discoverIE Group — Resilience from focus on strategic growth markets

discoverIE is a leading designer and manufacturer of customised electronic components for industrial applications. Over the last 13 years, the company has broadened its product range, customer base and geographical presence via a series of acquisitions. It designs and manufactures differentiated products and expansion along the supply chain has helped the company to grow operating margins. discoverIE continues to target growth both organically and via acquisition with a focus on higher-margin business. To grow revenues well ahead of GDP, it is focused on four structural growth markets: renewable energy, electrification of transportation, medical and industrial automation & connectivity. Its capital-light business model supports strong cash flow generation, with the aim of increasingly self-funding acquisitions.

Despite the weaker macroeconomic environment, discoverIE reported strong H124 results. Revenue was flat year-on-year (4% higher CER, 1% organic), underlying operating profit was 12% higher (17% higher CER) and underlying EPS 8% higher. Magnetics & Controls reported 2% organic growth and a 14.8% underlying operating margin (+1.9pp y-o-y); Sensing & Connectivity saw 1% organic growth and a 17.4% underlying operating margin (+1.1pp). Net debt/EBITDA stood at 1.6x at end-H124 and we expect this to reduce to 1.4x by end-FY24. Management anticipates delivering underlying earnings in line with board expectations for FY24; we maintain our earnings forecasts. We have raised our FY24 dividend forecast and reduced our debt forecasts for FY24 and FY25.

The stock initially declined 20% after the recent 2J Antennas deal, but since interims were announced, it has nearly regained all this ground. It now trades in line with its broader UK industrial technology peer group on FY24e P/E and at a discount to peers with a similar decentralised operating model (such as Halma and Spirax). Considering that the earnings outlook has been maintained and the company continues to make good progress towards its margin targets, we believe this discount is overdone. Despite the current higher interest rate environment, we expect discoverIE to continue to make accretive acquisitions to drive growth. Countering concerns on the market outlook, the focus on strategic growth markets should reduce cyclicality compared to the wider market and we note that the company has previously demonstrated its ability to manage costs and cash flow through periods of weaker demand.

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. Supply chain: raw materials and components are sourced globally so the company must manage around availability. Currency: with c 90% 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. 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 designs and manufactures customised electronics for industry, with operations throughout Europe and increasingly outside Europe. The last 13 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.

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 designer and manufacturer of customised electronics with operations in Europe, Asia and North America. The company has made a series of design and manufacturing acquisitions since 2011 – we provide further detail in Exhibit 9. discoverIE sold its Custom Supply distribution business in FY22 and is now fully focused on higher-margin design and manufacturing. The group has c 4,500 employees across 20 countries.

discoverIE specialises in the design and manufacture of technically demanding, bespoke electronics for industrial applications and is focused on four target markets comprising 76% of group sales – renewables, electrification of transportation, medical and industrial automation & connectivity – all of which are long-term structural growth markets. The market for niche electronic components is very fragmented and discoverIE mainly competes against small, privately owned, country-specific manufacturers in one or two technology areas. The company expects to continue its active role in consolidating this market.

discoverIE’s components tend to be a small but essential part of the systems they are designed into and as such, tend not to commoditise, supporting robust margins. discoverIE’s engineers work with customers throughout their product development process, from design concept to volume manufacturing. A customer will typically take six to 24 months to move a product from design to volume production, at which point the company should earn revenues for the life of the product, typically five to seven years.

We highlight that discoverIE is focused on industrial OEMs and does not serve the consumer electronics market (which tends to be highly commoditised with short lifetime products and often highly cyclical sales) or the semiconductor equipment market (which is highly cyclical). It also does not have high customer concentration.

discoverIE’s custom electronic products are either designed uniquely or modified from an existing product. The large majority of products are manufactured at 34 sites across 18 countries, with the remainder manufactured by third-party contractors. This enables the company to support customers operating internationally and provides flexibility if a customer wishes to relocate production. Due to smaller batch sizes, production is either manual or semi-automated, which provides flexibility and results in a capital-lite model. discoverIE spends c 2% of revenue per annum on its manufacturing facilities to support organic growth and another 2% on R&D (all expensed).

