discoverIE Group — Focused on sustainable growth

discoverIE is a leading designer and manufacturer of components for electronic applications. Over the last 12 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. The company is refining its ESG strategy, recently announcing net zero commitments, which should enable it to grow on a sustainable basis.

discoverIE reported robust H123 results: revenue was 26% higher y-o-y (23% constant currency, 14% organic), underlying operating profit was 42% higher and underlying EPS 37% higher. Magnetics & Controls reported 17% organic growth and a 13.2% underlying operating margin (+1.1pp y-o-y); Sensing & Connectivity saw 11% organic growth and a 16.3% underlying operating margin (+0.2pp). Management anticipates delivering underlying earnings in line with board expectations for FY23. We have revised our forecasts to reflect H123 performance. We raise our revenue and underlying operating profit forecasts, which are offset by increases in interest costs and in FY23, a slightly higher tax rate. We have raised our dividend forecasts for both years, bringing them closer to the historical 6% annual growth rate

The stock has declined c 17% over the last year, in line with the market, and continues to trade towards the top end of its broader UK industrial technology peer group on a P/E basis. However, it trades at a discount compared to peers with a similar decentralised operating model (such as Halma and Spirax). The focus on strategic growth markets supports sustained organic revenue growth and we see potential for upside to earnings through operating margin expansion and accretive acquisitions. The company has headroom for further acquisitions, with gearing of 0.8x at the end of H123 well below the target range of 1.5–2.0x, a recently expanded credit facility and a strong pipeline of opportunities.

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 90% 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. 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 12 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.

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 design and manufacturing acquisitions since 2011 – we provide further detail in Exhibit 9. discoverIE sold its Custom Supply distribution business in FY22 and is now fully focused on higher margin design and manufacturing. The group has c 5,000 employees across 20 countries.

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.

discoverIE’s components are used in both the design and production phases of a customer’s product, where they tend to be a small but essential part of the systems they are designed into. 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.

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 20 countries (principal facilities in China, India, Mexico, the Netherlands, Poland, Sri Lanka, Thailand and the UK), with the remainder manufactured by third-party contractors. This enables the company to support customers operating internationally and provides flexibility in the event that a manufacturing facility encounters challenges. discoverIE spends c 2% of revenue per annum on its manufacturing facilities to support organic growth and another 2% on R&D.

The majority of products are manufactured in-house from raw materials and base components. Energy costs represent less than 1% of group revenue, as operations are mainly manual or semi-automated.

Mainly through acquisition, discoverIE has built up its design and manufacturing capability in four areas of technology: sensors, magnetics, controls and connectivity. Since the sale of the Custom Supply business in FY22 (see Fully focused on Design & Manufacturing) the remaining design and manufacturing business has been reported through two divisions: Magnetics & Controls and Sensing & Connectivity. Exhibit 1 shows the companies and brands reported within each division. Magnetics & Controls consists of eight businesses across 17 countries with 20 manufacturing sites. Sensing & Connectivity consists of 13 businesses across nine countries with 10 manufacturing sites.

Exhibits 2 and 3 show the progression of revenue in each division and the timing of acquisitions.

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) and Simon Gibbins (CFO since 2010). The board is chaired by Bruce Thompson (non-executive director (NED) at discoverIE since 2018, ex-Diploma CEO 1996–2018, non-executive chairman at Avon Protection). Non-executive directors include Tracey Graham (also NED at Ibstock, Close Brothers Group, Nationwide Building Society and Link Scheme), Clive Watson (ex-group FD of Spectris 2006–19, NED at Breedon Group, Kier Group and Trifast, ex-audit chair of Spirax Sarco for 11 years) and Rosalind Kainyah (runs ESG consultancy Kina Advisory, NED at GEM Diamonds and CalBank, previously VP external affairs & CSR at Tullow Oil).

Group executive management includes the CEO and CFO supported by group commercial directors for Sensing & Connectivity (Paul Hill) and Magnetics & Controls (Martin Pangels), group head of corporate development (Jeremy Morcom) and group general counsel and company secretary (Greg Davidson).

Exhibit 4 summarises the steady progress discoverIE is making against its KSIs. We discuss below how it is meeting its strategic objectives. Data for H122, FY22 and H123 is for continuing 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. Since 2011, the company has acquired 20 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 FY23–24. FY21 results were affected by pandemic-related demand weakness, although the underlying operating margin remained flat in FY21. The margin increased 1.4pp y-o-y in H123 to 11.7% and was 0.8pp higher than the 10.9% achieved in FY22. The target is for a 13.5% underlying operating margin by FY25, to be achieved through a combination of organic growth and higher-margin acquisitions.

For FY24, we estimate that a 0.5pp organic increase in underlying operating margin from our current 11.2% forecast would increase our underlying EPS forecast by c 5%.

