discoverIE Group — H1 organic growth supports FY19 outlook

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discoverIE Group

H1 organic growth supports FY19 outlook

H119 results

Electronic & electrical equipment

18 December 2018

Price	389p
Market cap	£285m
€1.11:NOK10.98:£1
Net debt (£m) at end H119		62.6

Shares in issue	73.4m
Free float	96%
Code	DSCV

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	13.6	1.0	3.5
Rel (local)	18.2	10.5	15.1

52-week high/low

455p

325p

Business description

discoverIE (formerly Acal) is a leading international designer and manufacturer of customised electronics to industry, supplying customer-specific electronic products and solutions to 25,000 industrial manufacturers.

Next events

Q3 trading update

January 2019

Analysts

Katherine Thompson	+44 (0)20 3077 5730
Dan Ridsdale	+44 (0)20 3077 5729

tech@edisongroup.com

Edison profile page

discoverIE Group is a research client of Edison Investment Research Limited

discoverIE reported H119 revenue growth of 11%, with 7% organic growth and 5% growth from the Santon acquisition offset by a 1% currency effect. Good order intake in H1 provides support for growth in H2 and management sees FY19 trading in line with its expectations. We have revised our forecasts to reflect H1 trading, resulting in upgrades to our normalised EPS forecasts of 3% in FY19e and 2% in FY20e.

Year end	Revenue (£m)	PBT* (£m)	EPS* (p)	DPS (p)	P/E (x)	Yield (%)
03/17	338.2	17.8	19.9	8.5	19.6	2.2
03/18	387.9	22.6	23.0	9.0	16.9	2.3
03/19e	428.5	26.4	26.3	9.5	14.8	2.4
03/20e	445.4	28.0	27.5	10.0	14.2	2.6

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

Organic revenue growth and margin expansion in H1

discoverIE organic revenues grew 7% y-o-y in H119, with 10% growth from Design & Manufacturing and 2% growth from Custom Supply. The Santon acquisition (February 2018) added a further 5% to growth. Both divisions expanded margins year-on-year, resulting in an underlying group operating margin of 6.8%, +0.6pp versus H118. Net debt at the end of H119 was £62.6m, equating to a net debt/ EBITDA ratio of 1.85x. The company proposed an interim dividend of 2.8p per share (+6% y-o-y).

Outlook remains positive; preparing for Brexit

The company saw a 13% constant currency year-on-year increase in orders to close H119 with an order book worth £131m (+18% CER, +13% organic) and a book-to-bill for H1 of 1.03x. Our underlying operating profit forecasts are substantially unchanged. We have revised our forecasts to reflect the reduction in contingent consideration payable to Santon as well as a planned increase in inventory to manage any supply chain disruption relating to Brexit and slightly lower financing costs. This results in small upgrades to our normalised EPS forecasts (+3% FY19e, +2% FY20e), an increase in net debt at end FY19e from £70.0m to £72.7m and a reduction at end FY20e from £68.6m to £65.7m.

Valuation: Growth in D&M business to drive upside

The company continues to make good progress in its strategy to move up the value chain by building higher margin D&M revenues, acquire businesses with good growth and margin potential and internationalise its business. The stock is trading on an EV/EBITDA of 8.9x (at a 9% discount to its peer group) and broadly in line on a P/E basis. With continuing growth and higher margins, further progress in increasing the weighting of business towards D&M (including accretive acquisitions), combined with good control over the profitability of the CS business should help to close the valuation gap further. The stock is also supported by a dividend yield of more than 2%.