The majority of products are manufactured in-house from raw materials and base components. Energy costs represent less than 1% of group revenue, as operations are mainly manual or semi-automated.

Mainly through acquisition, discoverIE has built up its design and manufacturing capability in four areas of technology: sensors, magnetics, controls and connectivity. discoverIE reports through two divisions: Magnetics & Controls (M&C) and Sensing & Connectivity (S&C). Exhibit 1 shows the companies and brands reported within each division. M&C consists of one cluster plus seven further businesses across 17 countries with 21 manufacturing sites (main facilities in China, India, Mexico, Poland, Sri Lanka, Thailand and the UK). S&C consists of three clusters and four further businesses across nine countries with 13 manufacturing sites (main facilities in Hungary, the Netherlands, Norway, Slovakia, the UK and the US).

Exhibits 2 and 3 show the progression of revenue in each division and the timing of acquisitions.

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 has transformed the company into a technology led provider of customised electronics for industrial applications with design and manufacturing capabilities. The company has the following strategic objectives:

This is underpinned by the objectives of generating strong cash flows from a capital-light model and delivering long-term sustainable returns, while progressing towards net zero carbon emissions and reducing the group’s impact on the environment.

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) and Simon Gibbins (CFO since 2010). The board is chaired by Bruce Thompson (non-executive director (NED) at discoverIE since 2018, ex-Diploma CEO 1996–2018, non-executive chairman at Avon Protection). Non-executive directors include Tracey Graham (also NED at Close Brothers Group, Nationwide Building Society and Link Scheme), Clive Watson (ex-group FD of Spectris 2006–19, NED at Breedon Group, Kier Group and Trifast, ex-audit chair of Spirax Sarco for nine years), Rosalind Kainyah (runs ESG consultancy Kina Advisory, NED at GEM Diamonds, Kew Soda, BTE Renewables and CalBank, previously VP external affairs and CSR at Tullow Oil) and Celia Baxter (previously group HR director at Bunzl for 13 years; currently NED at DS Smith and Dowlais Group).

Group executive management includes the CEO and CFO supported by, amongst others, group commercial directors for S&C (Paul Hill) and M&C (Martin Pangels), group head of corporate development (Jeremy Morcom) and group general counsel and company secretary (Greg Davidson).

Exhibit 4 summarises the steady progress discoverIE is making against its KSIs. We discuss below how it is meeting its strategic objectives.

discoverIE started life as a pure distributor of electronic components, but through a strategy of specialisation and acquisition it has transitioned to become a designer and manufacturer of customised electronic solutions. Since 2011, the company has acquired 23 businesses with design and manufacturing capabilities; these are typically much higher margin than the original distribution business, with recent acquisitions generating operating margins of 20% plus.

The charts below show the financial performance of the continuing business over the last five years and our forecasts for FY24–25. FY21 results were affected by pandemic-related demand weakness, although the underlying operating margin remained flat in FY21. The margin increased 1.4pp y-o-y in H124 to 12.9% and was also 1.4pp higher than the 11.5% achieved in FY23. The target is for a 13.5% underlying operating margin by FY25 and a 15% margin in the medium term (by FY28), to be achieved through a combination of organic growth and higher-margin acquisitions.

For FY25, we estimate that a 0.5pp organic increase in underlying operating margin from our current 12.8% forecast would increase our underlying EPS forecast by c 5%.

The company noted that one lever of margin growth has been optimisation of its manufacturing capacity. It has consolidated some sites such as in North America, consolidating three sites into one, in UK/Europe, consolidating and transferring production from high cost sites to low cost sites, and is increasing capacity at lower-cost sites. It has also optimised production, moving some US production to Mexico, some from the UK and the US to Hungary and is optimising the design of certain products to improve the gross margin. It is increasingly undertaking intercompany production, where spare capacity at certain sites is used by other businesses.

