Small Cap Value Report (18 Oct 2016) - G4M, AVON, DOTD | Paul Scott

18th Oct '16 by Paul Scott

48 comments 25240 reads

Good morning!

More interesting news about the retail sector. I'm very fearful about this sector, and think it's generally best avoided at the moment. This is due to multiple headwinds - online is increasingly eating their lunch, plus overheads are rising fast (Living Wage, etc). The latest one - much higher input prices feeding through in 2017 due to weak sterling, could I think crush a lot of smaller retailers that have only just been hanging on. Plus margins are likely to be squeezed across the board, for all retailers.

This article makes some interesting points. There's evidence that consumers are tiring of buying "stuff", and are now prioritising holidays and entertainment (meals & nights out) ahead of adding to already groaning wardrobes.

All in all then, I reckon a lot of apparently cheap retailers could turn out to be value traps next year. So caution is definitely needed there. Which brings me on to probably my favourite GARP share at the moment, in a sector which is rapidly transitioning online.

Gear4Music (G4M)

Share price: 334p (up 5.7% today)
No. shares: 20.2m
Market cap: £67.5m

(at the time of writing, I hold a long position in this share)

Interim results for 6 months to 31 Aug 2016 - if you follow me on Twitter, then you'll already know that this is probably my favourite GARP (growth at reasonable price) share at the moment. The company is an online retailer of musical equipment. It operates about 17 websites across Europe, with the UK being the biggest market. It's based in York, and has been established for about 13 years. The founder CEO is still by far the largest shareholder.

The stock market is attributing very high valuations to growth companies. I'm not saying that is necessarily correct (as I think some valuations are too high now). However, if you spot something with outstanding organic growth, then it can pay to pile into it whilst the price is relatively cheap, because the rating is likely to expand dramatically once other people also spot it. That worked brilliantly for us with Boohoo.Com (LON:BOO) between Jan 2015 and now, I know a lot of readers joined me in that one (which I no longer hold personally, as the price seems quite high now).

For me, G4M is not dissimilar, although it's more niche. So some people question…

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WatsonNimrod

18th Oct '16

Lovely top up this morning and off it goes again.

From experience of raising kids in Scandinavia the music element of schooling is far greater than here in the UK so to me its an exciting market that isn't diminishing (as some of the negative stuff out there today seems to suggest).

Surely their main target market isn't established musicians that would require extensive testing of product, but the European scholastic market which is vast and growing all the time with the arrival of many school age migrants. We had to buy my daughters umpteen instruments some of which they had never played before, if only then we could shop around on the net.......!!

Damien84

What jumped out at me reading the results this am was this line ..

- Property lease signed on German Distribution Centre.

Looking at Edisons research note quickly Thomann is G4M biggest European competitor with 12.8% market share and over 500M turnover. The company is also German so interesting that Gear4 are setting up shop here. Having had a look at Thomanns website looks a bit naff and dated but i do have a bias as i hold G4M.

Could Gear4 start picking and nibbling away @ Thomanns lunch? Food for thought..

shanklin100

Hi Paul

Thank you for an excellent piece on G4M.

FWLIW, you may wish to correct "334p (down 2.4% today)". For much of this morning G4M was trading at 307-310, down 2.4%, albeit it was really 310 on both the bid and the offer.

Cheers, Martin

Kelvin Prescott

As a music nut, I have used both G4M and Thomann extensively to buy equipment for my band. Both are very good, (though as an investor I wish that Thomann was listed, as that is a business that Warren Buffett would be proud to own a piece of).

I've also observed the steady decline of local music shops over the course of the last few years as they found it harder and harder to compete. That process isn't over yet, the economics of music equipment are massively in favour of large distribution networks, as the stock has an indefinite life and customers value as wide a choice as possible. I think that there is still a lot of room for growth in this market.

If you look at Thomann, the undoubted market leader, their aggregate customer base is 7.8m. Getting an equivalent number for G4M is difficult as its not clear whether Thomann's figure is a lifetime number or an annual number, but assuming lifetime then G4M is probably just clearing 1m.

So, accordingly, I'm in. The warning sign on this kind of business is Inventories, currently 9m (and up 50% on the corresponding low point in February, post Christmas). It will be interesting to see what the position is at the start of next year.

truegent

Paul,

£G4M cash flow statement shows they are still loss making...does this not worry you ?

i avoided it for this reason.

Paul Scott

Hi Shanklin,

Ah well spotted, thanks. I will correct that error.

What happened was that I started writing the article when G4M shares were down, but then the price moved up so much that I thought I'd better amend the market cap bit at the top. But it looks like I overlooked the need to change the percentage too - doh, schoolboy error, sorry!

