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Audinate Group Ltd (ASX:AD8) FY 2019 Annual Results Analysis

2019-08-25T04:05:44+00:00

It has been a busy several months since we last checked in on Australian digital audio networking technology company Audinate (ASX:AD8) following the release of its 1H19 results in February (coverage here). Since then the share price nearly doubled (reaching an all-time high of $8.66 in mid-June) before trading back to the low-$6 mark briefly last month before recovering back above $7. The share price fell 6% today in response to the company’s FY19 results and is now 20% below its all-time high – more on that later, but first a re-cap of developments since our last report.

Capital raising and key growth initiatives

The $8.66 all-time high was achieved after the company announced in early June a $24M capital raising (comprising a $20M institutional placement and, welcomingly, a $4M Share Purchase Plan) – at $7.00 per share. The capital raise was launched to accelerate Audinate’s growth ambitions, specifically:

Expansion into new overseas markets;
Expansion of the Dante product range and investment to shorten software implementation periods;
Development of the next generation Dante IoT platform; and
Financial firepower to provide capacity for potential strategic acquisitions

This all makes sense strategically – as we’ve mentioned previously, Audinate is executing a land grab and positioning itself to be the de facto industry standard in the emerging audio and video digital networking industry. The company is a long way ahead of competitors. Per the oft-updated protocol-enabled-SKUs chart from the FY19 results presentation below, almost 6x as many products in the marketplace are based on the company’s Dante protocol, than its nearest competitor.

However, competitor metrics have not been updated since June 2018 and therefore may not be perfectly accurate. According to Audinate, Cobranet had 343 products at June 2018; Audinate’s 2,134 is therefore 6.2x as many but doesn’t give Cobranet the benefit of any additional products released into the marketplace in the last 12 months.

The mention in capital raising materials of the next generation Internet of Things (“IoT”) Dante platform I found interesting – and this is the first time I’ve seen the company reference IoT before in its materials – but this makes complete sense to me. As Ethical Equity readers will know, IoT is the extension of internet connectivity into physical objects to enable the networked connection of devices and sensors for the purposes of monitoring and control. IoT is a constantly evolving area which is benefiting from developments in machine learning and real-time data analytics, and further advanced through progress made in miniaturising sensors and processors. Readers will no doubt recognise IoT in the consumer context of the “smart home” which in the prototypical example involves the use of smart devices (smartphones, smart speakers such as Amazon’s Alexa etc) to control appliances and devices within the home.

The professional AV market feels like a logical area to utilise IoT connectivity – and clearly management are already thinking about what the Dante Domain Manager software will look like in its next iteration. Neither the capital raising materials nor the FY19 results presentation contained any further information on this IoT initiative – so I look forward to more detail in time.

In relation to potential M&A activity, I might have missed it previously, but in the capital raising presentation was first time I saw this explicitly called out by management. Given the company’s heavy focus on developing its Dante platform and technology, I personally feel that any strategic acquisitions are more likely to be concentrated on bringing additional capability and skills into the organisation – as opposed to bolting on companies with similar products which presumably won’t be immediately compatible with the Dante protocol. The potential for M&A activity was not reiterated in the FY19 results presentation – so we will have to see on this front.

The Dante ecosystem

As to the expansion of the Dante product range, in mid-July the company announced the commercial release of the Dante AV (combined audio & video) product – which was launched at a European trade show earlier in the year and for which the company has high hopes. The company has estimated the Video segment of the professional AV market to be similar in size to the Audio segment (~$400M currently) – so the launch of this product would seem to double the company’s Total Addressable Market.

The release of Dante AV follows the release of 2 software products in June (which enable the interoperability of Dante with Linux software and also PC and Mac applications), and the release of a suite of Dante AVIO adaptors (which enable legacy analogue equipment to be interoperable with the Dante system). Capital raising proceeds have been explicitly earmarked for the development of further AVIO adaptors and Dante AV product extensions in the short term.