Sales beyond Europe increased from 40% in FY23 to 42% in H124. Exhibit 7 shows organic revenue growth by geography in H124 on a group and divisional basis. Partly due to supply chain challenges over the last few years, but also due to the attraction of earning “Made in the USA” status, there is an ongoing trend to re-shore or near-shore manufacturing. The decline in Asia revenues is from a combination of production moving from China to the Americas and one large customer in India working through excess inventory (excluding them, India revenues grew).

As part of the group’s goal to grow revenue well 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 United Nations’ Sustainable Development Goals (SDGs).

The table below describes the four target markets, the growth prospects of each market and examples of products that discoverIE provides for each market.

In H124, the business generated 76% of its revenues from these four areas and is targeting this to grow to 85% by FY25. Typically, growth from target markets exceeds other markets; in H124, this situation was reversed, with growth from target markets down 1% y-o-y and growth from non-target markets up 10% y-o-y. This was due to lower sales in industrial automation (where four major customers were destocking), acquisitions with lower target market exposure at the outset and a recovery in some non-target market areas (aerospace and defence, some other industrial markets and distributor restocking).

While the company does not actively stop supplying customers in non-target markets, it encourages each business to focus its sales efforts on target markets and builds this approach into acquired companies’ three-year plans. As target markets typically grow faster than non-target markets, over time the contribution from target markets should grow as a percentage of total revenue. The company reported that revenue from target markets had increased cumulatively by 82% from FY17 whereas revenue from non-target markets had only increased by 27% over the same period, highlighting the benefits of focusing on structural growth markets. This focus should provide some insulation against a shorter-term economic slowdown, as it did during the COVID year FY21 when target market sales were down only 3% organically compared with a 9% reduction in other markets.

From 2011 discoverIE started to make a series of acquisitions of companies with design and manufacturing capabilities (see Exhibit 9 below). The company has a dedicated M&A team focused on developing and pursuing opportunities.

discoverIE’s focus for future acquisitions is to target design and manufacturing companies with commercially viable technologies that can be applied to its target markets or with complementary product(s) 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, but which need scaling up.

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.

The acquired businesses are 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 created technology clusters, where smaller businesses are taken under the wing of a larger business operating in the same product area. In September, a new cluster for industrial wireless connectivity was created with the acquisition of 2J Antennas Group, bringing the company together with Antenova.

Acquired businesses can 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. Efficiency improvements are achieved through knowledge-sharing among the businesses and group guidance on best practices. 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 FY12.

The company has taken a disciplined approach to M&A; based on initial consideration, it has paid an average of 8.6x trailing PBT and 1.5x trailing sales for businesses with average PBT margins of 18.6%. This compares to 14.1x, 1.5x and 10.9% for discoverIE, respectively.

For H124, the company analysed the current EBIT return on investment (ROI) of all 19 acquisitions that it has owned for more than two years. It measures ROI as annualised operating profit for H124 divided by acquisition cost (upfront consideration, acquisition expenses, earnout and integration costs). The average EBIT ROI was 19.2%, well above the group’s 15% target. Ten of the acquisitions were at or above the target ROI with the remaining nine positive, but below 15%. Most companies below this target were the more recent acquisitions, reflecting the time it takes to integrate businesses and exploit synergies.

The company is currently tracking more than 400 companies and has identified 250 potential targets. Of these, it is talking to 45 and in active deal discussions with 15 targets that combined make up more than £100m in deal value and could increase EBIT by more than 10%. The chart below shows the areas in which discoverIE already has some presence as well as areas that it is interested in but has yet to penetrate.

Despite the current higher interest rate environment, we expect discoverIE to continue to make accretive acquisitions to drive growth. As deals in the pipeline can take a while to come to fruition, the timing of deals is difficult to forecast and discoverIE wants to take advantage of good deals when they present themselves. Management noted that economic uncertainty is causing vendors to reduce their valuation expectations compared to a year ago and in some cases, is making them keener to sell.

