Diploma plc (LSE:DPLM), the UK distributor of controls, seals and life science instruments, delivered its half year results on the 16th of May. Trading for the first six months to 31st March has been buoyant, with underlying revenue growth of 16% led by stellar performance in Diploma’s largest division Controls which delivered growth of 28% during the period.
The strong performance in the Controls segment, where Diploma, through its various subsidiaries distributes specialised wiring, cables and connectors, was boosted by Diploma’s revenue growth initiatives, positive trading at a newly acquired business ‘Windy City Wire’ and the pull through of higher raw material prices to its product base.Positive performance was also seen in Diploma’s Seals distribution business, up 15% during the period. Seals make up roughly a third of Diploma revenues. This business has a large weighting to the US, which worked in Diploma’s favour during the period, as the company noted significant strength in all industries for seal components, with particular note to the positive performance of aftermarket sales.
Decline in sales in life sciences
Unfortunately for Diploma, positive performance in the aforementioned business units was partially offset by a 7% decline in sales in the life science segment, which has struggled to grow against tough comparables with high levels of non-recurring Covid ventilator sales the year prior. Diploma noted lockdowns in Australia and Canada and hospital staff shortages as another impact weighing on its life science business. Despite poor performance in this segment, there was one particular bright spot, Diploma’s sales to diagnostics customers were particularly strong, as we have also seen in recent positive results from another UK supplier to the sector, SDI.
2021 marked a step change in acquisition strategy for Diploma, as the company splurged over £400 million on buying up other niche distribution companies. In the first half of 2022, Diploma has kept up acquisition momentum, deploying £172 million in capital to buy three businesses, the largest of which being R&G Fluid Power Group, a UK aftermarket distributor of industrial, hydraulic and pneumatic products, acquired for £100 million in April. With a keen eye for value enhancing M&A, Diploma noted the average multiple paid for the three businesses was 9x EBIT.
With such a marked change in acquisition spend, investors should cast their eye over Diploma’s cash flow statements to understand the financial impacts of this change on the business. As you can see from the below graph, between the years 2016 to 2020, net operating cash flow vastly outweighed acquisition spend for the company. This left Diploma with a great balance sheet position and the ability to pay excess cash to investors through dividends. However in 2020, Diploma raised just under £200 million through an equity placing and subsequently spent over £400 million the following year on acquisitions, funded through the placing proceeds and additional debt issuance.
Diploma’s shift in strategy may divide opinion
Whilst Diploma remains with a fairly low level of debt on the balance sheet at 1.1x net debt to EBITDA, we need to remember roughly 10% of Diploma’s equity value was diluted in the 2020 placing and it is important to highlight that the current acquisition path Diploma is pursuing is detached from the strategy we have seen over the last few years.
What’s more, despite finding many new opportunities to acquire new businesses over the years, Diploma’s own success measure for its investments ‘ROATCE’ (Return on adjusted trading capital employed) shows a decline in performance for recent purchases. See the below graph for declining ROATCE from 2019 onwards.
Whilst this shift in strategy may divide opinion, Diploma received an upgrade from broker RBC after its latest half year results. Although RBC struck a cautious tone with regards to Diploma’s elevated valuation, they noted the recent share price decline and Diploma’s defensive end markets as reasons for a better outlook for the stock.
Diploma currently trades at 35 times forecast earnings in 2022. Whilst this valuation multiple is down from elevated levels seen in 2021, Diploma still trades at a premium to its historic valuation, which arguably reflects a better business than today.