H119 divisional performance

Exhibit 1: Divisional revenue and profitability (£m)

Revenues	H119	H118	H118 CER	Reported y-o-y	CER y-o-y	Like-for-like
Design & Manufacturing	127.8	108.2	106.7	18%	20%	10%
Custom Supply	83.9	82.0	81.9	2%	2%	2%
Total revenues	211.7	190.2	188.6	11%	12%	7%
Underlying operating profit
Design & Manufacturing	14.2	11.8	11.6	20%	22%
Custom Supply	3.9	3.3	3.3	18%	18%
Unallocated	(3.6)	(3.3)	(3.3)	9%	9%
Total underlying operating profit	14.5	11.8	11.6	23%	25%
Adjusted operating margin
Design & Manufacturing	11.1%	10.9%	10.9%	0.2%	0.2%
Custom Supply	4.6%	4.0%	4.0%	0.6%	0.6%
Total underlying operating margin	6.8%	6.2%	6.2%	0.6%	0.7%

Source: discoverIE

Exhibit 1 summarises divisional performance at the revenue and underlying operating profit level. discoverIE reported H119 year-on-year revenue growth of 11.3%, with 2.3% growth from Custom Supply (CS) and 18.1% growth from Design & Manufacturing (D&M). At constant exchange rates (CER), D&M revenues grew 20%, of which 10% was organic growth and 10% was from acquisitions. As previously flagged, in the summer Santon saw a drop in orders relating to the Chinese solar market after a cut in Chinese feed-in tariffs. Since the end of H119, orders have returned to the pre-tariff cut levels. Geographically, the division saw organic growth of 14% in Germany, 11% in North America and 25% in Asia. The company noted that the imposition of China/US tariffs is likely to have minimal impact on profitability: of the £11m of sales to the US in H1, c £2.5m were manufactured in China and were subject to tariffs of up to 25%. The company is passing on this additional cost to customers. Over time, the company expects to move some of this production to sites in India, Sri Lanka or Thailand.

CS saw reported and organic growth of 2% y-o-y, with Q2 growth of 4%; as well as good growth in continental Europe, the UK returned to growth (+1% for H1, +5% for Q2). Book-to-bill for H1 was 1.01x. Cost-cutting measures taken a couple of years ago combined with revenue growth resulted in operating margin expansion, up 0.6pp to 4.6% and close to the company’s 5% target.

The company continues to target the growth markets of:

■

Renewable energy

■

Transportation

■

Medical

■

Industrial connectivity

In H119, more than 60% of revenues and 80% of design wins came from these four markets.

Update on key performance and strategic indicators

The company’s strategy is to:

■

grow sales well ahead of GDP over the economic cycle by focusing on strategic growth markets;

■

move up the value chain by continuing to build revenues in the higher margin D&M division;

■

acquire businesses with attractive growth prospects and strong operating margins; and

■

internationalise the business by developing sales in North America and Asia.

To measure the progress of its strategy, the company tracks key strategic and performance indicators (KSIs and KPIs).

The company made steady progress against KSIs and KPIs in H119. D&M contributed 60% of group revenues. As adjusted operating margins for both divisions have grown and the proportion of higher margin D&M revenues has increased, this has resulted in expanding group operating margins. Sales outside Europe made up 20% of H119 revenues; the pace at which this increases will very much depend on the shape of businesses that discoverIE acquires. The company is very close to hitting its cross-selling target of £10m in annual sales. Operating cash flow generation of 84% was close to the target – the company noted that due to inventory requirements, the D&M business needs more working capital than CS (22% of sales in D&M versus 13% of sales in CS), and as it is growing much faster than CS, the conversion rate of operating cash reduces. Conversely, D&M is much more profitable (c 12% operating margin in D&M vs c 5% in CS) so the return on incremental capital in D&M is much greater.

Exhibit 2: KSIs


	FY14	FY15	FY16	FY17	FY18	H119	Mid-term target
Increase Design & Manufacturing revenue	18%	37%	48%	52%	57%	60%	75%
Increase underlying operating margin	3.4%	4.9%	5.7%	5.9%	6.3%	6.8%	8.5%
Build sales beyond Europe	5%	12%	17%	19%	19%	20%	30%

Source: discoverIE

Exhibit 3: KPIs

	FY14	FY15	FY16	FY17	FY18	H119	3yr target (FY20)
Sales growth: CER	17%	36%	14%	6%	11%	12%
Sales growth: organic	2%	3%	3%	-1%	6%	7%	Well ahead of GDP
Increase cross-selling	£0.3m	£0.9m	£3.0m	£4.6m	£8.8m	£9.7m*	£10m pa
Underlying EPS growth	20%	31%	10%	13%	16%	24%	>10%
Dividend growth	10%	11%	6%	6%	6%	6%	Progressive
ROCE*	15.2%	12.0%	11.6%	13.0%	13.4%	14.8%	>15%
Operating cash flow generation	100%	104%	100%	136%	85%	84%	>85% of underlying profit

Source: discoverIE. Note: *Annualised.

