discoverIE Group — Growth strategy drives strong FY19 results

discoverIE is a leading international supplier of customised electronics to industry. Over the last 10 years the company has broadened its product range, customer base and geographical presence via a series of acquisitions. It offers design and manufacturing and value-added distribution services; the focus on differentiated products and expansion along the supply chain is helping the company to expand operating margins. The company intends to continue to grow organically and via acquisition while maintaining its focus on higher-margin business.

discoverIE reported revenue growth of 13% for FY19, with 8% growth on an organic, constant currency basis. Underlying operating profit grew 25% y-o-y with a 0.7pp increase in operating margin to 7.0% and underlying EPS increased 22% y-o-y. The company closed the year with a net debt position of £63.3m, 5% below our forecast due to better than expected working capital management. Our revenue forecasts are substantially unchanged but we increase our Custom Supply operating margins and reduce net finance costs, resulting in a 5.4% upgrade to FY20e normalised EPS. We forecast net debt/EBITDA of 1.2x by the end of FY20.

The stock declined from June 2018 until the end of November 2018, when the company reported strong interims. It has substantially recovered over the course of 2019 and is down c 3% over the last 12 months. The discount to peers has widened since we last wrote and discoverIE now trades at a c 15% discount to its peer group on a P/E basis. Further progress in increasing the weighting of business towards D&M, combined with maintaining the profitability of the CS business should help to close the discount. As discoverIE increases the proportion of revenues generated from D&M we would expect to see meaningful increases in operating margins, which should flow through to the earnings level, and we expect the company to make further accretive D&M acquisitions to accelerate revenue and earnings growth. The stock is supported by a dividend yield above 2%.

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. Currency: with 80% of revenues generated in currencies other than sterling, discoverIE is exposed to the translation of euro and Nordic-denominated subsidiary results into sterling, which had a small negative effect on sales and profits in FY19. 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 may make further acquisitions, which could add integration risk and will require funding.

discoverIE is a supplier of customised electronics to industry with operations throughout Europe and increasingly outside Europe. The last 10 years have seen the integration of a series of acquisitions and a focus on growing the percentage of higher-margin specialist product, resulting in higher profitability. The company intends to continue to grow organically and via acquisitions while maintaining the focus on higher-margin design & manufacturing business.

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 provider of customised electronic solutions with operations in Europe, Asia, North America and South Africa. The company has made a series of acquisitions since 2009 – we provide further detail on page 6. discoverIE operates through two divisions: Design & Manufacturing (D&M: 61% of FY19 revenues) and Custom Supply (CS: 39% of FY19 revenues), with 4,400 employees across 23 countries.

Over the five years from FY13 to FY18, discoverIE more than doubled revenues and underlying EPS and increased underlying operating profit by more than four times. Over the same period, the share price saw a CAGR of 19% and the dividend a CAGR of 7.6%. Management is targeting a further doubling in underlying EPS from FY18 to FY23 (equivalent to a CAGR of 14.9%; the company grew FY19 EPS by 22%), along with a progressive dividend.

Management’s aim is to transform the company into a technology-led provider of customised electronics for industrial applications with design, manufacturing and distribution capabilities. To achieve this, the company has set 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. The company has also highlighted its priorities for the year ahead to generate earnings growth:

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 – bio on page 14) and Simon Gibbins (CFO since 2010 – bio on page 14). The board is chaired by Malcolm Diamond, who is also non-executive chairman of Trifast (where he was CEO from 1984–2002) and Flowtech Fluidpower. Non-executive directors include Bruce Thompson (ex-Diploma CEO 1996–2018), Tracy Graham (also NED at Royal London, Ibstock and Link Scheme) and Clive Watson (ex-group FD of Spectris 2006–2019).

discoverIE specialises in supplying technically demanding, bespoke electronics for industrial applications and has c 25,000 customers over a wide range of end markets. The company estimates that the global niche electronic components market is worth £20bn annually. discoverIE mainly competes against small, privately owned, country-specific suppliers in one or multiple technology areas and expects to continue its active role in consolidating this fragmented market.

Mainly through acquisitions, discoverIE has built up its D&M capability in four of the company’s five technology areas (see Exhibit 2). From this division, discoverIE supplies custom electronic products either designed uniquely or modified from an existing product. More than 80% of products are manufactured in house (with principal facilities in China, India, Mexico, the Netherlands, Poland, Slovakia, Sri Lanka and Thailand) with the remainder manufactured by third-party contractors. Increasingly, these products are also distributed through Acal BFi.

The main business in CS is Acal BFi, a specialist electronics supplier that differentiates itself from high-volume distributors such as Arrow or Avnet by supplying niche components from leading manufacturers (often on an exclusive basis) in a wide range of electronic component areas. The products that the company supplies are often technically complex and therefore require more technical sales support, which discoverIE is able to provide (this is not always available from the product manufacturer or smaller local distributors). discoverIE solutions range from the recommendation and supply of a part, modification of an existing product, or full design and development of a custom solution. A significant proportion of sales comes from products that are either uniquely created for one customer and/or exclusively sourced.