Sales beyond Europe increased from 38% of total revenue in H122 to 40% in FY22 and 41% in H123, benefiting from Beacon’s US exposure (see High-margin acquisitions). Exhibit 7 shows organic revenue growth by geography in H123. Partly due to supply chain challenges over the last few years, there is an ongoing trend to re-shore or near-shore manufacturing. The decline in China revenues is a combination of this and ongoing COVID shutdowns. On the contrary, growth in India reflects customers setting up production there to take advantage of the country’s India-first strategy.

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 United Nations’ 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 H123, the business generated 77% of its revenues from these four areas (FY22: 76%, FY21: 70%) and is targeting this to grow to 85% by FY25. Typically, growth from target markets exceeds other markets, as evidenced by the six-year organic CAGR of 12% and 7% respectively. In H123, this situation was partially reversed, with growth from target markets of 14% compared to growth of 17% from other markets. The company saw a 20% increase in three target markets but a 6% decline in renewables revenues, mainly due to weaker demand from wind turbine manufacturers, while other markets showed a strong recovery from a lower base. However, the company believes that the slowdown in the wind sector is temporary and remains confident of its long-term growth prospects driven by decarbonisation trends.

While the company does not actively stop supplying customers in non-target markets, it encourages each business to focus its sales efforts on target markets and builds this approach into acquired companies’ three-year plans. As target markets typically grow faster than non-target markets, over time the contribution from target markets should grow as a percentage of total revenue. The focus on these structural growth markets should provide some insulation against any shorter-term economic slowdown.

From 2011 discoverIE started to make a series of acquisitions of companies with design and manufacturing capabilities (see Exhibit 9 below). The company has a dedicated M&A team focused on developing and pursuing opportunities.

discoverIE’s focus for future acquisitions is to target design and manufacturing companies with commercially viable technologies that can be applied to its target markets or with complementary product(s) 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 which need scaling up.

The acquired businesses are 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 created 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 among the 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 acquisitions the group has made since FY12.

The company has taken a disciplined approach to M&A; based on initial consideration, it has paid an average of 8.2x trailing PBT and 1.4x trailing sales for businesses with average PBT margins of 17.5%. This compares to 20.0x, 2.0x and 10% for discoverIE, respectively.

For H123, the company analysed the current EBIT return on investment (ROI) of all 16 acquisitions that it has owned for more than two years. It measures ROI as annualised operating profit for H123 divided by acquisition cost (upfront consideration, acquisition expenses, earn-out and integration costs). The average EBIT ROI was 21%, well above the group’s 15% target and 2pp higher than for FY22. Thirteen of the acquisitions were at or above the target ROI with the remaining three positive, but below 15%. Two of the underperforming companies have been affected by the shortage of semiconductors and are expected to start to generate better returns as the supply chain normalises, while the third business is now under new management.

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 five more acquisitions and 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 H123, the company had a net debt position of £45.2m and gearing of 0.8x EBITDA. The company has a £240m revolving credit facility (RCF) due in June 2026, with an option to extend to June 2027. It also has access to an £80m accordion facility; the RCF can be used for acquisitions and working capital. The company targets a gearing range of 1.5–2.0x, suggesting c £70–100m headroom for further acquisitions.

This was set as an annual test compared to CY19 emissions. For CY21, emissions intensity was 33% below the level in CY19 on a like-for-like basis and the company estimates that this now stands at around 40%. With the new targets set for net zero carbon emissions (see below), the company has increased this target, seeking a 65% reduction in absolute emissions from the level at the end of CY21 by the end of CY25. During H123, the company accelerated its Sri Lankan solar panel installation project: phase 1 is already complete and phases 2 and 3 are expected to be finished in early 2023. Overall the three phases combined should reduce scope 1 and 2 emissions by c 15%. The company has also approved solar panel installation at its factory in Thailand, with completion expected by the end of 2023.

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, the company committed to spending £3m over the next five years to resource and deliver its ESG strategy.

In November 2021, the company appointed non-executive director, Rosalind Kainyah, with in-depth ESG experience, effective 1 January 2022. She has since established and chairs the sustainability committee (effective 1 April 2022), which includes all board members, to help set the group’s overall strategy and ensure the board has access to the knowledge and skills required in this area. Below this, the group sustainability team drives initiatives throughout the group and liaises with operating companies to consider what is practical and feasible.

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 on achievement of those targets. Recently, the company has rolled out ESG objectives to the management of individual operating businesses.

The company has set three primary aims for its ESG strategy:

As well as ongoing initiatives in each area (eg increasing diversity, development and training plans for staff, supplier audits, responsible sourcing policies, enhancing cyber security controls), measurable targets have been set to work towards achieving each aim. See Exhibit 10 for targets and progress to date. We note that the reduction in carbon emissions has also been added as a key strategic indicator for the group.

