Stock Pitch - Gear4Music (LON:G4M)

Gear4music Holdings (LON:G4M) is a leading UK based online retailer of musical instruments and equipment that is expanding quickly across Europe.

Launched in 2003 by current CEO and c30% shareholder Andrew Wass, revenue has grown every year since inception and has increased from £12m in FY13 to £157.5m in FY21. The Europe market for musical instruments is estimated to be around £5bn, so that suggests room for further growth.

There is competition with the likes of Thomann, but G4M has been built from the ground up as a website-based e-commerce platform and has invested in its own software and logistics capabilities.

Despite this evident specialisation and the recent rerating, G4M trades at a notable discount to other online retailers such as BooHoo and Asos. On this basis, the shares were pitched to the Stockopedia Investment Club on the 18th of May 2021 at 890p per share.

There’s no doubt business has been helped by Covid lockdowns, so it’s possible that the recent outperformance might revert to some degree.

That said, brokers expect net profit to fall by more than 50% in the year ahead. Is this caution warranted, or are G4M’s growth prospects being unduly discounted?

Summary

Bull points: multi-year revenue growth and market share gains across multiple territories (sales growth every year since 2003); improving profitability; trades on P/S discount to other e-commerce stocks; UK and Europe operations; proprietary e-commerce end-to-end platform; founder-owner CEO; own-brand product range built up over 17yrs; efficient logistics system

Bear points: Covid trade boost might subside; profitability has been an issue in the past; looks expensive on TTM basis; easy rerate has already happened

Profile

About the Stock:

Gear4music is a Consumer Cyclicals company in the Specialty Retailers industry group.

It trades on the LSE AIM market, with a market cap of £183.3m. Liquidity is a slight issue - although you can buy around £6,500 worth of stock on the market, the spread is 343bps.

The group is classified as a Speculative Small Cap Neutral, although it is on the verge of High Flyer status, with a Q Rank of 93, a V Rank of 45, and an M Rank of 76.

The share price has plateaued recently after a dramatic rerating, but the relative strength measures remain positive. Meanwhile the 5Y revenue CAGR is 37.8% and the operating profit CAGR is some 80.7%.

Most of this profit growth has come in more recent years as a result of management initiatives.

The StockRank has seen a couple of good jumps, which is testament to operational improvements made between 2019 and 2020.

These improvements mean Gear4Music is a better business than it was three years ago, yet its share price has only just recovered to previous highs.

About the Opportunity:

G4M is a combination of growth and turnaround, with the emphasis now shifting from the latter to the former.

Growth - this is a rapidly growing online retailer of musical instruments in terms of sales. Revenue has gone from £24.2m in 2015 to c£157m for FY21. The Europe and UK market for musical instruments numbers in the mid billions of pounds, and G4M’s FY21 revenue of £157m suggests plenty of runway for growth.

Turnaround - But investors became disillusioned a couple of years ago. The company spent a lot on scaling up but costs rose in line with revenue and profits were not forthcoming.

Management spent the next 18mths or so addressing these issues and embarked on a number of concrete tactical initiatives, including:

• Prioritising higher margin inventory within third party brands,
• Better control on price matching of lower margin products,
• Increased focus on higher margin own brand ranges and prices,
• Reduced level of promotions,
• Renegotiated courier agreements,
• Increased customer delivery prices where appropriate,
• A review of returns policies and charges for some collections, and
• Improved inventory management systems.

The result is a fundamentally more profitable business.

What’s important to note is that this problem was caused due to strong organic demand for G4M’s products. The group struggled to convert excellent revenue growth into profitability as it ramped up operations.

Lessons have been learned. Now, G4M has a continuing focus on higher-margin products, is taking market share through digital innovation, and has ongoing software development at the core of its growth strategy.

Business & Model

What is the company history & what does it do?

Gear4music sells musical instruments and music equipment across 20 websites in 15 languages and 9 currencies.

The group’s founder, Andrew Wass, remains G4M’s CEO and largest shareholder (c30%). A brief review of the story so far:

• Wass was a sound recording engineer in 1995 when he began supplying small recording studios and educational establishments with PC-based digital recording solutions.
• In 2003 he set up the Gear4Music website, which generated £0.7m of revenue in its first full year of trading.
• In March 2012 a PE firm, Key Capital Partners, invested £3.4m, allowing G4M to develop the e-commerce platform.
• In June 2015 it listed on AIM, generating £9.0m of net proceeds: £4.6m to repay private equity debt and £4.4m of growth capital.
• 2016 - opened its Swedish distribution centre and followed this up in February 2017 with the opening of a second European distribution centre in Germany.
• In January 2017 the group acquired a software development business, bringing software development in-house.
• In October 2018 the group relocated and expanded its Swedish distribution centre to add further capacity to meet demand over coming years.
• 2019-20 is the period where investors became disillusioned with the lack of profitable growth. Management initiatives put in place are now coming good and margins have improved.