Acal BFi supplies products from a selected group of manufacturers (including the D&M division), across five technology areas to more than 20,000 industrial customers (see Exhibit 2). It operates across Europe, with centralised warehousing, purchasing, finance, customer contact management and IT systems.

Additionally, the division has a separate medical business, Vertec, which supplies exclusively sourced medical imaging and radiotherapy products into medical and healthcare markets in the UK and South Africa.

discoverIE’s solutions are used in both the design and production phases of a customer’s product. The company works with R&D engineers to help them develop new products; once these move 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 service the consumer electronics market (which tends to be highly commoditised with short lifetime products and often highly cyclical sales). Across both businesses, 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.

Exhibit 3 summarises the steady progress discoverIE is making against its KSIs. We discuss below how the company is meeting its strategic objectives.

discoverIE started life as a pure distributor of electronic components, but through a strategy of specialisation and acquisition has transitioned to become a provider of customised electronic solutions. Over the last eight years, the company has acquired 14 businesses with design and manufacturing capabilities – these are significantly more profitable than the CS business. Consequently, while the D&M division generated 61% of FY19 revenues, it generated 78% of FY19 profits. In the CS division, discoverIE is focused on selling highly differentiated customised products. With D&M operating margins of 11.2% in FY19 compared to 5.0% for CS, as the company makes more D&M acquisitions group operating margins should continue to expand.

The company takes a two-pronged approach to growing its revenues ahead of GDP on an organic basis by:

The World Bank recently revised down is global GDP forecasts and is now expecting growth of 2.6% in 2019, 2.7% in 2020 and 2.8% in 2021 (1.7%, 1.5% and 1.5%, respectively for advanced economies). To generate growth ahead of GDP, the company is targeting end markets that look set to benefit from population growth and long-term technology and electronics trends. In FY19, the business generated 66% of its revenues from these four areas, up from 56% in FY18 and 53% in FY17:

Each of discoverIE’s five technology groups has a team of specialist sales and support engineers and their role is to identify customer opportunities. The company has initiatives in place to increase the level of cross-selling to existing customers, with a particular focus on selling D&M products between group companies. When a new company joins the discoverIE group, it can take around three years for cross-selling to become established. Cross-selling generated sales worth £10.6m in FY19 (FY18: £8.8m), ahead of the company’s target of £10m by FY20. The company has therefore increased the target for FY20 to £12m.

discoverIE started the transformation of the business in 2009 with the acquisition of BFi Optilas, the next largest European specialist distributor after discoverIE. This increased discoverIE’s presence in Germany, the UK, France and the Nordic region. discoverIE then proceeded to make a series of acquisitions (see Exhibit 4 above), the largest of which was Noratel for £73.5m in 2014, most with design and manufacturing capabilities.

discoverIE’s focus for future acquisitions is to target companies 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 and similar long-term growth drivers to discoverIE’s focus markets.

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. The acquisitions made post the year end are being managed in this way: Hobart reports into Noratel and Positek into Variohm.

The benefits of being part of the larger discoverIE group include:

The company has analysed the 14 D&M acquisitions it has made over the last eight years, excluding those it has not owned for more than two years (ie Santon, Cursor Controls, Hobart and Positek). Of the 10 businesses, seven have generated a return on investment (ROI1) well above discoverIE’s target of 15% (range 24–115%) and nine were above the company’s WACC of 9%. On average, the whole group is generating an ROI above the target: 20% versus 17% in FY18. The company is taking action to improve the performance of the small business that is generating returns below the company WACC.

Acquisitions remain a key part of the group strategy, with management considering two types: ‘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 ie companies with design and manufacturing capabilities in any of the group’s five technology areas, located in Europe, North America or Asia.

The company’s target for 75% of revenues to be generated from the D&M business in our view assumes a combination of good organic growth and a material level of M&A in that division, with no further acquisitions in the CS division.

At the end of FY19, the company had a net debt position of £63.3m. Its gearing of 1.7x EBITDA was well within the target range of 1.5–2.0x and helped by the £28m fundraising in April, we forecast it to fall to 1.2x by the end of FY20. In February, the company increased its syndicated banking facility from £120m to £180m and extended the remaining term by two years to the end of June 2023. It has an option to extend this by a further year. The facility can be used for acquisitions and working capital. We estimate that the company has debt headroom of £25–30m, based on a maximum of 2x our FY20 EBITDA forecast and the end-FY20e net debt position.

