discoverIE Group — Strong growth despite market challenges

We upgraded our forecasts in April when discoverIE provided its year-end trading update. Results were ahead of our upgraded estimates, with underlying diluted EPS 5.2% ahead of our forecast and 4.4% ahead of consensus. Underlying operating profit was 2.2% ahead of our forecast, with net finance costs £0.4m below our forecast and the effective tax rate of 25.0% 1pp lower than our forecast. Reported EPS includes one-off charges of £6.5m relating to acquisitions, £14m amortisation of acquired intangibles, £3.4m in share-based payments and a £15.5m contribution from discontinued operations (£9.3m results for the year plus £6.2m gain on sale).

The company declared a final dividend of 7.45p per share to make a full year dividend of 10.8p, 0.05p ahead of our forecast.

During FY22, the company disposed of its Custom Supply business for £45m (with a further £5m deferred for three years), raised £55m (gross) from an equity issue, and spent £85m on three high margin acquisitions: Beacon, Antenova and CPI, all with 20%+ operating margins. Tight control of working capital resulted in net debt well below our estimate at year-end and gearing of 0.6x versus the 0.7x disclosed in the April trading update.

Order intake increased 36% y-o-y on an organic basis and 32% versus FY20. The order book at the end of FY22 stood at £224m, up 62% y-o-y on an organic basis and 71% versus end FY20.

This is the first full year of reporting for the company since Custom Supply was sold and the remaining Design & Manufacturing business was organised into two divisions: Magnetics & Controls and Sensing & Connectivity. Exhibit 2 summarises divisional revenue, order and operating profit performance.

This business saw reported revenue growth of 23% in FY22, or 27% on a CER basis. Organic constant currency growth was 22%. This division includes the Beacon business acquired in H122 as well as eight businesses operating in 16 countries. Two businesses in this division were affected by the shortage of semiconductor components, slightly reducing the gross margin, but despite this, underlying operating profit grew 27% y-o-y and the margin expanded by 0.4pp.

Orders increased 36% y-o-y on an organic basis to £280m with a book-to-bill ratio of 1.19:1 in FY22.

This division has 20 manufacturing facilities and during the year production began at a new, larger facility in Mexico. Capacity at facilities in the US and India is being expanded.

This division includes the Antenova and CPI acquisitions that were made in H122 as well as 12 businesses operating in nine countries. Revenue grew 29% y-o-y on a reported basis, 31% at CER and 11% on an organic basis. Geographically, Europe saw 13% organic growth and Asia 6%, while the slower recovery of some transport infrastructure projects along with semiconductor shortages resulted in flat revenues in North America. Underlying operating profit increased 50% y-o-y and the margin expanded 2.3pp, helped by the higher margin acquisitions in H122.

Orders increased 36% y-o-y on an organic basis to £173m with a book-to-bill ratio of 1.20:1.

In both divisions, management has noted a trend for customers to localise production – in particular, it has seen volumes shift from China to India. This has an environmental benefit as product has shorter distances to travel to reach customers, and reduces an element of geopolitical risk.

When we wrote in December, we outlined the company’s ESG strategy and targets (Record order book drives upgrades). Since then, the company has been awarded an ‘A’ rating by MSCI.

As this is the first year that the UK requirement for Task Force on Climate-Related Financial Disclosures reporting is in force, the company has undertaken a preliminary assessment of the resilience of its business model and strategy and the potential effects of climate change over the short and medium term. It has concluded that while it is exposed to certain risks during the transition to a low carbon economy, such risks are considered to be low and are outweighed by opportunities presented to the company.

Since the disposal of the Custom Supply business, the target to reduce carbon emissions by 50% by 2025 (start point end CY19) has been rebased to reflect the remaining business (excluding acquisitions for the first 12 months). The strategy to achieve net zero is still being determined. As at the end of CY21, carbon emissions had been reduced by 33% compared to 6% at the end of CY20, mainly through switching to renewable sources of energy at manufacturing sites.

