discoverIE Group — Platform in place for recovery

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. discoverIE intends to continue to grow organically and via acquisition while maintaining its focus on higher-margin business. To grow revenues 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.

We have revised our forecasts to take account of H121 results, the H121 bookings intake and the Phoenix America and Limitor GmbH (Limitor) acquisitions. Our forecasts were based on COVID restrictions diminishing from H221. However, ongoing sporadic lockdowns all over the world lead us to take a more cautious approach to H221 and FY22 revenues. At the same time, management has indicated that it is starting to increase the operating cost base in readiness for stronger demand and is likely to increase capex too, in part to meet new ESG targets. We have revised down our normalised diluted EPS forecasts by 2.9% in FY21 and 11.9% in FY22. Our underlying diluted EPS forecast (which includes share-based payments) is unchanged for FY21 and is 10.9% lower in FY22. We forecast net debt of £66.0m by the end of FY21 (net debt/EBITDA 1.6x) and £65.7m by the end of FY22 (net debt/EBITDA 1.5x).

The stock has bounced back by 60% from the low it reached in March and is up 6% year to date. The discount to peers has reduced since we last wrote, from 23% to 18% based on FY21e P/E. Aside from continuing recovery in customer demand, we view the key trigger for earnings and share price upside to be progress in increasing the weighting of the business towards the higher-growth, higher-margin D&M business, which in turn should move the company closer to its 12.5% medium-term operating margin target. The stock is supported by a dividend yield approaching 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 87% 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 FY20. 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 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 products, resulting in higher profitability. The company intends to continue to grow organically and via acquisitions while maintaining the focus on its higher-margin D&M 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 and North America. The company has made a series of acquisitions since 2009 – we provide further detail on page 7. discoverIE operates through two divisions, Design & Manufacturing (D&M) and Custom Supply (CS), with 4,200 employees across 23 countries.

discoverIE specialises in supplying technically demanding, bespoke electronics for industrial applications and is focused on four target markets comprising 68% of group sales – renewables, electrification of transportation, medical and industrial & connectivity – all of which are long-term structural growth 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 two technology areas and expects to continue its active role in consolidating this fragmented market. The D&M business generates the majority of revenue and an even larger majority of operating profit. Future growth and investment plans are focused on this division.

Mainly through acquisition, discoverIE has built up its D&M capability in four areas of technology: power (40% of H121 divisional revenue), components (24%), systems (22%) and magnetics (14%). This division supplies custom electronic products either designed uniquely or modified from an existing product. More than 80% of products are manufactured at 27 sites across 17 countries (principal facilities in China, India, Mexico, the Netherlands, Poland, Sri Lanka, Thailand and the UK), with the remainder manufactured by third-party contractors. As well as direct sales, these products are also distributed through the CS business.

Acal BFi is the main business within this division and is a supplier of specialist electronics from a selected group of manufacturers (including the D&M division), to more than 20,000 industrial customers. It operates across Europe, with centralised warehousing, purchasing, finance, customer contact management and IT systems. Acal BFi 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. discoverIE solutions range from the recommendation and supply of a part, modification of an existing product, to full design and development of a custom solution. 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.

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’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.

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 14) and Simon Gibbins (CFO since 2010 – biography on page 14). 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) and Clive Watson (ex-group FD of Spectris 2006–19, NED at Breedon Group, Kier Group and Trifast).

Exhibit 2 summarises the steady progress discoverIE is making against its KSIs. The company set the previous KSIs in November 2016, for a period of three to five years. With FY20 results, discoverIE announced new targets to run for the next five years. We discuss below how it is meeting its strategic objectives. While COVID-19 means that operating margins dipped in H121, the company has made good progress on all other targets during H121.

discoverIE started life as a pure distributor of electronic components, but through a strategy of specialisation and acquisition it has transitioned to become a provider of customised electronic solutions. Over the last nine years, the company has acquired 15 businesses with design and manufacturing capabilities – these are significantly more profitable than the CS business. Consequently, while the D&M division generated 65% of H121 revenues, it generated 87% of H121 profits. With D&M operating margins of 12.8% in FY20 compared to 4.3% for CS, as the company makes more D&M acquisitions group operating margins should continue to expand. In addition, pre-COVID D&M was growing at a faster organic rate than CS (D&M CAGR of 8.6% over three years versus 0.3% for CS) so absent any acquisitions, the margin should continue to expand.

In June 2020, with the group delivering an 8% operating margin the company raised its margin target to 12.5%. This also reflects the fact that more recent acquisitions have been higher margin (eg Sens-Tech underlying EBIT margin of 35%, Phoenix 20%). The company expects to deliver this target through a combination of organic and inorganic growth.

As part of the group’s goal to grow revenue 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 supplies for each market. The group has focused on these markets for several years, but has only just added this to its KSIs. In FY20, the business generated 68% its revenues from these four areas and is targeting this to grow to 85% over the next five years.

The company has also looked more closely at the industrial & connectivity market and sees opportunities to meet three more of the UN SDGs (2 – zero hunger, 6 – clean water and sanitation and 12 – responsible consumption and production) by targeting products that support resource optimisation. Applications include smart agriculture, food manufacturing systems, efficient water use/management and water quality improvement.

During H121, D&M generated 73% of revenue from target markets (H120: 70%). Revenue generated from these markets declined by only 5% on an organic basis compared to an 11% organic decline in revenue from other markets. CS generates a lower proportion of revenue from target markets (59% in H121), which partially explains its larger organic revenue decline.

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 below), most with design and manufacturing capabilities. 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 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.

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, and efficiency improvements through access to the group’s purchasing scale, processes, warehousing and freight. 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 FY10.

