Deep Dive: Diploma plc (DPLM)

For those that read my deep dive on Judges Scientific, the basic idea was 1) Judges has a great track record 2) Judges has reinforced its management with people from Halma (also great track record) and 3) Judges is small so has a long runway.

I first looked at Diploma in 2020. The issue was Diploma had a great track record but in 2019-20, both the CEO and CFO, the primary drivers of capital allocation, left and Diploma did not have a “platform” that ensured the continuity of strategy and capital allocation as illustrated by a botched new-CEO hire (Richard Ingram) who was let go after 4 months. The subsequent CEO, Johnny Thompson, was unproven. However, since Johnny took the reigns in February 2019, his track record has been exceptional. Moreover, Johnny has taken steps to develop sustainable platform value. As a result, I believe Diploma’s next 10 years can be better than its last 10 years.

Diploma is a UK-based serial acquirer of value-added distributors focused on niche end-markets favoring specialization and service. Diploma has 100+ independent subsidiaries in 3 unrelated markets: Seals, Controls, and Life Sciences. The Seals Sector distributes seals, gaskets and hydraulic products used in everything from construction machinery, coffee machines, and fuel pumps. The Controls Sector distributes electrical wires, casings, fasteners, and harnesses used in everything from data centers, airplanes, to Formula 1 cars. The Life Sciences Sector distributes diagnostics equipment and related consumables primarily to clinics, labs, and hospitals. Over the last 10 years, Diploma has grown organic revenue 6% cagr, total revenue 16% cagr, EBITA 18% cagr and EPS 15% cagr. Pre-Tax ROIC on Total Capital has averaged 21% while Pre-Tax ROIC on Tangible Capital has averaged 87%, illustrating that Diploma is intrinsically a services business.

Investment Thesis Summary

• Diploma's end-markets are well-suited to the "platform" strategy. Diploma acquires distributors of high-margin niche products in fragmented end-markets where specialization and service are more important to price, which allows Diploma's niche businesses to earn 20%+ EBITA margins and very high returns on tangible capital. When Diploma acquires these businesses, they benefit from light integration, capital, mentorship, and Diploma's vertical expertise while largely retaining their original brand, management, and entrepreneurial culture.
• Diploma has multiple avenues where it can deploy capital. While Diploma is £1.3bn in revenue, the revenues are split between 3 unrelated verticals. This creates diversification. Moreover, it allows for capital allocation optionality and extends the runway where Diploma can do high-ROIC smaller deals across 3 seperate verticals. As a result, I believe Diploma should be able to sustain a redeployment rate of c.50% of FCFE at mid-teens returns for the next 10 years.
• Diploma has conservative guardrails. When doing M&A, Diploma has clear guardrails around business quality, organic growth (5%+), margins (20%+) and ROIC (high-teens pre-tax) and in-fact Diploma’s economics have improved over-time. Moreover, Diploma has committed to <2.0x leverage minimizing "blow-up" risk.
• Diploma's new CEO (joined 2019) is exceptional. When Johnny Thompson took over as CEO in February 2019, it was unclear what direction he would take but the operational and financial execution since he joined has been exceptional. Moreover, Johnny has taken steps to develop sustainable platform value (more on this later).

Generally speaking, I do not expect companies in my deep dives to be actionable.

• Diploma is reasonably valued. Assuming they can redeploy 50% of FCF at a 15% post-tax return and sustain 5% organic growth, I get to a 11% IRR or £42/share intrinsic value assuming a 10% cost of equity and 18x terminal P/E multiple. Diploma’s businesses compete on specialization and service rather than scale so there are no obvious margin expansion opportunities beyond 2024 levels so I assume minimal operating leverage. A 50% redeployment rate implies each of the 3 Sectors will have to redeploy roughly £50m annually by 2030 which is achievable with mostly small bolt-on deals.
• A buy price of £30/share implies a P/E of 18x which offers a 14% IRR with reasonable assumptions.
• There is upside optionality. First, since Johnny took over, organic growth is trending closer to 6% than 5% and the sectorization and processes put in place may help sustain organic growth in the 6%+ range. Second, Diploma has proven it can be opportunistic with M&A as witnessed by Windy City Wire. To the extent large opportunistic deals come up, there is room for significantly greater than 50% of FCF to be redeployed assuming some leverage is used. Finally, 18x is likely too low of an exit multiple as Diploma will continue to have M&A opportunities well into the 2030’s and Johnny has built out the platform which should minimize succession risk longer term.

In the next section (behind paywall), I will detail:

• Organizational structure, management, and capital allocation approach
• Seals Sector Deep Dive
• Controls Sector Deep Dive
• Life Sciences Sector Deep Dive
• Review the Key Risks
• Valuation and Key Assumptions
• Historical Financials
• Projected Financials