At the end of H124, the company had a net debt position of £111.3m and gearing of 1.6x EBITDA. The company has a £240m revolving credit facility (RCF) due in June 2027. It also has access to an £80m accordion facility; the RCF can be used for acquisitions and working capital. The company targets a gearing range of 1.5–2.0x, suggesting c £40–50m headroom for further acquisitions based on our forecast for gearing of 1.4x by end FY24.

In FY23, discoverIE set net zero carbon emission targets, including a 65% reduction in absolute emissions from the level in CY21 by the end of CY25. By the end of CY22, the company had reduced absolute emissions by 35% compared to CY21, helped by solar panel installation projects at manufacturing sites in Sri Lanka and Thailand, and the reduction now stands at 45%.

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 discoverIE’s approach to sustainability. As a result, the company committed to spending £3m over the next five years to resource and deliver its ESG strategy.

The company has a non-executive director, Rosalind Kainyah, with in-depth ESG experience. She established and chairs the sustainability committee, which includes all board members, to help set the group’s overall strategy and ensure the board has access to the knowledge and skills required in this area. Below this, the group sustainability team drives initiatives throughout the group and liaises with operating companies to consider what is practical and feasible.

Each member of the group executive committee has a specific ESG responsibility and targets within their personal objectives relating to ESG, with a proportion of annual bonus dependent on achievement of those targets. The company has also rolled out ESG objectives to the management of individual operating businesses.

The company has set three primary aims for its ESG strategy:

As well as ongoing initiatives in each area (eg increasing diversity, development and training plans for staff, supplier audits, responsible sourcing policies, enhancing cyber security controls), measurable targets have been set to work towards achieving each aim. See Exhibit 11 for targets and progress to date. We note that the reduction in carbon emissions is a key strategic indicator for the group.

In FY23, the company set net zero carbon emission targets (Science Based Targets initiative (SBTi)-aligned). Based on scope 1 and 2 carbon emissions, the company is aiming to reach net zero carbon emissions by 2030, and including scope 3 emissions, by 2040. Of the 7,745t carbon dioxide equivalent (CO2e) scope 1 and 2 emissions in CY21, 94% came from four emissions sources: purchased electricity (73%), natural gas (13%), company-owned vehicles (7%) and refrigerants (1%). To track progress, the company has set the following milestones:

In FY23, the company completed its first analysis of scope 3 emissions. CY22 emissions totalled c 70,000tCO2e, making up more than 90% of group emissions across all scopes. The largest source of scope 3 emissions was from purchased goods and services (c 75%) followed by freight (c 18%) and employee commuting (c 3%). In the next 12 months, the company intends to improve its knowledge of scope 3 emissions, start upgrading systems and processes to capture the data more efficiently, complete an equivalent exercise for CY23 scope 3 emissions and develop an SBTi-aligned plan to reduce scope 3 emissions.

In FY23, the company completed a detailed scenario analysis and quantified the potential financial impact of climate change per Task Force on Climate-Related Financial Disclosures (TCFD) requirements. Based on the 2DS (2oC warming or lower) and BAU (business as usual) TCFD scenarios, the net financial impact over the seven-year period to 2030 is immaterial and represents c 1–2% of group operating cash flows.

In its 2023 assessment, MSCI upgraded discoverIE’s rating from ‘A’ to ‘AA’. The company is rated as a low-risk by Sustainalytics ESG risk rating service, with a Regional Top Rating (Europe) and ranking 72 out of 653 in its technology hardware group.

discoverIE reported flat H124 revenue on a reported basis, up 4% y-o-y CER and up 1% on an organic CER basis, with both divisions reporting organic growth. Underlying operating profit increased 12% y-o-y or 17% CER, with the margin increasing 1.4pp to 12.9%. Both divisions increased their underlying operating margin. Reported operating profit includes amortisation of acquired intangibles totalling £7.7m and acquisition-related costs of £1.4m. Net finance costs increased from £2.1m in H123 to £3.5m in H124 reflecting higher interest rates and higher debt to fund acquisitions. Overall, underlying EPS increased 8% y-o-y.

Exhibit 13 shows discoverIE’s KPIs and we discuss the performance below.

