Companies: DPLM   

Fully-listed distribution business Diploma serves the life sciences, hydraulic seals and controls markets, and now boasts a geographic and sector diversity that marks it out as a quality counter-cyclical growth stock. Over the past five years, it has delivered decent organic growth for shareholders, with a major shot in the arm coming from some astute acquisitions.

Chief executive Bruce Thompson recently reported on another year of double-digit profits growth and strong cashflow that left the balance sheet in robust shape for acquisitive deals. Adding more thrust to the investment case are the group’s considerable land assets.

Strategy
Diploma’s strategy is to invest in specialised distribution businesses sporting long-term growth potential in the UK, North America and Europe, where it can wring superior margins from its strong service knowledge and depth of technical support. ‘Our binding theme,’ explains Thompson, ‘is specialist distribution. We have a good spread of risk as we operate in different geographies and sectors, factors that smooth out cyclicality.’

Unfortunately, it wasn’t always thus. Listed on the stock exchange back in 1960, Diploma built leading positions throughout the 1970s and 1980s in electronic component distribution, building products and special steels. Going into the 1990s, its core businesses matured into lower-margin cyclical operations.

To remedy this, Diploma went on an acquisitive spree, diversifying into more attractive sectors. Towards the end of the 1990s, its core businesses started to go into decline and it was time for a radical restructuring. Between 1998 and 2001, ten businesses were sold, bringing in more than £90 million, the bulk of which was returned to shareholders with the balance retained for acquisitions.

Now, the company is focused on a new cluster of specialised distribution businesses, each with excellent growth and margin potential. Restructuring has also altered Diploma’s geographic make-up, morphing the business from a UK-focused group to an international play. ‘We have made something like 18 acquisitions over the past ten years,’ recounts Thompson.

The life sciences arm distributes instruments to research, development and diagnostic laboratories, the seals operations deliver hydraulic seal kits and gaskets for repairing the likes of refuse vehicles and diggers, while controls distributes wiring and control devices.

Management
Diploma’s board is one of its chief assets. Thompson joined as a director in 1994, taking the mantle of chief executive two years later. He orginally cut his teeth in the car industry, initially as a design engineer and then as a marketing man. Before joining Diploma, he was a director of Cambridge-based strategy and technology consultancy Arthur D Little.

Finance director is Pricewaterhouse-qualified Nigel Lingwood. Prior to assuming this position in 2001, he was group financial controller of Uniq, the European chilled foods company.

Executive chairman is John Rennocks, who has been with Diploma since 2002 and was appointed chairman in January 2004. He was previously an executive director at Corus Group, and finance director of PowerGen and medical device maker Smith & Nephew.

There is also considerable gravitas on the non-executive side, where Diploma can call on the experience of veteran ex-Tory minister Lord Ian Stewartby, Economic Secretary to the Treasury from 1983 to 1987, and current deputy chairman of Standard Chartered and chairman at The Throgmorton Trust.

Readers might also recognise his fellow non-executive director John Matthews, who chairs major house-building giant Crest Nicholson and business centres outfit Regus. Matthews even finds time to lend advice in a non-executive capacity at Rotork, SDL and Center Parcs.

Prospects
Investors have every reason to be bullish on prospects in the wake of recent annual figures. Profits, before exceptional items and goodwill, sparked up 27 per cent to £16.6 million, as sales were lifted 11 per cent to £111.3 million (£100.5 million). At the pre-tax line, profits eased to £15.3 million (£15.4 million), however, the 2004 numbers enjoyed £3.9 million of exceptional gains on the sale of land (of which more later). Thompson and his board also rewarded shareholders with news of an 18 per cent dividend hike to 20p a share.

On the operations side, there were encouraging trends throughout the three divisions.
The life sciences business scored a 33 per cent sales leap to £34.7 million, with operating profits lifted 34 per cent to £4.7 million.

One acquired outfit, Anachem, which focuses on products and instruments supplied to research laboratories, has been repositioned for growth. This arm thrived throughout the 1990s on a wave of research and development spending from major pharmaceutical companies as well as a surge in biotechnology investment in 2000 and 2001. Sales and margins have come under pressure since, with ‘big pharma’ rationalising research operations and a second biotech investment wave yet to materialise.

To return to growth, Anachem has made inroads into the environmental sector, where it serves testing laboratories as well as health and safety professionals. Another key move was the acquisition of Somagen, a Canadian supplier of diagnostic instruments to pathology labs. Somagen had a strong first full year as part of the group, and has taken Diploma into a sector awash with rising public healthcare spend.

Diploma’s seals businesses – Hercules Bulldog in North America and FPE in the UK – offer a next-day delivery service for kits and components used to repair ‘mobile machinery’ such as JCB diggers and forklift trucks. Last year, operating margins leapt from 8.8 per cent to 14.5 per cent thanks to prior hefty investment in IT and operations.

‘We are the largest catalogue distributor in North America and, in 2004, we carried out some heavy investment in the operational and IT parts of the business,’ explains Thompson. ‘Though that investment hit our margins in 2004, we reaped the rewards of that forethought in 2005.’ Dependence on the North American market has also reduced, with 40 per cent of sales now won outside the US versus 26 per cent back in 2000.

Over the past five years, the controls division has shown the most dramatic growth. The core businesses here, IS-Rayfast and Sommer, have been bolstered by the acquisitions of Clarendon and Filcon. Clarendon boosted IS-Rayfast’s position in the UK motor sport market and added new ranges, while Filcon bought Sommer a bigger footprint in the German military and aerospace markets. Margins are also on the rise at Hawco, a recent acquisition supplying instrumentation and control devices used in the sensing, measurement and control of pressure and temperature.

Prospects are underpinned by the group’s free cashflow – some £11.9 million last year – which ensured year-end cash jumped by £7.8 million to £25.7 million, providing plenty of firepower for further earnings enhancing acquisitions.

Valuation
Year-end cash was swelled by the sale of a second phase of land the company owns in Lincolnshire. Over the summer, Diploma concluded a Section 106 agreement with local planning authorities for the residential development of this 12-acre former brickworks site, and management is currently marketing the land for sale, hopefully during the current half-year. By year-end, the market value of the site had grown by £3.5 million and Thompson expects to pull in ‘not less than £9 million’ when everything is sewn up. At present, it is on the books ‘at next to nothing’. It’s worth noting too that the group still owns substantial agricultural land in Lincolnshire, some of which will be sold to developers further down the track.

Asset attractions are the mere icing on the cake of a diverse and resilient growth business. Following the recent numbers, analysts upped forecasts on a combination of recovery in the German market and continued strength in North America. This year, they are gunning for pre-tax profits of £18.6 million from sales of £122 million. By 2007, those numbers should tick higher to £20 million off a top-line £133 million, sales only £34 million shy of the entire market value of the group. Forecast earnings per share are 56.6p and 59.6p, with dividend payouts of 22p and 24p likely.

On those metrics, the shares trade on forward price-to-earnings ratios of 13 and 12.3, well below the sector average. Prospective yields of three per cent and 3.3 per cent are not insubstantial. We are buyers of this exciting company.