The company has analysed the 15 D&M acquisitions it has made over the last nine years, excluding those it has not owned for more than two years (ie Cursor Controls, Hobart, Phoenix, Positek and Sens-Tech). Of the 10 businesses, six have generated a return on investment (ROI)2 well above discoverIE’s target of 15% (range of 18–65%) and nine were above the company’s WACC of 9%. On average, at 17% the whole group is generating an ROI above the target. Based on operating profit for FY20, the group generated an average ROI of 18.6%.

The company’s target for more than 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. While the company halted acquisition activity during the first COVID-19 lockdown, targets remained in the pipeline, and the company completed the acquisition of Phoenix America (Phoenix) in October 2020. discoverIE acquired the trade and assets of Phoenix, a US-based designer and manufacturer of magnetically actuated sensors, for $11.0m/£8.5m in cash with a three-year cash earn-out of up to $1.5m/£1.2m.

In December, the company announced a second acquisition, Limitor, a German-based manufacturer of custom thermal safety components for industrial applications with 85% of sales into the EU. discoverIE will pay an initial consideration of €14.5m with a further contingent consideration of up to €3.5m depending on hitting profit growth targets over three years. The Limitor acquisition, which is subject to regulatory approvals, is expected to complete in CY Q121.

Both Phoenix and Limitor will join the Variohm cluster while retaining their own brand identity.

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 H121, the company had a net debt position of £42.1m, and gearing of 1.0x EBITDA was well below the target range of 1.5–2.0x. Post period end, the company acquired Phoenix for £8.5m in cash and will acquire Limitor for €14.5m/£13.2m. On a pro forma basis, this has increased gearing to 1.45x, just below the target range. The company has a £180m revolving credit facility (RCF) due in June 2024, and also has access to a £60m accordion facility. The RCF can be used for acquisitions and working capital. Based on the end-H121 position and the Phoenix acquisition, we estimate that c £93m of the RCF has been drawn down. Until there is better clarity on how COVID-19 will affect the general economy over the next year, we would not expect the company to borrow up to the top end of its target gearing range.

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. Group executive committee remuneration outcomes are dependent on ESG. Areas in which the company has undertaken initiatives include:

The company took action at the beginning of the pandemic to reduce costs and preserve cash. This included:

Overall, this helped reduce H121 operating expenses by 4% y-o-y (£2.4m lower) and by 7% compared to the H220 run rate (£4.5m lower). Working capital was 9% lower than at the end of FY20 and capex was more than 50% lower leading to operating cash flow of £25.7m (+179% y-o-y).

The company established safe working practices for staff. Its 27 manufacturing facilities have been subject to various lockdown restrictions, but all sites are now open with capacity approaching normal levels.

The group has supported the development of more than 60 customer projects for virus-related medical products.

discoverIE last set KPIs three years ago, to run to March 2020. These KPIs remain relevant for future periods.

Group revenue declined 6% y-o-y, with an 8% decline on an organic basis boosted by 2% growth from acquisitions. Gross margin increased by 0.3pp y-o-y to 33.7%, within which organic gross margin declined 0.3pp y-o-y, mainly due to mix. As previously mentioned, cost-cutting measures in response to COVID-19 allowed the company to keep the underlying operating profit decline to 11% (10% CER) and the margin decline to 0.4pp. D&M revenues declined by 7% on an organic basis and 3% on a CER basis, including acquisitions. The D&M margin expanded by 0.2pp y-o-y reflecting the inclusion of higher-margin Sens-Tech from October 2019. CS revenue declined 10% (11% on a CER basis), resulting in a 1.5pp decline in operating margin. Overall, the group saw underlying EPS decline by 22%, reflecting the increased share count from two capital raises (April 2019 and October 2019). Lower capex and working capital requirements combined with no final dividend for FY20 resulted in operating cash flow of £25.7m (+179% y-o-y) in H121, free cash flow of £20.1m (+367% y-o-y) and a reduction in net debt of 24% y-o-y.

H121 orders reduced by 18% y-o-y on an organic basis, with a book-to-bill of 0.91x (Q121: 0.85x, Q221: 0.97x). Orders in September were up 6% y-o-y on an organic basis (monthly book-to-bill 1.04x) and orders in October and November have also shown year-on-year growth and a book-to-bill above 1x. The order book at end H121 of £140m was 10% lower y-o-y and 12% lower h-o-h. Design wins with an estimated lifetime value of £108m in H121 were 19% below the prior year. The company has seen customers continuing to place short-term orders at normal levels but more reluctant to place longer-term frame orders or work on new projects, typical behaviour in times of uncertainty. As visibility around COVID-19 recovery improves, the company is seeing customers returning to ordering on a longer-term basis and beginning to shift their focus to new projects.

We have revised our forecasts to reflect H121 performance and order intake, as well as to incorporate the recent Phoenix acquisition and the planned Limitor acquisition (we assume the deal completes towards the end of H221). We have brought down our underlying revenue and profit forecasts for FY21 and FY22, reflecting the longer duration of pandemic-related disruption and the expectation that the company will start to rebuild the operating cost base in anticipation of stronger demand and to support its growth plans.

Exhibit 8 shows financial metrics for discoverIE’s peer group and Exhibit 9 shows the valuation metrics. For the peer group, we use companies active in the electronics market and acquisitive industrial companies. The stock is trading at a discount to the peer group average on all valuation metrics. The company is growing revenue at a similar rate to peers but is below the average in terms of profitability. D&M made up 65% of H121 revenues; absent any acquisitions, we forecast this will increase to 66% by FY22 and the company is targeting this to exceed 75% over the next three to five years. To reach this target, we expect discoverIE to make further accretive D&M acquisitions, which would not only boost the revenue growth rate but would accelerate the growth in operating margins and EPS. Further progress in increasing the weighting of business towards D&M combined with a recovery in the profitability of the CS business should help to close the valuation discount.

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