Diploma PLC (DPLM) Earnings Call Transcript & Summary

Good day, and welcome to the Diploma Q1 Trading Update Call. This conference is being recorded. I will now hand over to Johnny Thomson, Chief Executive. Please go ahead.

Good morning, everyone, and thanks for joining us on our quarter 1 update call. I'm here with Chris Davies, our CFO. The agenda for this morning, I'll say about 5 minutes worth of comments on our strategy on the quarter 1 performance and a few words on the outlook at the end. And of course, we'll do questions after that. So to start with a quick reminder of our strategy, which is to build high-quality, scalable businesses for sustainable organic growth, we do that by focusing on diversifying our specialized business revenues to drive organic growth, to build scale and increase resilience. That diversification strategy entails driving great exposure to high growth end segments, penetrating further our core geographies and expanding addressable markets with new product. Alongside that, we're also progressing our scaling journey. We're developing the business' operating model, so they can execute their value-add customer proposition at scale, and that value-add model drives for us customer loyalty and, therefore, share of wallet. It drives for us reputation and, therefore, market share potential and, of course, it drives for us pricing power and margins. At the same time, we're building the structure, the capability and culture of the group for sustainable delivery. And together, this strategy, therefore, will continue to deliver in the future on the group's long-term excellent track record of compounding 15% EPS growth. So now the first quarter, we're very, very pleased with another strong quarter for us. Organic growth was 10%. The demand environment remains largely positive. We're seeing encouraging trends across all the sectors, similar to what we saw in the old year. We continue to drive the organic revenue diversification initiatives I've just been talking about. And indeed, we come into quarter 2 continuing to see very, very good trading. So we feel very positive about growth -- organic growth. Reported revenue growth was 30%, another a very good number, reflecting, again, the contribution from the high-quality acquisitions we did last year, particularly R&G and Accuscience. And of course, we've got some FX tailwind in there, too. A few words on the M&A environment. As we said in November, market conditions mean that it's more important than ever for us that we retain our discipline, and we have done. We don't feel under pressure to acquire businesses because of the great organic growth potential we have. But having said that, we continue to do the small stuff, the Diploma style deals, which support organic growth. We did 5 in the second half of last year, if you remember from our November update. In quarter 2, we had another 2 small, $7 million, but very, very attractive valuations. And we want to expand this small deal approach across more of our business lines in the future. The immediate pipeline for the next few months looks encouraging. And actually, as we step out of that into slightly bigger or medium-sized deals for us, the pipeline is also surprisingly active. Our operating margin in the quarter is strong and consistent with the guidance. As we've said to you before, we continue to see the benefits to margin of scale. We continue to drive performance activity, which helps us to see our operational disruption and installation. And as per our margin formula, we reinvest some of those upsides into the scaling activity to sustain the model that I talked about a little earlier. So very, very strong quarter, and we're pleased with it. In terms of the outlook, it's been a strong start to the year, but we're not complacent about the potential for a tougher environment ahead. We feel the model is resilient, and the strategy makes us more so. Continued revenue diversification, of course, brings with it resilience. The value-add servicing components to our model supports pricing power and margins through cycles, and we have very, very strong cash flow dynamics as well. So we feel the model is resilient. And as I said, it's early days, but a strong first quarter performance underpins our confidence in the full year guidance that we set out in November, which is double-digit revenue growth, mid-single-digit organic half 1 weighted, plus 6%-ish from acquisitions and a strong operating margin in the range of 18% to 19%. So a good start, and reinforcing our guidance for the full year. And I'll take your questions.

[Operator Instructions] We will take our first question from James Rosenthal from Barclays.

Just 2 for me, please. First of all, could you give us an indication of volume and price within that 10% organic, please? And then secondly, could you talk through Controls in a bit more detail? Presumably, volumes are still very strong in Windy City, despite the tougher comps.

Yes. I mean, volume and price, well, the 10% is mostly volume, a little bit of mix and a little bit of price in there as well, obviously. I feel like most of our significant pricing increases from a supply chain and product perspective were quite a long time ago now, and we're kind of lapping beyond that. So price is becoming a lower component of our growth, albeit with still some price to cover wage inflation. What's really encouraging, therefore, is that we're still seeing very, very good volume growth, which, I think, is partly supported by an encouraging demand environment, but I think mostly driven by the activity that we're driving across the sector to diversify and scale up the businesses. So we feel really, really encouraged about that. From a Controls perspective, look, I mean, last year's organic growth in Controls was 24%, which was an exceptional performance. It's not growing in the first quarter by quite that amount, not because anything has changed from a trading perspective, maybe just a little bit tougher comparators, but the trading is still very, very strong in Controls. Windy City Wire, consistent with the way it finished last year, which is really, really encouraging, of course. But also, as we've said to you before, one of the advantages to the diversification is that we've got some great end segment exposures. And the control -- international Controls business continues to benefit from the likes of exposure to energy, to aerospace, to defense. And even, as I said, in November to electrification in some of these newer end segments we're looking at. So there's great structural growth trends, which is supporting a consistently high growth across the Controls businesses.

The next question comes from Sylvia Barker from JPMorgan.

Well, a similar question to Control. So I guess, if you can just talk about the other 2 businesses maybe relative to how they did last year and what you're seeing by region as well within those.

