Acal — Update 10 June 2016

Acal is a leading international supplier of customised electronics to industry. Over the last seven years the company has broadened its product range, customer base and geographic presence via a series of acquisitions. The company offers value-added distribution and design and manufacturing 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.

In FY16 revenues grew 6.1% y-o-y on a reported basis and 13.8% at constant exchange rates. On an underlying basis (pre-currency effects and acquisitions), the D&M business showed organic growth of 3% and the ongoing business in CD also grew 3%. Operating profit and normalised EPS came in ahead of our forecasts, with the underlying operating margin expanding from 4.9% in FY15 to 5.7% in FY16 as the higher margin D&M grew to nearly half of group revenues (51% once acquisitions are annualised). We leave our FY17 EPS forecast unchanged and introduce a forecast for 3.2% revenue growth and 5.2% normalised EPS growth in FY18.

Over the last year the stock has declined 17%, suffering from the adverse effects of currency headwinds and weaker demand in the UK. It is now trading at a small discount to the peer group on EV/EBITDA and P/E multiples. The company is well positioned for volume orders as economic conditions improve and, combined with the increased geographic coverage, integration benefits and cross-selling potential of recent acquisitions, should support revenue growth above market levels and further expansion of operating margins. The stock is supported by a dividend yield above 3%. In the medium term we expect to see improving operating margins driving earnings upside as Acal grows the proportion of revenue generated from design and manufacturing.

Our estimates and Acal’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 90% of underlying profits outside the UK, Acal is exposed to the translation of euro and Nordic-denominated subsidiary results into sterling, which negatively affected sales by 6% and profits by 8% in FY16. Pricing: Acal’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. Acquisitions: Acal may make further acquisitions, which could add integration risk and will require funding. Pension deficit: Acal has a £4.9m pension deficit and, as agreed with the pension trustees in 2009, started increasing contributions from FY13 to reduce this (£1.6m in FY16).

Acal is a supplier of customised electronics to industry with operations throughout Europe and increasingly outside Europe. The last seven 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 business.

Acal 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, the company has, through its strategy of specialisation, transitioned to become a provider of customised electronic solutions with operations in Europe, Asia, North America and South Africa. Acquisitions include BFi Optilas in 2009, CompoTRON, Hectronic and MTC Micro Tech Components (MTC) in 2011, Myrra Group, Young Electronics Group (YEG) and RSG in 2013, Noratel in 2014, Foss and Flux in 2015 and Contour and Plitron in 2016. The company now operates through two divisions: Custom Distribution (52% of FY16 revenues) and Design & Manufacturing (48% of FY16 revenues, forecast to exceed 50% in FY17), with 3,800 employees across 23 countries.

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 KSIs (key strategic indicators) and KPIs (key financial performance indicators), which we discuss in more detail in this report.

Acal 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 markets it operates in are worth c £4bn in Europe, c £6bn in North America and c £2bn in Asia. Acal 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, the company has built up its Design and Manufacturing capability in four of the company’s five technology areas (see Exhibit 2). From this division, Acal supplies custom electronic products either designed uniquely or modified from an existing product. Products are manufactured in house (with principal facilities in China, India, Poland, and Sri Lanka) or via third-party contractors. Increasingly, these products are also distributed through Acal BFi.

The main business in Custom Distribution 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 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 Acal is able to provide (this is not always available from the product manufacturer or smaller local distributors). Acal 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 come from products that are either uniquely created for one customer and/or exclusively sourced.

Acal BFi aims to work with the leading suppliers for a given product or technology and seeks to supply products that are not supplied through other distribution channels. It currently has c 500 suppliers across a number of specialist areas, as shown in Exhibit 2. 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.

Across both businesses, a customer will typically take six to 24 months to take a product from design to production, at which point the company could earn revenues for several years.

Exhibit 3 summarises Acal’s progress against its KSIs. We discuss below how the company is meeting its strategic objectives.

Acal 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. Recent acquisitions have added companies with design and manufacturing capabilities, which are significantly more profitable. The Design & Manufacturing division generated close to half of FY16 revenues and over three-quarters of FY16 profits. In FY17 we forecast that Design & Manufacturing will contribute 51% of sales and with organic growth higher than for Custom Distribution, we expect this proportion to continue to increase. In the Custom Distribution division, the company withdrew from selling non-specialist products in FY15, instead focusing on selling highly differentiated customised products. With Design & Manufacturing operating margins of 12.0% in FY16 compared to 3.1% for Custom Distribution, it is clear that this strategy should result in upward pressure on group operating margins.

Acal started the transformation of the business in 2009 with the acquisition of BFi Optilas, the next largest European specialist distributor after Acal. This increased Acal’s presence in Germany, the UK, France and the Nordic region. Acal then proceeded to make a series of acquisitions (see Exhibit 4), the largest of which was Noratel for £71m in 2014. These are all companies where Acal has seen the opportunity to access design and manufacturing capability, to access new specialist technology areas or to return loss-making businesses to profitability using Acal’s scale. Acal has spent nearly £150m on acquisitions over the last seven years.

Design and Manufacturing acquisitions typically continue to operate under their own brands and entrepreneurial management, with the advantage of being part of the larger Acal group (in terms of cost synergies, access to Acal’s distribution network for cross-selling and investment for growth). The Design & Manufacturing division currently operates through the following brands: Contour, Flux, Foss, Hectronic, MTC, Myrra, Noratel, Plitron, RSG, and Stortech.

