Description

Diploma plc is a manufacturer and distributor of niche components listed with an almost unparalleled track record of sustainable growth over the last 20 years. It has grown both its revenues and earnings in every single year for the last 10 years and on average by about 10% p.a. Its source of consistent growth comes from its organic business growth, its business model of related bolt-on acquisitions, and its strong management team. We believe it makes an excellent long term investment candidate at its current valuation. Share price has come down due to Covid19; they have somewhat recovered, but remain at fair levels. 

Business Background:

It has 3 primary businesses, which each make up roughly 1/3 of the over all business. 

Life Sciences:

The life sciences business is primarily (80%) a Canadian healthcare distribution business that focuses on supplying hospitals with specialized medical equipment where Diploma serves as an exclusive distributor. It is based on the 2004 acquisition of Somagen (Canada).

A secondary business (20%) is involved providing environmental compliance products and services. (We did not focus on this)

Their detailed strategy in Life Sciences is focused on in achieving good ROTCE through focusing on distribution businesses in Canada in specialized niche segments including endoscopy as a treatment mechanism rather than detection mechanism.

Seals Business:

The Seals business is primarily a North American (63% revenues) distribution and service business selling heavy machinery seals for the after-parts market. Diploma holds an own-brand version (branded Hercules) set of replacement valves for all major lines of seals provided by the OEMs i.e. CAT, John Deere.

There is a secondary business (37% revenues) distributing similar seals to OEM in a variety of specialized industries such as hearing aids and wind power.

Controls:

The Controls business is a Europe focused specialty distributor of niche high-value components for controls. Items Diploma handles include specialized wiring, junctions, lacing for fly-by-wire systems, and items for electro-surgery.

Investment Case:

Diploma plc is a business with favorable business and competitive econmics and in each of its businesses is set-up as a business with high returns on capital and sustainable growth. 

In the life sciences business, being a distributor of in a specialized market area in a specific region, Diploma tries not to compete directly with anyone. Their main competition comes from major life sciences companies who can supply a broad range of medical products to hospitals and have the scale to do so themselves. Diploma does not compete against the original OEM businesses (no threat of disintermediation) as they are locked-up under long term exclusive distribution agreements and are usually themselves subscale to distribute to Canada or Australia. Diploma only works under exclusive distribution agreements as their investments in training the sales staff is significant.

In heavy industrial seals business, the aftermarket (after 3 years) is highly fragmented. The OEM’s still control ca 20% just based on legacy, while Diploma with its established Hercules brand also has ca 20%. The rest of the market is highly fragmented. The advantage of Hercules is that they are ca 20-30% cheaper than OEMs, but are manufactured from the same manufacturers. Furthermore, they are able to deliver within 24 hours which is industry leading.

In the controls business, Diploma-IS aims to be the leading supplier in each of their niche area. We do not have further details on this, but the fact is supported by their near 20% EBIT margins. Overall, Diploma’s distribution business faces competition mostly from OEMs who have the scale to distribute themselves. Second to this, they face other distributors, but try to limit this exposure by being in niche markets.

Besides its fundamentally strong businesses, Diploma also derives roughly half of its 10% p.a. top line growth from targeted bolt-on industrial acquisitions in their related industries. This has been a major source of value creation for the firm in the last 10 years. Specifically, they look for businesses that have a better home in their organization and a stringent IRR metric of 13% after-taxes, taking into account total gross capital including WC needs and intangibles. In EV/EBIT they have been able and continue to be able to pay roughly 6 - 7x current EBIT for these businesses. 

Businesses with extremely reliable structural growth and good management are not easy to find. At a valuation of 26x next year's earnings, we believe Diploma continues to offer a strong investment case.  

Catalyst

Continued sustainable growth