Editing MusicMagpie

 

musicMagpie (MMAG) provides a cost-effective and sustainable alternative to buying and selling consumer technology and physical media. Future growth is supported by the positive tailwinds of increasing awareness of sustainability issues and the growing importance of the circular economy. It has a significant growth opportunity from the rental of technology, which is expected to generate greater revenue and profit over the life of a device than an outright sale. The addition of the new recurring subscription revenue has the potential to accelerate annual revenue growth from mid- to high-single digits and significantly increase profitability (low-teens EBITDA margin from FY26). Its DCF-based valuation is 168p per share.

The business mix, before rental income, is capable of consistent mid-single-digit revenue growth. The transition to monthly subscriptions for consumer technology should accelerate overall medium-term growth rates and profitability but compresses growth in the near-term as it moves from one-off/upfront revenue to monthly revenue recognition with a significantly higher margin. Edison forecasts 6–8% pa revenue growth in FY22–24, but the above near-term dampening effect of the transition to rental and lower ‘outright’ Technology gross profit will lead to lower FY22 EBITDA, before Edison Investment Research expects EBITDA growth to resume from FY23. At end-FY21, MMAG had a net cash position of £1.8m. Its future cash generation and net financial position will be sensitive to the phasing and extent of capital investment required to support the expansion of its rental services.

Its base case DCF-based valuation indicates a share price of 168p per share, significant upside from the current share price. Following a de-rating, MMAG’s FY22e EV/EBITDA of 4.6x represents a discount to other UK consumer-facing online companies, but the uniqueness of MMAG’s business model and category exposure means there are few direct peers with which to satisfactorily compare its valuation.

MMAG demonstrated strong revenue growth, with a CAGR of 8% in FY18–21, ahead of market growth estimates, due to growth in consumer numbers and repeat customers. This points to growing engagement with the circular economy and market share gains, and a further boost to demand during the COVID-19 pandemic. At the same time, refinement of the buying and selling processes led to significant gross margin enhancement (from c 23% in FY18 to c 30% in FY21). Edison forecasts 6–8% pa revenue growth in FY22–24 despite further normalisation to pre-COVID-19 levels for Media and Books. Edison forecasts that FY22 EBITDA will decline as the transition to building rental income - which is more profitable in the medium-term - dampens near-term growth, and reflecting recent trends in Technology outright gross margin, before growth resumes in FY23.

Its primary method of valuing MMAG is a discounted cash flow (DCF) analysis, with a fair value of 168p per share. Beyond its explicit forecast period Edison assumes 5% annual revenue growth for ‘outright’ sales, fading down to c 4% growth by its terminal year, FY31, and rentals to increase revenue growth by 2–5% pa. The higher-margin subscriptions potentially increase the EBITDA margin from 8.4% in FY21 to c 21% by FY31. Edison uses a WACC of 10% (risk free rate of 3%, risk premium of 6%, Beta of 1.2 (limited trading history), and little debt) and a 2% terminal growth rate.

In 2020/21, MMAG launched three UK-focused initiatives that are expected to drive further revenue growth with three key aims from customers, ‘buy more, sell more, rent more’, while enhancing MMAG’s profitability. For ‘buy more’ and ‘sell more’, two initiatives are focused on increasing the potential sources of products that can be on sold: the SMARTDrop kiosk, in which sellers can easily recycle phones in partner retail locations in a quicker/more efficient way; and Magpie Circular, a first step that introduces MMAG’s trade-in offer to corporates. For ‘rent more’, the October 2020 launch of smartphone rentals, and the February 2022 expansion of the service to other consumer technology products such as tablets, gaming consoles, MacBooks and wearables, is focused on building recurring revenue, with significantly higher EBITDA over the life of the device, as opposed to the outright sale historically pursued by MMAG. Its estimates suggest MMAG’s rental activities are likely to be the most significant driver for future growth in revenue and profits.

Having outlined the MMAG’s core operations above, below Edison highlights the new initiatives that management believes should drive the company’s future growth. MMAG has distilled its strategies under the three pillars of ‘Buy more’, ‘Sell more’ and ‘Rent more’, each of which is described below.