This acceleration of product development in my view only serves to strengthen the Dante ecosystem. If the company’s protocol does become the industry standard, in future all OEMs will need to have Dante embedded in their products. The chart below rolls forward the company’s key metrics to 30 June 2019 and in my opinion is *the* key set of metrics to understand for Audinate and its long term growth potential.

This chart illustrates the growing Network Effects in play here as the Dante ecosystem expands with each new OEM customer added and each Dante-enabled product released into the consumer market.

Note from the above that in the 12 months to June 2019:

Licensed OEMs increased by 8% to 459 (CAGR since FY14: 25%. This includes pre-eminent global AV manufacturers such as Yamaha (a ~10% shareholder in the company), Sony, Bose, Roland and Bosch; and
The number of OEMs selling Dante-enabled products increased by 22% to 270 (CAGR since June 2014: 39%).

In my view, the chart above directionally points to the company’s future growth runway. The blue line represents all OEM customers who have signed up to license Audinate’s technology, while the orange line represents those OEMs who have actually released Dante-enabled products into the market. The delta between the blue line and the orange line therefore represents licensed OEMs which are still in development phase (which I understand to be 12-24 months) and yet to launch their first Dante-enabled product. Critically, this delta suggests a significant future pipeline of Dante-enabled products which will be generating meaningful revenue for Audinate in the medium term – as only ~59% of licensed OEM customers as of June 2019 have yet released products utilising Audinate’s technology.

Most striking of all, the total number of OEM Dante-enabled products for sale (the green line) increased by 30% to 2,134 (CAGR since June 2014: 57%). This suggests an average of 7.90 Dante-enabled SKUs in the marketplace per OEM (an increase from 7.68 at December 2018 and 7.41 at June 2018). That means that Audinate continues to increase its penetration within its OEM customers’ product portfolios. I continue to believe that this represents a small fraction of the OEMs’ product range, and that further long term growth will be possible as existing OEM customers embed Dante in more of their products.

We should think of this chart like a funnel. One would expect that the majority of newly licensed OEM customers (blue line) will in time become OEMs selling Dante-enabled products in the global market (orange line). And over time if Dante becomes the de facto standard, then the average number of Dante products per OEM is likely to increase, and therefore the total number of Dante-enabled products available will also increase (green line). **In my opinion**, an increase in the slope of the blue and orange lines should in time result in an even steeper slope in the green line (and accelerating revenue for Audinate).

Management have previously estimated that there are more than 2,000 professional AV OEMs in Audinate’s target ‘Sound Reinforcement’ segment. As such, the 459 licensed OEMs at June 2019 represents customer penetration of only ~23% - suggesting there is still substantial potential upside from contracting new OEM customers and increasing the blue line above.

The company has also previously quoted research from Frost & Sullivan that the digital audio networking market would grow from ~$360M in 2016 to ~$455M by 2021. At that pace of growth, market size is probably currently ~$400M. Management has previously estimated that digital penetration of this market is still only 7-8%. If this is accurate, Audinate’s FY19 revenue of ~$28M (which should be entirely audio products given video-enabled products were only made commercially available in mid-July) would represent a market share of close to 90%.

FY19 results and illustrative FY20E projections

On Friday, the company released its FY19 results – which are summarised below.

The headline numbers are impressive: 44% annual revenue growth and improving EBITDA margins, demonstrating the company’s operating leverage. Gross margin has remained stable at 74-75% over the last 3 years which is a good sign, and the company will continue to invest in R&D to grow the top line and further entrench its already strong market position (signalling on the conference call that the R&D and engineering team will be doubled over the next 2 years).

To understand why the market may have been slightly underwhelmed by the result, however, we need to dig into half-on-half performance. The table below shows historical 1H vs 2H performance for FY17 to FY19 and my attempt at projecting both halves of FY20E based on management’s guidance on revenue and seasonality.

Management provided FY20 guidance of 26-31% revenue growth and a reversion to historical 1H/2H sales splits (approximately 45%/55% in FY17 and FY18). Interestingly, management commentary was that economic conditions (including as a result of the tariff war) were creating potential uncertainty heading into FY20 and that 1H19 had benefited from the pulling forward of some customer orders from 2H19 (i.e. in advance of tariffs taking effect). We can see this in the fact that 1H19 ended up comprising 50% of full-year FY19 revenue – such that 2H19 demonstrated minimal growth on 1H19. However, such an explanation is difficult to verify, and it is possible that the second half was a bit weak. We note they did not mention this pull-forward when reporting the first half results.

