Gear4music’s apparently unstoppable growth received a sudden jolt on Friday 4th as the company’s share price dropped by over 40 per cent following a reduced profits forecast.
In a trading update for the four months from 1 September 2018 to 31 December 2018, Gear4 claimed it had recorded overall sales growth of 41%: ‘driven by significant customer demand, delivering strong growth both in the UK as well as Europe and the Rest of the World’. However, alarm bells were sounded when the company’s statement revealed underlying earnings (EBITDA) for 2019 were now expected to be ‘slightly below’ 2018 levels despite the impressive growth record. As a result, analysts slashed their target price to 500p from 1,000p while cutting pre-tax profit forecasts for 2019 by 69% to £0.8million.
Gear4 blames the poor figures primarily on congestion problems at its York warehouse but they also raise questions that will be familiar to most UK MI retailers about the 2018 squeeze on margins, ironically not helped by Gear4’s drive to increase growth.
Gear4 says: ‘Further sales growth in excess of expectations was constrained by our York distribution centre, which reached maximum capacity during the peak trading period between Black Friday and Christmas. Whilst there was an improvement in margins in the Period compared to H1 FY19, these capacity constraints prevented further sales growth compensating for the lower gross margins and, as a result, the Board now expects FY19 EBITDA to be slightly below FY18 levels’.
Analysts cut their target price to 500p from 1,000p while cutting pre-tax profit forecasts for 2019 by 69%.
Gear4’s Chief Executive Officer, Andrew Wass, said: ‘We are pleased to have delivered strong sales growth of 41% over the last four months, building on the 36% sales growth achieved in the first half of the year. In addition, our strategic initiative to expand in to Europe has shown further good momentum, with sales growth of 47% in the Period, an increase from 39% at the half year.
‘We have seen high levels of consumer demand alongside positive margin momentum, but sales growth has been constrained by our UK logistics operation reaching maximum capacity during our peak trading period between Black Friday and Christmas. This capacity limitation means that sales growth during the Period has not fully compensated for the lower product margins as we hoped. We are already working on plans to further expand our UK distribution capacity ahead of our peak trading period next year and we are confident that this can be achieved by Autumn 2019.
‘During the Period we successfully relocated our Swedish operation into a larger facility, and now have significant capacity headroom at both European locations, supporting the strong consumer demand we are seeing. We expect this high consumer demand and strong sales momentum to continue over the remaining three months of the financial period and into the next financial year.
‘Our focus has been on gaining market share in what has been a highly competitive environment, and in support of this target and following a period of planned investment, margins during the Period began to return towards historical levels. We are confident of further improvements as we progress through FY20.’
However, Peel Hunt (appointed joint Corporate Broker and joint Financial Adviser to Gear4music (Holdings) plc in May, 2018) was quoted by the website Proactiveinvestors.co.uk saying: The outcome in H2 in terms of gross margin decline (160 bps) won’t be as bad as in H1 (230 bps), but the absolute gross margin is now 350 bps lower than when the business was half the size in sales terms… There’s no doubt that management is pursuing the right policy in winning as much short-term market share as it can and not giving up its competitive position. The problem is that the irrational pricing behaviour is persisting longer than expected.
‘It is difficult to see the shares coping terribly well with the downgrades, even if the policy of prioritising winning market share is well known, and it may take a couple of solid earnings prints to reassure investors that the margin picture has truly stabilised.’