Interactive Investor

Stockwatch: is this musical small-cap a long-term winner?

10th September 2021 12:21

Edmond Jackson from interactive investor

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After a remarkable rise in the share price, our companies analyst gives his view on potential for this exciting AIM share.

Can the UK’s largest retailer of musical instruments sustain its overall growth trajectory by diversifying into audio video devices?

With its AGM trading update, Gear4music (Holdings) (LSE:G4M) has announced the £9.2 million acquisition of AV Distribution including £3 million for its domain name to re-brand the group as AV.com. 

Fair to demanding, valuation criteria 

While the price of a domain name seems expensive, the overall consideration for this step-change deal is small in context of Gear4music’s £203 million valuation – with its stock broadly unchanged around 975p.

That represents around 1.3x projected sales after a bumper year to March 2021 is expected to consolidate around £157 million in the current financial year, which is not over-extended as a key valuation benchmark for an online retailer. Boohoo Group (LSE:BOO) is on 1.9x though is a £3.4 billion business and growing faster.  

Assuming Gear4music makes around £6.4 million net profit this year and £8.6 million to March 2023, it trades on a price earnings (PE) of 33x easing near 24x.  

There is no dividend and the stock is on 8.5x net tangible assets, hence earnings tending to be in focus. The table shows 2021 as a bumper year for free cash flow but it has only lately swung positive.

Similarly, the operating margin only jumped near 10% last year otherwise has been low to mid-single digits, somewhat at odds with a big price/earnings (PE) ratio. 

Such parameters and a pretty tight market in the stock mean it can be sensitive to changes in the narrative.

Gear4music has to date carved out a successful business selling decent quality instruments and equipment – for example a well-regarded student cornet for £200, I am told is less than the cost of repairing one passed down a family.  This went down brilliantly during Covid lockdowns, when people could cultivate their musical talent – helped nowadays by lessons available online. 

I suspect the directors know that to meet implied growth expectations of the stock’s high rating they need another string to their bow.  

Benefiting also, from very low interest rates and meme culture? 

I also reckon the stock’s 550% capital growth from 150p in March 2020 reflects popularity of growth stocks – and those readily identifiable with consumers – when trading also soared in lockdowns. But if interest rates do have to rise to contain inflation, highly-rated growth stocks are exposed. 

It is largely forgotten now but even modest disruption triggered a sharp fall in early 2019 after a fine bull trend. 

Gear4music - financial summary          
year end 31 Mar   2016 2017 2018 2019 2020 2021
Turnover (£ million)   35.5 56.1 80.1 118 120 157
Operating margin (%) 0.8 4.7 2.5 0.0 3.4 9.8
Operating profit (£m) 0.3 2.6 2.0 0.0 4.1 15.4
Net profit (£m)   0.0 2.3 1.4 -0.2 2.6 12.6
EPS - reported (p)   -0.2 11.4 6.7 -0.8 12.2 59.7
EPS - normalised (p)   1.9 11.4 6.7 -0.7 12.3 59.7
Price/earnings ratio (x)           16.2
Return on equity (%)   22.0 9.1 -0.9 12.8 45.2
Return on total capital (%) 3.0 19.9 7.9 0.0 11.3 32.7
Operating cashflow/share (p) -1.8 0.5 0.8 12.3 35.3 70.4
Capital expenditure/share (p) 8.3 10.8 43.9 21.4 16.8 20.6
Free cashflow/share (p) -10.1 -10.3 -43.2 -9.1 18.5 49.8
Cash (£m)   3.6 3.0 3.5 5.3 7.8 6.2
Net debt (£m)   -2.6 -0.4 5.0 7.5 16.2 6.7
Net assets (£m)   9.4 11.7 18.9 18.7 21.6 34.3
Net assets per share (p) 46.4 58.2 90.5 89.3 103 164
Source: historic Company REFS and company accounts      

I drew attention in October 2016 at 370p when Gear4music was showing fast revenue growth and management hinted it could beat forecasts.