My FY20E projections in the table above are based on management’s FY20 guidance above, plus some assumptions of my own, namely:

75% assumed gross margins (being the weighted average over FY17 to FY19);
35% increase in employee costs over FY20 as management expands its R&D efforts (staged 30% YoY in 1H20E, 40% YoY for 2H20E, assuming it will take time to ramp this investment);
20% increase in marketing costs to accompany the launch of the Dante AV (combined audio & video) product, and newly released software products; and
Growth in miscellaneous opex of 8% in 1H20E vs. 2H19 and 7% in 2H20E vs 1H20E

These assumptions result in a forecast skewed towards 2H20E from both a revenue and EBITDA perspective (in line with management guidance) and slower growth of ~16% for 1H20E vs both 1H19A and 2H19A. Given the recent launch of Dante AV and the software products, I’m not surprised that revenue might be skewed towards the second half as there will likely be a lag before (A) these new products demonstrate real traction, and then (B) start receiving repeat orders from OEM customers.

This slower half-on-half growth from 1H19A to 2H19A (flat) – and then implied growth from 2H19A to 1H20E (16% is nothing to sneeze at but below historical levels) – is likely what drove the 6% share price decline today, and it wouldn’t surprise me to see a bit of further weakness over the short term as the market fixates on 1H20E numbers. But note the implied 2H20E growth – 41% at the top line based on guidance – above historical trend.

These assumptions result in a 36% increase in FY20E EBITDA to $3.8M – but clearly the key moving parts here are the actual revenue levels achieved (noting that management have historically skewed towards the conservative end of the spectrum in forecasting revenue) and the timing of the acceleration in investment in R&D (which of course is a short term hit to earnings in order to drive revenue over the medium to longer term – especially in the current Land Grab phase). The assumed FY20E increased employee costs may prove to be too aggressive – we won’t know until 1H20E results in February (given Audinate is no longer required to lodge quarterly cashflow reports).

Closing thoughts

I continue to believe that Audinate remains an attractive longer term investment opportunity. The key operational metrics suggest the business is now scaling nicely and demonstrating Network Effects (our favourite Economic Moat). There continues to be a significant growth opportunity in the migration of the audio networking industry from audio to digital (below 10% penetration currently), and approximately 77% of global OEM players haven’t yet started licensing the Dante platform and products. The company generates very high gross profit margins from its IP portfolio, and is focused on further expanding its product portfolio and innovative capabilities.

Given the Audinate share price is up 40% over the last 6 months alone, it wouldn’t surprise me if the stock took a breather and either tracked sideways for the next several months or retraced further in the current Risk Off environment. I would think very hard about adding to my position if the stock price returned back to low-$6 levels – reflecting my view on the long term growth trajectory for the company.

At a current market cap of ~$450M the company is clearly not a Value stock and relatively expensive on traditional metrics – particularly as earnings are sacrificed in the short term as management instead invest in R&D and growing longer term revenue. As we flagged in our previous note, the focus now is (rightly, in my view) on investing to build a dominant global leader – and so in the absence of meaningful profits over the near term we continue to suggest Audinate is a stock for readers with a higher appetite for risk.

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Disclosure: I (the author) owns shares in Audinate. I participated in the Share Purchase Plan and then bought more shares on market during the share price drop in July, and the company is one of my largest positions. I continue to view the company as a long-term portfolio cornerstone (Tier 1 High Conviction for readers who made it through the Gent Manifesto omnibus.) I may buy more shares in the future – but, as always, not for at least 2 days after the publication of this article.

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This article does not take into account your individual circumstances and contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

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Audinate (ASX:AD8) Q3 2019 Quarterly Cashflow Report

2019-04-21T04:02:13+00:00

Just prior to Easter, audio networking protocol (Dante) owner Audinate (ASX:AD8) released its quarterly cashflow report. Receipts from customers were down on the prior quarters, at about $6.2 million, but up 40% on the prior corresponding period. As you can see in the chart below, the third quarter was the weakest quarter last year, so it seems likely that the result was impacted by some seasonality.