At the end of H124, the company had used £144m of its £240m RCF. The chart below shows discoverIE’s gearing levels since FY15, with gearing only higher than 1.5x on two occasions, after the acquisitions of Contour and Cursor Controls. The lower level of gearing in FY21–23 reflects the focus on cash preservation during COVID, which included a brief pause in acquisitions, as well as equity fund-raising in FY22 to partially fund the acquisitions of Beacon EmbeddedWorks and Antenova. Our forecasts, absent any further acquisitions, assume that gearing reaches 1.4x by the end of FY24 and declines to 1.3x by the end of FY25.

As previously highlighted by the company, the order book has been normalising from its peak of £257m at the end of H123 (equating to around seven months of revenue visibility), declining to £223m at the end of FY23 and to £203m by the end of H124, providing more like five months’ forward visibility. Management believes that customer destocking is largely complete.

H124 orders of £193.9m were 18% lower y-o-y (down 16% CER). B:B for H124 was 0.87:1 versus 1.08:1 in H123, with Q224 orders 2% ahead of Q124. The company exited September on a B:B close to 1:1 and so far in H224, orders have been ahead of sales.

Design win activity is a leading indicator of future revenue growth. In H124, the company generated design wins with an estimated lifetime value of £190m, 23% higher year-on-year, with 89% from target markets.

Management anticipates delivering underlying earnings in line with its expectations for FY24. We leave our revenue, underlying operating profit and underlying EPS forecasts unchanged. We note that with an unchanged operating profit margin forecast of 12.5% for FY24, this implies a reduction in margin in H224 to 12.1%. While this may appear conservative, the company noted the negative effect of the strength of sterling on profitability. We have slightly increased our FY24 full year dividend from 12.0p to 12.1p. Based on the company’s expectation for gearing approaching 1.3x by year end, we have lowered our working capital forecasts and reduced our net debt forecasts by 2.5% in FY24 and 6.6% in FY25. We note that our conservative forecast results in gearing of 1.4x by end FY24.

Exhibit 15 shows financial metrics for discoverIE’s peer group and Exhibit 16 shows the valuation metrics. For the peer group, we use companies active in the electronics market and acquisitive industrial companies. discoverIE’s stock has declined c 9% over the last year compared to a flat UK market. It initially declined 20% after the 2J Antennas acquisition was announced in mid-September but since interims were announced has nearly regained this ground. The stock trades in line with the average of its broader UK industrial technology peer group on an FY24e P/E basis but 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 through the cycle and we see potential for upside to earnings through operating margin expansion and accretive acquisitions.

As interest rates have risen to combat inflation, concerns about a potential recession have weighed on discoverIE’s share price, exacerbated by the higher level of debt post the acquisitions of Silvertel and 2J Antennas. The company has previously weathered downturns in demand, such as the downturn in FY17 due to a global adjustment in capex and in FY21 (the COVID pandemic). The company saw a 1% decline in organic revenue in FY17 but managed to expand its adjusted operating margin from 5.7% to 5.9%. Since then, the company has further diversified in terms of customer, technology, end market and geography, potentially adding more resilience to the group. The focus on strategic growth markets should also help during periods of economic weakness.

We estimate that discoverIE is paying close to 7% for its debt (all floating rate) so any debt-funded acquisition will have a higher bar to clear to generate earnings accretion than was the case a couple of years ago. The company has a good track record for buying high-margin businesses on lower multiples than its own and is usually able to improve the businesses it buys, for example by focusing on design wins and target markets, optimising working capital or benefiting from group volume discounts and better sales reach. As an illustration of the potential for earnings accretion, if we assume that discoverIE spends £30m on a company with operating margins of 20% and pays 8x PBT, we estimate that this would increase our FY25 underlying operating margin by 0.27pp to 13.0% and increase our FY25 underlying diluted EPS forecast by 3.3%, while increasing end-FY24 gearing to 1.8x (compared to our current forecast of 1.4x). The same calculation on a 10x deal multiple would reduce EPS accretion to 1.8%. In the current uncertain macroeconomic environment, management noted that sellers’ price expectations have started to become more realistic.

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