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Low(ish) cost provider with wide gross margins, high return on capital and high growth
As usual the below is NOT an investment advice.
Focusrite is a developer and manufacturer of music software and hardware. They sell their product across the world.
The product range is wide so I won’t go into much detail here (other people have done a better job here - see link at the bottom of the post).
Attractive gross margins
What I want is to focus on is the business high level. I think gross margins are a pretty desirable thing. To me they suggest there is not much pressure on the company to reduce prices. Or they could be a sign of quality. Or it could be that the amounts are inconsequential so people don’t mind paying. Or the business is in a good niche/semi-monopoly.
One reason (I can think of) why high gross margins might be a bad thing would be if it’s a real monopoly it is actively exploiting and it’s eventually going to be either disrupted by competition or eroded by regulation. Other than that under-investment might be a problem but that doesn’t seem to be a problem here…
From the 2022 results - Focusrite has pretty high gross margins:
Attractive return on capital
This is also coupled with very high returns on net tangible capital (Greenblatt’s favourite measure). Net Tangible Capital is Net Working Capital + PPE, meaning Current Assets - Current Liabilities + Plant Property and Equipment. Greenblatt’s argument for using this measure is that goodwill/intangibles is acquired in the past and there is not much you can do about it.
So let’s say that return on capital is defined as EBIT / Net Tangible Capital. My take on EBIT in this case is that it’d normally and conservatively be somewhere around £20 - £25m.
In our case Net Tangible Capital is going to be somewhere around £40m (£35m in 2021 and £46 in 2022). Hence EBIT / NTC would be ~ 60% which is exceptionally high.
Looking at some of the latest acquisitions:
Sonnox Ltd (designer of audio processing software plugins) - bought for £9.1m - but the company has £2.1m in cash so in effect £7m. It makes £0.9m PBT so P/E of say 8 - not awful. The existing team remains with the company which is a good sign.
Linea Research Holdings Ltd (they design, develop, manufacture and market innovative professional audio equipment - think amplifiers etc). They paid £12.6m but the company has £1m in cash so £11.6m. They will pay additional £0.5m later. All told some £12m. The contribution to PBT of Linnea would be some £1.4m so again P/E of 8-9. The management is also staying. There may be some actual synergies here. Linnea is a supplied to Martin Audio - another of the Focusrite’s earlier acquisitions.
Back of the envelope valuation
It’s obviously impossible to put any precise number on it. So let’s be conservative.
In the above I’m assuming that they’ll be able to grow their operating cash flow (OCF) by 15% for another five years (they managed that for the last decade) and then the growth will drop to 5%. I’m assuming Capex of about 15% of OCF. I’m also assuming that the terminal value of the business is only the current market cap discounted to today’s money. It’s likely to be much higher.
With these assumptions the business is not super cheap but I think it’s attractive because of the high growth, decent acquisitions, high return on capital, good products and good management.
Little debt - they have about £13m in net debt but it was used for recent acquisition and for higher stock levels.
Long-ish runway and some tail-wind with more content being produced all the time.
Cons / Risks
China - they have high dependence on it - so any disruption will be very bad. However, they don’t have their own manufacturing there so might be able to shift to some other suppliers. As per annual report they are aware of it and working on it but clearly this would be very hard.
They identify most of their acquisitions via the founder’s network at the moment. What happens when he fully steps down?
Management paying themselves high-ish base salaries (£300k+) - but hey who cares if they do a good job? Also they have performance targets to meet - in 2022 they got 0 cash bonus because they worked against high comparables from the year before.
Management selling (tax reasons) and not buying at the moment. Other than the founder (who owns 30%+ the management team don’t have much of a stake). They have some performance option grants but again not huge quantities.
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