Thanks for pointing out my mistake.

Regards, Paul.

jjis

Not being a musician I picked a bit of musical equipment from the European Website mentioned above & did a search for a Fender Mustang III V.2 (an amplifier). Widely available via Amazon and others at same £235 price as G4M. Google search they didn't seem to be anywhere on the first page as far as I could but a one shop operation in Guildford at the top! Google's shopping tab listed 27 online sellers listing it at same price.

So not too sure what their USP is or how people would find them on this limited basis? I guess their own label stuff might be cheaper & more profitable for them. I see the operating margin was only about 4% - where do you think that can get to as 1x+ sales seems a bit rich at this point.
Looks like a classic growth / momentum stock not my kind of thing but good luck with it.

BIACS

Have not looked into G4M but a few thoughts out loud from a quick glance after Paul's report this morning would be:

1) 40% of sale going to Europe must raise some questions regarding potential issues once actual Brexit takes place next year? (local distribution hubs being set up may mitigate some of this but not all risks). There is a lack of global diversification presently to offset any such effects too.

2) Where margins are small as here currency effects can have a major impact. Where do they source the equipment from? If any of it is outside UK then sterling depreciation will be a hit to margins in the UK, assuming they can't raise prices in line with that (would be good to know if they have any room in terms of competitiveness to lift prices outside UK due to Sterling depreciation - i.e. pricing the at same level in Euros despite sterling depreciation - helping them on the Euro sales side). They will make a limited win back in any event on Euro denominated sales translating into Sterling, but since Sterling depreciation against Euro has not been (and probably not likely to be going forward) as dramatic as against Dollar and other global currencies they won't get quite the same tailwind from this as the more globalised businesses have done. Unless they have managed to currency match using their Euro revenues for Euro stock purchases of course (if they buy from Europe) which may help offset the effect of this. Won't help them if they have to buy stock from US or other sources of course.

3) If we do find ourselves facing a drop in consumer spend next year if things get tough in the broader economy then discretionary spend on recreational music gear would likely take a hit? With such a high rating it probably wouldn't take much to rattle the stock?

4) Sales figures comparisons this year will be flattered by Sterling decline but this will be a one-off benefit (unless the plunge in exchange rate continues into next year). Continuation of low Sterling would aid competitive pricing in Europe but , as above, all depends how much of their cost side is non-Sterling based and how much this undercuts the European sales side currency benefits.

I have no view either way on this company having not looked into it in any detail, so the above are just some initial musings.

Hi truegent,

The cashflow statement looks fine to me, for G4M, given where it is in terms of very rapid expansion, seasonality, etc.

Maybe I've missed something. What in particular concerns you?

Regards, Paul.

I don't think the cashflow statement says that?

There is a significant movement (£2.5m) in working capital that results in negative operating cashflow, but that is the buildup of stock for the Christmas period, and is highlighted in the first page of the statement.

Hot Socks

Paul

In answer to your call for bearish comments, the following para leapt out at me from your article:

"In the past, I've worried too much about the low margins achieved by G4M, but for me the penny dropped recently that this is an irrelevance. The stock market is interested in top line growth, rather than profitability, right now. Again, I'm not saying that's necessarily correct, but that is what's going on, and it's a good way to make money by observing what the market does."

Wasn't valuing tech businesses by sales not profit a major sin of the dot com boom?

Accepted you can speculate on the price rising because of what other market participants do, but as an investment it doesn't stack up unless you think it will generate future cash returns from profit so by definition there's shed loads of assumptions and execution risk. Not saying you're wrong to buy it (and I will have a closer look myself) but surely whether revenue growth is profitable is never irrelevant.

Hi Paul

It seemed churlish to mention it but I thought it might be useful as and when people look back to today's report in a few month's time.

Cheers, Martin

Hi Martin,

Not churlish at all - if people spot a factual/figures error, then I definitely want them to flag it to me, so I can correct. Minor spelling mistakes, where it was obvious what I meant, less so.

So thanks again for flagging.

Regards, Paul.

hi paul, cash generated from operations was negative, plus a further cost for capitalized dev costs....so reported profits are no where near free cash flow, which is actually negative and was in last prelims too....do you not see this as an issue ?
thank you.
Paul

Ned Kelly

Hi Paul,

Thanks for your report. Despite some of the comments above I'm very encouraged. I read the report this morning and couldn't understand why the price was down. It would be interesting to know how much of their sales relate to instruments to school students as that would seem to be a huge, but price sensitive, part of the market where people will be happy to buy online if the price is right.
G4M certainly made my trip to your Brighton ShareSoc meeting worthwhile.