The company produced $1.6 million of positive operating cashflow but only about $300,000 if you exclude the government rebate. This lead to negative free cash flow of just under $1.5 million (in its weakest quarter). While I would prefer to see free cash flow breakeven, this level of outflow is acceptable given that the company still has $12 million cash in the bank.

The number of Dante enabled products available for sale increased by 11% over the quarter, to 1,946. This increase of 197 is a really strong result, given that the prior 4 quarters have averaged about 115 new products per quarter. This was explained by a big leap in the number of Original Equipment Manufacturers (OEMs) shipping a Dante enabled product, up by 13, to 241. Again, this was a strong result compared to prior recent quarters -- the last half saw an increase of only 7 OEMs shipping Dante enabled products, while the half before that saw a gain of just three.

This growth in customer numbers could be seen as a strengthening of Audinate’s network effect, whereby widespread acceptance of its Dante protocol support further acceptance. In selling the shares down, upon release of the quarterly, the market has perhaps overlooked this fact.

Having said that, I believe that the market price for Audinate is now far more reflective of its potentially strong market position, despite the fact the company has yet to exercise its (theoretical) pricing power to drive profitability. So while I would not say the opportunity has passed, I cannot deny that as the share price has risen strongly in recent months, the balance of risk and reward has become less favourable.

Nonetheless, I remain a happy holder of Audinate shares.

Finally, Audinate has now produced four quarters of positive operating cashflow and will therefore no longer be required to submit quarterly cashflow reports.

Claude Walker owns shares in Audinate and will not sell for at least 2 days after the publication of this article.

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This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.

Audinate (ASX:AD8) 2nd Quarter 2019 Results Analysis

2019-01-24T21:42:23+00:00

Audinate Group Ltd (ASX:AD8) today released its quarterly cashflow showing receipts from customers up 6.5% quarter on quarter, over $400,000 in operating cashflow and negative free cashflow of about $550,000. You can see how receipts have improved since listing, in the image below.

At this rate of cash burn Audinate could continue to fund its own growth for many years, due to the $12 million on its balance sheet, so I continue to consider the business funded to breakeven.

While none of this is groundbreaking stuff I believe these results are consistent with my thesis that the company can continue to grow through selling more product and that management are honest and competent in their reporting to shareholders. For example I note that they emphasised that the current quarter benefited from a stronger US dollar relative the the prior corresponding period. I don't think we will see the true value of Audinate's technology for 3-5 years, but as long as they keep selling more Dante chips then it seems quite possible their protocol will become completely dominant and remain that way for a decade or more.

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Disclosure: The Author, Claude Walker, owns shares in Audinate at the time of publication, and will not sell for at least two days after this article. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker

Audinate (ASX:AD8) Sounds Good: FY 2018 Results And Investment Thesis

2018-08-28T00:50:52+00:00

Yesterday, Australian digital audio networking technology company Audinate (ASX:AD8) announced its full year FY18 results. The company joined the ASX on the last day of the FY17 financial year and has enjoyed a strong start to its life as a listed company, with its share price rising from $1.22 at IPO to above $4.30 late last month.

Audinate supplies software and hardware products to global Original Equipment Manufacturers (OEMs) under its Dante brand – which stands for Digital Audio Network Through Ethernet. These OEM partners embed the Dante platform and the associated hardware components (such as chips, cards, modules and adaptors) within their own products which are then sold into the professional Audio Visual (AV) market – products such as microphones, mixers, amplifiers, speakers, receivers and tuners, intercoms, headsets and public address systems. These products end up in recording and broadcast studios, airports and public transport areas, sporting stadiums and racetracks, night clubs, theatres and concert halls, universities, hotels, conference rooms and other public areas. The Dante technology was first developed in 2004, and the company founded in 2006 and spun out of the National ICT Australia (now part of the CSIRO) soon after to commercialise the technology.

