Diploma: a class act

Riding the tricycle

Diploma sells into three different markets – seals, controls and life sciences. All face short-term difficulty due to Covid-19, but also offer long-term promise.

Diploma reoriented to these sectors around two decades ago after finding itself stuck in three UK-focused industries in structural decline – electronic component distribution, building products, and steel. The radical transformation, which has been supported by frequent small acquisitions, has proved savvy, spreading the business across niche markets with different demand cycles where there is still considerable room for growth.

The ‘seals’ division accounts for more than two-fifths of overall revenue and is largely US-focused. It sells aftermarket products for heavy machinery and while demand has been subdued in recent years amid higher levels of new equipment that is under warranty from manufacturers, the need for spare parts should pick up as these warranties expires. Longer term, aftermarket sales should benefit from rising investment in infrastructure and a new automated warehouse should lower logistics costs and help expand e-commerce operations. But in the meantime, Covid-19 has exacerbated the wider industrial slowdown this year.

The ‘controls’ business generates just under a third of total revenue and supplies wiring, cables, connectors and fasteners for a variety of settings – everything from Formula 1 cars to electricity distribution networks. Vulnerability comes from exposure to civil aerospace – which accounts for around a fifth of the segment’s sales – but it also enjoys more defensive end markets such as food and beverage. Amid the recent Covid-19 turmoil, underlying controls revenue plunged by over a third year on year in the three months to 30 June, recovering to a 17 per cent shortfall in July.

The smaller ‘life sciences’ segment provides scientific instruments and ‘consumables’ to the healthcare and environmental industries, with much of its revenue underpinned by multi-year contracts. Typically, this makes the division less cyclical, but during lockdown it has been hit by the cancellation of elective medical procedures and delays in clinical testing. Diploma believes these revenues have been deferred rather than completely lost, as routine healthcare spending will return to normal once this crisis abates. In the longer term, the division stands to benefit from structural growth drivers such as health and safety regulation.

Adding value

Distribution is often a fairly low value activity. But in contrast to more generic distributors, such as Bunzl (BNZL), Diploma focuses on specialist applications, making it more akin to the likes of Spirax-Sarco (SPX). Like Spirax, Diploma has developed strong customer relationships and its essential goods tap into more resilient operating expenditure budgets rather than discretionary capital spending. By offering value-added services as well as products – such as the bundling of technical support – it also enjoys higher margins than other distribution businesses (see table).

Margins were above 20 per cent back in 2012, but have been squeezed by foreign exchange headwinds in life sciences – products are bought in US dollars and euros but billed in relatively weaker Canadian and Australian dollars. But with the easing of currency pressures, tighter cost control and a high proportion of fixed costs, the adjusted operating margin has gradually improved. Diploma aims to sustain its margin above 17 per cent.

Going for growth

Diploma frequently features in this magazine's ideas farm as a popular choice among UK fund managers. Royal London is one of the group’s top 10 shareholders holding shares across a number of its funds, including the Royal London UK Mid Cap Growth Fund (GB00B5BRW420). Manager Henry Lowson likes the group’s strong track record, in particular “an excellent history of organic growth supplemented by earnings accretive bolt on acquisitions. It has always maintained a strong balance sheet and generated prodigious cashflows that have largely financed its growth.”

Diploma aims to increase its organic revenue above global GDP growth, at around 5 to 6 per cent. It has largely hit this target over the past decade, although due to Covid-19, this year is set to be the first time it registers negative organic growth since 2009 – broker Numis is anticipating a 9 per cent contraction. As we face a global recession, it’s worth looking back to Diploma’s performance during the global financial crisis. The seals and controls businesses were hit hardest – underlying revenues fell by 21 per cent and 15 per cent, respectively, in 2009 – but they bounced back quickly in 2010. Something similar is expected this time around, with analysts forecasting Diploma’s earnings will rebound to above pre-pandemic levels in 2021.

Underpinning these expectations is a recent step-up in acquisitions activity. Taking advantage of fragmented markets, the group supplements organic growth with a ‘buy and build’ acquisitions strategy, having spent £283m on 39 acquisitions since 2010. And last month the group announced its largest ever deal to buy low-voltage wire and cable distributor Windy City Wire for an upfront payment of £345m.

The news saw Diploma’s shares climb by almost 30 per cent and spurred double-digit upgrades to analyst EPS forecasts. The positive reaction is based on the substantial opportunity on offer – the deal expands the group’s presence in the US controls market and taps into long-term growth trends including the digitalisation of infrastructure, the build-up of 5G networks and higher demand for data centres. While Windy City already has a large national account base, high customer retention and 97 per cent recurring revenues, a low market share means there is scope to scale up operations and also harness Diploma’s existing controls business to expand into Europe .

Windy City has been on the group's radar for some time and Diploma was approached by the majority owner and founder over the summer for a deal. The purchase will be funded through £194m from a placing and retail offer – for which Diploma didn’t need to offer a discount to its prevailing share price – and the rest from debt. At 11.5 times Windy City’s operating profits, this acquisition is more expensive than previous purchases, but it is expected to cover the cost of capital and boost Diploma’s earnings from year one of ownership.

Investors should approach serial acquirers with caution – they can create the illusion of growth and can struggle to balance expanding their existing business while integrating new ones. But Diploma’s decentralised business model limits potential integration challenges and it has form in generating value from acquisitions. This is reflected in what it calls ‘return on adjusted trading capital employed’ (ROATCE) – an alternative measure to ‘return on capital employed’ (ROCE) which adds back goodwill and acquisition charges previously written off. Diploma targets a ROATCE above 20 per cent, and it has consistently exceeded this threshold since 2010. ROATCE came in at 22 per cent in the six months to 31 March.

Strong cash generation supports the group’s acquisition strategy. Even if revenues were to halve during this current crisis, Diploma believes it would remain cash generative. It produced £21.8m of free cash flow in the first half of the year, a more than 50 per cent increase from a year earlier. Prior to the Windy City acquisition, net debt (excluding lease liabilities) stood at £30m, equivalent to just 0.2 times cash profits (Ebitda) and well below its lending covenant multiple of 2. Once the Windy City deal closes in November, net debt will go up – Diploma is guiding that it will equate to around 1 times cash profits in 2021, with Numis forecasting £151m of net debt for the year. But analysts expect leverage will come down swiftly, leaving Diploma plenty of headroom for further deals.

Having raised its dividend every year since 2004, Covid-19 has not put an end to that streak. While there was no half-year payout, the group plans to declare a 30p dividend for the full year, up from 29p in 2019.