The company has few non-financial KPIs, which reflects the dynamics of the different product categories (mix, volume and price) and, in part, the initiatives that are expected to stimulate future demand are relatively new. From recent presentations, Edison notes MMAG has enjoyed strong growth in customer numbers, from 7.1m customer registrations at the IPO to 7.5m at end FY21, and there has been consistent growth in the proportion of repeat customers (from 27% of the total in FY16 to 50% in FY20).

MMAG’s smartphone rental business, Rent-a-Phone was launched in October 2020, and represented the company’s first move into generating recurring revenue versus its traditional one-off transactional relationship in the core business. In February 2022, MMAG announced the extension of its rental offer to other consumer technology products, namely tablets, games consoles, MacBooks and wearables, following the popularity of the smartphone rental offer. Management sees potential to expand into other types of consumer technology in the future. As highlighted later (see Financials section), the rental business has the potential to increase MMAG’s revenue growth profile (Edison estimates adding 2–5% to annual revenue growth rates) and significantly improving its profitability (from FY21 adjusted EBITDA margin of 8.4% to low-teens and above from FY26).

Edison believes the key risks to MMAG’s performance are as follows:

* '''Developing internationally:''' decluttr is a relatively small business in a re-commerce market that is in its relative infancy, which presents the potential risks of failing to execute on management’s growth strategy and that greater investment than expected is required to deliver on the growth strategy. Although Edison believes management has no aspirations to diversify geographically, new markets with similar characteristics as existing markets may become more interesting.

As highlighted previously, management’s estimates of market growth rates for the product categories would indicate a weighted average market growth profile of 4–6%, using FY20’s pre-rental business mix, increasing as Technology’s importance to the group grows. As rental income grows, it should be incremental to group revenue growth. Its forecast of c 6–8% revenue growth in FY22–24 is consistent with management’s medium-term guidance.

Edison forecasts Technology revenue growth of c 20% to £103m in FY22, 15% growth to £119m in FY23 and further 15% growth to £136m in FY24, to c 89% of total group revenue in the final year. For outright sales, Edison assumes 15% growth in FY22 (helped by the rollout of SMARTDrop kiosks and the launch of corporate recycling) and 10% growth thereafter, lower than the anticipated mid-teens market growth rates indicated earlier, recognising the substitution effect of new rentals. For rental income, Edison assumes the number of active subscribers grows from 13.5k at the end of FY21 and 24k at the end of H122, to c 36k by end FY22, c 62k by FY23, and c 89k by end FY24 that is, net new additions of c 23k, 25k and 27k pa, respectively. The growing number of active subscribers at the period ends reflects an increase in gross customer additions per day to 80, 100 and 120 respectively and a modest annual reduction in the rate of defaults of new customers in the first year (starting at 10% in FY22) and churning customers after the first year (starting at 25% in FY22). Edison assumes revenue per active subscriber per month of £20 in FY22, which increases by 3% thereafter. These assumptions lead to forecasts for rental income of £6m in FY22 (+230% y-o-y), £12m in FY23 (+102% y-o-y), and £19m in FY24 (+58% y-o-y).

Edison forecasts revenue declines for Media of 12% to £45m in FY22, and declines of 10% in both FY23 (to £40.2m) and FY24 (to £36.2m). Its FY22 forecast represents a decline of c 2% versus H221’s revenue of £22.7m when annualised.

For Books Edison forecasts a revenue decline of c 18% in FY22 to £7m, which is equivalent to H221’s revenue of £3.6m on an annualised basis, and thereafter assume modest growth of c 1% pa. It represents c 5% of its FY22 group revenue forecast and will become a gradually less significant part of the group as Technology increases. Management believes there is still good money to be made in Books and Media well into the future whilst recognising the structural challenges, given the variable operating costs and ability to transfer resources to focus on the higher growth offered by Technology.

For all categories, except Technology outright sales as guided above, Edison assumes a stable trading margin (selling price less buying price of the item), which along with the growing contribution of higher-margin Technology rental income, leads to a reduction in the gross margin to 27.7% in FY22 before resuming growth to 28.6% in FY23 and 29.6% in FY24. As a result, in absolute terms, Edison forecasts a 3% decline in FY22’s gross profit to £43m, before 11% growth in FY23 and 12% growth in FY24.