Okay. We'll talk about -- I think I've just talked about Controls. We're talking about the other 2. I mean, Seals was very, very similar. I mean, last year, yes, remember, we're only 2 months on from when we last talked to you, so not a lot has changed, really. But last year, we did organic growth in Seals of 14%. So a very, very pleasing number. We're still seeing very, very high growth rates in Seals, which is fantastic. The work that we've done in North America with Louisville to transition to a new distribution facility is continuing to support market share gains in North America. Our new acquisition in the U.K., I think a year ago, R&G has seen fantastic organic growth since it came into the group in April, May time, and that continues to flourish into the quarter. And we're seeing pretty strong performances across the rest of Seals. So still very, very good growth rates there. Life Sciences, as we've talked about, was slower last year mainly driven by -- or party driven by much, much fewer surgical procedures across international health care systems. I think, as I said in November, we expected a quarter or 2 of continued sluggishness, let's say. And Life Sciences has been broadly flattish in the first quarter, absolutely as we expected. What we do expect now is to see that starting to tick up. The surgical procedures are improving. They're not at pre-COVID levels yet, but they are improving, which is encouraging. And therefore, our growth rates coming into quarter 2 are starting to tick up. So I would expect, by the time we get into certainly the second half, that Life Sciences will be a fantastic contributor to the group's full year growth. And don't forget also, longer term, we're very excited about it because of the backlog of surgical procedures, which will have to unwind over the coming years, but also because, importantly, of the increased investments into the diagnostics space, which supports the other half of our health care businesses. So I think we're starting to get into a place now where Life Sciences is going to be a big contributor to growth, short and long term.

Very helpful. And just my second one. Could you maybe provide a rough bridge, just broadly, to the various impacts on the margin year-on-year in full year '23 versus '22 in those buckets? If we think about, I guess, any potential negative impact year-on-year on some pricing becoming just a little bit less prominent compared to operating leverage compared to, I guess, the small drag from your reinvestment as well.

Okay. I mean, we're tactically ahead of [indiscernible] a little bit here. We've done 2 years' worth of just under 19% margin. And through those 2 years, of course, with the extremities of particularly supply chain and product inflation, we've managed to maintain our margin through our pricing activity. Our pricing activity is supported, of course, by the value-add proposition and what that gives us in terms of customer loyalty and, therefore, supporting our ability to be able to pass on price. My comment about less price is not about -- it's not a factor of the fact that we're going to under recover. It's just the fact that inflation is going down. So there will be less of inflation. But there's less pricing. But that doesn't mean that, that had an effect on our margin. Actually, we've, I think, quoted here 18% to 19%. So broadly, we're expecting consistent margins -- strong margins going into the year ahead. Perhaps you're a little newer to our story. So just to reiterate the margin formula, of course, we see inflation with price. But longer term, the formula says that the benefits of scaling our business will flow to margin. The performance improvement from our action will flow to margin, but we will incrementally and quietly reinvest those upsides into the longer-term development of our businesses as they scale. And therefore, we seek to maintain high margins over the long term, and that's really the way we see margin. I don't think there's anything different in this year's margin from that longer-term perspective.

[Operator Instructions] We'll take the next question from David Brockton from Numis.

Can I ask a couple around acquisitions, please? Firstly, I think you touched on the fact that you want to expand the small deal approach across the business. I guess, you were sort of referring to how successful R&G is performing there. Are there any other businesses that sort of could naturally replicate that? And any changes you need to make elsewhere across the business? That's the first question.

Yes, that's a great question. And we're quite excited about it, really, because I guess it's about, as the businesses get bigger, they build the capability to be able to do the very, very small stuff for themselves, stuff that maybe at Diploma PLC level, we wouldn't necessarily see or have the resource to get to. And that means as those businesses build capability, it gives us access to those smaller deals and allows them to accelerate their growth strategy. And generally speaking, it allows us to do a very, very low multiples and, therefore, a fantastic returns. R&G have come with a track record of being able to do that and have bought a number of very small businesses since we acquired R&G in April, so that's exciting. We've been doing it -- actually, we have been doing -- we've done one, I think, in Techsil, our specialty adhesive business. And if you remember, that was a product adjacency that we're building out in Controls. And therefore, to be able to add to it is exciting, and they've got more in their pipeline that they can do. There are -- I think -- I can think, off the top of my head, there are 2 or 3 other businesses that over the next 6 months, I think, can replicate that. And of course, over time, we would carefully like to expand that capability into more of our businesses. It's something, of course, that we have to do with some care, some caution and some oversight to make sure that we have the capability to get it right. So we'll build out gradually over time, but I think it would be great for us if that level of very small deals could just increase in volume over time, and that would be a huge value driver for the group's future.

Great. And the second question sort of almost relates to that. Presumably, as you develop that capability, the sort of the competition for these deals is less. But I just wondered more broadly if you could just talk about how the sort of competitive landscape for M&A is looking at the moment given the sort of the changes in interest rates, et cetera.

Yes, yes. We'll have that very small level. I mean, generally, we're talking about -- probably, I should just say we're talking about deals in the $5 million sort of bracket, maybe between $0 and $10 million. So we're talking about very, very small stuff, and they will almost entirely be exclusive one-on-one processes. So that's that. To your broader question, I suppose -- we talked about it in a bit in November. Debt markets, et cetera, will it affect valuations? Will there be less deal processes, et cetera? And I think the answer to that is there probably has been a little bit less. But I suppose we've been quite surprised by how much activity there still is. And so our pipeline in that kind of, I guess, I don't know the right word, but medium size for us, let's say $0 to $100 million or something around, $0 to $150 million, and that kind of medium-sized sweet spot, the pipeline is surprisingly active. I don't -- one of the challenges here is that everyone automatically relates debt markets must equal cheaper deals. The reality is that, yes, there might be a turn or maybe 2 here and there, but great businesses are not going to go on cheap. And so I'm not going to sit and promise that we'll do deals, and there'll be half the multiple because I think that would be churlish. Might they be a little cheaper than they were a year ago, I would hope so. But I think it's more about the pipeline of activity. And as I said, I've been surprised that the pipeline is as active as it is.