Time to back this FTSE 100 newcomer

Diploma is a specialist distributor made up of about 20 separately managed businesses. Its products fall into three categories – controls, seals and life sciences – and include products such as wiring and cables, gaskets to prevent the leakage of toxic materials, and medical instruments. 

Demand for these types of products tends to be resilient as, despite their small size, they are crucial for making things work. If a digger blows a seal, for example, it needs to be urgently replaced. “In a world of artificial intelligence (AI) and technological change, Diploma looks to be a business that is at a relatively low risk of technological obsolescence,” notes Charlie Huggins, who runs Wealth Club’s Quality Shares Portfolio.

It helps that its products are also fairly cheap and funded from operating budgets as opposed to capital expenditure. While a company might hesitate over the purchase of a big machine when times are tough, it is unlikely to scrimp on everyday necessities. This is reflected in Diploma’s record of consistent organic sales growth, which has only wavered once in the past decade. 

Acting as a middleman is not typically a high-margin activity. Bunzl (BNZL), which describes itself as the largest value-added distributor in the world in certain markets, has achieved an average operating margin of just 6.1 per cent over the past five years. At the other end of the market cap spectrum, Aim-traded Midwich (MIDW), which supplies specialist audiovisual equipment, has an average margin of just 2.4 per cent. 

It is a different story at Diploma, however. The group has achieved an average operating profit margin of 14.7 per cent over the past five years, and profitability is improving across all three of its divisions.

How, an intelligent investor might reasonably ask, has it managed to do this?

At its capital markets day in June, chief executive Johnny Thomson described Diploma as “a service business as much as a distribution business”. This is crucial to understanding the investment case: the quality of the company’s customer service, together with the technical sales advice it offers, bolsters its pricing power, while exclusive supply agreements keep customers loyal. Just as important is the availability of parts: Diploma is both large and specialised, meaning it has a huge variety of stock that can be delivered the next day – something customers are willing to pay extra for. 

Diploma’s own business model is fairly lean. Capital expenditure typically represents 2 per cent of revenue, compared with about 5 per cent at specialist manufacturer Spirax-Sarco (SPX). It doesn’t need big factories or machines and doesn’t need to plough lots of cash into research and development. It simply requires warehouses within easy reach of end customers. 

Scaling up 

Diploma’s combination of organic growth and roomy margins – together with sporadic bolt-on acquisitions – has resulted in an impressive financial performance over more than a decade and established the business’s reputation as a highly consistent and high-return company. For proof, look no further than our recent High-Quality Large Caps screen ('A new era for our most successful stock screen', IC, 6 October 2023), which identified Diploma as one of five FTSE 350 stocks scoring full marks on a raft of measures including a consistent record of higher than average returns, rising profits, rising returns and forecast earnings growth. 

Over the past 15 years, Diploma has achieved average annual organic growth of 6 per cent, average annual total sales growth of 14 per cent and average annual adjusted earnings per share (EPS) growth of 15 per cent. It is also extremely cash generative, turning around 90 per cent of its after-tax profits into free cash flow, while its return on equity has consistently exceeded 15 per cent. 

This is reassuring. However, the big question for investors is whether the group can keep delivering as it increases in size. There are certainly risks. One of Diploma’s great strengths is its decentralised model, which fosters a culture of entrepreneurialism and accountability. However, since Covid-19, it has massively upped dealmaking and is pushing for larger and more frequent acquisitions. For context, the group spent £40.5mn on M&A in 2017 and 2018, compared with £650mn between 2021 and 2022.

As well as increasing leverage on the balance sheet, this also alters the dynamic of the group as a whole, and risks a certain loss of agility. RBC Capital Markets thinks return on invested capital (ROIC) will be a “key focus” going forward “to ensure the higher acquisition spend is not diluting returns”.

It’s also key to note that, while resilient, demand for Diploma’s products is not immune to economic pressure. If US construction activity slows down, for example, the seals division could take a hit, and last year organic growth in the life sciences division suffered as a result of hospital staffing shortages.

Diploma is doing all it can to counter these external pressures, however. Diversification has improved its resilience and it is consciously targeting structural growth areas. US onshoring, electric vehicles, data centre expansion, clean energy and the 5G rollout have also been cited as potential tailwinds. Geographically, there is also a lot of room for growth, and management thinks that by expanding its footprint and extending its product lines it could also add 1-2 per cent to organic growth over time.

Indeed, analysts at Berenberg have already noticed a "step-change in the rate of organic growth as the group enters markets with higher structural growth, making it hard to hold on to management’s baseline guidance of 5 per cent organic performance".

Quality worth paying for 

Ultimately, the question mark dangling over Diploma shares relates not to its operations, but to its valuation. The shares trade on a forward price/earnings ratio of 22 and have commanded a similarly high multiple for many years. This has led analysts at RBC to conclude they would be “happy to own the stock” but “for new money we continue to see valuation as a limiting factor”. 

We have seen some other high-quality large caps take a knock recently. Specialist equipment maker Halma (HLMA), for example, has lost 10 per cent of its value since April. The track record of our once-stellar High-Quality Large Caps screen has also started to lose ground.

For investors with a long-term outlook, however, Diploma is an excellent and convincing buy-and-hold option. Next to industrial peers, its valuation looks reasonable given its growth trajectory, and the group promises both consistency and opportunity. As M&S wrestles with consumer spending, reinvention and fickle fashions, therefore, its FTSE peer begins to exude an unlikely charm.