H119 results review

Exhibit 4: Half-year results highlights

£m	H119	H118	y-o-y
Revenues	211.7	190.2	11.3%
Custom Supply	83.9	82.0	2.3%
Design & Manufacturing	127.8	108.2	18.1%
Gross profit	69.9	61.2	14.2%
Gross margin	33.0%	32.2%	0.8%
Normalised operating profit
Custom Supply	3.9	3.3	18.2%
Design & Manufacturing	14.2	11.8	20.3%
Central costs	(3.1)	(3.0)	3.3%
Total normalised* operating profit	15.0	12.1	24.0%
Normalised operating margin
Custom Supply	4.6%	4.0%	0.6%
Design & Manufacturing	11.1%	10.9%	0.2%
Total	7.1%	6.4%	0.7%
discoverIE underlying** operating profit	14.5	11.8	22.9%
discoverIE underlying operating margin	6.8%	6.2%	0.6%
Reported operating profit	8.1	8.4	(3.6%)
Reported operating margin	3.8%	4.4%	(0.6%)
Normalised PBT	13.3	10.6	25.5%
Normalised net income	10.0	8.0	24.3%
Normalised EPS (dil) - p	13.4	10.7	25.1%
Underlying EPS (dil) - p	13.0	10.5	23.8%
Reported EPS (dil) - p	6.3	6.5	(3.1%)
Dividend - p	2.80	2.65	5.7%
Net cash/(debt)	(62.6)	(37.6)	66.5%

Source: discoverIE, Edison Investment Research *Excludes amortisation of acquired intangibles, exceptional items and share-based payments. ** Excludes amortisation of acquired intangibles and exceptional items.

Helped by organic growth in both divisions, gross margin expanded 0.8pp y-o-y to 33%. Underlying operating profit increased 22.9% y-o-y through a combination of organic revenue growth, higher gross margins and acquisitions. The company incurred exceptional charges of £3.3m: £0.4m relating to acquisitions and a £2.9m provision for a fraud perpetrated against the group in one of its US subsidiaries. Strong and decisive action has been taken to resolve the matter and the group is expecting to recover the loss, which is also covered by insurance. Until then, a provision has been made in respect of the gross loss associated with this.

The company reported an effective tax rate of 27% (acquisition costs are not allowable for tax purposes) and an underlying effective tax rate of 25%. Underlying diluted EPS grew of 23.8% y-o-y.

The company announced an interim dividend of 2.8p per share, 6% higher year-on-year. Management expects to maintain dividend cover of 2–3x underlying EPS, with cover trending towards the upper end of the range to preserve funds for further M&A.

The company ended H119 with net debt of £62.6m compared to £37.6m at the end of H118 and £52.4m at the end of FY18, equating to a net debt/annualised underlying EBITDA of 1.85x, within the company’s targeted range of 1.5–2.0x.

Outlook and changes to forecasts

The company saw a 13% CER year-on-year increase in orders to close H119 with an order book worth £131m (+18% CER, +13% organic) and a book-to-bill for H1 of 1.03x. The estimated lifetime value of design wins in H119 was £126m, +40% y-o-y.

We have revised our estimates to reflect H119 operating performance, including lower than expected finance costs and dilutive share count, and a reduction in the Santon contingent consideration. The end FY18 balance sheet has been restated to reflect a £1.4m reduction in the fair value of assets acquired and a £6.8m reduction in the fair value of consideration. The sellers of Santon have also reimbursed discoverIE the €2.5m paid to cover investment in automation of production facilities.

We have also factored in higher inventory at the end of FY19, reflecting the company’s intention to increase stock to cope with any potential supply chain disruption from Brexit.