In 2020 the company set a target for 80% of operations, by revenue, to be covered by an ISO 14001 accreditation by the end of 2025. At the end of CY21, 63% of operations had achieved this accreditation.

After making three acquisitions in H122, the company paused for breath. With the decline in equity markets, we believe that pricing in private markets is likely to follow suit, which could provide opportunities for discoverIE.

In May, the company increased its syndicated banking facility from £180m to £240m and extended the term of the facility by two years to June 2026. It has an option to extend this to June 2027 as well as an £80m accordion facility. Gearing of 0.6x at the end of FY22 was well below the target range of 1.5–2.0x providing plenty of headroom for further deals.

The company regularly updates on its target key strategic indicators (KSIs) and key performance indicators (KPIs) – see Exhibit 3. With the FY21 performance affected by the COVID pandemic, the company has treated FY21 and FY22 as a composite period to show the real underlying performance. The table shows performance including Custom Supply up to and including FY20.

discoverIE is making good progress towards its FY25 targets. Looking at the KSIs, the company expects to meet the operating margin target through a combination of organic growth and acquisitions of higher-margin businesses (targeting companies with a minimum 15% operating margin). Sales from target markets reached 76% of the total and made up 86% of design wins during FY22.

Looking at the KPIs, group organic revenue of 14% compared to FY20 (18% versus FY21) was well ahead of GDP growth over the same period (9% from March 2020 to March 2022). The company has achieved a compound annual growth rate (CAGR) of 10% for organic revenue from FY18–22. Underlying EPS grew 20% compared to FY20 and has grown at a CAGR of 26% FY18–22. While ROCE slipped just below the 15% target, the company noted that acquisitions often start below the target but as they are integrated, move above it. Operating profit and free cash flow conversion both exceeded 100% compared with their 85% targets averaged over a two year-period (as disclosed in Exhibit 3). On a one-year basis, operating profit conversion was 141% in FY21 and 80% in FY22, reflecting working capital flows as revenue declined during the pandemic and then recovered in FY22. Free cash flow conversion was 157% in FY21 and 77% in FY22, for similar reasons.

Management noted that FY23 has started well, with continued strong growth in organic sales and the order book at record high levels. While supply chain headwinds and inflationary pressures remain, the company views these as manageable.

The company has generally been able to pass on increased input costs to customers, although this may not always be the case if cost increases show no sign of abating. Management noted that pricing for some raw materials has started to stabilise, and it is seeing better availability of some semiconductor components. In-house manufacturing tends to use a relatively low level of bought-in components, which reduces the company’s exposure to supply chain shortages. Labour costs are increasing at double-digit rates in lower cost regions and at c 4–5% in higher cost regions, with bonus schemes helping to dampen demand for increases.

The strong order book at the end of FY22 provides the company with c 6.5 months of revenue visibility, up from the low of c 2.5 months during the pandemic and a pre-COVID level of 4–4.5 months. Customers have been placing both higher volumes of orders and ordering further ahead to be sure of availability. While it is possible that some customers may reduce their own inventory as supply chain issues abate, any slowdown in order intake is likely to be due to reverting to shorter order windows. Management believes it is likely that growth of the order book will moderate and revert to pre-COVID levels (in terms of months of revenue), although it has seen no signs of this happening yet.

We have revised our forecasts to reflect the better-than-expected outturn in FY22. We raise our revenue estimate by 1% in FY23 and our underlying EPS estimate by 4.8%. For FY24, we conservatively forecast revenue growth of 3% and underlying EPS growth of 3.6%.

The share price is down 33% year-to-date, slightly more than the average for the peer group of 28%. It now trades marginally above the average of its broader UK electronics peer group on a P/E basis for FY23 but is below industrial 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 0.6x well below the target range of 1.5–2.0x, a recently expanded credit facility and a strong pipeline of opportunities.