Diploma delivers lessons in dealmaking

The higher interest rate environment has made things trickier for companies whose growth has been underpinned by acquisitions in recent years. This doesn't appear to be a problem for Diploma (DPLM), though.

Although more of the 30 per cent of revenue increase achieved in its half-year came from acquisitions rather than  organic growth, it is less reliant on bank debt having convinced shareholders to pony up £235mn in March via an equity placing to fund opportunities. 

A slice of this is being used to refinance debt used for the recent £76mn purchase of Tennessee Industrial Electronics, which provides parts and services for industrial automation equipment. However, the rest is to allow it to carry on spending, having identified acquisition targets worth up to £1bn.

Its pitch to investors was twofold. The first part was based on its track record – it has spent more than £820mn on 27 deals over the past four years, which have delivered average annual revenue growth of 15 per cent and a return on adjusted capital of 16 per cent.

The second was around the opportunity. After spending a long time identifying suitable targets, it has suddenly found competition from private equity bidders is waning.

“Frankly, their days of free money have gone,” said chief financial officer Chris Davies.

It tapped investors because it is conscious of the danger of stretching its own balance too far.

The company wants to keep net debt lower than 2-times cash profit, and Davies said it will only pursue deals that stack up financially. "At current rates, we think we can generate very, very attractive returns from that pipeline."

The half-year results provide evidence of this, with operating profit up by a third to £109.7mn and the firm's adjusted operating margin increasing by 40 basis points to 18.8 per cent. An increase to full-year guidance means the latter figure is expected to reach 19 per cent by year-end. Meanwhile, the placing proceeds and an expected free cash flow conversion of 90 per cent would cut leverage to an expected 0.4 times in absence of further deals.

Diploma's shares are highly rated, at 25 times forecast earnings, which is understandable given its performance. Yet, as RBC Capital Markets analysts argue, such a rating places it comfortably above peers and based on expected cashflows its analysts "struggle to justify material upside".

A quality share, undoubtedly, but it is already priced as such. Move to hold.