Focusrite (LON:TUNE) is a global audio equipment company based in High Wycombe, United Kingdom. Through its various brands, Focusrite caters to all types of musicians: entry-level through to professional, throughout all stages of the music lifecycle: production to live consumption. As you may expect, coronavirus has delivered significant challenges for certain aspects of Focusrite’s business (namely live venue audio equipment). However, with strong market positions in recording and home studio equipment, Focusrite’s core business has seen strong growth throughout 2020 off the back of increased demand in music-making over lockdown. Will this demand for Focusrite’s equipment continue to grow in the years to come? Is Focusrite a business that investors should look to add to their portfolios? This article will aim to shed some light on these important questions.
Focusrite was founded in 1985, with the purpose of providing high-quality recording equipment to serve professional recording studios. Focusrite’s mission statement is ‘enriching lives through music’, and its products exemplify quality. A quote from the Focusrite annual report helps illustrate the story behind Focusrite’s quality product offering:
‘Focusrite’s legacy was born out of a request from the Beatles producer, Sir George Martin, ultimately resulting in the Focusrite console, which is still regarded as one of the finest analogue studio consoles ever made’.
Since Focusrite’s inception in 1985, it has made various strategic acquisitions to grow its product offering and market opportunity. It now splits its business into three distinctive units: Focusrite Audio Engineering Limited (FAEL) and the recently acquired business units of Martin Audio and Adam Audio. Focusrite Audio Engineering Limited contains the Focusrite, Focusrite Pro, Novation and Ampify brands, which cover recording equipment and digital apps (downloadable from your App store) for music production. Martin Audio is a specialist in live concert speaker arrays, and Adam Audio is a professional audio equipment maker with German precision.
This snippet from the 2020 annual report helps to show the size of each business unit, with the bulk of Focusrite's revenues derived from the Focusrite and Novation brands. The more recent acquisitions of Adam Audio and Martin Audio are smaller units. However, it is worth noting that Martin Audio’s revenue has been significantly impacted due to the pandemic.
In terms of recent performance, Focusrite last provided an update to the market through their trading announcement on the 19th of February, which was very positive indeed. Revenue is tracking at just under double the level it was in the prior year’s six month period, and cash flow has continued to remain strong. Focusrite announced a high likelihood of exceeding expectations for the year-end. Looking back to the final results for the year 2020, revenues for the core Focusrite business were up 21.5%. I chose to focus on the core results here as total group revenues were actually up 53.7%. However, this is reflective of the contributions from Focusrite's recent acquisitions of Adam Audio and Martin Audio and so does not give a good overview of actual performance. Whilst 21.5% growth is a fantastic result, and a result clearly boosted by the tailwind of Covid-19, growth in the years prior has been pretty solid too — an average of 15% revenue growth per annum in the last three years shows that Focusrite’s core business has been performing well even without the effect of Covid-19.
In terms of business operations, there have been some key developments that highlight the progress Focusrite is making to becoming a global leader in audio:
The Ampify software unit hit a milestone of 12.5 million app downloads.
The new product launch of the Scarlett 3rd Generation audio interface has driven Focusrite brand sales to a growth of 32% YoY.
Acquisitions of Martin Audio and Adam Audio have transitioned Focusrite into an ecosystem business, which caters to customers across all aspects of the music production lifecycle.
Novation product launches have led to 9% revenue growth for 2020.
I would like to discuss the recent acquisition of Martin Audio a little further, as I believe this to be a great strategic fit for the Focusrite group. Martin Audio is a live venue audio equipment provider, best known for its loudspeaker 'array' setups at concerts (in layman's terms, the big stacks of speakers that thump out high wattage sounds at live music events). Martin Audio’s clients vary from travelling bands such as Stereophonics and Pink Floyd to Festival productions such as British Summer Time at Hyde Park. More refined audio installation wins for Martin Audio also include hotel and restaurant complex Nobu in Chicago, the multiplex Armagh Planetarium in Northern Ireland and CÉ LA VI, a new luxury dining, bar and club lounge complex in Shibuya, Tokyo.
In terms of Martin Audio's strategic fit with Focusrite, Martin Audio is based less than a mile away from Focusrite’s HQ in High Wycombe. Secondly, Focusrite has followed the Martin Audio business for many years, so you would like to think Focusrite is very well aware of the business it is buying (not always the case in corporate acquisitions I can assure you!). Martin Audio also fits the quality aspect of Focusrite’s business very well, and I am sure Focusrite will do well to leverage all of the technical knowhow Martin Audio has built up over its years of trading. We are yet to truly find out the potential for profit accretion from this acquisition due to the poor performance of this segment in 2020. However, the total sum of £35 million (net of Martin Audio’s cash) represented around 13 times EBITDA for Martin Audio in 2019, which is not overly expensive.