Below gross profit Edison assumes inflationary growth for operating costs, including 6% growth in the National Minimum Wage in FY22 and higher marketing costs as MMAG increases spend on brand and promoting its new rental and SMARTDrop kiosk initiatives. As Media revenues decline, Edison assumes its operating cost base naturally reduces. This leads to estimated EBITDA margins of 6.0% in FY22, 6.8% in FY23, and 8.7% in FY24, and normalised operating margins of 1.5% in FY22, 1.2% in FY23, and 3.4.% in FY24 versus 5.8% in FY20. The lower margin in FY22–24 is due to mix changes, central cost investment and higher depreciation charge on the capitalised smartphones.

FY21 bore the costs of the exceptional IPO expenses (£3.9m) and the vesting of options on the IPO (£17.4m). Edison accrues £1.5m of share-based payments in future years.

Its forecast for higher investment in tangible assets from FY22 reflects the capitalisation of devices for rentals (Edison assumes £280 for each new phone in FY22–24) and the costs of rolling out the SMARTDrop kiosks (FY22 only). The capital investment leads to estimates of negative free cash flow in both FY22 and FY23.

Its primary valuation methodology is DCF as it captures the potential long-term growth of the business, specifically from MMAG’s rental business, which is in its infancy. Beyond its explicit forecast period Edison assumes 5% (between weighted average market growth rates of 4–6%) annual revenue growth for ‘outright’ (ie non-rental) revenue through FY25, before prudently fading down to 3.5% growth by its terminal year, FY31. The aggregated growth rates reflect:

For rental income, Edison estimates strong growth in the active subscriber base from 13.5k at end FY21 to c 36k in FY22 and to 286k active subscribers by FY31. This reflects growing the daily gross additions from 60 in FY22 to 200 from 2027, namely increasing the rate of daily new additions by 20–40 pa. Edison also assumes revenue per active subscribers increases by 3% pa, to £26.10 pm in FY31. These assumptions lead to estimated rental income of c £87m by FY31 so that it represents c 28% of group revenue. Its estimates for rental income increase MMAG’s estimated revenue growth by 2–5% pa through FY31.

For outright revenue Edison assumes a gradually reducing contribution after direct labour margin from 21.4% in FY21 to c 16% by its terminal year, which reflects a stable margin for Technology (c 15%), and declining margins for Media (c 19% in FY31 versus c 24% in FY21) and Books (c 27% in FY31 versus 29% in FY21). For Media and Books, Edison assumes a stable gross margin and cost deleverage due to wage inflation. The growing contribution of rental income with a 70% estimated contribution after direct labour margin naturally increases the group margin from 22% in FY21 to 32% in FY31. In aggregate, its EBITDA margin increases from 8.4% in FY21 to 21.3% by FY31.

Using a WACC of 10% (risk-free rate of 3%, risk premium of 6% and Beta of 1.2, limited trading history, with low debt) and 2% terminal growth, its DCF-based valuation is c 168p per share. The table below shows the sensitivity of the DCF to changes in assumptions for the WACC and terminal growth rate.

The valuation is sensitive to the growth rate and timing of the active rental subscribers and the associated capex on signing a new customer. If Edison assumes slower growth in rentals to c 157k active subscribers by FY31, the DCF valuation would reduce to c 141p per share. Edison reiterates its forecasts, which reflect more pessimistic assumptions for Technology outright revenue growth and declines in Media revenue growth than management expects, in order to be prudent on the valuation.

Below Edison shows MMAG’s valuation relative to UK consumer-facing companies that also predominantly operate online. Edison would highlight none of these are direct comparators given different business models, category mix and geographic exposures. All multiples are annualised to MMAG’s November year-end, but sales growth rates and margins are for the individual company’s financial year.

The UK online peers have de-rated significantly during the last 12 months as forecasts have been downgraded due to a combination of slowing revenue growth versus initial expectations and lower profits due to higher costs, eg freight. The latter is less of an issue for MMAG given its local sourcing. In addition, Edison believes WACCs have risen due to higher interest rates and likely greater required market risk premium.

Relative to the peers, MMAG’s forecast revenue growth of c 6% in FY1 and c 7% in FY2 is more consistent than the group median (4% and 11% respectively) albeit there is a wide range of expectations. Its expected EBITDA margin for MMAG of 6.0% in FY1 and 6.8% in FY2 is comparable with the median of the peers, 4.9% in FY1 and 6.1% in FY2, but as indicated above, MMAG’s EBITDA margin has potential to accelerate quickly as rental income grows.