What are the key business segments?

G4M notes two business segments by geography: UK and Europe and Rest of the World (RoW).

FY21 results show UK revenue +27% to £78.7m and RoW +35% to £78.8m. Total revenue +31% to £157.5m. This is the first time that RoW revenue has exceeded the UK market.

What is the business model? How does it make money?

G4M operates from 284,000 square feet of operational space - 135,000 square feet in York, 72,000 square feet in Germany, and 77,000 square feet in Sweden.

The 50,000 square feet freehold Head office provides back-office facilities sufficient to support the business in the long-term.

Its bespoke and proprietary e-commerce platform is key to ensuring profitable operations. This is ‘an end-to-end solution covering all aspects of retail operations, including website content, inventory management, multi-currency pricing, logistics and dispatch, CRM, automated marketing, purchasing, customer receipts and management reporting.’ It is highly specialised and is something that competitors will have to build for themselves if they want to effectively compete online.

Delivery - the e-commerce platform is configured to select the most cost-effective delivery options from seventeen different delivery service providers.

Market & Competition

What is the state & size of the company's market?

In December 2017, Music Trades estimated the global music products market in 2015 to be $15.9bn, including a $7.8bn US market and $5.8bn European market.

The top ten European retail markets for musical instruments and music equipment (including the UK) are estimated to be worth approximately £4.9bn, and are undergoing a profound shift towards online retail.

The G4M board continues to reference the significant degree of fragmentation in the UK market, with no large or dominant retailers, which presents a consolidation opportunity.

Acquisitions aren’t a core part of the current strategy but opportunities are reviewed on an ad hoc basis and the group could become more active here.

Who are the company's key competitors?

The largest retailer serving the European musical instruments and equipment market is Thomann.de, based in Germany, with a 2018 reported turnover figure of approximately £730m.

Other competitors in the European market include Musicstore.de (Germany), Bax Shop (Netherlands) and Woodbrass (France). Competition is a risk but G4M has gained market share fairly consistently.

What is the company's strategy?

G4M intends to use its proprietary e-commerce platform to continue consolidating the UK market and taking share across Europe. This platform is a key competitive advantage, with 44 in-house software developers continually improving the G4M experience across its 20 websites.

G4M has also spent 17yrs developing its own-brand range of products. Growth here will help to drive margins. The group has over 54,200 products from over 880 brands and 3,400 own-brand SKUs (stock keeping units).

How does it derive its competitive advantage (if any), is it durable and is there evidence of one in the financials?

Barriers to entry and competitive advantages include:

• Data - making it agile and able to quickly respond to consumer trends,
• Market position - G4M has a strong market position as the UK’s largest retailer of musical instruments and music equipment,
• Its bespoke e-commerce platform provides a high degree of operational flexibility and scalability which cannot easily be replicated,
• A strong own-brand offering has been developed over 17 years,
• The group has developed long-term relationships with the major branded manufacturers, and
• It has scalable distribution capabilities.

Financials & Ownership

What is the record of growth & profitability?

Revenue has grown at a compound annual rate of 37.8% over the past five years and has increased every year since launch in 2003.

Recent updates show good progress on profitability and it looks like the group may be at an inflection point here.

Cash flow CAGRs are good, and this is more representative of operational growth.

What is the state of the balance sheet? (debt/cash etc)

Gearing is a little high but this is more a reflection of the group’s relatively asset-light operating model. The increase in total debt of c£11.5m is driven mostly by IFRS 16 accounting changes and the inclusion of £9.5m of capital leases. Meanwhile, the cash position is growing.

Interest cover is very safe at 9.07x.

Liquidity ratios are tight but then again G4M is a highly efficient operation.

Is there evidence of historic share dilution or buybacks?

Stable shares in issue.

What is the ownership structure of the company and do management have stakes?

Wass has 30%.

There are some well-regarded institutional small-cap names on the register including Aberdeen, AXA, Amati, BlackRock, Octopus, and Canaccord.

Valuation

How does the relative valuation compare versus industry and sector?

G4M trades on a significant discount to other e-commerce companies, particularly on a TTM P/S basis.

Note - although Deliveroo is a different type of business, it’s still useful in gauging the kind of multiple applied to high growth disruptive stocks.

If you apply the average sales multiple of the peer group (3.58x) to G4M’s FY21 revenue of £157m, that would give a market cap of £562m or +207% from current levels.

