Diploma PLC (DPLM) Earnings Call Transcript & Summary

Good day, everyone, and welcome to the Diploma Webcast and Conference Call. Today's call is being recorded. And now at this time, I would like to turn the call over to Johnny Thomson, CEO. Please go ahead.

Thank you very much, and thank you to everyone for joining us today at short notice. I'm joined here, as usual, by Chris Davies, CFO. Hopefully, you'll have seen the RNS that we released this afternoon U.K. time, through which we've announced another really exciting acquisition for Diploma, Tennessee Industrial Electronics, which we're very pleased about. We've also today given some color on what we see as a very positive active acquisition pipeline ahead of us in the short to medium term, and therefore, our proposal to raise up to 7.5% from our shareholders in equity to support that. I'll take you through 5 minutes or so of context, and then we can hand over as usual to questions and answers. So I suppose the context really from a Diploma performance and strategy perspective is, first of all, on performance, as many of you will know, Diploma has a long multi-decade track record of delivering great performance, compounding grade earnings growth and good returns. We feel, over the last few years, we've been accelerating that up to nearly 20% returns over the last 3 or 4 years. And again -- sorry, 20% earnings, and again, good returns. And of course, as we said in last year and the quarter 1, trading continues to be very positive and underpins that performance. So that's the performance context that we're in, and we feel good about that. Secondly, strategically, we feel the strategy is embedded, is clear and is working, building high-quality, scalable businesses for sustainable organic growth. And we are focused very much on organic growth. We have massive white space across all of our businesses. And we drive that, as we've mentioned in the past, through 3 distinct buckets, which are: getting involved, getting more exposed to structurally high-growth both-end markets, penetrating in our core geographies further and extending our product capability to grow market share. And we feel very excited about the progress with that. We feel we've accelerated organic growth, and there's lots of white space and runway for us to go in the future. Also strategically, of course, over the last few years, we've complemented that by doing a number of acquisitions, which help us accelerate that organic growth. We've done around about 30 or so acquisitions with spend of about GBP 800 million over the last 3 or 4 years, and those have accelerated our growth, as I say, and also been at very good returns, Windy City being the obvious stand out there. So I guess the context therefore is performance track record, and currently it's there; the strategy feels in a good place; and we're feeling positive about our momentum and the future. If I fast-forward that then to today, as I said, we've announced the acquisition of TIE, Tennessee Industrial Electronics, which we're very, very excited about. It's in the industrial automation space, which is something that we've been looking at for some years as a vertical within our controls business. If you remember, we've talked over the last few years about some potential new verticals that would help us expand product capability, and therefore, addressable market. We did specialty adhesives a few years ago. This is now an entry point for us into the exciting automation space, and particularly an exciting space in the U.S. with fantastic growth drivers to support it. It's very much a Diploma style business, very strong value-add, and therefore, great margins, as you can probably see from the information. As a result of that, we expect this to be growth and margins accretive straight off the bat for us. I suppose TIE is also representative of a very encouraging pipeline that we have right now. For those of you who have known Diploma for a long time, a long-term track record of successful M&A, and I myself and the team here have inherited the disciplines and the approach of previous management teams to focus our M&A by targeting core characteristics of great value-add businesses with good gross margins, management teams that we came back, and organic growth potential with great returns, of course, being the underpin on discipline. And we've inherited and stuck with that. But what we've done on top of that is to work to build out strategically and in a structured and proactive way, a bigger pipeline that's mapped against those organic priorities I mentioned a little bit earlier. And of course, as time goes on, that pipeline has got better and better. And the pipeline today is very, very encouraging. We have visibility, big picture, of 2,000-plus types of targets. In the shorter term, we have around about 35 active targets within the pipeline, representing around about GBP 800 or so million worth of EV. And we feel very excited about that because it's a healthy mix within that, across sector, across geography, a healthy mix of small and medium sized for Diploma, and therefore, at low multiples and medium-sized multiples as well. And we feel, therefore, not just the size of the pipeline, but the quality will help us to continue to drive the growth and returns that we've been doing over 12 or 18 months. I would just emphasize that this doesn't represent a change. It doesn't represent a step change either. It represents a continuation. If you look back over the last 3 or 4 years, as I said earlier, we've done 30 or so deals at GBP 800 million, and this represents really the continuation, therefore, of that strategy. We stuck very much to the financial disciplines which underpin our compounding model. And that means, of course, for us, making sure that these businesses fit the portfolio, of course, strategically. It also means financially that we drive the right returns, and we've been doing that in the acquisitions that we've recently done, and that will be important to us in the future, too. But finally, from a discipline perspective, it also means having a disciplined balance sheet. And therefore, without stretching our balance sheet and our leverage, we have decided that we would like to ask our shareholders for some support in order to be able to access some of these opportunities. We clearly will not do all, but some, and some support from our shareholders will help us to fund this in a very disciplined way. And if we can continue to do that and deliver deals like Windy City, like TIE over the coming months, which I'm sure we can, then we can continue to deliver the great organic growth, the great margins, the EPS compounding, and very, very good returns, which we're obviously very excited about. That is my summary. I will hand over for questions and answers.