Acal integrates Custom Distribution acquisitions into the Acal BFi brand. In such cases, the company typically integrates office and warehouse facilities, manufacturing, IT systems and makes use of group purchasing, freight and logistics.

Acquisitions remain a key part of the group strategy, with management considering 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. We would expect Acal to focus on acquisitions for the higher-margin Design & Manufacturing division, targeting companies active in developed markets that offer higher growth opportunities. We expect the company to consider targets in both Europe and North America. The company estimates it has access to funds of up to £20m for acquisitions.

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

Looking at global GDP growth, the World Bank is forecasting annual growth of 3% to 2030, with developing markets expected to grow at 4.5% and emerging markets at 2%. In the shorter-term, the World Bank is forecasting global GDP growth of 2.4% in 2016, 2.8% in 2017 and 3.0% in 2018 (1.7%, 1.9% and 1.9% 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 trends. In FY16, the Design & Manufacturing division generated 48% of its revenues from these four areas:

Acal’s product range encompasses five specialist technology areas – each technology group has a team of specialist sales and support engineers and their role is to identify customer opportunities. Through its design and manufacturing businesses and Custom Service centres (two in Germany, one in France and one in the UK), Acal is able to offer customers assistance with design (including prototyping and pre-testing for statutory approvals), assembly (including manufacturing, configuration and on-site installation) and lifecycle support. The company has initiatives in place to increase the level of cross-selling to existing customers. Cross-selling generated sales worth £14.2m in FY16 (FY15: £11.2m). Acal focuses on two key areas:

In FY16, 17% of revenues were generated outside of Western Europe (up from 12% in FY15). Acal’s strategy is to support existing customers’ business outside Western Europe and to make further acquisitions that expand the group’s geographical coverage, such as the recent acquisition of Canadian-headquartered Plitron.

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

Acal reported FY16 revenues 2.5% below our forecast, although gross margins were higher and normalised operating profit was 1.7% above our forecast, resulting in a normalised operating margin of 5.9%, up from 5.2% a year ago. Net interest expense of £1.8m was lower than our £2.2m forecast, resulting in normalised EPS 7.8% ahead of our forecast. Net debt came in lower than forecast, mainly as a result of higher cash flow from operations. The company announced a full year dividend of 8.05p, ahead of our 7.98p forecast.

Exhibit 6 shows the split of revenues and operating profit by division. D&M revenues came in slightly ahead of our forecast, with operating profit 4.4% ahead, resulting in an operating margin of 12.0% compared to 11.3% a year ago. CD revenues were 4.8% below our forecast, while the UK business was weak, demand in continental Europe was strong. This dropped through to the operating profit level, reducing the operating margin to 3.1% compared to 3.9% a year ago. Unallocated costs were well-controlled and came in below our forecast. Overall, the stronger D&M profitability outweighed the weakness in CD to drive higher operating profitability than forecast.

In FY16 the strength of sterling versus the euro (+7% vs FY15) and the Nordic currencies (+9%) negatively affected reported revenue growth as highlighted in Exhibit 6. Based on constant exchange rates (CER), ie the FY16 rate applied to FY15, D&M grew 50% y-o-y, through a combination of acquisitions and 3% organic growth. CD declined 6.7% on a CER basis, although excluding the impact of one-off large contracts in FY15 and the discontinuation of non-specialist lines, underlying ongoing revenues grew 3% y-o-y.

The company continues to make good progress towards its medium term KPI targets.

Acal’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, Acal supplies on a volume basis for the life of the product. 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 8 shows the movement in the manufacturing PMI for the eurozone, France, Germany, the UK and the US since the start of 2014. Several factors, including Brexit and the US elections, have created uncertainty and hence impacted confidence, as evidenced by the most recent data.

The company expects challenging trading conditions to continue through H117; however, recent customer project activity gives management confidence that it will see improved demand in H217. In H216, the company won a number of new large contracts which are expected to generate revenues from the end of FY17. At year end, the order book stood at £85m.

We summarise the changes to FY17 forecasts below and introduce FY18 forecasts. We have reduced our forecast for CD revenues in FY17, although we expect the recent restructuring of the UK CD business to drive improved CD operating margins in FY17 (3.4% vs 3.1% in FY16). The reduction in FY17 normalised operating profit is offset by slightly lower interest costs and lower dilutive share count. We forecast 3.2% revenue growth in FY18, with D&M showing stronger growth than CD and a small increase in the underlying operating margin to 6.2% (compared to the medium term target of 7%). Our dividend forecasts fall within the company’s target range of 2-3x cover. By the end of FY18, we forecast a net debt/adjusted EBITDA ratio of 1.5x (management’s target: 1.5-2.0x).

Exhibit 10 shows valuation metrics for Acal’s peer group and Exhibit 11 shows their financial performance. Over the last year, the stock has declined 17%, affected by currency headwinds and weaker demand in the UK. The stock is now trading at a small discount to the peer group average on EV/EBITDA and P/E multiples. The company is well positioned for volume orders as economic conditions improve and, combined with the increased geographic coverage, integration benefits and cross-selling potential of recent acquisitions, this should support revenue growth above market levels and further expansion of operating margins. As Acal 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. Design & Manufacturing made up 48% of FY16 revenues and we forecast this will increase to 51% in FY17. XP Power is an example of a distribution company that progressively increased its levels of design and manufacture, with operating margins growing from 6.6% in 2003 (when 51% of revenues were generated from distribution of third-party products) to 23.6% in 2015 (when 96% of revenues were from own-branded products and 68% manufactured in house).