AD8 has all the ingredients you want in a long-term investment; growing economic moats, strong pricing power, operates in an industry experiencing a long-term structural shift, sound balance sheet and founder-led focused on long-term growth.

It has enormous potential to strengthen its economic moats by continuing to develop innovative intellectual property and educating end users to amplify its network effects, driving higher switching costs for customers.  

However, I am not yet convinced of AD8’s ability to compete in the video networking market given the high rate of increase of intangible development costs, which will be monitored. Another purpose of monitoring this metric is to ensure AD8’s foray in the video networking space does not erode its core competency in the audio market over the long-term.

This is definitely a business that I would like to invest for the next five to seven years but not at its current price. I believe the COVID-19 economic headwinds on live sound entertainment will drag AD8’s revenue to lower levels for the next 12-18 months and will enter at a cheaper price once I see signs of declining intangible development costs and plans to reinstate live sound events free of COVID-19 restrictions. 

I really do think this could surpass $15 over the long-term given AD8 currently only has 26% of the audio networking market and the video networking market presents a long runway of growth.

In May 2019, former CEO, Mr Lee Ellison announced his retirement effective from 13 September 2019 and the board determined that the co-founder, Mr Williams was the best candidate to take the helm. Mr Ellison’s retirement was a big loss as he helped significantly grow AD8’s customer base over 11 years of strong growth. A brief overview of Mr Ellison’s experience shows he was able to leverage his global sales experience to grow AD8’s sales, which is something that Mr Williams lacks.

As mentioned earlier, Mr Williams was the brains behind the ground breaking digital audio networking technology, Dante. So, it is interesting to see that the former CEO with strong sales experience was replaced by the innovator. Although sales does not appear to be Mr Williams’ key strength, I believe the sales experience factor is less important now as AD8 has already built a strong reputation within the audio networking market and more focus needs to be placed on developing products for the video networking market.

Compensation

Mr Williams’ compensation structure is strongly aligned with long-term value creation as he currently holds 2.81% of equity and annual performance objectives are 70% weighted to the achievement of corporate financial goals and 30% to individual key performance objectives. The corporate financial goals for FY20 were as follows:

·         Revenue

·         Gross margin

·         EBITDA

I note no annual rewards were paid in FY20 as management failed to achieve the above financial goals due to the impact of COVID-19.

Character

Mr Williams appears to be a measured, pragmatic leader focused on achieving long-term growth. His measured and pragmatic approach is reflected in his views on COVID-19 and a potential merger or acquisition at the recent investor conference in August 2020. Mr Williams provided investors with a measured view on AD8’s future performance, noting that revenue could be lower next financial year given the adverse COVID-19 impact on live sound entertainment. I think providing investors with a realistic expectation of future performance was a sensible approach. As noted previously, Mr Williams advised investors that they had decided against proceeding with a potential acquisition because of the lack of synergies and failure to agree on a price, which illustrates his pragmatic approach to value creation.

Mr Williams has reiterated the importance of utilising the capital raised to transform hardware-based solutions into software format to drive future growth. This is a strong indicator of Mr Williams’ focus on achieving long-term growth.

Founder-led

A study by three professors at Purdue’s Krannert School of Management showed strong evidence that S&P 500 companies where the founder is still the CEO are more innovative, generate 31% more patents, create patents that are more valuable, and are more likely to make bold investments to renew and adapt the business model[1].  The below graph shows an index of S&P 500 companies in which the founder is still deeply involved performed 3.1 times better than the rest over the past 15 years prior to 2014.

The professors also interviewed number of executives and founders around the world, analysing another 200 founder-led companies with the help of an expert who knew each company well. They identified the following three reasons why found-led companies outperformed.

·         Insurgent vision – identifying and building a purpose that attempts to disrupt industry norms e.g. Google’s mission to organise all the world’s information. The study found that employees were much more likely to be engaged if there was a clear purpose.

·         Frontline obsession – being focused on monitoring what is going on in the frontline e.g customer experience and building a culture that empowers those in the frontline.

·         Owner’s mindset – founders know the details of the business and have better instincts, so they are in a better position and personally invested to focus on building a company that lasts.

[1] https://hbr.org/2016/03/founder-led-companies-outperform-the-rest-heres-why

Rising payments for intangibles

Even though AD8 has a healthy cash balance, close attention must be paid to the amount of payments for intangibles, which is predominantly comprised of capitalisation of development costs. As you can see below, payments for intangibles are growing at a much higher rate compared to cash receipts. Also, it is concerning that payments for intangibles as a percentage of cash receipts is rising.

