discoverIE Group — Record order book drives upgrades

discoverIE is a leading designer and manufacturer of components for electronic applications. Over the last 11 years, the company has broadened its product range, customer base and geographical presence via a series of acquisitions. It designs and manufactures differentiated products, and expansion along the supply chain is helping the company to expand operating margins. discoverIE intends to continue to grow organically and via acquisition while maintaining its focus on higher-margin business. To grow revenues well ahead of GDP, it is focused on four structural growth markets: renewable energy, transportation, medical and industrial & connectivity. Its capital-light business model supports strong cash flow generation, with the aim of increasingly self-funding acquisitions.

H122 results were the first to be reported under the new group structure, with CS treated as a discontinued operation. The D&M business, treated as continuing operations, reported strong organic revenue growth versus H121 (+15%) and pre-COVID H120 (+8%), resulting in 32% y-o-y growth in group underlying operating profit and an operating margin of 10.3%. The disposal of CS will provide c £40m in cash in H222, resulting in pro forma net debt/EBITDA of 0.9x at the end of H122, compared to the company’s target range of 1.5–2.0x. On the back of strong H122 revenue and order performance, we have revised up our underlying EPS forecasts by 5.6% in FY22 and 3.0% in FY23 and our normalised EPS (excluding share-based payments) by 7.1% for FY22 and 3.4% for FY23. With debt headroom of c £70m, we expect the company to continue to make acquisitions in the D&M space, with a focus on higher-margin businesses operating in structural growth markets.

The stock has gained 63% over the last year and now trades towards the upper end of its peer group on an EV/EBITDA and P/E basis. In our view, this reflects the group’s potential to drive earnings growth through accretive acquisitions. The disposal of the CS business provides the company with resources to fund further acquisitions and frees up management to fully focus on the growth of the D&M business.

Our estimates and discoverIE’s share price will be sensitive to the following factors. Customer demand: demand will be influenced by the economic environment in Europe and increasingly in North America and Asia. Supply chain: raw materials and components are sourced globally so the company must manage around availability. Currency: with 89% of revenues generated in currencies other than sterling, discoverIE is exposed to the translation of euro, US dollar and Nordic-denominated subsidiary results into sterling, which had a small negative effect on sales and profits in FY21. Pricing: discoverIE’s revenues and profitability are sensitive to its ability to include in price quotes engineering time spent on designing customer solutions. The company normally passes through supplier price increases and tariffs. Acquisitions: discoverIE expects to make further acquisitions, which could add integration risk, and larger deals may require equity funding.

discoverIE designs and manufactures customised electronics for industry with operations throughout Europe and increasingly outside Europe. The last 11 years have seen the integration of a series of acquisitions and a focus on growing the percentage of higher-margin specialist products, resulting in higher profitability. The company recently agreed to sell its distribution business, leaving it fully focused on growing its higher-margin D&M business through a combination of organic investment and acquisitions.

discoverIE was founded in 1986 and was admitted to the official list of the LSE in 1994 as a pure distributor of electronic components. After a change in management in 2009, through its strategy of specialisation the company has transitioned to become a designer and manufacturer of customised electronics with operations in Europe, Asia and North America. The company has made a series of acquisitions since 2009 – we provide further detail on page 7. Until recently, discoverIE operated through two divisions, Design & Manufacturing (D&M) and Custom Supply (CS). As the disposal of the CS business should be completed by the end of FY22, it is now treated as a discontinued operation in the company’s accounts. The remaining D&M business has 4,500 employees across 24 countries and our report focuses solely on the continuing operations.

discoverIE specialises in the design and manufacture of technically demanding, bespoke electronics for industrial applications and is focused on four target markets comprising 77% of group sales – renewables, electrification of transportation, medical and industrial & connectivity – all of which are long-term structural growth markets. The market for niche electronic components is very fragmented and discoverIE mainly competes against small, privately owned, country-specific manufacturers in one or two technology areas. The company expects to continue its active role in consolidating this market.

Mainly through acquisition, discoverIE has built up its D&M capability in four areas of technology: sensors, magnetics, components and systems. discoverIE’s custom electronic products are either designed uniquely or modified from an existing product. More than 80% of products are manufactured at 30 sites across 18 countries (principal facilities in China, India, Mexico, the Netherlands, Poland, Sri Lanka, Thailand and the UK), with the remainder manufactured by third-party contractors. discoverIE spends c 2% per annum on its manufacturing facilities and another 2% on R&D. As well as direct sales, some products are also distributed through the CS business, and this will continue post-disposal of CS.

discoverIE’s components are used in both the design and production phases of a customer’s product. discoverIE’s engineers work with its customers throughout their product development process, from design concept to volume manufacturing. Once the new product moves into production, discoverIE supplies on a volume basis for the life of the product. We highlight that discoverIE is focused on industrial OEMs and does not serve the consumer electronics market (which tends to be highly commoditised with short lifetime products and often highly cyclical sales). A customer will typically take six to 24 months to move a product from design to production, at which point the company should earn revenues for the life of the product, typically five to seven years.