[Operator Instructions] And we'll first hear from Henry Carver of Peel Hunt.

Well done on the acquisition. It looks like another decent deal. I just wondered, on TIE, sort of any more details about how that came to you? How long you've been looking at it? And sort of taking that wider, sort of to the rest of the pipeline, sort of what is it looking like in terms of where these deals are coming from? And also just, again, on the pipeline, any sort of indicator of if there's any bias to any particular geography or sector for you guys?

Yes, I'll let Chris say a few words on TIE, and then I'll pick up the point on the broader pipeline.

Hi, Henry. Look, TIE, and in particular, industrial automation was a vertical we've been mapping for some time, probably a couple of years now as a strategic target for controls. And TIE came to us through that route. It was a competitive process. It was in PE ownership. They've had it for about 8 years. During their tenure, they've grown this thing or it's grown about 7% organic revenue pretty smoothly for those years at mid-20s margins. We think we can accelerate that by a number of things, not least extending its geographic footprint from the kind of southern states it operates in. Yes, I'll let Johnny talk about the pipeline, but we have others like that. I mean, do you want me to give you just a little bit more detail, Henry, on what the thing actually is, because I'm aware you probably only got one paragraph in an RNS.

Yes. I mean I'm sure that would be useful, yes.

Yes. So this is -- I mean, effectively, this operates in CNC and robotics space, and it is a -- we think of it a little bit like a Hercules aftermarket-type business. So it distributes parts for these machines sort of in the post-warranty to end-of-life phase. So from 5 years old to 25 years old. And it could be anything from a hard-to-obtain part right away through to an exchange program. You send in your faulty machine, we send you back a reconditioned, new -- well, we then harvest your parts and you've got that kind of circular economy type thing. So it's much, much cheaper for our customers than going to the OEMs, and importantly, much, much faster. So they could have a CNC machine or a robot back up and operational in their production line many, many months faster than they could going to the OEM. And because of that, that is highly valuable. And because of that, it's got strong and sustainable margins and a really sticky and diversified customer base.

Okay, that's very useful.

