Focusrite hits the right notes

Investing in pop stars’ record sales has not always been a viable long-term strategy. But that looks like it could be changing: a rush into music royalties funds meant that this year Hipgnosis Songs Fund’s market value breached the £1bn milestone, profiting from the works of the likes of Bruce Springsteen, Stevie Nicks and Rihanna. 

For investors looking for a little studio sparkle elsewhere, Focusrite (TUNE) looks like a compelling option. The music recording equipment company is chaired by former Led Zeppelein soundman Phil Dudderidge, who bought the business in 1989, four years after it was founded. Dudderidge still owns a 33 per cent stake. 

Long live indie 

Focusrite develops its own hardware and software, which ranges from smartphone apps to mics to headphones. Its two main brands are Clarett (prices from $400 to $1,200) aimed at the professional user, and Scarlett (from $100 to $500) for the home consumer. If it sounds niche, that is because it is. The company’s client base consists mostly of amateur hobbyists and indie music artists. 

In fact, the group’s products are so niche that it carved out a specific ‘Focusrite Pro’ division in 2017, as more expensive corporate and commercial tools needed a unique sales approach. But the original Focusrite brand still makes around two-thirds of the group’s profits. It sits alongside the Novation division, which sells the technicoloured Launchpad and Launchkey interface products.  

Focusrite does not sell most of its devices itself – instead it pedals its stock through distributors and third-party retailers, which means it logs its sales as ‘external revenues’. It does, however, have its own e-commerce platform. Unsurprisingly, that grew massively during lockdown, with sales more than doubling – albeit from a small (and undisclosed) base. 

Manufacturing its extensive range of equipment accounts for most of its costs of sales. But return on capital employed, which indicates how effectively money invested into the business is turned into profit, is very healthy at over 30 per cent based on underlying operating profits. Meanwhile, its gross margin has been relatively stable, consistently sitting above 40 per cent since 2018. 

Growth at its feet 

But as the company eyes the expansion of its software products, that figure should start to tick up. Take its ‘Ampify’ app business, which is free to download but includes the option to pay for additional features. Anyone with an iPhone can use it to make music digitally, massively reducing barriers to entry for novices – and drawing in more customers into Focusrite’s universe of integrated software and hardware products. Management only created the business in 2017 and does not break out its revenue contribution (although describes it as "modest"), but the potential for growth here is significant, especially in the age of self-made content creators.  

A strategic focus on more software and hardware upgrades in its other devices should bolster the long-term value of each customer, and help fatten up its net cash position, which currently sits £3.3m.

That extra cash should help fund the group’s merger and acquisition (M&A) strategy. Its 2019 acquisitions of ADAM Audio for £16m and Martin Audio for £35m pushed it further into the recording studio market with speakers and monitors. Now that the group has cleared all of its bank debt, we would not be surprised if it goes full steam ahead, picking up music equipment companies that may have struggled last year during various lockdowns. 

Growth via M&A looks all the more appealing as the company eyes expansion outside of its traditionally niche corner of the audio market. About 28 per cent Americans over the age of 12 now listen to a podcasts during a typical week, according to Edison Research’s Infinite Dial. That amounts to about 80m people. And while that isn’t as popular as radio, it’s one of the fastest-growing areas in the media industry. 

Combine that with the sudden realisation that you can achieve studio quality sound from home with the right equipment, and Focusrite looks like a clear beneficiary. The group says that the ‘passionate maker’ consumer group – who may not play an instrument but want to record high-quality audio such as podcasts – represent a market opportunity of between £500m and £600m. And even in the professional market, Focusrite estimates that musicians not yet using technology to capture and edit sound outnumbers those who do by as many as 14 to one.

The flipside of the 2020 effect

Focusrite's shares outperformed over 2020, buoyed by a rush of musicians and hobbyists kitting up at home and entertaining themselves during lockdown: its top line jumped 54 per cent to £130m in the 12 months ended in August. As reflected in the forecasts in the accompanying table, the bonanza is expected to peak in the current financial year before the group settles back to a more sustainable base from which to grow as its main territories of North America and Europe make their slow transitions back to normal. 

It is also worth noting that while the group logged a happy jump in sales, its statutory operating profit still dropped by almost two-fifths to £7.9m. That was led by a £10.2m write-down on its recently acquired live music equipment business, after concerts and festivals were wiped out by the pandemic. The group has  paid off the debt related to the acquisition, and further write-downs should not be a major risk in its full-year results when they are published in late April. But investors should be wary of the impact of a weakened live music industry, and possible hesitancy to splash out on expensive new equipment. 

Even if demand holds up, Focusrite could end up dealing with constraints on supply. Management warned last month that it was conscious of factors that were adversely impacting its operations – namely, the market-wide shortage of semi-conductors and other hardware components. Supply tightened last year after the automotive industry cut back orders on the back of weak sales forecasts at the peak of the Covid-19 crisis – and now it has started to spill over into consumer electronics. Last week Samsung Electronics (KRX:005930) warned that it could be forced to delay the release of its new Galaxy smartphone this year, for the first time since the series launch in 2009. The shortage has not yet affected Focusrite’s ability to meet demand, but investors should be mindful that the situation is effectively outside of management’s control – and could worsen.  

The path ahead 

There is some change coming at the top, with Sally McKone replacing Jeremy Wilson as the group's chief financial officer this month. We expect that this will be a smooth transition, given that McKone will be inheriting a clear, long-term growth plan. That winning strategy comes with a valuation to match, with a forward price/earnings multiple of 37. But with a strong foothold in its native market, improving customer value and plenty of avenues for new growth, we think that Focusrite makes for an attractive holding.