The group is focused on markets with sustainable growth prospects and increasing electronic content where there is an essential need for its products. It invests in initiatives and businesses that enhance design opportunities for customised products in targeted long-term structural growth markets.

Management has transformed the company into a technology-led provider of customised electronics for industrial applications with design and manufacturing capabilities. The company has the following strategic objectives:

To track progress with these objectives, the company has set key strategic indicators (KSIs) and key financial performance indicators (KPIs), which we discuss in more detail later in this report.

To support its growth ambitions, discoverIE has constructed a board with substantial experience in acquisitions and international growth. Executive directors include Nick Jefferies (CEO since 2009 – biography on page 13) and Simon Gibbins (CFO since 2010 – biography on page 13). The board is chaired by Malcolm Diamond (previously non-executive chairman of Trifast (2017–19) and CEO (1984–2002)). Non-executive directors include Bruce Thompson (ex-Diploma CEO 1996–2018, non-executive chairman at Avon Rubber), Tracey Graham (also NED at Royal London, Ibstock and Link Scheme), Clive Watson (ex-group FD of Spectris 2006–19, NED at Breedon Group, Kier Group and Trifast) and Rosalind Kainyah (runs ESG consultancy Kina Advisory; previously VP External Affairs & CSR at Tullow Oil and various roles at De Beers).

Exhibit 1 summarises the steady progress discoverIE is making against its KSIs. These were updated with the FY20 results with new targets to run for five years, and more recently revised to reflect the disposal of the CS business. We discuss below how it is meeting its strategic objectives. As H121 was hit by the impact of COVID, the company compares H122 performance to the pre-COVID period H120. The table summarises group performance including D&M and CS for the years FY14 to FY21 and for H120. H122 and the new targets are for continuing D&M operations only.

discoverIE started life as a pure distributor of electronic components, but through a strategy of specialisation and acquisition it has transitioned to become a designer and manufacturer of customised electronic solutions. Over the last 10 years, the company has acquired 19 businesses with design and manufacturing capabilities; these are typically much higher margin than the original distribution business, with recent acquisitions generating operating margins of 20%+.

The charts below show the financial performance of the continuing business over the last five years and our forecasts for FY22-23. FY21 results were affected by pandemic-related demand weakness, although the underlying operating margin remained flat in FY21. In H122, growth rebounded and the group achieved 15% year-on-year organic revenue growth, 8% organic revenue growth versus H120 and a 10.3% underlying operating margin. The revised target is for a 13.5% underlying operating margin by FY25, to be achieved through a combination of organic growth and higher-margin acquisitions.

Sales beyond Europe increased from 28% of total revenue in H121 to 38% in H122. Of this 10pp increase, 7pp was from the disposal of the CS business, which had a higher proportion of revenue from the UK and Europe, 2pp was from the five acquisitions over the last year and 1pp was due to strong organic growth in Asia. As the continuing operations already have 40% annualised sales from outside Europe, the FY25 target has been raised from 40% to 45%.

As part of the group’s goal to grow revenue well ahead of GDP on an organic basis, discoverIE is targeting higher-growth markets. These are markets that are exhibiting structural growth and depend on technology for product development, resulting in increasing electronic content. discoverIE aims to supply essential products to OEMs in these markets. With the increasing focus on ESG by investors and consumers alike, the company is keen that its target markets also align with the UN’s Sustainable Development Goals (SDGs).1

The table below describes the four target markets, the growth prospects of each market and examples of products that discoverIE provides for each market. In H122, the business generated 77% of its revenues from these four areas (H121: 68%, H120: 66%) and is targeting this to grow to 85% over the next five years. Of the 9pp increase y-o-y, 5pp came from the disposal of CS, which had less exposure to the target markets. As business in the target markets tends to grow faster than other markets, and recent acquisitions have a higher weighting towards target markets, this accounted for the remaining 4pp of the increase.

From 2011 discoverIE started to make a series of acquisitions of companies with design and manufacturing capabilities (see Exhibit 5 below). The company has a dedicated M&A team focused on developing and pursuing opportunities.

discoverIE’s focus for future acquisitions is to target D&M companies with commercially viable technologies that can be applied to its target markets or with complementary product and/or geographical capability supplying common markets and customers. The preference is to buy businesses that are successful and profitable, with good growth prospects, good margins and similar long-term growth drivers to discoverIE’s focus markets but need scaling up.

Many of the acquired businesses have been led by entrepreneurial managers and discoverIE is keen to retain this culture. To support this, acquired businesses typically continue to operate under their own brands and management, working towards agreed business plans. discoverIE has started to create technology clusters, where smaller businesses are taken under the wing of a larger business operating in the same product area. At the same time, they are able to take advantage of being part of the larger group, with access to the wider discoverIE customer base, support for product development and manufacturing, centralised finance and administrative support. Efficiency improvements are achieved through knowledge-sharing amongst the D&M businesses and group guidance on best practices. Where appropriate, manufacturing is rationalised to make the most efficient use of the group’s network of manufacturing facilities.

