Interactive Investor

Stockwatch: This share could 'easily double'

21st October 2016 10:31

Edmond Jackson from interactive investor

Should you heed the exorbitant ratings on online retail stocks as reason to prioritise this sub-sector, or regard them as a warning the market is over-cooked?

In one sense it recalls the 1999-2000 tech boom when anything "dotcom" soared, while shares in traditional industries languished, despite attractive dividend yields.

There's a similar brushing aside of conventional valuation measures like the price/earnings (PE) multiple to focus on revenue or earnings before interest, tax, depreciation and amortisation (EBITDA), which makes it easier to promote stocks that have leapt.

Admittedly, there is so much cash side-lined to help central banks backstop any market correction that this is a momentum trading game with ongoing pay-offs - assuming no genuine debacle.

Amazon's stockmarket success has coalesced sentiment; online retail can command very high earnings multiples while the businesses pursue revenue at the expense of profit. Sometimes they will hike margins, but let's not worry about that just yet. If high street retail is suffering then it's vindication for these stock traders: average up!

The sense is that maybe up to 1.5 times forward sales is fair value, hence huge capital gainsSuch thinking is reinforced as there are few genuine growth stocks in a sluggish global economy. The Amazon experience transferred to the UK in the form of ASOS, London's original "exorbitant" online retail stock, on a PE somewhere between 50 and 100 times.

A few short-sellers tried to call it down; but while ASOS has been volatile and 2014 did see a plunge, its stock has recovered such that Company REFS cites an annual average historic PE of over 70 during the last two years.

Other stocks have followed similarly e.g. Boohoo.com, now on a forward PE of 60, and AO World, capitalised at 1.3 times sales albeit loss-making. The sense is that maybe up to 1.5 times forward sales is fair value, hence mouth-watering capital gains.

Can it double?

The latest example in the sugar-rush is Gear4music, which listed on AIM in June 2015, before drifting from 146p to 100p by end of last June. It's now more than tripled to 370p amid fast revenue growth and confirmation from management that it can beat forecasts.

Memories in the stockmarket are generally short and online retail is in vogueWith just 20.2 million shares issued the capitalisation is £75 million, but if European sales continue to grow fast (now helped by lower sterling) then £100 million group revenue beckons. A price of 650p would reflect 1.3 times sales, a conservative metric versus Boohoo.com's 6.7 times historic sales.

To anyone who experienced the 2000 bubble/debacle and has a few grey hairs, it's Alice in Wonderland, but memories in the stockmarket are generally short and online retail is in vogue. Indeed, the valuations will drive more private equity investment and flotations, a genuine reason why this sub-sector is worth watching.

Gaining momentum

Gear4music has been established for 13 years, supplying popular instruments and equipment from its website and new showroom in York. In principle, online suppliers can undercut shops, the prize target consumer being younger people buying guitars, synthesisers and instruments for schools.

Own-brand instruments are purchased in US dollars so are costlier after sterling's fallGear4music markets its own-brand instruments, which could transform sales and margins if it builds a good reputation for value, although it's not clear what extent they will be affected by exchange rates - own-brand instruments are purchased in US dollars so are costlier after sterling's fall.

A quarter of British homes supposedly house a musical instrument; whether these are genuinely played or have accumulated down the generations. Mind that anyone getting seriously into an instrument may prefer to size it up with the help of a retailer, especially when making a pricey commitment.

I still recall spending much of a day at Howarth's in London's West End over a tenor saxophone, nearly 30 years ago. With a vaster sax range than Gear4music, Howarth's currently offer my Yamaha YTS 28 entry-level instrument new for £1,270 including VAT, while Gear4Music does the usual trick of asserting a "discount" from the RRP of £1,444 but quotes exactly the same price of £1,270.

Given the extent of help Howarth's gave me and the subsequent ongoing advice, it's a no-brainer that any keen musician should prefer a relationship with a traditional supplier. Yet nearly 20,000 Gear4Music customers have raved about good service on TrustPilot - typically involving Fender acoustic guitars arriving by courier - so plenty are pleased.

Mind, though, if profits take off there are no barriers to entry except rivals needing capital to get established.

The board is now guiding to full-year results to end-February 2017 being ahead of expectationsLatest interim results affirm a September trading update indicating UK sales growth of 44% to £13.8 million in the six months to end-August and growth in Europe via its website of 169% to £7.9 .

Its first European distribution centre will open in Sweden next month and a second should be established by the 28 February 2017 year-end.

"These first two distribution hubs will not only transform our European customer proposition, but also increase the overall capacity of our business to deliver over £100 million revenues," said the group.

The board is now guiding to the full-year results to end-February 2017 being ahead of expectations. With numbers to the Company REFS data feed presently embargoed, I've input the table (below) with those from Edison Investment Research but they need upgrading.

As a result the PE has been pulled down to about 30 times, which is outstandingly cheap in this sub-sector context. Not to worry about expansion risks such as IT development or Britain's EU negotiations encountering tariffs - perish the thought!

Festive carols

Momentum traders can take heart that these good vibes from Gear4music come ahead of the significant Christmas period. The company could well deliver a bumper update in early 2017 as awareness rises.

Its interim cash flow statement shows gross cash flow swinging from a £0.4 million loss to £1.4 million positive, although this is still nearly £1 million in the red at the net operational level when adjusting for inventories' change. Development costs of £0.6 million were capitalised.

There's no margin of safety, but the story is strong and the near-term growth profile attractiveThe cash flow profile needs to improve, although interims reflect the period up to an annual low-point in August. End-August cash was £1.8 million against scant debt, so the balance sheet supports growth without earnings dilution.

There's no margin of safety, but the story is strong and the near-term growth profile attractive, in the context of online retailers sustaining high ratings. This will help speculators entertain positive scenarios and talk Gear4music up - so, if management executes well, it can easily double in two years.

Early investors lock in gains

But if the music stops, fancier valuations could easily turn into pumpkins and mice. The likes of Key Capital Partners invest at the earlier stage at the private company lifecycle, and they sold 2 million shares at 300p on results day and then disposed of all their remaining equity on 19 October.

Gear4music's chief executive has sold 400,000 shares, but retains 7,886,593 and a non-executive director sold 75,000 shares retaining 249,520.

Plenty of examples exist of private equity and founder directors selling down once a listed company is established, with the stock still going on to prosper - ARM Holdings directors did so substantially in 1999.

Given a modest 20 million shares issued here, major holders know the only time to sell in size is amid keen demand. With trading lots limited to a few thousand pounds, smaller buyers will regard it as a high risk/reward punt.

For more information see the website.

Gear4music - financial summaryBroker estimates
year ended 28 Feb201320142015201620172018
Turnover (£ million)12.317.724.235.5
IFRS3 pre-tax profit (£m)-0.6-0.4-0.80.0
Normalised pre-tax profit (£m)-0.2-0.2-0.60.61.62.7
Operating margin (%)1.61.1-2.31.9
Return on capital employed (%)5.95.7-19.69.2
IFRS3 earnings/share (p)-2.8-1.5-3.4-0.2
Normalised earnings/share (p)-0.8-0.6-2.63.16.510.8
Price/earnings multiple (x)119.356.934.3
Cash flow/share (p)-5.92.66.8-2.6
Capex/share (p)8.3
Net tangible assets per share (p)30.4
Source: Company REFS     

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