Confessions Of A Baggy: Why I Bought Audinate (ASX: AD8) On Its H1 FY 2020 Results

Update: more recent coverage of Audinate here.

Today’s diary entry on Audinate (ASX: AD8) is not a full write up of its results. In the coming days, we look forward to publishing Fabregasto’s thoughts on how the company is tracking and his response to today’s results.

However, as many shareholders would have noted, the market had a very cold reception to these first half results, sending the shares down more than 20% at one stage, to below $6.

At a high level, the company disappointed the market with its lacklustre revenue growth which was only 14% on the pcp in Australian dollars to $16.1 million, and a painfully low increase of 7.9% in US dollars. This result was hampered by a 33% drop in revenue from Asia (pre-coronavirus) and the company is rightly concerned that the coronavirus will further reduce revenue in the coming months.

Getting into the details, a lot of the stats we monitor to understand the quality of the business moved in the right direction. First, we have revenue from software up 50% to $3.3 million. That’s still not much of the total but it is higher margin, and it saw overall gross profit increase about 20%, to $12.5 million.

On top of that, operating cashflow was strong, coming in at about $2.9 million or $2.5 million if you adjust it for rent payments which are now classified as a finance outflow. Free cashflow was negative, at an outflow of about $2.5 million, but that includes almost $1 million related to a new office, and encompasses a fairly strong increase in product development. With over $30 million in cash available, even adjusting for some cash held on behalf of the former CEO, the company is well positioned to continue this kind of spending on growth.

To paraphrase the CEO on the conference call:

“Generally speaking Audinate is a technology business which is establishing a platform, Dante technology, inside lots of microphones, amplifiers, and speakers… [This] gives us the ability to drive the transformation of the industry towards software based solutions… We see the chips and adapters as a land grab… the key is to take advantage of that potential upside in the medium term…”

Audinate has over 292 Original Equipment Manufacturers (OEMs) incorporating Dante into 2,371 products, which is 8.1 product per OEM — a consistently increasing figure. As a result, it’s hard to think of any organisation better situated to dominate the increasing field of software based audio visual networking.

At the current share price of about $6.50, Audinate has a market capitalisation of about $450 million. The key question for me is whether the opportunity to dominate the niche of AV over IP is worth $450m. No-one can really be sure of that, at this stage, since we are relatively early in the journey to replace old switching networks with modern fibre optic ones, but the high gross profit margins Audinate is already achieving should give us a hint about its likely profitability as a more mature company.

Once the company does flip into serious profitability mode, its high (and improving) gross margins should turn relatively modest revenue growth into relatively impressive profit growth. Even if it grows revenue at around 12% per year, it could have over $55 million in revenue and EBIT margins of around 25%, similar to Cochlear.

While that would still look like an optimistic multiple of earnings, the actual growth rate of those earnings should exceed revenue growth rate as the company continues to shift its revenue mix towards software products. Keeping in mind software should be a higher proportion of total sales, I would expect margins to continue to improve for many years to come,

While there will be many ups and downs along the way, I don’t see what will stop Audinate continuing to grow for a very long time indeed. Ultimately, I think that this is one company which benefits from the passage of time because they way its industry is evolving increasingly makes it more powerful. I could be wrong, but it still looks like a high quality business to me, albeit one that just reported a disappointing half and warned about the potential impact of the novel coronavirus on its supply chain.

As always, this is not advice and I’ll be looking forward to what Fabregasto has to say when he does a deeper dive into these results.

Edit March 3: I subsequently sold down some Audinate shares after the share price rebounded, though I still hold.