FWIW Morningstar has also updated their coverage on Audinate
Morningstar currently rate AD8 as a 5 Star stock with a Fair Value of $18.50 (so they see it is significantly undervalued)
Audinate Earnings: No Signs of Improvement Yet
Analyst Note
We maintain our AUD 18.50 per share fair value estimate for narrow-moat Audinate following its first-quarter fiscal 2025 update. The company indicated that it does not expect to meet its previously issued guidance for the full year, which it issued in August. Specifically, the company no longer expects to generate “slightly lower USD gross profit compared to fiscal 2024.” The company did not update its guidance but will update the market after the completion of second-quarter fiscal 2025 trading. Although the update is a further disappointment, we, like management, expect fiscal 2025 to be a transition year for the company and expect growth to reaccelerate from fiscal 2026. At current prices, Audinate shares screen as materially undervalued, as the market appears to believe the company’s current slowdown may signal a loss of competitive position or exhaustion of its addressable market.
We view the current slowdown as a combination of a resolved backlog of hardware products and a transition of the business from hardware-based sales to software-based sales. The former echoed the covid-19-induced chip shortage, which led to artificially high demand in fiscal 2024, which the company is now lapping. The second is more structural in nature. To increase market penetration, the company needs to offer original equipment manufacturers lower-cost ways of implementing the Dante protocol, primarily by allowing them to implement Dante through software instead of through separate hardware chips. We view this transition as analogous to what we have seen in many software-as-a-service businesses, where the transition initially led to slower growth but where the new price points unlock sufficient incremental volume to make up the difference.
Business Strategy and Outlook
We expect Audinate’s strategy to primarily focus on accelerating the secular transition toward digital audio networking. Secondarily, we expect Audinate to focus on building out its nascent business for digital video networking.
Audinate’s Dante protocol has become the world’s most widely used protocol for digital audio networking and boasts a more-than 10 times lead over its nearest competitor, Ravenna, in terms of the number of products enabled with the protocol. Given Dante’s dominant market share, we see little remaining upside for Audinate from gaining incremental market share from direct competitors in digital audio networking. However, we do expect Audinate to use its network effect, its existing customer relationships, and its scale on research and development to accelerate the AV industry’s transition toward digital audio networking. Specifically, we expect Audinate to continue creating new hardware and software solutions that unlock new device use cases and to continue developing new software solutions for AV professionals. We estimate Audinate has around 10% market share in audio devices, which leaves Audinate with a large and highly winnable market opportunity, as the industry digitizes. Additionally, we expect Audinate to gain significant pricing power, especially in its software segment, as its network effects continue to strengthen.
We also expect Audinate to continue developing its nascent digital video networking business, although we view this as a more uncertain and likely less profitable opportunity. Video networking has unique challenges compared with audio, primarily due to the larger data intensity inherent in video data delivery. Because of this, digitally networked video uses various compression technologies that are usually not compatible with each other and therefore hinders the establishment of network effects. However, we believe network effects from Dante’s audio solutions will help pull in AV professionals, who are already familiar with the Dante protocol, which in turn pulls in original equipment manufacturers, or OEMs.
Economic Moat
We assign Audinate a narrow economic moat based on network effects in its digital audio networking protocol, Dante. We expect Dante to become the standard for digital audio networking, and for digital to continue to take share from analog networking.
Dante is the world’s most widely used protocol for digital audio networking. Over 400 OEMs, such as Bosch, Bose, and Yamaha, license the Dante protocol to enable digital delivery and management of audio for over 4,000 products, such as microphones, mixers, and speakers. Dante’s closest competitor, Ravenna, has fewer than 400 products enabled with its own protocol, and works with fewer than 100 OEMs.
Network effects arise from strong interoperability within networking protocols, and limited interoperability between them. When audio products are enabled with Dante, these products can be easily discovered by- and connected to the Dante- network and other Dante-enabled products on the network, which is required for their audio delivery to be synchronized. Such automated discovery and connection provides a compelling benefit for AV professionals because it allows them to easily add, move or remove audio equipment to their installations. This benefit may even exceed any perceived brand value toward specific OEMs. Products not enabled with Dante can still be added to the network through AES67, which is an industry standard for audio over IP, but the networking process is more cumbersome. Similarly, competing networks can add Dante-enabled products through a more cumbersome networking process. Given the limited interoperability between the various networking protocols, Dante’s leadership position of more-than 10 times in terms of the number of enabled products results in clear demand pull from AV professionals.
OEMs, in turn, need to cater to the preferences of AV professionals and are therefore increasingly choosing to enable their products with Dante, which leads to Dante’s leadership position expanding over time and a positive flywheel between supply and demand. Dante today enjoys a more than 10 times lead over Ravenna, in terms of enabled products, which is a significant improvement from a 6 times lead in 2017. We also expect Dante’s leadership in terms of deployed products to be even larger than its leadership position in available products, due to Dante’s larger network of interoperable products making its products more appealing to AV professionals.
