Focusrite — Uptempo

Focusrite has reported a reassuring trading performance in H120 with revenue growth driven by acquisitions.

Revenue increased by 23.5% to £49.9m, which represents growth of 25.3% in constant currency terms. Currency had less of an impact on reported results than in recent periods as exchange rates versus sterling were relatively stable year-on-year: the average US dollar rate was 1.28 in H120 versus 1.29 in H119, and the effective hedged euro rate was 1.13 in H120 versus 1.11 in H119.

The results include the first-time contributions from the acquisitions of ADAM Audio (six months) and Martin Audio (two months), which contributed revenue of c £7m and c £4.5m respectively. As highlighted previously in the trading statement in March, excluding these acquisitions, underlying revenue declined by c 5% due to the tough comparative of H119, when it benefited from tariff-related price increases in the US. In addition, the outbreak of COVID-19 led to orders for c £2m not being able to be fulfilled during the period, but they will move into H220. Therefore, the results are reassuring once these items are taken into account.

The gross margin increased substantially from 44.3% in H119 to 46.1% in H120. Excluding the one-off benefit to the gross margin in H119 of one percentage point due to the US price rises to reflect tariff increases versus cost of sales of pre-tariff products, the underlying improvement in gross margin was 280bp. The gross margin of 46.1% also compares favourably with H118 gross margin of 41.7%. The strong gross margin performance was due to: mix changes (higher margins of the acquired businesses eg ADAM Audio’s 54% gross margin replacing the Distribution sales with a gross margin of c 28%); lower royalties and better management of discounts; and benefits from the higher prices of improved new product launches. We believe that these are mostly sustainable.

EBITDA increased by 2.9% but the reported EBITDA margin fell from 22.0% in H119 to 18.3% in H120. Drivers included the lower margins generated by the acquired companies and higher operating costs in Focusrite, which management is dealing with. H119 included a one-off benefit of c £0.7m due to US tariff increases, and H120 includes a benefit of £0.4m due to the adoption of IFRS 16.

Focusrite’s reported operating profit now includes the amortisation of intangibles that arise from the recent acquisitions of £1.1m in H120, as well as one-off acquisitions costs of £1.8m and one-off redundancy costs of £0.4m, which will help to improve operating costs from H220. Depreciation increased due to the adoption of IFRS 16 and higher depreciation following the launch of Scarlett third-generation products.

Given the economic uncertainty due to the COVID-19 pandemic, management has chosen to defer the declaration of an interim dividend until later in 2020. The interim and final dividends will both be reconsidered later in 2020. We assume that the absolute level of dividend declared for FY20 is maintained from our prior forecast, but that payment occurs in FY21. In the last four financial years, the interim dividend has represented between 27% and 32% of the total annual dividend, and in the current financial year would represent a deferred ‘saving’ of c £0.7m from an expected total dividend cost for FY20 of c £2.3m.

It is very encouraging that the acquisitions, ADAM Audio and Martin Audio, have performed in line with or better than management’s expectations with growth of 13% and 22% y-o-y respectively. The tone of the outlook for ADAM Audio is very encouraging as the group looks to increase cross-selling opportunities.

Performance in the Focusrite group brands was mixed during the interim period. The core Focusrite brand was flat year-on-year as it transitioned to the newer generation of Scarlett products, which required clearance of the older products that affected the early sales of the newer products. Net-net the number of registrations increased significantly, which provides comfort for the outlook of the products. Focusrite Pro had a more challenging H120 as it declined by 27% due to new product releases being delayed into H220, and a restructuring in the division. Novation increased by 1% driven by new launches of Launchpad and Launchkey.

Revenue from third-party brands fell by 43% and will be fully discontinued by the end of FY20, as management focuses on the greater opportunities from its own brands.

There is no disclosure of constant currency growth by geography as in recent years, but as previously highlighted the impact of exchange rates on H120 performance is relatively low given the stable exchange rates year-on-year.

Revenue from Europe, the Middle East and Africa grew by c 20% in H120, but the underlying growth for the core Focusrite group of brands, ie excluding ADAM Audio and Martin Audio, fell by c 4%. The decline was due to distribution changes in Scandinavia and Italy that led to either no orders or reduced orders, and a tough comparative in H119 due to distributors stocking up ahead of potential Brexit disruption. ADAM Audio and Martin Audio produced double-digit growth, which is stated to be in line with expectations.