Audinate’s blue chip customer base includes prominent OEMs such as Sony, Bosch, Bose, Roland and Yamaha – its largest customer (22% of FY16 revenue) and interestingly also a 10% shareholder. Having been a customer since 2009, Yamaha partnered with Audinate in 2012, making a $5M strategic investment. The following year it released its first Dante-embedded products.

As you can guess from the Dante acronym, Audinate’s software distributes digital audio signals across computer networks using standard IP networking. The company is leading the migration away from old world analogue point-to-point cabling. (The old system allows only one channel per cable and can therefore result in the kind of spaghettified tangled mess of cords that I’ve had in my lounge room for much of the last 20 years). The next generation digital technology permits the transmission of multiple channels via a single cable without any deterioration in signal quality, and typically is lower cost than traditional analogue installations.

The digital audio networking industry is still in its infancy – only ~$360 million in size in 2016 per market research firm Frost & Sullivan. It is projected to grow to ~$455M by 2021 – tiny compared to both Audinate’s target Sound Reinforcement segment (~$9B globally in 2016) and the broader professional AV market (~$150B) as a whole. However, it seems the migration from analogue to digital audio networking is a genuine structural shift and a (sine) wave the company is going to ride.

Audinate appears to be the largest player in the digital audio networking space – as measured by its continually reported benchmark of OEM adoption for its products versus its competitors (more than 5x its nearest rival as at June 2018 (per the oft-repeated chart originally in the prospectus – below)).

Note that the company’s nearest rival is Cobranet – apparently the first mover in the space (in the 1990s) but which appears to have been left behind (1) following a period of underinvestment since its acquisition by Cirrus Logic in 2001; and (2) by Audinate’s accelerating traction with OEMs over the past few years.

Observers with a keen eye may have noted that the number attributed to Cobranet appears to have increased from 220 per the previous version of this chart from February 2018 to 343 below. However, this may just be a definitional issue and doesn’t detract from the conclusion of the widening chasm when compared with Audinate.

Audinate is attempting a land grab. It is aiming to become the de facto industry standard and on the way build our favourite economic moat: the Network Effect. The Dante-enabled ecosystem grows with each new OEM customer and Dante-enabled product released.

The key KPIs communicated by the company to track its progress on this front are summarised in the chart below:

The other metric it would be interesting to know would be the proportion of Dante-enabled products in the market as a proportion of each OEM’s product portfolio – which I haven’t seen pointed to. I would expect the 1,639 figure above (just 7.4 SKUs on average for the 221 OEMs) to be a tiny fraction of their range – suggesting there should be a long runway of future OEM product rollouts as the structural tailwinds strengthen. Also, nearly half of licensed OEMs at June 2018 are still in development phase and yet to launch Dante-enabled products, further supporting the medium-term revenue outlook.

The company estimates there are more than 2,000 professional AV OEMs in its target ‘Sound Reinforcement’ segment – in which case only ~22% have adopted the Dante technology to date. So if Dante does become the industry standard, there is a large potential revenue opportunity available to the company. Management believe digital penetration is only 7% of a ~$400M current market size. This suggests Audinate has ~70% market share based on FY18 revenue.

Audinate generates ~85% of its revenue from hardware components with the remaining ~15% from royalties, license, maintenance and software fees. Once an OEM has embedded the Dante technology into its products, it will need to reorder Dante chips, modules or cards, and pay royalty fees to the company.

Revenue increased by 30% in FY18 from FY17 in A$ terms, or +35% in US$ terms (Audinate generates ~99% of its revenue from outside of Australia). Pleasingly, FY18 revenue beat the prospectus forecast by ~6%, and revenue has grown at a 32% CAGR since FY14.

Audinate generates very high gross profit margins (~75%) – reinforcing the company’s commentary around its strong IP portfolio (25 patents in force in US, UK, Germany and China as of November 2017 with 13 patent applications pending at that time). As the company aims to further strengthen its market position, management is focused less on the bottom line (noting that the core product portfolio is likely already nicely profitable given those gross profit margins), and instead is focused more on investing in R&D to expand the product portfolio, and in marketing to increase OEM adoption.