We view analog networking as Audinate’s primary competition. In analog networking, AV professionals connect products by drawing physical cables between them. This cabling is usually many times pricier than digital networking because the cables need to be drawn the full distance between devices. By contrast, the Ethernet cables used to connect Dante-enabled devices can typically be drawn to the nearest Ethernet port in a building. Many devices also don’t require separate power cabling after they are connected with an Ethernet cable. This provides material savings in terms of hardware and labor costs. Additionally, over longer distances, analog audio cabling can suffer from reduced audio quality, which digital audio delivery does not suffer from. Unsurprisingly, the industry has been rapidly digitizing. We estimate that digitally enabled audio devices doubled their market share as a share of new sales to around 10% in 2023, from 5% in 2016. Analog networking continues to be the dominant networking technology, primarily due to switching costs from existing installations and digital networking being cost prohibitive for lower-value devices and use cases.
We don’t yet see similar network effects in Audinate’s video networking business. Video networking has unique challenges compared with audio, primarily due to the larger data intensity inherent in video delivery. Because of this, digitally networked video uses various compression technologies that balance speed, cost, data, and quality for specific use cases. As a result, products using different technologies are often not compatible, not just in their discovery and connection, but also in their data delivery. The industry is therefore still much earlier in its digital transition.
We do believe Audinate enjoys several distinct advantages in pursuing video networking. Audinate has existing relationships with hundreds of OEMs, many of which also make video products. We believe offering bundling deals through these established customer relationships has traces of an intangible moat. A subset of AV products also has networking needs for both audio and video, which makes them an attractive market entry point for Audinate. Also, over the years, Audinate has been training hundreds of thousands of AV professionals on its technology. These professionals already know how to work with Dante-enabled products and are familiar with the brand, which, we believe, makes for an appealing proposition for OEMs. So far, Audinate is demonstrating strong momentum on all relevant metrics for its video networking business. These include growth in the number of OEMs licensing the protocol, the number of products enabled with the protocol, and in the number of products shipped with the protocol. However, this is from a small base, and we consider the market still up for grabs.
Fair Value and Profit Drivers
Our fair value estimate for Audinate is AUD 18.50 per share, implying an enterprise value/sales multiple of 18 on our fiscal 2025 estimates. We use a weighted average cost of capital, or WACC, of 9%, reflecting high revenue cyclicality, medium operating leverage and low credit risk.
We assume revenue to grow at an organic CAGR of 15% over the next decade, driven primarily by Audinate expanding the market for digital audio networking. We expect EBIT margins to expand to 38% by fiscal 2034, compared with 9% in 2024. We expect Audinate’s operating margins to expand because of sales and marketing spending, as well as research and development declining as a share of revenue, once its network effects strengthen. We also expect gross margin expansion as strengthening network effects result in increased pricing power and the higher gross margin software segment becomes a larger share of the business.
Risk and Uncertainty
We assign Audinate a Morningstar Uncertainty Rating of High.
The AV industry is still in the early stages of digitizing, which means there is still high uncertainty regarding the ultimate market opportunity for Audinate’s products. Given that we view competitive risk as low in digital networking for audio, due to Audinate’s economic moat based on network effects, our uncertainty revolves around the market’s ultimate size, rather than Audinate’s share within this market. Within video, we see additional uncertainty around Audinate’s ability to take market share.
We see high risk from economic cyclicality. Audinate’s devices or license designs are used in products which are highly discretionary. Although these products are often part of systems which eventually need to be replaced, customers can choose to defer these purchases in challenging economic times.
We see high risk from technological disruption. Audinate’s Dante protocol primarily uses Ethernet cables for data delivery. We cannot rule out other methods of data delivery eventually substituting Ethernet cables, such as wireless internet or other technologies.
Capital Allocation
Audinate has an Exemplary Morningstar Capital Allocation Rating, reflecting our assessment of a sound balance sheet, exceptional investment efficacy, and appropriate shareholder distributions.
Audinate’s balance sheet is sound. As of the end of June 2024, it held significant cash with no debt.
We rate investment efficacy as exceptional. Although Audinate is supported by network effects, when it started, it faced the traditional cold-start problem, whereby no AV professionals wanted to use Dante’s protocol because there were no products supporting it and no OEMs wanted to develop products because no AV professionals wanted to use them.
Audinate demonstrated exceptional execution to solve this problem. Audinate found the right entry points into the market, strategically attracted early customers by making them part owners of the business, developed a product portfolio with the right breadth and depth and delivered the right levels of customer service. All of these competing objectives were achieved with limited resources, which demonstrates to us exceptional capital allocation skills.
Audinate does not currently return capital to shareholders, which we view as appropriate given the opportunities for investment into the business.
DISC: Held in RL & SM