North American revenue increased by c 21% in H120, with the core Focusrite group of brands, ie excluding ADAM Audio and Martin Audio, falling by 3.5%, and the latter growing since their acquisitions by 14% and 17% y-o-y. Excluding the one-off benefit from tariff increases in H119, the underlying growth for the core Focusrite brands was roughly flat.

Revenue from the rest of the world increased by c 42%, with ADAM Audio growing by 26% y-o-y and Martin Audio growing by 30% y-o-y since their acquisitions. The core Focusrite brands declined by 7%, with all of the decline in Asia due to the COVID-19 outbreak, and changes in management, which should help to improve growth going forward. ADAM Audio, which grew by 21% in Asia, was not affected by the pandemic, and the narrative for Martin Audio highlights that Asia was strong for it too. Latin America was very strong across the board, in particular for the core Focusrite brands, which grew by 48% y-o-y.

On a reported basis, the company’s free cash flow (FCF) generation (relative to sales) deteriorated from 12.0% in H119 to 8.8% in H120, with forex excluded from the calculation of operating cash flow and excluding the one-off costs due to acquisitions etc. This was close to the company’s long-term average of c 10% since the IPO. The key drivers to FCF generation were: the lower EBITDA margin; working capital representing a cash inflow versus an outflow in the comparative period; and increased investment in tangibles and intangibles.

Focusrite has moved from a net cash position at the end of August 2019 of £22.8m to a net debt position of £19.9m at the end of February 2020, having been c £25m on completing the acquisition of Martin Audio in December 2019. By the end of April, the net debt position has improved by a further £4m to £16m, so cash generation remains strong.

The current trading statement points to continued strength in consumer demand as previously highlighted in the trading statement in March, and the short-term supply disruptions in China are behind the company.

In particular, e-commerce demand is strong for the Focusrite and ADAM Audio brands. The record levels of product registrations of Focusrite products by customers indicate that demand in parts of the supply chain where the company typically has more limited visibility is strong.

As expected, the lockdowns due to COVID-19 and halting of live music events in most countries is having an impact on demand for Martin Audio products. It is likely that demand will be affected for the rest of the FY20 and into FY21.

At the time of the trading statement we highlighted that the outbreak of COVID-19 could have both a positive and negative influence on supply and demand. On the positive side, enforced isolation could increase demand as musicians and hobbyists have more time to devote to music. On the negative side, fulfilment of orders from online retailers, etc, could be more challenging, halting the live performance market could negatively affect demand, and there could be further supply disruptions from sourcing. Therefore, it is relatively pleasing that only one of these potential risks, ie the halting of live performances has materialised.

We upgrade our revenue forecasts for FY20 and FY21 by 2–3% and our EBITDA forecasts by c 7%.

Our revenue forecasts increase by c 2–3% in both FY20 and FY21 to reflect better trading at Focusrite and ADAM Audio offset, in part, by a weaker outlook for Martin Audio, for which we assume a modest decline in FY20 and some continuation of weakness in the live performance market in FY21.

We increase our gross margin assumption by 1.0–1.2% in FY20 and FY21 to reflect the continuation of trends from H120, including improved mix with greater growth from ADAM Audio while Distribution winds down. This leads to an increase in our estimates for EBITDA of 7% in FY20 and FY21.

From FY21, the company highlights that due to its increasing scale the underlying tax rate will increase as the tax treatment of non-underlying costs and tax relief on development costs becomes less favourable. Therefore, in FY21 we assume that the tax rate increases from 11.5% to 19%.

At the adjusted EPS level, the higher profitability translates to a 6% upgrade in FY20e and a very modest increase in FY21e given the increase in tax rate. This produces EPS growth of 9% in FY20e and 1% growth in FY21e.

Our forecast for net debt at the end of FY20 and FY21 improve due to the growth in profit, improved working capital and the timing of payments of dividends (FY20e only).

Following the recent rally in the share price, on our new forecasts, at 580p the shares are trading at EV/EBITDA multiples of 15.4x for FY20e and 14.5x for FY21e. These multiples compare with the average multiple since the IPO of 11.1x, and the all-time high multiple of 17.8x that was reached in FY19.

The P/E multiples are 24.9x for FY20e and 24.6x for FY21e, which compare with the average multiple since the IPO of 17.8x, and the all-time high reached in FY18 of 28.3x.

As highlighted earlier we hold our dividend forecasts as they were previously, ie 3.9p in FY20e and 4.0p in FY21e; therefore the dividend yield is 0.7%, which is below its average historical dividend yield of 1%.