Gear4Music Group is a success story with shareholders since it debuted back in 2015. The shares were priced around £1.30 and have since risen to £7.50, giving it a value of £156m.
Their latest trading update saw another bumper increase in sales of 42% to £34.6m in the 4 months to December, slightly lower than the same period (55%) last year.
Like last year, there is no mention of profitability.
What does Gear4music sell to warrant the sharp rise in valuation?
The company sells musical instruments online through their website.
A third of sales came from their own-brand products.
It also has an increasing product line of over 37,000 from 710 manufacturers.
The market for selling musical instruments is big and the growth potential is geared towards “Online Sales!”
For instance, the value of the UK market totals £750m with £178m coming from online sales.
A quarter of their sales comes from Europe. The combined top 10 EU markets of musical instruments have a value of £4bn, but the online market is undisclosed.
So, the potential is there, but what else warrants Gear4Music share price rising?
Since 2011, sales rose from £12m in 2013 to £56m by 2017.
Given investors addiction in placing high multiples on anything internet, Gear4Music has a PE Ratio close to 67 times!
Mix that in with other impressive “non-financial” KPIs (key performance metrics) measurements like:
-Registered users rising to 1.36m from 992k;
-During the December month, it manages to attract 1.266m visitors alone.
– Active customers now stand at 450,000 at 31st Dec 2017, along with average spend per basket of £131.66.
-The number of unique visitors in the last six month totals 7.1m, up from 5.58m during the same period last year.
Also, they have over 700,000 email subscribers.
And we can see the excitement from shareholders. But is this company worth £156m?
Personally, I believe it comes down to solving one issue they have been avoiding for such a long time.
That is PROFITABILITY!
Problem isn’t with Capital Expenditure
One of the reasons that Gear4Music didn’t experience a BIG increase in capital expenditure is because they outsource their manufacturing overseas to “Third-party” sub-contractors.
A little lesson for retail investors
I know cash flow is King and all that. And investment managers recommending Gear4Music shares would study the cash flow statement and tell you the following:
“After deducting depreciation from capex and acquisitions, you get growth capex. That’s the EXTRA capex to increase a company’s sales.
In five years, G4M spends a total of £5.3m and manage to increase incremental sales by £43.8m.
They would say for every £1 invested it generates circa. £9 in new sales.”
It sounds like a no-brainer. There is one problem.
That is the LACK of positive cash flow from operations!
When you outsource to third parties to help with manufacturing you don’t need to spend heavily on capex. Instead, the bulk of the costs appears in their Income Statement, hence the lack of profitability.
And is probably why they raised £4.2m in equity issue last year.
The problem I have with Gear4Music
If you have been paying attention, then the lack of profitability is my NUMBER ONE concern.
In 2017, it made a small profit of £2.3m, despite market capitalisation of £156m.
And brokers are forecasting a lack of profit, here is their forecast: –
Given the market capitalisation of £156m, then forward-PER by 2020 is around 45 times.
Despite forecast sales of £126m!
So, what is blocking the firm from increasing profits at the same pace as sales?
Let us breakdown G4M Income Statement.
As an internet business, they require marketing to promotion website traffic, also they need staff to work in the warehouse and answer customers’ enquiries.
Looking at their marketing and labour costs, it accounts for 17% of group sales (numbers from their interims).
But the bulk came from the cost of selling musical instruments that took up 67%-69% of Gear4Music group sales (see chart below).
If Gears4Music can’t take advantage of economies of scale while taking more market share, then we have a problem.
And that problem is reflected back to PER multiple.
Gear4Music’s Market Valuation
My fear is, if Gear4Music don’t show increasing profit margin or cash profit margin, the market could begin to “de-rate” the share price.
At £156m valuation along with 67 times PER, then the “de-rating” could nearly half their PER.
Or, they could do a “Mulberry”, where the fashion line saw a collapse in profits, but manage to keep a PER multiple of over 100. But the one difference is Mulberry manages to increase operating cash flow rather than operating profit, where the P/OCF is 30 times.
Share Price prediction and range of forecasts
If brokers are right about the Gear4Music net profit of £3.69m by 2020, then expect PER to “de-rate” down to 20 times, giving a valuation of £80m or £4 pence per share.
N.B.: The compound growth in net profit is 20.48%.
But, if Gear4Music was to smash expectation with a (hypothetical) £10m net profit by 2020, then the market might keep the PER rating close to 65 times.
The logic behind the big difference between £4m and £10m in net profit
Answer: The rate of earnings growth
I mentioned earlier that a £3.69m net profit by 2020 means earnings growth of 20.5%.
And sticking with this growth logic, a £10m net profit is an annualised growth rate of 67%. But keep in mind this thought:
“Will the market expect this growth rate to continue for the foreseeable future?
The answer is probably not, but having a high earnings growth does help with its PER multiple, so I would prudently attach a PER of 45 times.
So, if it achieves a £10m net profit by 2020, you could expect a valuation of between £450m (£22.50 per share) and £650m (£32.50 per share).
Depending on where the future profit lies that will determine the future share price of Gear4Music.
For those who believe brokers’ forecast for £3.69m in net profit, then expect the de-rating of Gear4Music PER multiple to 20 times, which leads to the share price falling to £4 per share price.
For those believing in economies of scale and smashing earnings expectation, then you should hold on to your Gear4Music shares because valuation could top £32.50 per share, but expect a minimum of £22.50 per share.
What I do know is Gear4Music should begin to enhance earnings profitability, if not the market will adjust its PER multiple.
Also, whether earnings underperformed, meet brokers’ forecasts or smash expectations it is always wise to check the cash flow statement to see if accounting profit is translating into cash profit!
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Thank you for your patience!
The above analysis is based on my opinion and nobody else. It does not constitute professional investment advice. Data is correct on at the time of availability. I don’t hold the company’s shares unless stated.