Interactive Investor

Richard Beddard: gettin’ on down, movin’ on up

21st January 2022 15:04

Richard Beddard from interactive investor

This electronic music business appears to be operating in more or less perfect harmony; only the share price jars with our columnist.

At the dawn of electronic music in the 1980s and 1990s, Focusrite (LSE:TUNE) manufactured mixing desks for recording studios. Today, recording is computerised and everybody is doing it.

Focusrite sells Scarlett, the most popular hardware interface connecting musicians to their computers via their instruments. It has a more upmarket sibling, Clarett. Studio monitors from Focusrites ADAM Audio brand, acquired in 2019, enable musicians to hear the music they are recording and perfect it.

In 2004, Focusrite moved into the creation of electronic music when it acquired Novation, a synthesiser brand that also makes grooveboxes and created Ampify, a music creation app. It diversified again in 2019, this time into playing music, when it acquired Martin Audio. Martin Audio makes speaker systems for festivals, theatres and large nightclubs.

In 2021, the company launched another commercial audio brand, Optimal Audio, which supplies speaker systems to smaller concerns – restaurants and gyms for example – that do not have the money or expertise for high-end equipment.

Customer-friendly policies

Optimal Audios systems work out of the box, an innovation that echoes Focusrites strategy since those early years. It has broadened the market by simplifying its products so that they appeal to hobbyists and novices as well as professionals.

Other customer-friendly policies, frequent software updates, the development of innovative products and the provision of 24/7 follow-the-sun support for the lifetime of the product have all contributed to its considerable reputation among hobbyists and indie bands.

Focusrite has not given up on the professionals, though. In 2017, it established Focusrite Pro, which delivered the audio for the presidential inauguration in 2021. That year it also acquired Sequential, an American brand that makes the famous Prophet synthesisers heard in many of the hits of recent decades. Like all of Focusrites brands, its professional brands are highly profitable, but their smaller customer bases mean they are smaller businesses.

No red flags

There are no red flags in the numbers. Focusrite earns great returns, inflated because people had more time to make music during the pandemic, but before the virus struck the company was earning good profits, and it reckons it is maintaining its swollen customer base post-lockdown.

The obvious concern for a company that has recently stepped up acquisition activity is diworsification – the risk that Focusrite might be blowing its prodigious cash flow on less profitable businesses. This is a particular worry in the case of Martin Audio, which supplies a completely different market – venues as opposed to musicians.

But despite the fact that the pandemic closed down festivals and stopped bands touring, Martin Audio made good profits in 2021 by focusing on venues that stayed open longer, like clubs and places of worship.

The rest of Focusrites subsidiaries earn comparably high profit margins, and the companys overall Return on Total Invested Capital (ROTIC), including the money spent on acquisitions at cost value, is 38%.

2021

Revenue (£’000)

Profit (£’000)

Profit margin

% of total revenue

Focusrite

97,218

47,798

49%

55%

ADAM Audio

23,865

14,040

59%

14%

Novation

22,262

7,965

36%

13%

Martin Audio*

20,398

9,471

46%

12%

Sequential**

5,299

2,341

44%

3%

Focusrite Pro

4,877

2,540

52%

3%

Distribution

16

-25

-156%

0%

*Martin Audio acquired 30 Dec 2019, contributed to 8 months of year to August 2020
**Sequential acquired 26 April 2021, contributed to 4 months of year to August 2021
Profit excludes central costs. Source: Focusrite annual report 2021

Valuation is a bit more tricky. An enterprise multiple of 25 times adjusted profit might be justifiable for such a high-quality business, but Focusrite was way more profitable in 2022 than it was even in the recent past.

The questions I cannot answer are to what extent Focusrite is a better business than it was a few years ago, how far increasing demand for digital audio as society has permanently improved Focusrites prospects, and the extent to which the boom in profitability is a lockdown-related flash in the pan.

I have hedged my debts in assessing the companys share price by using the profit Focusrite would have earned had it had achieved its average Return on Capital (RoC) over the last three years. That puts the enterprise on a heady multiple of 39 times adjusted profit.

Enthusiast culture

Apart from the price, I like Focusrite. It helps musicians make and record music more easily, and now it is helping venues play it more easily too.

Its heritage is as long as the history of electronic music. Focusrite was founded by an electronic music visionary, Phil Dudderidge, who remains chairperson and a majority shareholder. Dudderidge was Led Zeppelins sound engineer and the mixing desks he worked on have a legendary status. In acquiring Sequential it has acquired the services of another music industry visionary in Dave Smith, that companys founder. Smith invented perhaps the most fetishised synthesiser of them all, the Prophet-5.

Dudderidges legacy is a business populated by enthusiasts, and the company has recognised  that strength by making creating a great place to workthe fourth element to its strategy after innovation, focusing on lifetime value for customers and expanding into new markets. One of those enthusiasts is Tim Carroll, 20 years a professional keyboard player before he joined Avid, developer of the industry standard software often used with Focusrites hardware interfaces, and then became Focusrites chief executive in 2017.

The market is still growing. Focusrite has products that address podcasting and gaming, for example, and the company thinks there may be 14 times as many musicians who do not yet use technology to create, perform or capture sound as do use it.

It is restlessly creating and acquiring brands to help them.

Scoring Focusrite

Does the business make good money? [2]
+    High RoC and ROTIC
+    High profit margins
+    Strong cash flow

What could stop it growing profitably? [2]
+    Hobbyist market is probably resilient to recession
+    Strong brands resistant to competition
?    Early days for acquisitions, they may be more risky

How does its strategy address the risks? [2]
+    Customer-friendly policies increase loyalty
+    New products and updates develop brands
+    Acquisitions appear to be good-quality businesses

Will we all benefit? [2]
+    Founder and chairperson is majority shareholder
+    Liked by customers and staff (Net Promoter Scores are +74 and +43)
+    Executive pay does not look especially greedy

Is the share price low relative to profit? [-2]
+    A share price of £14.50 values the enterprise at about 39 times normalised profit.

There is nothing I can find to dislike about Focusrite except the share price, which is of course determined by investors, not the company.

A score of 6 out of 9 means Focusrite probably is a good long-term investment. It is ranked 16 out of the 40 good businesses in my Decision Engine.

 

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.

For more information about Richards scoring and ranking system (the Decision Engine) and the Share Sleuth portfolio powered by this research, please read the FAQ.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

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