Exhibit 5: Changes to estimates

£m	FY19e old	FY19e new	Change	y-o-y	FY20e old	FY20e new	Change	y-o-y
Revenues	426.3	428.5	0.5%	10.5%	442.5	445.4	0.7%	3.9%
Custom supply	167.0	168.0	0.6%	1.7%	168.6	169.7	0.6%	1.0%
Design & manufacturing	259.3	260.5	0.4%	17.0%	273.8	275.7	0.7%	5.8%
Gross margin	33.0%	33.0%	0.0%	0.4%	33.0%	33.0%	0.0%	0.0%
EBITDA	35.0	35.3	0.7%	20.4%	37.4	37.4	0.0%	6.0%
EBITDA margin	8.2%	8.2%	0.0%	0.7%	8.4%	8.4%	(0.1%)	0.2%
Underlying operating profit	29.4	29.4	0.1%	20.1%	31.6	31.6	0.0%	7.6%
Underlying operating profit margin	6.9%	6.9%	(0.0%)	0.5%	7.1%	7.1%	(0.0%)	0.2%
Normalised operating profit	30.2	30.4	0.8%	20.7%	32.5	32.5	0.0%	7.0%
Normalised operating margin	7.1%	7.1%	0.0%	0.6%	7.4%	7.3%	(0.0%)	0.2%
Normalised PBT	25.8	26.4	2.4%	16.9%	27.6	28.0	1.5%	5.9%
Normalised net income	19.4	19.8	2.4%	15.7%	20.7	20.8	0.7%	5.1%
Normalised EPS (p)	25.5	26.3	3.1%	14.1%	26.9	27.5	2.0%	4.7%
Reported EPS (p)	15.0	14.9	(0.3%)	(10.4%)	17.6	17.9	1.6%	19.9%
Net (debt)/cash	(70.0)	(72.7)	3.8%	38.7%	(68.6)	(65.7)	(4.1%)	(9.6%)
Net debt/EBITDA (x)	1.9	2.0			1.8	1.8

Source: Edison Investment Research

Valuation

Exhibit 6 shows valuation metrics for discoverIE’s peer group and Exhibit 7 shows their financial performance. The stock continues to trade at a c 9% discount to the peer group average on EV/EBITDA multiples and is broadly in line based on P/E multiples. Further progress in increasing the weighting of business towards D&M combined with good control over the profitability of the CS business should help to further close the gap.

D&M made up 57% of FY18 revenues 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 earnings.

Exhibit 6: Peer group valuation metrics

	EV/Sales			EV/EBITDA			P/E			Dividend yield
	Last yr	This yr	Next yr	Last yr	This yr	Next yr	Last yr	This yr	Next yr	Last yr	This yr	Next yr
discoverIE	0.8	0.7	0.7	10.8	8.9	8.4	16.9	14.8	14.2	2.3%	2.4%	2.6%

Design & manufacturing
Gooch & Housego	2.7	2.3	2.2	16.3	12.1	11.6	22.7	19.9	18.9	0.9%	0.9%	1.0%
TT Electronics	1.0	0.9	0.8	10.5	8.0	6.9	18.2	13.8	11.5	2.9%	3.1%	3.4%
XP Power	2.8	2.4	2.2	11.3	9.5	8.7	15.0	12.6	11.4	3.5%	3.7%	4.0%
Specialist distributors
Diploma	2.7	2.5	2.4	14.8	13.6	13.0	21.3	19.4	18.5	2.1%	2.4%	2.5%
Solid State	0.5	0.5	0.4	6.2	6.1	5.9	9.9	10.2	10.9	3.9%	4.0%	4.0%
High service & commodity distributors
Electrocomponents	1.4	1.3	1.2	11.9	9.6	8.7	17.6	14.1	12.7	2.6%	3.0%	3.2%
Average	1.9	1.6	1.5	11.9	9.8	9.1	17.5	15.0	14.0	2.7%	2.9%	3.0%
Versus peer group					(9%)	(8%)		(1%)	1%