With H123 results, the company announced that it had set net zero carbon emission targets (Science Based Targets initiative (SBTi)-aligned). Based on scope 1 and 2 carbon emissions, the company is aiming to reach net zero carbon emissions by 2030. Including scope 3 emissions, it is targeting 2040. Of the 7,745tCO2e scope 1 and 2 emissions in CY21, around 95% came from four emissions sources: purchased electricity, natural gas, company-owned vehicles and refrigerants. To track progress, the company has set the following milestones:

As the group operates on a decentralised model, it is more time consuming to measure scope 3 emissions from the supply chain, and these are not yet disclosed (scope 3 emissions from the group’s own operations are). The group is undertaking a full screening of scope 3 emissions, which it expects to complete in early 2024, after which it will produce and submit a detailed reduction plan to SBTi .

In its FY22 annual report, discoverIE published its first Task Force on Climate-Related Financial Disclosures (TCFD) report. The group has undertaken a preliminary assessment of the resilience of its business model and strategy, and potential impact of climate change over the short and medium term. It has concluded that while it may be exposed to certain risks during the transition to a low carbon economy, such risks are considered to be low and more than outweighed by the opportunities presented to the group. In 2022, the company disclosed climate change related information through the Carbon Disclosure Project for the first time.

In April, the company received an ‘A’ rating from MSCI in its 2022 ESG rating assessment. In October, the company received a low-risk rating from Sustainalytics ESG risk rating service.

discoverIE reported H123 revenue growth of 26% (23% CER, 14% organic CER). Organic growth was from a combination of 8% volume growth and 6% price increases (pass through of higher input costs to customers). The company no longer reports gross profit but confirmed that gross margins were maintained despite supply chain challenges and the inflationary environment. This resulted in good operational leverage, with underlying operating profit increasing 42% y-o-y and the margin increasing 1.4pp to 11.7%. The effective tax rate of 26% was slightly higher than our 25.4% expectation, due to the profit mix towards higher-rate territories. With higher share diluted count than a year ago reflecting the September 2021 fund raise, underlying diluted EPS increased 37% yo-y. Reported operating profit, which reflects one-off costs of £0.9m (acquisition and disposal expenses) and amortisation of acquired intangibles of £7.8m, increased 104% y-o-y.

Exhibit 12 shows discoverIE’s KPIs and we discuss the performance below.

Book-to-bill for H123 was 1.08x versus 1.27x in H122. H123 orders were 5% higher y-o-y at constant exchange rates and 1% lower on an organic basis (after 64% organic growth in H122). The order book at end-H123 of £257m was 21% higher year-on-year on an organic basis. Management expects the order book to gradually unwind as customers take delivery of orders in H223. In H123, design wins with an estimated lifetime value of £154m were 6% ahead of the prior year, with 85% of wins in target markets, and management highlighted a strong ongoing project pipeline.

Management anticipates delivering underlying earnings in line with its expectations for FY23. We have revised our forecasts to reflect H123 performance. We raise our revenue and underlying operating profit forecasts, which are offset by increases in interest costs and in FY23, a slightly higher tax rate. We have raised our dividend forecasts for both years, bringing them closer to the historical 6% annual growth rate.

Exhibit 14 shows financial metrics for discoverIE’s peer group and Exhibit 15 shows the valuation metrics. For the peer group, we use companies active in the electronics market and acquisitive industrial companies. The stock has declined c 17% over the last year, in line with the market, and continues to trade towards the top end of its broader UK industrial technology peer group on a P/E basis. However, it trades at a discount compared to peers with a similar decentralised operating model (such as Halma and Spirax). The focus on strategic growth markets supports sustained organic revenue growth and we see potential for upside to earnings through operating margin expansion and accretive acquisitions. The company has headroom for further acquisitions, with gearing of 0.8x at the end of H123 well below the target range of 1.5–2.0x, a recently expanded credit facility and a strong pipeline of opportunities.

As we discussed earlier, discoverIE has historically made accretive acquisitions, paying on average 8.2x trailing PBT for companies with an average PBT margin of 17.5% (which we assume is broadly equivalent to operating margin). In recent years, the company has focused on companies with higher margins, typically 20%+. As an illustration of the potential for earnings accretion, if we assume that if discoverIE spends £50m on a company with operating margins of 20% and pays 8x PBT, we estimate that this would increase our FY24 underlying operating margin by 0.6pp to 11.8% and increase our FY24 underlying diluted EPS forecast by 7.5%, while increasing end-FY23 gearing to 1.3x (compared to our current forecast of 0.7x). In the current uncertain macroeconomic environment, management noted that sellers’ price expectations have started to become more realistic.

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