To that end, operating expenditure (opex) increased by 34% versus FY17 though according to the company this includes $1.2M of public company costs not borne previously. Adjusting for these costs suggests EBITDA increased by $1M in the financial year just ended.

One positive for the future is that R&D investment increased significantly in FY18 – up 73% year-on-year and comprising two-thirds of the increase in total opex from the year prior. The intense R&D focus is aimed at growing Audinate’s addressable market from ~$400M currently to more than $1B.

To that end, the company previewed a video prototype in early June 2018 which it expects to release commercially to OEMs at the end of FY19 with initial revenues commencing in FY20. In the second half of FY18 the company also launched a system management software product (Dante Domain Manager) and a suite of Dante AVIO adaptors (which will enable legacy analogue equipment to be interoperable with the Dante system). On these recently launched products, management reported stronger initial sales than expected. We would expect further significant levels of R&D over FY19 and the medium term as the company aims to grow the market via expanding its product portfolio.

Management has also flagged further investment in the sales and marketing team to accelerate penetration with OEM customers. Actual marketing spending in FY18 of $2.3M was $0.3M higher than the prospectus forecast – although mysteriously FY18 actual employee costs ended up being $1.5M lower than forecast, which may reflect a higher proportion of capitalised R&D than assumed in the prospectus. Given the skew in the workforce towards engineers and development personnel as a proportion of total staff, and the material jump in R&D spend above, it seems unlikely that management skimped on making key hires in the engine room.

Finally, Audinate’s statutory NPAT benefited from a one-off $2.4M tax gain from the company entering into a tax consolidated group (not contemplated by the prospectus); the FY18 tax benefit line also includes the R&D incentive previously recognised in Other Income (which was forecast to be $0.6M).

In terms of the outlook for FY19, the company did not provide much in the way of hard number guidance – as is de rigueur – neither did fellow (much larger) growth stablemates A2 Milk or Aftepay. But there are many reasons for optimism ahead as directionally suggested by the Dante OEM adoption chart above.

The potential market opportunity for Audinate is significant. The company appears to have a dominant market share of a growing market which it is itself building. So far it has demonstrated an attractive combination of high margins derived from its intellectual property, and a strong recent growth trajectory.

This trajectory could accelerate given:

(1) the increasing trend in Dante-enabled products launched by its existing OEM customer base;

(2) the significant amount of licensed OEM customers still in development phase and yet to launch Dante-enabled SKUs;

(3) the increased investment in R&D to expand Audinate’s product portfolio and underpin the launch into new market segments (i.e. video); and

(4) the expansion of the global sales and marketing team to further grow OEM adoption (only ~20% of global OEMs to date).

Just don’t expect fat dividend cheques anytime soon. The next several years for Audinate are about maximising this land grab opportunity – reinvesting gross profits into building the value of the network and sacrificing short term NPAT for the long term benefits of the positive feedback loop. The aim is to become the industry standard in a much larger global market. Fingers crossed.

Disclosure: I (@Fabregasto ) own shares in Audinate – accumulated between January and June 2018 at a VWAP of $3.14 – and I am strongly considering buying more shares at least 2 days after the publication of this article. As Stephen King once said, “I write to find out what I think” – and writing this piece has further increased my enthusiasm for the company and its potential opportunity. This is however by no means a recommendation and readers will need to decide for themselves whether Audinate is a suitable investment for their own portfolio.

A note from Claude:

We are extremely lucky to have this comprehensive coverage from The Gentleman. It is one for those who never saw my original recommendation. Right or wrong, this is honest and thoughtful analysis.

As both of you still reading will probably know, I encouraged many people to buy this stock at $2.90. I bought myself around those prices. I continue to hold and – after 2 days or more – I shall consider adding to my holding. And a special thanks to the person who told me to recommend this at $2.00. That was next level, I should have listened.

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Disclosure: The Gentleman and Claude Walker both own shares in Audinate at the time of publication. This article contains general investment advice only (under AFSL 501223). Authorised by Claude Walker.