Source: Thomson Eikon (at 18 December), Edison Investment Research

Exhibit 7: Peer group financial metrics

	EBITDA margin			EBIT margin			Revenue growth			EPS growth
	Last yr	This yr	Next yr	Last yr	This yr	Next yr	Last yr	This yr	Next yr	Last yr	This yr	Next yr
discoverIE	7.6%	8.2%	8.4%	6.5%	7.1%	7.3%	14.7%	10.5%	3.9%	15.8%	14.1%	4.7%

Design & manufacturing
Gooch & Housego	16.3%	19.2%	19.4%	15.3%	15.5%	14.5%	11.5%	14.1%	3.4%	16.5%	14.2%	5.2%
TT Electronics	9.7%	10.9%	11.4%	6.8%	7.8%	8.4%	8.2%	16.0%	10.9%	39.7%	31.2%	20.5%
XP Power	25.0%	24.9%	25.4%	21.8%	21.5%	21.9%	28.5%	19.3%	7.2%	27.5%	19.3%	10.8%
Specialist distributors
Diploma	18.5%	18.6%	18.7%	17.5%	17.1%	16.8%	7.3%	8.8%	4.0%	13.3%	9.6%	5.0%
Solid State	8.4%	8.0%	6.9%	6.5%	6.0%	5.6%	15.8%	7.6%	18.4%	(1.6%)	(2.8%)	(6.9%)
High service & commodity distributors
Electrocomponents	11.6%	13.1%	13.7%	10.4%	11.5%	12.1%	12.8%	9.8%	5.7%	35.2%	24.8%	11.0%
Average	14.9%	15.8%	15.9%	13.0%	13.2%	13.2%	14.0%	12.6%	8.3%	21.8%	16.1%	7.6%

Source: Thomson Eikon (at 18 December), Edison Investment Research

Exhibit 8: Financial summary

	£m	2013	2014	2015	2016	2017	2018	2019e	2020e
Year end 31 March		IFRS	IFRS	IFRS	IFRS	IFRS	IFRS	IFRS	IFRS
PROFIT & LOSS
Revenue		177.4	211.6	271.1	287.7	338.2	387.9	428.5	445.4
Cost of Sales		(123.0)	(148.6)	(186.7)	(195.1)	(227.2)	(261.2)	(287.0)	(298.3)
Gross Profit		54.4	63.0	84.4	92.6	111.0	126.7	141.5	147.1
EBITDA		7.4	9.1	16.6	19.8	24.3	29.3	35.3	37.4
Operating Profit (before am, SBP and except.)		6.1	7.7	14.0	17.0	20.6	25.2	30.4	32.5
Operating Profit (before am. and except.)		5.5	7.1	13.4	16.3	20.0	24.5	29.4	31.6
Amortisation of acquired intangibles		(0.7)	(1.0)	(2.1)	(2.8)	(3.9)	(4.9)	(5.9)	(6.0)
Exceptionals		(3.4)	(0.9)	(5.2)	(2.1)	(8.4)	(1.1)	(4.8)	(3.2)
Share-based payments		(0.6)	(0.6)	(0.6)	(0.7)	(0.6)	(0.7)	(1.0)	(0.9)
Operating Profit		1.4	5.2	6.1	11.4	7.7	18.5	18.7	22.4
Net Interest		(0.5)	(0.8)	(1.6)	(1.8)	(2.8)	(2.6)	(4.0)	(4.6)
Profit Before Tax (norm)		5.6	6.9	12.4	15.2	17.8	22.6	26.4	28.0
Profit Before Tax (FRS 3)		0.7	4.2	4.3	9.4	4.8	15.8	14.5	17.6
Tax		1.4	(0.5)	(1.4)	(2.2)	(1.3)	(4.0)	(3.6)	(4.5)
Profit After Tax (norm)		4.6	6.0	10.0	11.8	13.6	17.1	19.8	20.8
Profit After Tax (FRS 3)		2.1	3.7	2.9	7.2	3.5	11.8	10.9	13.1