Lower sterling was assisting expansion across Europe. Boohoo traded on 6.7x historic sales but if you assumed 1.3x sales for Gear4music’s projected sales then fair value equated to 650p. 

This was surpassed with the stock reaching 836p in October 2017 but after the directors reduced their holdings in a 690p placing I suggested locking in gains at 730p that July.  

Around this time they were also saying new European distribution centres had materially improved the customer proposition there. 

Then in early 2019 the stock plunged from over 500p to 180p after a trading update revealed 41% sales growth over four months; however, the UK logistics operation had reached maximum capacity between Black Friday and Christmas.

Lower product margins were not compensated for and the group saw modest losses (see table).   

This episode removed the stock’s growth halo and it traded sideways until Covid lockdowns triggered exceptional demand for musical instruments. Together with a speculative bull market in smaller growth plays, the current environment is quite rarefied. 

In this context, the directors are upping the risk/reward profile, embarking on a quite radical acquisition. 

Curiosity of European cross-border shipping challenges 

While the latest update cites UK revenue returning to growth during July and August, in Europe it has slowed after Brexit.

New distribution centres being opened in Ireland and Spain are intended to address this, but after investors were assured on logistics a few years ago it sounds as if Gear4music was not ready for Brexit or reality has proved tougher. 

The stock is broadly firm because as yet, the company is on course to meet financial expectations however I am not surprised the directors are taking action to refresh growth.  

This AV deal exemplifies “horizontal integration” where acquisitions are made at the same level in the value chain, compared with vertical integration where a group expands into manufacturing and/or distribution. 

Hopes for significant synergies 

AV is a UK online retailer of home cinema and hi-fi equipment that grew revenue 54% to £8.6 million in its last financial year to 31 March, with an adjusted operating profit of £1.3 million.

Like with Gear4music’s exceptional last year however, people were improving their home interiors with extra disposable income given travel and eating out were curtailed. 

Audio video does look a broadly complementary market and which constitutes £400 million in the UK alone. I am quite wary however the products are complex and fast-moving, hence a test of this management’s marketing skills to integrate with musical instruments.

AV will be transferred onto the group’s existing European e-commerce platform and the business be rebranded as AV.com. Time will tell whether this just proves another bland acronym compared with the explicit “Gear4music”. 

“These acquisitions will significantly increase the group’s addressable market size and (we believe) there are significant synergies between the market in which Gear4music operates and the closely related but separate AV market…” 

Fair enough, and assuming no IT issues arising as a result of the integration. 

Debt-funded, versus £6.2 million cash as of end-March 

The company is adding to £3.5 million existing debt to buy AV and its domain name, in context also of £8.3 million lease liabilities.

At the financial year end, cash outweighed debt anyway by £2.9 million. Given interest rates seem unlikely to rise materially anyway, debt funding therefore looks apposite.   

Earnings enhancement is anticipated from the March 2023 year, on the basis the group re-branding plus enhanced product ranges and expansion into Europe should “quickly grow revenue and profits”. Such is the gambit. 

Indeed, there is logic in e-commerce where a technology platform – also logistics operation – supports a widening product range.  

No room for setbacks, on a high PE 

If the stock was modestly rated, then “buy” as potential rewards could outweigh risks. But on a PE in the high twenties and as past experience has shown there is no room for setbacks.  

In support of this combination, the AV brand has potential to become a long-term winner. Gear4music has achieved a strongly competitive marketing pitch for “value” instruments.

It now needs to show itself adept also, reading demand for fast-moving electricals.  

This move does however typify a listed enterprise trying to achieve another leg of earnings per share (EPS) growth.

Would such businesses combine if privately owned? A “sell” stance seems harsh but respecting risks with integration also a possible change in the financial environment, it looks wise to lock in some gains. Broadly: Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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