discoverIE Group — Raising the bar

discoverIE’s 19 April trading update expected reported revenue growth of 16% and organic revenue growth of 8% for FY23. The final reported revenue for FY23 came in ahead of this, partly due to a revenue contribution of £5m for a one-off pass-through of elevated semiconductor costs. At constant exchange rates (CER), the group generated revenue growth of 15% and organic revenue growth of 10% (which includes the semiconductor cost pass-through). The company noted that of the 10% growth, c 5% was from volume, 4% from pricing and 1% from the semiconductor cost pass-through.

While the margin is not disclosed, the company noted that organic gross margin improved by 1pp at the group level. Underlying operating profit grew 25% y-o-y and was 4% higher than we forecast, resulting in the underlying operating margin increasing 0.6pp to 11.5% (versus our 11.3%). The company estimates that the drop-through from organic revenue growth (excluding the semiconductor cost pass-through) to underlying operating profit was 19%, mainly due to scale and internal efficiencies. Acquisitions made over the last two years contributed revenue of £14.9m and underlying operating profit of £2.2m.

Reported operating profit included £15.8m amortisation of acquired intangibles and exceptional charges totalling £1.4m (£1.8m acquisition costs and £1.5m contingent consideration accrual offset by a £1.5m insurance receipt and a £0.4m credit relating to last year’s disposal of Acal BFi). The tax rate on reported PBT was 26.8%; on an underlying basis the rate was 25.3%. Overall, this resulted in underlying diluted EPS of 35.2p (+20% y-o-y), 5.6% ahead of our forecast and 4.5% ahead of consensus.

The final dividend of 7.9p was in line with our forecast, resulting in a full year dividend of 11.45p (+6% y-o-y, 3.1x cover).

Net debt came in significantly lower than forecast at £42.7m. The company converted 94% of underlying operating profit to operating cash flow (EBITDA less working capital and capex) and generated free cash flow of £33m in the year. The company had estimated a year-end net debt/EBITDA of 0.9x in its April trading update, but the lower net debt position brought this down to 0.7x.

discoverIE sets and tracks key strategic indicators (KSIs) and key performance indicators (KPIs). Exhibit 3 summarises the company’s performance since FY14.

The current underlying operating margin target of 13.5% is for FY25. The company has introduced a new target of 15% over the next five years. In both cases, it expects to achieve these margins through a combination of organic and acquisitive growth.

The company targets four key markets: Industrial & Connectivity, Medical, Renewables and Transport. Revenue from these markets made up 77% of group revenue, up 1pp from FY22 and equivalent to 12% organic growth in FY23. This compares to organic growth of only 3% from other markets. Within the target markets, Renewables saw a 6% decline, mainly due to lower demand for wind power-related products, but the three other markets more than compensated for this with 15% growth. The focus on four markets helps diversify the risk from any one market.

Until last year, the company had a target to reduce scope one and two carbon emissions intensity (tCO2e/£m revenue) by 50% from CY19 to CY25. In November 2022, it changed the target to reduce carbon emissions on an absolute basis (including acquisitions) by 65% from CY21 to CY25. By the end of FY23, it had already achieved a 35% reduction, mainly from installing renewable energy at manufacturing sites (eg solar panels in Sri Lanka and Thailand). It expects to achieve the remaining reduction through a combination of manufacturing site renewable energy generation, switching energy providers to renewable sources, shifting from gas heating to electric options and, where this is not possible, buying renewable energy certificates. To support this process, M&A due diligence specifically includes ESG considerations to enable the company to quickly reduce the target company’s carbon footprint once acquired.

The company was slightly less active in terms of completed acquisitions during FY23, mainly due to the elevated price expectations of vendors. According to management, expectations came down earlier this year but have started creeping up again more recently. However, pricing is now within the company’s target range. At the same time, it has a very active pipeline of potential deals and with gearing of 0.7x, plenty of headroom to fund these deals (its target gearing range is 1.5–2.0x).

The company has a £240m syndicated bank facility and in May, it extended the remaining term by one year to June 2027. It also has an £80m accordion facility which it can use to extend the facility to £320m. At the end of FY23, it had drawn down £88m of the facility. We estimate that it has headroom of £70–100m at its target gearing range.

The group received orders totalling £437.5m in the year (£236.9m in H123, £200.6m in H223), resulting in a book-to-bill of 0.97x (H1: 1.08x, H2: 0.88x). This resulted in an order book of £223m at the end of FY23, essentially flat y-o-y. At the end of FY22, management noted that the order book revenue visibility was c 6.5 months, compared to 4.0–4.5 months pre-COVID. As expected and flagged by management, this has reduced over the course of the year to stand at roughly 5.5 months now. As supply chain issues have eased, customers have not felt the need to place orders as far in advance. Management believes that the order book may not revert to pre-COVID levels but could sit at more like five months’ visibility, as the recent memory of supply chain disruption may make customers more cautious in their ordering behaviour. For the same reason, the company is likely to carry a slightly higher level of inventory than pre-COVID.

In FY23, the company won new project designs with a lifetime value of £273m, up 11% y-o-y – this is a key driver of organic growth.

So far this year, management commented that it had seen organic revenue growth in the mid-single digits. We have revised our forecasts to reflect FY23 results and introduce forecasts for FY25. We note that our FY24 revenue forecast equates to 1.9% growth over FY23. However, if the £5m one-off semiconductor cost pass-through is excluded from FY23 revenue, the growth is 3%. Overall, we upgrade our FY24 underlying EPS forecast by 3.5%. Based on lower net debt at the end of FY23, we reduce our end-FY24 net debt forecast by 17% and expect net debt/EBITDA to reduce to 0.5x from our previous 0.7x forecast.

Exhibit 5 shows financial metrics for discoverIE’s peer group and Exhibit 6 shows the valuation metrics. For the peer group, we use companies active in the electronics market and acquisitive industrial companies. The stock has gained 15% since results were announced, so despite an upgrade to our forecasts, the stock trades at a small premium to its broader UK industrial technology peer group on an FY24e 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 (we note that for FY18–23, the five-year CAGR for organic revenue was 10%) and we see potential for upside to earnings through operating margin expansion and accretive acquisitions. The company has debt headroom for further acquisitions and a strong pipeline of opportunities.