These trends appear to indicate that the costs required to develop new products are steep but why is this so? Since 2017, AD8 has been committing resources to develop video capabilities in Dante to penetrate the video networking market but it seems like it requires significant time and materials. In the latest FY20 annual report, the auditors reported the capitalisaton of development costs ($10.47M) as a key audit matter[1] and the auditors were required to assess the appropriateness of costs capitalised, which include material costs, overheads and engineers’ hours (internal & external). This makes me wonder whether AD8 is finding it difficult to compete with the bigger players in the video industry, especially since it does not have a competitive advantage in this space. It appears the video industry is much more competitive relative to the audio industry based on comments by Fury13 on a HotCopper thread[2], who appears to work in the industry. My biggest concern is the risk of AD8 channeling its focus away from its core competency in audio to a new market that is dominated by the stalwarts, potentially reducing its competitive advantage in the audio space over the long-term. 

In July 2019, AD8 announced the commercial availability of two key Dante video products, however it appeared to not have a significant impact on AD8’s revenue given it only increased by 7%. AD8 recently disclosed that they released the first demo of the Dante video camera and attained 20 initial video and software design wins, so there is still a long way to go before AD8 establishes ground breaking products.

As you can see in the table, I have used PushPay Holdings (PPH) and Xero (XRO) to gauge whether AD8’s intangible costs are reasonable. I note both PPH and XRO operate as a software as a service business, the former providing donor management systems to the faith sector and the latter providing accounting software, which is what AD8 is striving to achieve. Both these businesses still incurred significant intangible costs in absolute terms but they managed to hit an inflection point and the rate of increase in intangible costs declined substantially thereafter. I believe the reason why AD8 has been struggling to contain intangible costs is due to the nature of the business model and industry. As outlined earlier in the business overview section, AD8 offers chips, cards, modules, adapters and software solutions. This is quite an extensive range of solutions available to OEMs, which indicates the wide range of customer needs that AD8 attempt to meet. When you scroll down the list of products on the AD8 website, there are ten different product solutions available for OEMs and four different software solutions. This is a stark contrast to the product offerings of PPH and XRO. PPH offer four different solutions, all of them being software and Xero only sell one product.

Given AD8 is still in the primitive stages of developing quality and superior products in the video market and also attempting to transform existing hardware units into software format in the audio market, I expect intangible costs to continue to rise in the next few years.

Once the rate of increase in intangible payments decreases for two years in a row, I think this is strong indicator of AD8 hitting an inflection point in developing high quality and standardised products.

COVID-19 impact on AD8's customers

COVID-19 will significantly decrease demand for audio equipment manufactured by AD8’s customers due to the headwinds faced by the live music industry as illustrated by the closures of a number of theatres. I believe the live music and performances industry will not be financially sustainable even with COVID-19 measures in place, which is echoed by Charlotte St. Martin, president of the Broadway League, the trade association that represents the Broadway industry, “Broadway will not be able to socially distance. It’s just a physical impossibility—the same with the Metropolitan Opera. Our financial model is so [dependent upon] attendance and revenue. In order to socially distance, we would have to completely break the Broadway model. That would mean lower wages, lower rent at theaters, lower fees from designers and specialists. And that’s going to be coupled, of course, with lower ticket prices and lower attendance, and I don’t think anybody thinks we can do that.”[3]

This potential impact is reinforced by the projected decline in demand and revenue for AD8’s biggest customer and second largest shareholder, Yamaha Corporation.

Yamaha

Yamaha reported the following in their investor briefing for the first quarter of FY2021 on 5 August 2020[4]

·         Professional Audio equipment slumped but equipment installation in Japan was robust.

·         Yamaha expect stay-at-home demand to grow but professional audio equipment faces headwinds. Yamaha also expected professional audio equipment to decline with no recovery in sight for the live performance market but more music production products are projected to arise.

·         Yamaha predicts double digit growth in sales of conference systems.

Notwithstanding, I believe this adverse impact will be short lived and live music will eventually return to normal in 12-18 months. In this regard, I think it’s more likely than not (60% chance) that AD8’s share price will drop consistently over the next 12-18 months due to lower rates of growth, which will present a great opportunity to buy shares at a discount.

[1] Page 71 of the AD8 FY20 annual report

[2] https://hotcopper.com.au/threads/what-is-dante.5464431/

[3] https://www.fastcompany.com/90516669/are-concerts-festivals-and-live-events-ever-coming-back-heres-what-6-experts-say

