Stockwatch: When this AIM star is a 'buy'

Do prelims from Gear4music, the AIM-listed online retailer of musical instruments and equipment, imply further upside, or is exuberance manifest in online retailing stocks the classic sign of a market top?

Financial history shows bull markets typically maturing with sectors in vogue reaching exotic valuations: e.g. railroad stocks in 19th century Wall Street, and radio in the early 20th century. Both proved durable industries, but the sentiment bubble burst and their stocks went ex-growth.

Online retailing does, however, present a long-term business opportunity to transform various product sales and roll out internationally, with far less risk than the old fear of "small companies trying to take on the world".

AIM-listed ASOS has for over 15 years sustained high price/earnings (PE) ratios, and the progressive attrition of high-street retailers' sales to online operators shows the stockmarket anticipating a revolution was justified.

The market is a weighing machine, all equity values get reconciled with underlying earning power, so online retailers will eventually lose their growth halo. Meanwhile, the business models are relatively early-stage, so it is right to be attuned.

Attractive if international sales can be leveraged

At about 680p currently, I estimate Gear4music trades on a forward PE possibly in the order of 40 to 45 times, having achieved a maiden £2.6 million pre-tax profit in the latest year to end-February. Projections are tricky at this most dynamic stage in long-term development.

There is no dividend yield as profits are being re-invested, although the board says it will keep this under review, which is encouraging as proof of cash flow. Revenues are the current focus for perception.

I drew attention last October at 370p with an approximate near-term target of 650p, assuming 1.3 times projected revenues versus Boohoo on 6.7 times historic sales.

Gear4music sports 58% annual revenue growth to £56.2 million (versus expectations of about £49 million) by undercutting shops on price and marketing own-brand instruments.

While the UK market looks robust with a quarter of homes owning at least one musical instrument, the company's international revenue growth is 124% to £21.3 million, with new distribution centres in Sweden and Germany. Management says it has enabled delivery to another 150 countries beyond Europe with the global market constituting some £13 billion equivalent.

As yet the number of active customers is up 50% to 340,000 and the range of products marketed has risen 37% to 37,000 since the group floated two years ago. Own-brand instrument sales are up 58% to £14.5 million.

The chief uncertainty in this promising story is whether the return of inflation compromises UK sales growth: consumer discretionary spending has been strong, but is expected to flatten or fall given wage rises generally aren't enough to bridge the gap with a higher cost of living.

Alternatively, this could encourage demand for keener-priced instruments, for example from parents who are committed to giving their children a musical education. Be aware, 62% of group revenue has represented UK sales, hence sentiment is exposed to signs the consumer environment may be worsening.

Improving margins as business gains mass

The table shows they are historically more reflective of a construction group. There has been an improvement from 1.9% to 4.7% at the operating level, and the gross margin is up from 25.9% to 27%. It somewhat quashes a worry that buying equipment in US dollars would compromise margins, or at least the company's progress is absorbing this.

Earnings per share (EPS) of 11.5p beat previous expectations of 6.5p. Indeed, it's tipped to make 10.8p for the year to end-February 2018; but mind how the original forecast may be closer to true earnings - annual investment spend on the IT platform was £1.5 million and, because this sum represented acquiring the out-sourced software development team which made the group's bespoke platform, it has been capitalised as a cost (see note 9, intangible assets) thereby enhancing profits.

While IT spend appears a genuine cost compared with goods for sale, ambiguity exists in terms of enhancing the company's asset base and earnings potential. Not surprisingly, the £5.3 million purchase of a 50,000 sq ft new head office in York is being funded with debt, albeit an element of lease-back with the vendor to cover interest costs in the first year. But, with end-February cash down modestly from £3.5 million to £3 million, shareholders need not fear dilution in pursuit of growth.

The 70% rise in inventories to £11.7 million is actually quite consistent as a percentage of revenue, around 20%; similarly it's easy to see a 42% rise in trade payables and wonder if this enhances profit, but the rise reflects growth in the business.

Mind how "additional investment of about £1 million will mean profitability will be more second-half weighted for the current financial year", although it's not as if revenues are being delayed (the more typical risk when companies caution of being "second-half weighted").

Technical situation

After testing 700p in February, the stock saw a first serious bout of profit-taking down to about 500p, but has since shown a volatile uptrend with the latest prelims affirming confidence.

Fundamentals and the chart imply "buy the dips" as a medium-term approach, given this business offers plenty of long-term upside if international opportunities are seized, versus a capitalisation currently around £137 million.

Be aware, any adverse change to the story on revenue growth will mean a sharp drop. Time will tell how Gear4music shapes up against European competition and I repeat an underlying caution on all UK companies selling into the EU whether by exports, websites or locally-owned subsidiaries: all will be examined by the EU's Brexit negotiators, and investors are paying scant attention to this risk.

At least Gear4music is setting its international objectives widely so the Brexit years are not critical to its long-term development success; and if they did cause a setback it could be a prime buying opportunity. A modest 20.2 million shares issued will help EPS upside, hence a lower rating, as profits build.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.