risk factor.

Key man: The company is closely associated with the vision of its founder and CEO, Andrew Wass, representing a key man risk. Against this, a substantial management structure has been developed reporting to the operating board (see Management section above) and the non-executive structure also provides, in our view, substantial assurance.

Results were excellent with 73% revenue growth resulting in 330% PBT growth to £2.7m, 12% ahead of our forecast. EPS growth was 272% to 11.6p, which on a lower tax rate was 25% higher than our forecast.

Analysis of the H1:H2 split shows that the 73% revenue boost in H117 was complemented by a strong operating margin increase in the second half, when operational gearing come into play in the busier pre-Christmas period. As a result, operating margin made a material increase from 2.5% in FY16 to 4.7% for FY17, resulting in the remarkable pre-tax profit growth of 331%. The tax rate, though increasing, remained low as a result of research grant claims, so that EPS grew by 272%.

Net operating cash flow was small as a result of growth in working capital. This mainly reflects the 58% rise in revenue, but in addition there was a stock investment associated with the growth in own brand sales, because of the necessity of taking ownership of the full production quota, a deliberate increase in range, and some early stock investment in the new European distribution centres. Investment in the platform was significant at £1.5m and warehouse capex was £0.7m. In addition, the first £0.1m quarterly payment for the software business meant that net cash outflow was £2.3m.

As a result of the cash outflow, net cash reduced from £2.6m at February 2016 to £0.4m at February 2017. This was before most of the £1.5m payment for the software business, and the £5.3m freehold office purchase. However, the purchase of the software business has been structured as 15 quarterly payments of £0.1m and is therefore payable out of future cash flow, while the freehold purchase is entirely debt funded and so does not fundamentally change the debt exposure. The debt funding takes the form of two five-year loans: £3.7m at 2.04% over LIBOR, and £1.8m at 2.85% over LIBOR.

We forecast FY18 revenue to grow 42% to £79.7m and EBITDA to grow 12% to £4.1m. While our revenue growth forecast is materially unchanged, EBITDA will reflect the early-stage inefficient costs of the German distribution centre. We also expect the new UK and European properties to add c £0.3m depreciation to our forecast. As a result, we reduce our operating profit forecast from £2.9m to £2.6m. In addition, we expect new borrowings to add interest costs, meaning that at the pre-tax level we downgrade from £2.9m to £2.4m. The impact of the additional costs is likely to be slightly countered by a reduction in our expected tax rate from 20% to 12% (as in FY17) as a result of continuing R&D allowables.

G4M is a seasonal business, which in FY17 delivered an H1:H2 PBT split of 37:73. In FY18, as a result of the early inefficiencies of the German operation in particular, we expect that effect to accentuated, with a lower proportion of PBT in the first half.

For FY19 higher depreciation, amortisation and interest costs slightly reduce the operating gearing effect of 28% revenue growth, driving a net £0.3m reduction in forecast PBT, which nevertheless grows 39% in our forecast, driving 33% EPS growth. The same trends are reflected in our new FY20 forecast, where revenue growth of 25% to £127m drives 35% earnings growth.

Inventory is the main driver of working capital changes and in FY17 G4M has made an active investment in stock, which has driven a £4.8m increase in inventory against FY16. At 69%, this is higher than the 58% increase in revenue representing 115 days of product COS, up from 105 in FY16. Management intends to control working capital in FY18, and we forecast inventory days to reduce to 102 with a FY18 balance of £15.1m, a 29% increase, less than forecast 42% revenue growth

As a result we expect working capital growth of £0.6m, down from £3.6m in FY17. Net cash flow, other than the £5.3m freehold acquisition cost, is then effectively neutral.

We use both a peer comparison method and a DCF to derive indicative value for G4M.

We reference UK quoted online retailers distinguishing between larger e-tail and smaller operations which are to some extent hybrid. We allow a 15% discount against ASOS and Boohoo for size, liquidity and their established growth record. On a price/sales basis, G4M stands at a considerable discount to the group. In terms of P/E ratios, it is at a P/E premium to the group of 40% for FY18 and 48% for FY19. However, compared with the larger e-tailers ASOS, Boohoo and AO World, it is at a 19% discount, reducing to 12%.

The same is true on EV/EBITDA measures, where G4M for FY18 stands at a 38% premium to the group as a whole, but at a 15% discount to the average of ASOS, Boohoo and AO World for FY18 increasing to 16% for FY19.

Pricing the shares on a P/E basis in line with a 15% discount against the average of ASOS and Boohoo, averaged across FY18 and FY19 puts the shares at 591p. A similar pricing exercise based on EV/EBITDA multiples puts them on 653p. Averaging the two metrics gives a valuation of 622p.

G4M is rapidly growing its share of a substantial market through its disruptive competitive position but is still at an early stage. We therefore believe a DCF approach is a relevant valuation metric, particularly as the expansion to European bases temporarily slows short-term earnings growth.

Our DCF model is based on our three-year forecast, extended for a further seven and to a terminal year. We fade revenue growth from 2019e (+25%) by c 3% pa to terminal growth of +2%. We assume that EBITDA margin grows gradually from 5.3% in FY20e, on economies of scale, to a terminal 10% (we increase this from the previous 9% reflecting the greater certainty of scale growth in Europe giving the company better pricing power. We regard the achievable sector margin to be 7-11%). We use a weighted cost of capital of 8.7% (vs 9% equity only previously), reflecting the reduction in cost of capital through the use of balance sheet gearing. We assume capex at a constant proportion of revenue on the assumption that the company will continue to invest in its platform and expand significantly in Europe; however, we do not assume continuation of the instalment payments for the software operation beyond the four-year period. These assumptions, reflecting the longer-term growth potential, result in a valuation of 627p, of which 505p is in the terminal value.

Exhibit 11 shows the effect on this valuation of differing assumptions for cost of capital and terminal growth.

We also test scenarios for differing medium-term growth rates and terminal margin. This indicates that the share price would be 100-140p sensitive to a 1% change in revenue growth rate from 2021, and around 100p sensitive to a change in the terminal margin assumption.

On averaging our two valuation metrics, we derive a valuation of 625p per share.