Shares in fast-growing music equipment retailer Gear4Music Holdings (LSE: G4M) are down by more than 50% at the time of writing, after the group said profits were expected to fall this year.
It’s a painful blow for shareholders in this internet retailer, but I’m not sure things are as bad as today’s sell-off suggests. Here’s why.
Sales up 41%
The first thing to remember is that sales rose by 41% to £48.7m during the final four months of 2018, compared to the same period in 2017. This is the firm’s busiest period of the year, due to Christmas buying.
Customer numbers rose by 47% to 666,000 last year, suggesting that the firm’s market share is continuing to expand.
Given such strong sales growth, you would expect profits to have risen as well. Unfortunately this wasn’t the case.
Why are profits falling?
Management said that earnings before interest, tax, depreciation and amortisation (EBITDA) are expected to be “slightly below” the level reported last year.
When a firm’s sales are rising but its profits are falling, it usually means that profit margins are getting smaller. That’s part of what is happening here. Gear4Music is cutting prices and spending more on marketing to increase its share of a competitive market.
However, the company said that profit margins were improving during the second half of the year. By securing better prices from suppliers and improving its distribution facilities, it was winning the battle.
Unfortunately the firm’s York distribution centre reached maximum capacity during the busy Christmas period. This seems to have limited sales growth in the final part of 2018, reducing the firm’s profits. Plans are under way to increase capacity for next year, so this should be a one-off problem.
Should you buy, sell or hold?
Gear4Music’s strategy is to compete on price in order to gain market share. This should then give the company more pricing power and higher profit margins in the future.
This strategy looks like a difficult balancing act to me. It could be a great success, but it’s not without risk. Competition is always likely to be intense, as many of the same products can be bought elsewhere.
Overall, I think today’s sell-off could be a buying opportunity. But this situation is too speculative for me.
One retailer I would buy
Pet superstore chain Pets at Home Group (LSE: PETS) has been a disappointing investment. The firm’s share price has fallen by about 50% since its flotation in March 2014, compared to an 8% gain for the FTSE 250 index.
However, a new chief executive took charge in May and I think this stock offers turnaround potential. Debt levels are low and the firm is still generating strong free cash flow to support the dividend, which now yields 6.4%.
Boss Peter Pritchard is restructuring the group’s vet business and optimising the firm’s store network. Profits are expected to be flat over the next 18 months, as these changes take place.
I think the shares look good value, on a cheap-looking forecast price/earnings ratio of 8.8. I’d rate Pets at Home as a turnaround buy.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.