Stockwatch: Time to lock in gains from this AIM high-flyer

Is the story weakening at online retailer Gear4music? As a stock-picking moral now consumer discretionary spending appears to be slowing, should you beware those not quantifying the trend?

The AIM-listed shares in the seller of musical instruments and equipment have dropped 8.5% in response to a 28 July AGM statement citing "very strong" growth this time last year apparently moderating to "strong"; and, unlike all previous trading statements, the recent growth rate hasn't been quantified.

Experienced interpreters of company statements will recognise "strong" as a sop, a respectable catch-all; whereas genuine strength is provided by figures.

Moreover, the context is directors reducing their holdings in a 690p placing 10 weeks ago, with the stock having soared from 100p about a year ago to 823p just a few weeks ago.

Over half (58%) of placed stock came from the directors, while a 42% new element raised £4.2 million (before expenses) for the company.

Stock soars past medium-term target

I advanced a case for Gear4music initially last October at 370p with a 650p price target. I revisited again at the year-end as a growth play for 2017 at 450p; and was positive about the scope for international roll-out when I updated at 610p in May.

Alighting on this stock, though, right from the start I've had a sense of déjà vu regarding the sentiment upswing that's reminiscent of the 1999/2000 tech-stock boom.

At 730p presently, Gear4music is capitalised at £153 million, trades on 2.7 revenues in the last financial year to end-February, and a forward price/earnings (PE) multiple of 75 times, reducing to 56 times (see table).

The yawning divide between revenue/earnings ratings follows from a modest operating margin albeit which has improved from sub 2% to test 5%.

That's not too much of a worry unless price cutting results in the UK market, if discretionary spending falls further, and/or European competition increases. But it does help explain why sentiment is edgy towards a (hint of) change in the story.

Update breaks with past practice, of quantifying

UK and international revenue growth "continued to be strong relative to a very strong H1 financial year 2017, and our new European distribution centres are materially improving our customer proposition in Northern Europe".

Gear4music has financial and PR advisers who would have been fully aware of likely sensitivity to omitting figures, but they still opted to omit them; although Edison, which produces investment research sponsored by the company, targets 35% revenue growth for H1 2018 versus 73% achieved in H1 2017 and 58% for the year to end-February 2017 as a whole.

As I've made plain before, musical instruments/equipment are discretionary spending items, thus with the UK representing 62% of group revenue they're at risk as inflation ticks higher than wage growth.

Not surprisingly, management dangles a carrot and says it anticipates "further momentum in European sales during the second half of the financial year" than include the UK.

While the business has historically shown a second-half bias (H1 FY 2017 being quite exceptional) reading between the update lines begs a mild caution on the UK.

Also considering the macro context of consumer credit once again near record levels like in 2007; for how long can this last, and is discretionary spending now exposed?

What's different this time, versus 1999/2000?

While current exuberance towards online stocks has parallels with 1999/2000, the businesses are far more substantive. Marketing reach is vaster after the progression from "dial-up" internet access to super-fast broadband; and smartphones have proliferated. Thus, retail sectors are undergoing a major shift to online sales.

Online specialists can often undercut bricks-and-mortar retailers with lower fixed costs, and web skills extend their showcase - particularly abroad. If they can drive international sales, operational gearing kicks in once infrastructural investment has been made: Gear4music covers 19 countries, with distribution capacity in Germany and Sweden.

Acquiring a software development team enables swifter response to trends, and scaling of systems. While I've questioned how Brexit trading arrangements may affect this free-wheeling approach, it's possible - just highly speculative as to forecasts - that international growth mitigates UK slowdown.

Bear in mind, also, long-term success in this regard could happen despite some near-term caution as to what's appropriate for the stock's rating, which has expanded very fast.

For early-stage investors such as the directors, it's entirely sensible to lock in some gains while institutions are keen to assume the risk.

2018 forecasts are undemanding

All this would raise the odds of a formal caution, were it not that Edison's 5 June numbers already project normalised pre-tax profit to ease from £2.6 million to £2.4 million, and earnings per share (EPS) by about 12%, then for a 33% EPS rebound in the year to end-February 2019.

This accords with Gear4music having explained that H1 2018 "will include the costs of embedding our new European distribution centres and setting up our recently acquired head office in York"; although companies are prone to charge such costs to exceptionals.

So, if the finance director has offered Edison any guidance by way of signing off the forecasts, he's been prudently cautious. Again, how they are rated constitutes the chief near-term market risk, while in terms of business risk its long-term profile remains attractive.

See from the table how returns on capital employed have improved sharply: to 29.3% on total capital and 19.2% on equity.

It's yet to prove materially cash-generative, though, versus capital spending needs; hence the share placing for investment, although a relatively modest 20.9 million shares issued will aid profits translation into EPS.

Pressure on the US dollar lately mitigates the cost inflation aspect of buying instruments made abroad, although the sterling/dollar rate remains key.

Market technical dilemma: buyers await more evidence?

Holders had best be steeled that drops are possible on the more volatile AIM market, simply if "fresh money" bides its time now the directors have sold stock and turned somewhat coy as to underlying progress.

Last year there was a 6 September trading update that cited 73% overall revenue growth (44% for the UK, 169% for Europe), although the tone of "second-half weighted" has already been set.

For the short to medium term, plenty depends on UK consumer behaviour, counterbalanced by European potential. So, consider if you are content to ride out volatility in the months ahead, lest the rating continues to ease, or prefer to lock in some gains.