Focusrite (LSE:TUNE) is a company I’ve had on my watchlist for a while. In fact, I’ve had their annual reports sat next to me for a good month or so now. Lazy investing does have its pitfalls! With their half-year results released this past week, I thought it time to actually take a look.
First up, Focusrite is not particularly cheap at its current valuation, at around thirty times earnings and four times sales. That being said, per share earnings grew at over 30% last year, and EPS growth is accelerating. Commensurate with that growth has been the stock price performance since the beginning of 2017:
Focusrite manufacture and distribute proprietary hardware and software for home users and professionals to make music and record audio. The company has two divisions, ‘Focusrite’ and ‘Novation’, the latter being acquired back in 2005. Revenues are generated in an approximate 66%/33% split respectively. The ‘Focusrite’ division is responsible for the design and manufacture of high quality audio interfaces and equipment against a range of price points. The bulk of revenues come from the more affordable (sub-$500) ‘Scarlett’ range which has a dominant market share of around 50% globally. The company have successfully leveraged this brand in enabling them to broaden their product range into more premium, professional equipment.
‘Novation’ is centred around keyboard and grid-based controllers, as well as mobile applications for the creation of increasingly popular electronic music. I won’t lie, it’s not an area I’m particularly familiar with. (Put it this way, if it was made after 1980 I likely don’t have a clue). That being said, it is clearly a growth area, particularly with the transition from professional production studios to individuals producing their own music and sharing it socially. A point of note to say Focusrite acknowledge the importance of social media in their annual reports, both from the perspective of customer usage and marketing for the company.
The board clearly understand the importance of maintaining the high quality reputation of their ‘Scarlett’ range, having released a second generation version within the last 18 months. This is a big earner for Focusrite, and I think it sensible to ensure the dominance of this product is continued. Last weeks’ half-year report notes a further gain in market share for this range.
What Do I Like?
Reading the annual reports of the company, a few things jumped out that I found encouraging. Firstly, the chairman, Phil Dudderidge, owns 52% of the company. Further to that, as of 2016 87% of employees held either shares or stock options in the business. Arguably this is possibly commonplace in larger organisations through share-save schemes and the like, but to see it in a £260m market cap company suggests to me that employees have bought into their mission, literally and figuratively.
There are hints towards this being a prudently run company, which is always appealing to me. The board reiterate in each annual report their desire to maintain R&D spending at 6-7% of revenues, a philosophy shared with another of my holdings, Avon Rubber PLC. The CFO, Jeremy Wilson, makes a point of highlighting successful attempts to reduce days outstanding for receivables, and improved terms with suppliers for trade purchases.
Focusrite has experienced consistent growth since their IPO in late 2014:
This growth has been entirely organic, through the development and release of new products and software each year. The company recognise the importance of maintaining their position on the cutting-edge of music production and distribution, and have identified that their current market share is only around 11% across all divisions. This leaves plenty of scope to grow in future.
Looking at the cash flow statement, free cash flow is consistently positive, and growing. This free cash flow is boosted to some extent by Focusrite capitalising most of their R&D and amortising that back each year. By treating R&D as a capital expense, the company understand and expect that newly-researched products will generate income for the business over a number of years. The company therefore amortise R&D costs over a period of three years, which seems sensible for a fast-moving business of this type. This process is made somewhat clearer in the recent half-year report.
If you look at free cash flow generated since IPO, it has been a little bit bumpy due to fluctuations in levels of stock held by the business. I will however note that the board prudently anticipated a surge in demand for their new products in 2016 and built inventories appropriately, which increased working capital and reduced cash flow. This stock was successfully shifted during the following year which again has led to a little bumpiness in returns. The most recent half-year report suggests they have begun repeating this pattern once again. Unusually (in my experience) the board note in last weeks’ report that average free cash flow since IPO represents 7% of revenues. This is skewed somewhat by the report also noting free cash flow growth of nearly 50% in the most recent six months. Again, inventory build up and working capital requirements make FCF a little lumpy.
Focusrite are however cash generative, with cash and receivables consistently covering all liabilities by a factor of 1.5x-3x. This appears to be growing as well. They have no long-term debt.
I mentioned earlier that TUNE isn’t especially cheap:
- Price/Earnings: 30
- PEG: 0.97
- Price/Sales: 4.2
- Price/Book: 6.7
- Price/Cash Flow: 20
- Yield: 0.61%
That being said, net income has grown at a compound rate of around 19.2% a year for the past three years with free cash flow representing 7% of revenues as mentioned.
It is at this point that I would usually work through a discount cash flow model for the business. I am however finding that the more I look at businesses and their reports, the less I feel the need to rely on a valuation model to understand the future value of a company. That being said, let’s model it out:
- Full year free cash flow last year represented approximately £9.5m, and based on half-year numbers in 2018 I would anticipate FCF to be in the range of £11-13m. I’ll assume the lower end of £11m for the model.
- As mentioned, three year net income has grown at approximately 19.2%. Let’s assume this continues for the next five years due to the company’s regimented approach stock management, product development and sales growth.
- As I usually do, I assume growth slows to 3% after these five years to reflect an implied average inflation rate.
- I will, as usual, set a discount rate of 10%.
Based on this calculation this gives a potential intrinsic value of £5.72, against a current valuation of £4.55. A potential discount to intrinsic value of 25.7%.
Leave a comment below, or find me on Twitter @BritishInvestor.
AVON is a constituent of the portfolio.