Why Gear4music shares just crashed 50%

AIM-listed Gear4music made a costly error during its busiest time of year, but can management resurrect this growth business and make it investible again? Lee Wild shares his thoughts.

What a difference a year makes. This time in 2018, Brexit talks had finally made it to Phase Two, a hopeful Theresa May was trying to reshuffle her cabinet, and the FTSE 100 was making a record high near 7,800. A small AIM company called Gear4music was also dreaming of big things – it's broker even published a note titled Stairway to Heaven - but the online musical instrument retailer has overseen its own downfall which will have shareholders tearing their hair out!

At first glance, today's official trading update for the final four months of 2018 is packed with impressive growth statistics – UK sales were up 36% year-on-year, sales everywhere grew by 47%, and active customers jumped 47% to 666,000. But it could have, and should have, been much better. 

Gear4music has a great business. There is clearly demand for what it does, which is why failing to ensure your business can cope with an anticipated uptick in orders is not acceptable. 

"Further sales growth in excess of expectations was constrained by our York distribution centre, which reached maximum capacity during the peak trading period between Black Friday and Christmas," wrote the company Friday. Shareholders will have heads in hands, neutrals will wince. 

"These capacity constraints prevented further sales growth compensating for the lower gross margins and, as a result, the board now expects FY19 EBITDA to be slightly below FY18 levels."

But management's decision to chase market share in an already difficult retail environment is also forcing margins lower. So, while the 50% plunge in Gear4music's share price Friday looks harsh, it's the standard punishment being meted out right now to companies on sky-high earnings multiples that fail to live up to expectations. 

Source: TradingView (*) Past performance is not a guide to future performance

Before this shocker, the shares were trading on a forward price/earnings ratio of 50, dropping to a still-meaty 32 times for one year further out. After the downgrades, Gear4music shares trade on 27 times the 8.9p forecast by Peel Hunt for the year to February 2020.

Peel Hunt has slashed profit forecasts for the current financial year to February 2019 by 69%, from £2.6 million to just £0.8 million. Estimates for 2020 are halved to £2.3 million and cut by 21% for the year after to £5 million. The price target is cut by 50% to 500p.

"The persistence of the pricing competition will concern investors, and with big downgrades to the bottom line today it may take a while for the shares to regain their poise," admits Gear4music's joint house broker.

Worth 772p exactly a year ago, Gear4music shares were changing hands for as little as 230p on Friday, valuing the business at just £50 million. Long-term shareholders are still in the money, however. When it floated on AIM in June 2015, the company raised £10 million at 139p for a market cap of £28 million.

And, while a new long-term management incentive plan announced in November now looks super ambitious – the first share price hurdle on 31 March 2021 is set at £13 – it will certainly sharpen the mind. Directors must now make good on a promise to fix capacity issues, improve margins and return to growth. 

Chief executive officer Andrew Wass says: "We are already working on plans to further expand our UK distribution capacity ahead of our peak trading period next year and we are confident that this can be achieved by Autumn 2019.

"We have a clear strategy of targeted expansion and remain confident of the continued long-term growth opportunity alongside an expectation of a return to increasing profitability."

The market isn't convinced yet, and management hasn't covered itself in glory with this one. But, this is clearly not a demand problem, quite the opposite. As long as the customer base hasn't gone elsewhere, and pricing does not deteriorate further, there's a good chance that Gear4music can do the new numbers. This has been a setback though, and investors will first demand evidence that this is the case.   

*Horizontal lines on charts represent levels of previous technical support and resistance. Trendlines are marked in red.