In FY19, 21% of sales were generated outside of Europe, up from19% in FY18. discoverIE’s strategy is to support existing customers’ businesses outside Europe and to make further acquisitions that expand the group’s geographical coverage. Recent acquisitions have targeted companies with sales in North America and Asia Pacific. The two acquisitions made post year-end add international revenues of c £10m on an annualised basis.

discoverIE reported revenues in line with our forecast and underlying/normalised operating profit ahead of our forecast. The group underlying operating margin increased from 6.3% in FY18 to 7.0% in FY19, helped by strong organic growth and the contribution from higher-margin acquisitions. Net interest expense and tax was lower than forecast, resulting in normalised diluted EPS 5.8% ahead of our forecast. The company announced a full year dividend of 9.55p (+6% y-o-y), slightly ahead of our 9.50p forecast. It will review the level of future dividend growth with a view to achieving dividend cover of 3x underlying EPS in the long term (FY19 2.8x).

Exceptional costs totalled £2.0m for FY19, with £1.3m costs incurred for acquisitions, £0.9m to equalise benefits under Guaranteed Minimum Pensions, £0.5m in contingent consideration, £0.4m for IAS 19 pension charges and a credit of £1.1m relating to the insurance payout for the fraud previously disclosed at interims (£2.6m inflow from insurance offset by £1.5m fraud costs incurred in the year).

discoverIE closed the year with net debt of £63.3m, 5% below our forecast. Cash flows benefited from lower than forecast working capital consumption, interest and tax payments, in part offset by slightly higher capex.

Both divisions saw organic growth, with D&M exhibiting strong growth of 10% and CS also benefiting from strong demand in FY19 generating organic growth of 5%. D&M increased underlying operating margins by 0.3pp to 11.2% and CS by 0.4pp, hitting its mid-term target margin of 5%. The company noted that if Santon had not suffered from weak solar demand earlier in the year, the D&M margin would have been above 12% for the year (demand improved in H2). In particular, CS saw good demand from Germany, Italy and the Netherlands.

discoverIE’s performance in FY19 was strong across all KPIs and the cross-selling target has now been increased after the company hit its original target a year early. Operating cash flow improved compared to FY18 – despite building inventory to cope with the possibility of Brexit, working capital consumed less cash than we forecast in FY19. We note that the D&M business requires more working capital than CS, so as the D&M side of the business grows faster, both organically and via acquisition, this puts pressure on the cash flow.

The company ended FY19 with an order book of £139m – 15% higher than a year ago on a constant currency basis and 12% higher on an organic basis. New project wins with an estimated lifetime value of £266m were signed in the year (+40% y-o-y) and 75% of these were in target markets. Book-to-bill for the year was 1.03x, flat compared to FY18. Group orders increased 13% y-o-y (14% CER/8% organic). On a divisional basis, D&M saw 11% organic order growth.

Design activity tends to be technology driven, whereas production activity is more geared to general economic conditions. The manufacturing PMI indices are useful indicators of the health of the industrial sector. Exhibit 9 shows the movement in the manufacturing PMI for the eurozone, France, Germany, the UK and the US since the start of 2017.

After reaching peaks towards the end of 2017, all countries have contracted. Germany, the UK and the wider Eurozone have fallen below 50, with the combination of Brexit and trade tariffs creating significant uncertainty for the global economy. The UK saw a bounce up to 55.1 in March, but it is widely assumed that this was due to inventory building in advance of the original March Brexit date.

The company has not yet seen any significant slowdown in order activity, although it has more modest expectations for FY20 after the strong organic growth of 8% achieved in FY19 and 6% in FY18. As the company is targeting the higher growth markets of renewable energy, transportation, medical and industrial connectivity, in the event of economic slowdown it would expect to be more resilient than the broader market. We believe our revenue forecasts are conservative, assuming CS growth of 1% in FY20/21 and D&M underlying growth of 3% in FY20 and 4% in FY21.We have revised our forecasts to reflect FY19 results and introduced FY21 forecasts. We have lifted our CS margins to 5% ongoing and have reduced our net interest payable forecasts to reflect lower than expected finance costs in FY19. On a reported basis, we have increased our share-based payment forecasts to more accurately reflect the costs and raised amortisation of acquired intangibles to factor in recent acquisitions.

Exhibit 11 shows valuation metrics for discoverIE’s peer group and Exhibit 12 shows their financial performance. The stock declined from April 2018 until the end of November 2018, when the company reported strong interims. It has substantially recovered over the course of CY19 and is down c 3% over the last 12 months. Since we last wrote in April, the discount to peers has widened, with discoverIE trading at a 17% discount this year and 12% discount next year on a P/E basis. Further progress in increasing the weighting of business towards D&M, combined with maintaining the profitability of the CS business should help to close this discount.

D&M made up 61% of FY19 revenues; absent any acquisitions, we forecast this will increase to 63% by FY21 and the company is targeting this to reach 75% over the next three to five years. We expect the company to make further accretive acquisitions in the D&M space, which should boost the revenue growth rate and accelerate the growth in operating margins and EPS.

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