The table below summarises the D&M acquisitions the group has made since FY12.

The company has analysed the D&M acquisitions it has made since 2011, excluding those it has not owned for at least two years, to calculate the return on investment (ROI: average operating profit since acquisition divided by acquisition cost, which includes acquisition costs, earn-outs and integration costs). These 13 businesses delivered an average ROI of 16% by FY21 over the life of the acquisitions, ahead of the company’s 15% target, and nine of the 13 businesses are generating an average ROI of 15% or more.

After a brief halt at the height of the pandemic, discoverIE resumed its M&A strategy in October 2020 with the acquisition of Phoenix America (Phoenix). It has since made four more acquisitions and notes that it has a pipeline of deals under consideration.

Management considers two types of acquisition: ‘platform’ to create a new position in a technology and/or geography and ‘bolt-on’ to expand the position of an existing business. The company’s M&A director is focused on sourcing new acquisition targets in discoverIE’s key technological and geographical markets, namely companies with design and manufacturing capabilities in any of the group’s technology areas, located in Europe, North America or Asia.

At the end of H122, the company had a net debt position of £75.6m and gearing of 1.3x EBITDA. Taking into account the soon to be completed CS disposal, pro-forma gearing was 0.9x at the end of H122. The company has a £180m revolving credit facility (RCF) due in June 2024, and also has access to a £60m accordion facility; it can be used for acquisitions and working capital. The company targets a gearing range of 1.5–2.0x, suggesting c £70m headroom for further acquisitions.

At the start of 2020, the board and group executive committee initiated a review of the company’s approach to ESG matters, with the aim of further improving the group’s approach to sustainability. As a result of this, the company has committed to spending £3m over the next five years to resource and deliver its ESG strategy. From a governance perspective, the company has appointed a new non-executive director, Rosalind Kainyah, with ESG experience, and has set up its first external board evaluation. Each member of the group executive committee has a specific ESG responsibility and targets within their personal objectives relating to ESG, with a proportion of annual bonus dependent upon achievement of those targets.

After the review, the company set three primary aims:

The table below shows the targets set to work towards achieving each aim, and progress to date.

Exhibit 7 summarises the performance of the continuing operations in H122 and H121. Reported revenue increased 21% y-o-y or 24% at constant exchange rates (CER). On an organic, CER basis revenue increased 15% y-o-y, or 8% compared to H120. Underlying operating profit increased 32% y-o-y and the margin expanded from 9.5% to 10.3%. Underlying EPS increased 37% y-o-y.

The company recorded one-off acquisition-related charges totalling £3.3m in H122, including £1.6m for the three acquisitions made during the period, £1.3m for accrued contingent consideration and £0.4m for integration of an earlier acquisition. Amortisation from acquired intangibles increased to £6.4m in H122 from £5.3m in H121, reflecting the acquisitions made over the last 12 months. Overall, this resulted in reported EPS increasing by 14% y-o-y.

The table below shows discoverIE’s KPIs and we discuss the performance below.

H122 orders increased 75% y-o-y CER to £221.2m and by 64% y-o-y on an organic basis. Compared to H120, orders were 49% higher CER and 34% higher on an organic basis. Book-to-bill for H122 was 1.27x, versus 1.16x in H221, 0.9x in H121 and 1.02x in H120. The order book at end H122 of £198m was 71% higher year-on-year on an organic basis and 54% higher than at the end of H120. Design wins with an estimated lifetime value of £145m in H122 were 56% ahead of the prior year, with 80% of wins in target markets. A year ago, customers were placing short-term orders at normal levels but were more reluctant to place longer-term frame orders. Normal ordering behaviour resumed in H221; c 80% of the order book is due for delivery in the next 12 months.

Management noted that the second half has started well with continued order and sales growth over the same period last year and two years ago. The group is on track to deliver full year earnings for the continuing operations ahead of the board’s previous expectations, despite ongoing supply chain and foreign exchange headwinds.

We have revised our forecasts to reflect H122 performance and order intake, lifting our underlying diluted EPS forecasts by 5.6% in FY22 and 3.0% in FY23 and our normalised EPS (which excludes share-based payments) by 7.1% in FY22 and 3.4% in FY23

Exhibit 10 shows financial metrics for discoverIE’s peer group and Exhibit 11 shows the valuation metrics. For the peer group, we use companies active in the electronics market and acquisitive industrial companies. After a gain of 63% over the last 12 months, the stock is trading at the upper end of its peer group on EV/EBITDA and P/E multiples. The company is growing revenue at a faster rate than peers but is below the average in terms of profitability. Management has set a new underlying operating margin target of 13.5% by FY25, which we expect to be achieved through a combination of organic growth and higher-margin acquisitions.

Our estimates and the discoverIE share price will be sensitive to the following factors: