A beaten-down stock with 60% upside

A global market leader which boasts all the qualities of a good small-cap stock has been indiscriminately caught up in the tech sell-off, and is now ripe for the taking, says Market Matters' James Gerrish. 

Over the past three months, audio (and now video) technology innovator Audinate (ASX: AD8) has seen its share price plummet around 22%. Since the beginning of the year, it has fallen 14%. 

But Gerrish believes the stock is a screaming buy and says his team will be adding to their position in light of this recent share price weakness. 

"We would definitely be a buyer of this stock," he said. 

"(Audinate has) a clear competitive advantage in what they do. It's well-run, it's founder-led. It's got the ability now to leverage its position into other areas like video. It's growing its top line strongly. And it's handled a pretty challenging period over the past 12 to 18 months." 

Having come in 10th on your top-tipped small-cap list for 2022, there was, perhaps, a lot riding on Audinate as it sidled up to the February reporting season.  

However, it reported that its revenue had lifted by more than 30% in the half to $20.23 million, despite a "very challenging operating environment". Meantime, a slight fall in gross margins saw its net losses after tax lift 77.8% to $2.15 million. 

In its report, the business said it is focused on driving the development of its video and cloud services, and as such, is aiming to hire an additional 50 staff members by the end of the financial year.

While it expects to report revenue growth during the remainder of 2022, Audinate noted that this would not be at "historical rates" with the company and its OEM customers impacted by supply chain challenges in the chip market. 

"Further supply chain tightness is expected in 2H22 but we are pleased to have received indicative additional commitments from chip suppliers," Audinate co-founder and CEO Aidan Williams said. 

In this wire, Gerrish takes you through the highs and lows of Audinate's first-half earnings report and shares why his team would be adding to their position on the back of the result. 

Audinate key results H122

• Revenue up 31.6% from the previous period to $20.23 million
• EBITDA up 11% from the previous period to $2.04 million 
• Net loss after tax up 77.8% to $2.15 million
  
• Gross margin down 1.7% to 75.6%
• No dividend
• 403 brands shipping products enabled by Dante
• 13 times the market adoption of its nearest competitor, with 3,301 Dante-enabled products available to the market

Note: This interview took place on Monday 14th February 2022. 

What were the key takeaways from the result?

James Gerrish: I thought it was a solid result. The top line was as expected. Revenue was US$14.8 million, which was up 33% on the first half of '21 - that was in line with our expectations. EBITDA and profit was a touch below our expectations. And that was driven by some margin pressure. But that was not material. It's only very slight. 

The outlook was in line with what they said in October of 2021 when they last updated the market, which was for revenue growth in FY22. They did site supply chain issues, which has had an impact on the availability of chips, which has hurt them. And that's why the stock has dropped from that $11 mark, down to trading around $7.60 today. 

They are going to be investing more heavily in increasing headcount, so costs are going to be increased going forward. They expect headcount to increase to 185 over FY22. Their previous guidance for the headcount was at 170. So they are going to have more costs to drive their growth, which is probably what the market is focusing on today.

What was the market’s reaction? Do you think this was an overreaction, underreaction, or appropriate?

There has been obviously a sell-off in tech and high valuation names. But they have had impacts on their business and they are saying that the top line will grow. It's not going to grow at the pace that it has done in the past, and that's because of these supply chain issues. So that is a factor and it probably deserves to have been sold down from $11 to $7.60. But it's the clear global leader in audio networking. It's got 13 times the market adoption of its nearest competitor. So there's nothing that concerns me in this result.

If I look at the short term, it's probably the right reaction, because that whole area of the market has been sold down. If you take a medium-term view, so out over the next two to three years, I think this is a clear buying opportunity. 

We own it. If we didn't own it, we'd be buying it. We hold it in our emerging companies portfolio. There's nothing in that result that would suggest that it shouldn't be a buy down here.

I can understand the market's reaction. But I think the business is still progressing in line with where you'd want it to be. It still sets it up very well for the next couple of years. They're going into video, which is going to be an area of growth for them. 

They're doing all the things that you'd want them to be doing. They're increasing headcount to go and capture growth. They've got cash on their balance sheet of $60 million. So they're well capitalised, that's more than 10% of their market cap. 

I don't know what it'll do in the next week or two or the next month, but it's definitely in that value range. In fact, Shaw and Partners' has a $12 price target on it.

Were there any major surprises in the result that you think investors should be aware of?

The biggest surprise to me was around the increased headcount. They're going from 135 at year-end to 185. They had guided previously for an increase, but not to that extent. 

Skilled worker shortages is a legitimate concern. Every corporate you speak to has had issues attracting staff and having to pay more for staff. 

So if you think, 'I want to increase my headcount materially, over a pretty short amount of time,' in an environment where the labour market is really tight, then you're going to be spending more. They've already got some slight pressure in terms of margin. That could be a concern for the market.

It's a loss-making business. Loss in the first half of '21 was $1.2 million. Loss this half is $2.1 million. It is up more than 70% and it was bigger than what we expected. We expected them to be making a slight profit of about a million dollars. Whilst the revenue was in line with expectations, a slight change in margins when you're talking about these sorts of low numbers can impact the P&L line pretty easily.

However, you're not holding this company because it's losing $2 million or $1 million, or it's making a million bucks. You want them to be scaling for future growth. You want them to be taking advantage of the market opportunity they've got, which is having such a dominant position in that audio networking space. And then leveraging that into other areas. 

So do those losses concern me? No, not at all. Audinate is not about the P&L. Obviously, you've got to be conscious of it, but it hasn't blown out materially.

Would you buy, hold, or sell Audinate following this result?

We would definitely be a buyer of this stock. It's obviously corrected around 30% over the last few months. Which is greater than the market. Looking forward, it's all about Audinate taking advantage of its dominant market position. 

You want something that's got a clear competitive advantage in what they do. It's well-run, it's founder-led. It's got the ability now to leverage its position into other areas like video. It's growing its top line strongly. And it's handled a pretty challenging period over the past 12 to 18 months. 

And on top of that, this is also going to be a reopening trade. As the world comes out of it and we spend more on changing offices, but also, stadiums and the like, it's going to benefit Audinate's earnings over time.

We are definitely topping up our position right now. 

What are your expectations and outlook for Audinate and the technology sector?

There are strong tailwinds in the audio space that fit into the reopening thematic that we're seeing at the moment. We do channel checks and they're talking to improving sentiment, improving intentions to buy at the back end of '21. That's likely to continue into the second half of '22. On top of that, everyone is back going to live events. That's a strong driver of their business going forward. 

Audinate's global dominance is the key. If you think about the business from here, it's the dominance they've got in their market that is the reason to own this.

Rising interest rates will result in valuations coming down, which is negative for technology stocks and companies like Audinate. But I think the key is being very selective in the stocks that you own in this space and owning them for a reason.

That said, I think in the short term, bond yields have run too hard. I think the market is now short bonds, long bond yields and that trade will revert. 

I'm not negative on technology in the very short term. I think there's probably a bounce there in technology stocks sometime this year as bond yields come down. In the medium term, I think you're going to need to be very selective in what you own.

It's a very crowded trade. Everyone thinks interest rates are going higher. To me, the direction of most pain, which markets tend to go in, is against that trend.

Enjoy this wire? Hit the 'like' button to let us know. Stay up to date with my content by hitting the 'follow' button below and you'll be notified every time I post a wire.

Not already a Livewire member? Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.