What is the intrinsic valuation of the business?

Running some assumptions helps to quantify the potential.

• If we assume G4M takes 10% of the £5bn Europe market in the next five years, that makes for £500m of annual revenue. This implies a forecast 5Y revenue CAGR of 17% compared to the historic 5Y CAGR of 38%.
• FY21 forecast net profit margin is 7.8%.
• Applying that profit margin to the £500m 5Y revenue forecast gives £39m in net profit.
• Divide that by the shares in issue: £39m/20.95m = £1.86 earnings per share in five years’ time.
• G4M could target the rest of the world from a strong Europe base so we can still apply a growth multiple of perhaps 15-20x earnings. This scenario would result in a 5Y share price of around 2,790p-3,720p per share, or upside of between 219% and 326%.

There’s a reasonable chance the share price can treble or quadruple over the next five years assuming management continues to execute.

Trends & Catalysts

Are there any significant macro trends or catalysts that the business is benefiting from?

• Shift to online / e-commerce - G4M has first-mover advantage, scale, and best-in-class operations,
• Europe - RoW revenue now exceeds UK revenue,

• As it grows G4M might attract more institutional interest
• Covid lockdowns - at least some of the shift to online purchasing could be permanent.

There are several key developments on the agenda over the next two years, including:

• Digital products download system (Q3 FY21) - instant download of certain software products, sound libraries, and music sheets,
• Marketing platform upgrade (end of FY21),
• Third party integrations (Q2 FY22) - deep level integration with selective distributors to enhance customer deliver options,
• Second hand platform (Q4 FY22) - new platform addressing the second-hand market,
• Agency sales platform (mid FY23) - provision of specialist ‘Fulfilled by Gear4Music’ solutions to meet latent demand from brands.

These projects have the potential to drive significant profitable growth in the future, both domestically and internationally.

Risks, Threats & Hurdles

What are the biggest risks, threats or hurdles that the business may face?

• As lockdowns end, customers could revert back to physical stores.
• Profitability issues may arise again - management has done well here over the past couple of years but international expansion always brings additional costs and execution risk.
• Some anecdotal reports of G4M prices not being the best value for money.
• Brexit - but the group has German and Swedish bases so is relatively well positioned.
• G4M could once again struggle to translate revenue growth into profit growth. Price competition or rising costs could impact results.

Recent Trading & News

Summarise the most recent trading statements and comment on them

22nd April 2021 - FY trading update

I am very pleased to be reporting results that are ahead of our previous expectations, representing a transformational FY21 trading performance for the Group, and building on the significant progress we made in FY20.

Further improvements in gross margins have driven our profits to record levels... As we lay the foundations in FY22 for the next stage of our growth journey, in addition to establishing new sales verticals, we will further strengthen our European distribution network, accelerate investment into our e-commerce platform, and consider acquisition opportunities as they arise.

...we are pleased with FY22 trading to date, relative to the exceptional period of trading during April FY21.

Sentiment

What do the brokers currently think?

22 April 2021 N+1 Singer

Positive trading in Q4 leads to another 6% upgrade, with EBITDA margin over 11% for the year (pre-IFRS16). Alongside growing confidence that the core margin and efficiency gains from 2020 can largely be retained, prospects look bright… fair value is estimated to be in the range 1100-1400p.

...key assumptions… could be on the conservative side.

What would the person selling to us be thinking and who are they?

• There has been a substantial rerating over the past year. There may be profit taking.
• Others will wonder if we are in for a dip in revenue and/or profitability post-Covid.
• The stock looks expensive based on relative valuation metrics.

Conclusion

Gear4Music has a lot going for it, but risks remain and the fact is that shares have performed extremely well over the past year.

In what proved to be a tricky case, the Club voted marginally in favour of buying shares at 890p.

The decision was based on G4M’s track record of revenue growth and market share gains, improving profitability, valuation discount to other e-commerce plays, and the size of its addressable market.

With the Club’s fund now at its max of 16 holdings, we had to vote to eject a stock.

N Brown (LON:BWNG) made way and has now been sold. This was done on the basis that:

• Both are e-commerce stocks,
• N Brown has a Highly Speculative RiskRating, compared to G4M’s less volatile Speculative classification, and
• While N Brown represents a turnaround looking to emulate established fashion e-commerce stocks, G4M is more of a first mover in the musical equipment space.

Votes on which stock to sell:

This is the first time the Club has had to sell a holding in order to make a new purchase. Did we make the right choice in picking G4M over N Brown?

(Disclosure: I hold shares in Gear4Music)