Average Number of Shares Outstanding (m)		39.2	43.1	57.6	63.3	65.4	70.8	72.9	73.4
EPS - normalised & diluted (p)		11.3	13.1	16.4	17.8	19.9	23.0	26.3	27.5
EPS - IFRS basic (p)		(4.8)	3.0	5.0	11.4	5.3	16.7	14.9	17.9
EPS - IFRS diluted (p)		(4.7)	2.8	4.8	10.9	5.1	15.8	14.4	17.3
Dividend per share (p)		6.2	6.8	7.6	8.1	8.5	9.0	9.5	10.0

Gross Margin (%)		30.7	29.8	31.1	32.2	32.8	32.7	33.0	33.0
EBITDA Margin (%)		4.2	4.3	6.1	6.9	7.2	7.6	8.2	8.4
Operating Margin (before am, SBP and except.) (%)		3.4	3.6	5.2	5.9	6.1	6.5	7.1	7.3

BALANCE SHEET
Fixed Assets		30.9	33.1	88.6	108.4	122.2	136.0	148.3	141.9
Intangible Assets		24.2	25.5	69.9	88.2	100.7	106.8	119.8	113.7
Tangible Assets		3.1	3.5	13.8	14.7	16.0	23.4	22.7	22.4
Deferred tax assets		3.6	4.1	4.9	5.5	5.5	5.8	5.8	5.8
Current Assets		81.8	92.7	127.3	128.3	148.4	168.4	182.3	193.1
Stocks		19.3	19.4	39.8	42.9	50.1	60.6	72.8	75.7
Debtors		44.7	48.3	60.2	65.5	77.3	84.6	91.6	97.6
Cash		17.8	18.1	26.7	19.9	21.0	21.9	16.6	18.6
Current Liabilities		(50.9)	(58.3)	(62.1)	(61.7)	(78.1)	(93.6)	(102.2)	(105.8)
Creditors		(46.6)	(51.5)	(61.9)	(60.9)	(77.1)	(87.2)	(95.8)	(99.4)
Short term borrowings		(4.3)	(6.8)	(0.2)	(0.8)	(1.0)	(6.4)	(6.4)	(6.4)
Long Term Liabilities		(10.3)	(19.0)	(61.1)	(73.1)	(68.7)	(81.5)	(93.5)	(88.5)
Long term borrowings		(1.7)	(9.5)	(45.5)	(57.2)	(50.0)	(67.9)	(82.9)	(77.9)
Other long term liabilities		(8.6)	(9.5)	(15.6)	(15.9)	(18.7)	(13.6)	(10.6)	(10.6)
Net Assets		51.5	48.5	92.7	101.9	123.8	129.3	134.8	140.7

CASH FLOW
Operating Cash Flow		5.7	6.1	6.6	14.6	20.5	21.7	21.9	30.2
Net Interest		(0.6)	(0.8)	(1.6)	(1.8)	(2.8)	(2.6)	(4.0)	(4.6)
Tax		(1.4)	(0.9)	(3.3)	(4.3)	(3.0)	(3.7)	(5.6)	(7.1)
Capex		(1.3)	(1.4)	(2.5)	(2.3)	(3.4)	(4.3)	(4.0)	(4.5)
Acquisitions/disposals		(0.5)	(9.2)	(37.3)	(19.8)	(11.8)	(25.4)	(22.0)	0.0
Financing		5.7	0.1	52.7	0.0	13.6	(1.5)	0.0	0.0
Dividends		(2.3)	(2.7)	(3.6)	(4.9)	(5.2)	(6.2)	(6.6)	(7.1)
Net Cash Flow		5.3	(8.8)	11.0	(18.5)	7.9	(22.0)	(20.3)	7.0
Opening net cash/(debt)		6.3	11.8	1.8	(19.0)	(38.1)	(30.0)	(52.4)	(72.7)
HP finance leases initiated		0.0	0.0	0.0	0.0	0.0	0.0	0.0	0.0
Other		0.2	(1.2)	(31.8)	(0.6)	0.2	(0.4)	0.0	0.0
Closing net cash/(debt)		11.8	1.8	(19.0)	(38.1)	(30.0)	(52.4)	(72.7)	(65.7)

Source: discoverIE, Edison Investment Research

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