[4] https://www.yamaha.com/en/ir/presentations/pdf/2021/pres-200804e.pdf

• AD8 has made significant progress in the video networking market, facilitating a demo of the first Dante video camera by Bolin and securing 20 design wins including Yamaha and Patton.
• Aidan Williams also advised at the investor results conference on 20 August, 2020 that they had conducted due diligence on a potential merger or acquisition but failed to agree on a price. Mr Williams also indicated that they want to find teams that have specific skills in video and compression technology. It is reassuring to know that management are taking a measured approach in selecting who to merge or acquire and doing it for the right reasons i.e. not for the sake of a boost in revenue but investing in a team with the right skillset to achieve sustainable long-term growth.
• The rise in remote online communications will increase the adoption and reliance of communication platforms. AD8’s Shure product recently became Zoom Rooms Certified for several key audio-conferencing solutions and received the Microsoft Teams Certification for a select portfolio of networked systems products.6                                                                       
• Yamaha has witnessed a surge in demand for conference systems7 as organisations around the world try to work remotely. As more organisations embrace remote working as part of their culture, there will be a growing demand for equipment to facilitate this environment.
• The rise of Esports will also present a significant market for AD8 as it will create a need for entirely new infrastructure that might not be what traditional broadcast is used to.8
• COVID-19 has forced universities to finds ways to teach students in a COVID safe environment and the best option is to provide a hybrid remote/on campus educational program. In order to facilitate this, universities will need to deploy an AV network like Dante networking to enable faculties to simultaneously give lectures on campus, on-stream, and also archive for future use. Given the adverse financial impact of COVID on university revenue, universities will want to ensure they provide the best possible educational experience for its students, so I expect this accelerated adoption will boost AD8’s revenue.
• AD8 has set up offices in Mexico and the Philippines to provide training resources for the Latin American market and extend its South East Asian Pacific sales. 

Intellectual Property

The 2017 prospectus indicated AD8 had 25 patents (with a further 13 applications filed, in the key markets of USA, UK, Germany and China). AD8 listed eight different types of inventions that are either patented or the patent application was pending at that time.

Since AD8 listed on the ASX, they have grown the number of patents significantly as illustrated below:

• USA – 21 patents
• European – 8 patents
• China – 8 patents

AD8 appears to have a decent track record of developing patents that relate to a diverse range of applications. Such a competitive advantage is difficult to overcome by competitors as it takes significant time and costs. The costs relating to researching and developing inventions have been growing exponentially, which should be monitored.

Switching Costs

OEMs take 12-24 months to design and develop new products embedded with Dante. If an OEM is already manufacturing and offering Dante embedded products to its customers, imagine how significant the lost time and cost would be to design and develop products with a different platform.

Considering AD8 already has such a strong foothold over its competitors in terms of the number Dante enabled audio products, other OEMs are likely to follow the herd to ensure they provide their customers with the best product offering. As the number of Dante enabled audio products grows, Dante will become more entrenched as the industry standard.

AD8 also offers free official Dante Certification training courses to enable end users to operate Dante networking solutions. This is another factor that would drive switching costs for the OEMs as end users will likely become frustrated if they need to relearn a completely different platform.

Network Effects

In the book, “The Little Book That Builds Wealth” written by Pat Dorsey, a business has a competitive advantage in the form of a network effect where the ‘value of a good or service increases with the number of people using it, then the most valuable network-based products will be the ones that attract the most users, creating a virtuous circle that squeezes out smaller networks and increases the size of dominant networks’. Some famous examples that spring to mind include, Paypal, American Express, Microsoft and eBay etc.  

AD8 benefits from network effects through an increase in the number of users, being the OEMs and the end consumers of the equipment e.g music producers, universities. The increase in the number of OEMs adopting Dante will produce more Dante enabled products available to consumers to purchase, leading to an increase in the likelihood of an end consumer picking a Dante enabled product. On the flipside, when more end consumers purchase Dante enabled equipment, this will exert pressure on OEMs to continue manufacturing Dante enabled equipment because it will be influenced by the majority of what its end consumers prefer.

These network effects are being played out in the private Facebook group, Dante Users Forum, which was created in October 2017 and already has 12,000 members to date. A majority of these members are end users trying to set up the Dante platform, which can get quite complicated depending on the user’s existing equipment and needs. There are daily posts of queries and a lot of the members are very helpful. As more issues arise and become resolved, Dante becomes more ingrained as the predominant networking solution preferred by consumers. Once end consumers fully adopt Dante, they will want to ensure any future equipment they buy is Dante enabled, generating additional revenue for AD8 in the future. The only other competitor that has a similar forum is the Milan AV Community Forum (https://milanavcommunity.proboards.com/), however it only has 135 members and it is not really active. 

Moat Summary

AD8 has a proven track record of developing innovative products with the potential to deepen and widen its moat as more OEMs and end users adopt Dante. I will be using the following lead indicators to monitor AD8’s economic moats.

Intellectual Property

• Number of new patents registered
• Number of design wins with OEMs

Customer loyalty

• Gross profit margins
• Number of OEMs selling Dante-enabled products
• Number of Dante units sold per OEM selling Dante-enabled products
• Number of social media followers and members

Network Effects

• Number of people trained and certified
• Number of social media followers and members