Thanks, Roger

i guess so....but a loss is a loss and to this day they havent made a single penny...so for me, reported profits need to start translating to cash....

sydb

Hi Paul,

Thanks for in depth and interesting report as usual!
Any thoughts on UTW? Results today look good, debt down and cash up but eps slowed and share price still going nowhere!

Syd.

JDW72

Hi,

One of the things I try to do in life is to find things that work and try to replicate as much of what worked as possible. It has done me proud in a huge number of scenarios from cleaning up my diet, getting more sleep, even ultra running - simply find somebody as much like you as possible, and copy what they did and generally, hey presto, target achieved.....

I do the same with my investing, analysing the best investments I and others like me have made and trying to find similar stories and situations.

Which leads me to £G4M. The parallels with Boohoo.Com (LON:BOO) are there but there are some key (to me) differences.
- One thing that is in BOO's DNA, part of their USP, is their ability to pick clothes from a huge range that will sell and are selling and sell more of them. Not sure there is quite the range of violins to choose from that will enable that differentiation for G4M.
- Amazon would not find it hard to muscle in on G4M. Indeed, an earlier post has found 27 different ways of buying an identical item. They'd (or anyone else) find it much harder to do that to BOO.
- BOO have the advantage that fashion changes four times a year. Whilst people take up musical instruments all the time, they tend to only do it once or twice.
- Nobody really buys second hand clothes. Why would you? You'd get them new from BOO. Lots of people buy second hand musical instruments though, particularly beginners who are the key market. Ebay is awash with second hand instruments.

Not sure about buying a group of developers either. I know that industry well and they are pretty much the least sticky staff you can imagine so it's likely that a lot will have left before long leaving not much behind......surely let somebody else carry that risk?

On the other hand, average order value is good, they are growing revenue and the inventory should not lose value in the same way clothing does.

I'm not saying G4M is a bad investment, just trying to draw out some differences between it and Boohoo.Com (LON:BOO) with which it has frequently been compared.

Disc - no position in either (any more).
JDW72

will89

I think G4M is an interesting one, it's a marketplace that I vaguely know, having been a semi-professional Trumpeter in a past life.

I think the key marketplace is youth, the number of late school/college age people who 'form a band' and need to buy some equipment is huge, and the push on the homepage seems to be towards 'cool' instruments rather than more traditional brass/woodwind etc. If I was a 17 year old who wanted to buy an electric guitar to appear cool to my peers I would probably be looking online...?

When I was a kid we had a fantastic brass instrument shop in town, and I've keenly watched their evolution (as a much smaller business) over the years. As has been mentioned above, by the time I was wanting to spend £1000+ on a Trumpet I would need to go in and try it, but the range on G4M seems good even at the top end where I expect sales are tiny. Equally, they sell plenty of own brand trumpets in a much lower price bracket that I am sure the margins and volumes are better on. Interestingly even 10 years ago my local shop had an own brand range, so that in itself doesn't say a huge amount.

I actually had a chat with the online manager of the local shop recently (yes they now have an online manager) as they were having some development work quoted by our web developer and wanted a referral. He said that something like 80% of their sales are now online, with the volume market being schoolchildren, and they do very well with lease type agreements both to educational establishments and individuals, perhaps a growth area for G4M? If interested, the business is 'John Packer'.

I think this is going to be one that might fly for a while, and then hit a bit of a growth wall, so I'm in for the ride at the moment!

ericb

Paul
You asked for bearish views, so I gave you an angle on the big share placing this morning. You have seen previously how private investors can be easily led into stocks by following guru and twitter comments, so there is plenty of reason to suggest there is evidence of that here too.
However its just as easy to look for other explanations, depending on whether you are cynical or over excited.
I didnt think I was suggesting Panmure was publishing bullish updates in order to facilitate a seller, more that the large sales being handled by Panmure were at odds with the enthusiasm they have for the stock.
I remind of your statement above "I usually ignore broker price targets, but in this case the valuation comments & calculation look sensible to me." I certainly usually ignore Panmure notes as they are often the wildest out there for variable quality. But I guess even Panmure can look sensible when over excitement kicks in.
£G4M results have all the right headline figures and glossy internet sales excitement, but there is a lack of actual cash building up and alot of expenditure coming up to grow the business. Certainly not enough for a dividend.
So these are all things to consider when looking for bearish views, this is what makes a market and should be encouraged rather than brushed off as being clever. Is this another AO World (LON:AO.) in the making ?

Small Cap Value Report (18 Oct 2016) - G4M, AVON, DOTD

Gear4Music (G4M)

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