The table above picks out some key financials for Focusrite. As alluded to earlier, revenue has grown at a double-digit rate for the last four years, underpinned by growth in the core Focusrite Audio Engineering business unit. On an adjusted basis, operating margins average 15.5%, which is reasonable. However, you will notice a steady trajectory of improvement in each year since 2017, showing that as Focusrite builds scale, it is also becoming more profitable. Investors should typically be cautious of adjusted results, as some companies have a tendency to over adjust profits to flatter financial results. However, I would argue here that Focusrite is prudent in its adjustments, as the typical figures for adjusted profit in the years up to 2019 are equal to the reported amount or just narrowly off the reported figure. A great sign is the 2018 result, where adjusted profit comes in below the reported figure, owing to the honesty of the companies accounting practices (I talk a little more on this in the summary). Return on capital employed is also very solid, with a five year average of 43%, showing that Focusrite is more than capable of deploying its capital for an efficient return.
Looking at the balance sheet, Focusrite is prudent in this context too. The recent acquisition of Martin Audio was paid for with a mix of cash and debt from new bank facilities at HSBC and Natwest. At 2020's year-end, the remaining debt balance was £19.9m. However, at the half-year update for the first six months of 2021, Focusrite had paid off all of this debt and managed to close the period with no remaining bank debt.
So, we know Focusrite has delivered good financial results in the past, but what does the future hold for Focusrite in terms of growth? Focusrite’s strategy is to look to grow in three specific areas:
Core customer base; current core markets are growing, with the main driver being new people who are interested in making music as creation becomes democratised. There is also a growing demand for experiences and live events.
Increase value to customers; by improving quality, bringing out new products and providing greater support and warranties.
Expanding into new markets; through new verticals, new regions and acquisitions.
The democratisation of production is probably the most significant growth driver for Focusrite. New technologies have enabled a dramatic reduction in cost for production (such as the invention of the laptop, which has replaced much of the technology in an old school recording studio). The invention of apps to synthesise music has also made production more accessible, and Focusrite has spent significant resources translating its business model into one that compliments this new digital mode of production. The age of streaming services has also helped Focusrite, with the creation of new content categories, such as podcasts, driving growth in simple production equipment such as microphones. With an increasingly global customer base, and as the world becomes more technologically advanced, I would only expect this type of content category expansion to continue creating opportunities for Focusrite.
There is only one drawback I can see with Focusrite’s business model and thus its scope for growth over the coming years. The best hardware businesses the world over have realised that service revenues are the key to profitability. Whether the hardware is supported by software packages that need to be renewed or, in a more literal sense, that the hardware needs to be serviced (for instance, the business model of an elevator or from aero-engine companies), this service revenue can provide a much-needed revenue source for companies with large installed bases, especially if demand falters for the core product. It strikes me that audio equipment is likely a one-off, low maintenance purchase and, due to Focusrite’s quality, it likely doesn’t need replacing for many years. If you contrast this with Barco, a Belgian company in the adjacent business of visual equipment (screens, video walls and projections), a significant chunk of its revenues are derived from maintenance contracts to service their installed base of hardware — a key profit driver throughout the business cycle. I suspect Focusrite are aware of this and that the recent developments in software at Ampify and the purchase of Martin Audio (which is more likely to need to service its installed base) are a step in the right direction. However, I do wonder if this aspect is a permanent weakness in Focusrite’s business model.
In terms of valuation, Focusrite trades at 30 times 2021's estimated earnings, which are likely to be beaten. The market has forecasted a moderation in growth in 2022 and 2023, which is likely due to the effect of the lockdown consumption of audio equipment starting to wear off. This has the effect of pushing up Focusrite's forward valuation for 2022 to a P/E of 38. I believe the market is being too cautious on Focusrite, especially with the above expectations update in the recent quarter. However, it is difficult to forecast the extent to which growth will moderate post the pandemic. With the ability for improved revenue contribution from the Martin Audio segment as live events start to take place, I think there is a good chance Focusrite will continue its double-digit revenue growth for the next few years to come. Despite the low need for replacement of Focusrite’s quality products, many companies that cater to ‘one-off’ purchases can exhibit good growth over the long term. Looking at Gear4music’s web store, you are also greeted with an infinite array of products that you can upgrade or that you can add to current production suites, increasing the likelihood Focusrite can keep selling to its existing customer base.
Finally, I think the real value of an investment in Focusrite is its quality offering to investors. Not only in its quality products, but in its transparency, robust accounting policies and prudent acquisitions. Considering the company is listed on the AIM market in London, a market that has been known for its corporate trickery, this robustness delivers significant value to prospective shareholders. A dive into the companies ownership will show that the founder and chairman Philip Dudderige owns 32.8% of the equity, ensuring the company policies are aligned to the long term interests of shareholders.
At the current price of 1,100p per share, I think the market is fairly valuing the prospects for Focusrite. I currently do not own shares in the company, but I will personally be looking to see how growth moderates post 2021 to evaluate whether to open a position.