A rather peculiar profit warning came out today from Gear4Music (LON:G4M). If you wanted to read a warning, you would have thought this would been it: profits and margins hit due to capacity constraints – it’s products have been selling well, too well in fact. The markets seem to have heavily disagreed with this assessment and the price was marked down over 40% in early trading:
This is a remarkable fall considering the content of the profit warning, but it should be noted that previously the shares were trading on an extremely high multiple, with the company being valued as a growth one. Considering the market at the moment we should not be surprised with massive falls on the back of even a whiff of bad news. The question is, whether the current price allows us a buying opportunity?
The warning came out in the latest trading update detailing the last four months business. Virtually all the headline metrics were good – total sales are up 41%, active customers almost up by a half. However, the negative parts of the statement comes about when speaking about profits:
Further sales growth in excess of expectations was constrained by our York distribution centre, which reached maximum capacity during the peak trading period between Black Friday and Christmas. Whilst there was an improvement in margins in the Period compared to H1 FY19, these capacity constraints prevented further sales growth compensating for the lower gross margins and, as a result, the Board now expects FY19 EBITDA to be slightly below FY18 levels.
It seems rather pleasant that the drop off of growth came as a result of limited capacity as opposed to reduced demand (one of the other common causes). And whilst there have been other profit warnings based on logistical problems (for example Moss Bros), the company are hopeful that this will be resolved fairly quickly:
We are already working on plans to further expand our UK distribution capacity ahead of our peak trading period next year and we are confident that this can be achieved by Autumn 2019.
More importantly, the outlook is still good:
During the Period we successfully relocated our Swedish operation into a larger facility, and now have significant capacity headroom at both European locations, supporting the strong consumer demand we are seeing. We expect this high consumer demand and strong sales momentum to continue over the remaining three months of the financial period and into the next financial year.
On the flipside, it should be noted that projections were in line with expectations in October’s interims, suggesting that the capacity constraints were not anticipated.
Gear4Music is a rapidly growing business. Started in 2003 as a retailer of musical equipment, the firm floated on AIM in 2015 and began rapidly expanding, beginning to offer own-brand equipment as well as websites targeting different countries. They are the UK’s largest retailer of musical instruments and equipment, which is an easier feat than it sounds: the UK market is extremely fragmented with many players choosing to be very niche (focusing on only one aspect, for example guitars, or DJ equipment). Gear4Music is about the only large retailer that attempts to stock such a wide range.
Since IPO sales revenues have rocketed here. At £80m for 2018, this was almost four times the £24m seen in 2015. Profits have not followed the same trend, as the company has chosen to target growth, and has invested for it, with large investments in software and logistics.
It cannot be denied that G4M are operating in an exciting market, which is still transitioning to online. As their annual report says:
The online European market is worth an estimated £4.2billion a year, so it’s not that difficult to see that there is plenty of market share to be wrestled away from other firms.
Current product splits suggests that G4M is more of a band retailer as opposed to electronics: most of its sales come from guitars (27%), PA equipment (20%) and drums (12%). Only 11% of sales come from the DJ-related equipment of mixers and interfaces. Own-brand sales come in at roughly a quarter of the sales total, whilst the UK is the biggest territory at over 50% (although this is falling as overseas markets are targeted).
The company now carries a modest amount of debt, up to £8.529m from £2.645m in 2017. Virtually all of this relates to the purchase of a new head office, which is a modern facility in York. With this property backing this debt is not an onerous one. There is a modest amount of intangibles on the balance sheet, mostly related to software development. £1.8m was capitalised this year in relation to the moving of team to in-house, which renders the EBITDA charge less useful as these costs bypass that.
It would be fair to say that there doesn’t appear to be any signs of immediate financial distress, as there would be a variety of options open to the company should hit some troubles, such as sale/leaseback, further loans or issue of equity. However, there is a pressing need to make some genuine profits. As we can see from Stocko, the summary reads:
Given today’s update we can probably forget about the estimated 2019 figures. The question will be: when will some profits be made? At these levels, we can still see that there is a level of operational gearing at play: the level of the European logistics centres are high relative to sales but should improve with sales. And this takes us back nicely to today’s update with the UK-related capacity problems: will this be a cheap fix or something more substantial to sort out? If the latter, this may delay the move to tangible profits even further.
Most of today’s statement was good – after all, who doesn’t want a company growing metrics at such a rate? But the share price reacted in a way that did not reflect this. I think most of this can be attributed to what the projected vision of the company is. A retailer such as AO has also posted terrific growth figures (going from £294m to almost £900m in 6 years, but without any visibility of profitability, investors may find it hard where any real returns lie for them.
Not enough detail was listed in the statement to allow us to know how these logistical problems will be fixed. Assuming that the company is still in growth mode, this problem will still be rearing its head next year, and in greater magnitude due to increasing metrics. Can this be managed without affecting business like this year? We get that the company are ‘confident’, but to run into this type of problem suggests either poor forecasting or poor management, perhaps both. After all, anyone can look like a genius pushing out brand name products cheaply and with great logistics, but doing it profitably is the tough part. Just ask AO.
One threat in the market may be the development of competitors. G4M rightly point out that the music markets are very fragmented, but there is a reason for that: the music markets themselves are fragmented, with minimal cross-over. Many of the smaller players have chosen to add value to their products by specialising heavily in their own fields. So firms such as Focusrite have heavily invested into their own brands in a narrow field, and are having a success out of it.
I feel that on some levels, G4M may have two distinct businesses. The branded gear market seems susceptible to entrants such as Amazon, where the ‘value added’ approaches (product bundles, logistics, relationship with suppliers) could easily be replicated. The own-brand level is where the higher margins are, and there could be tremendous value in the brand if it gained mainstream acceptance. Neither has happened yet, I feel.
It could be that the problems they had were of their own doing – nobody makes a firm take part in Black Friday, and there must have been someone who knew that taking orders would lead to logistical problems. Sales level figures are a KPI for them, so it may be a case of getting the numbers in the door first and considering the consequences later.
Despite this blip I feel that G4M are still running a slick business, which is in a market that is growing and is fragmented. Even with today’s share price fall the shares are expensive on traditional valuations, but I feel longer-term this will be good. 5/5. It should be noted that Stockopedia heavily disagrees with me, rating this as a measly 22 at the time of writing.