I'll pick up, Henry, on the point on the broader pipeline. Look, I mean, as I said, there's, I think, around 35-odd businesses in the pipeline. I think it's a very healthy mix as I was kind of talking about a little bit before. We kind of loosely quantified those 35 at around GBP 800 million of EV at a rough estimate, which tells you that the average size is really right in the Diploma sweet spot, kind of GBP 20 million, GBP 25 million. Many of them are smaller than that, and many of them will be the kind of small deals that we've been continuing to do at lower multiples and great returns. Some of them will be a bit bigger than that, I guess, the TIE size; GBP 100 million, R&G side; that kind of thing. So there's a good healthy mix between that small and medium size in there. Across the sectors, it's fairly balanced. Maybe a little bit more Seals this time around. But then again, we've done a little bit more Controls and Life Sciences in recent times. So that's just a product of timing rather than choice. The balance is fairly healthy across the 3. Geographically, again, it's well balanced. There's almost an even split between the U.S. and Europe. And that's really exciting because, of course, those our core markets that we're going after. There's a good balance between the product verticals that we're already in, and we want to strengthen and bolster. There's also some like TIE, where we're moving into some verticals that we think are really, really attractive. So overall, it's a very healthy balanced mix, very similar to the way we've been behaving over the last 2 or 3 years. And that's why I say that there's kind of no change here in terms of approach or pace necessarily. I think what's exciting about the healthy breadth of it is that it's very much in the Diploma style and Diploma opportunity. We've got fantastic white space across all of our businesses. And what this pipeline does is, just as we've been doing, plugging in different parts of this white space to access the growth in it as we go. And that's what we intend to continue to do. So there's nothing in here that's binary. There's no 1 or 2 deals, that's the whole thing. It's very spread across the whole portfolio, which I think is very healthy.

That's great. Thanks guys. Much appreciated.

Thanks, Henry.

Our next question comes from David Brockton of Numis.

I've got 2 questions just around TIE as well, please. Can you just give a bit more insight into how broad the OEM base is for TIE? Any concentration we should be aware of? That's the first question. And then the second question, I just wondered if you can just touch on how well invested you feel the platform is, and whether you've already started to progress your thoughts in terms of how you will expand the business geographically?

Yes. Why don't you take the first one? I'll take the second one.

Yes, sure. I mean, it has a center of gravity around Fanuc, and that is where it sort of grew up from. Now clearly, they have a huge share of that CNC and robotic space anyway. So you would expect that. And from a Fanuc perspective, in CNC machines, they are pretty much the only independent distributor. And in robotics, it's an even more kind of symbiotic, almost licensed aftermarket operation, if you like. But they're not solely a Fanuc shop. They've been branching out recently; ABB, Mitsubishi, Siemens now are all covered. So a good anchor OEM, very long-term relationship, and now branching out into others.

I'll just pick up, I guess, on the opportunity -- the second part of that question. I think for us, there's a number of things that are exciting about this. I mean, the first thing is, there's clearly a base level of market growth here, which is pretty exciting. I suppose, the drivers that we all know, with manufacturing wages going up, a shortage of labor in the U.S., and the onshoring of manufacturing in the U.S., I think that those are going to be great long-term drivers for this business. On top of that, for some of the reasons Chris was talking about a minute ago, we feel it's a really strong value-add player in the market, and therefore, it is winning share. That's technical capability, speed to market, products and repair, et cetera. So there's real market share win within its existing customer base. And then finally, we can take it to new geographies in the U.S. and to new customer bases and markets, I suppose. We're getting a bigger and bigger spread across the country now in terms of our own footprint. We have access, therefore, to different OEMs and other customers across the country. And we feel that we can help take them to some new customer sets in different places around the country. We also feel that down the line, we can add to this, and that's not something we're thinking about in the short term. But we don't want to stop here. We want to build on top of it. And once we get established, once we get a track record with the management team there, of course, much like we've done with R&G, there'll be ways to -- and with textile and specialty adhesives, there'll be ways to build on the platform, which we're excited about. And I suppose drawing it to a close, for those reasons, we think this is massively growth accretive. It comes at a great margin because of the value-add characteristics. But I would just point out that we don't see that, that's the end of the road on the margin journey either. And if you look at the kind of comparative businesses within our portfolio, as Chris mentioned, Hercules aftermarket is a bit like Windy City in some respects, as well as transactional value add, lots of customers, speed to market, et cetera. These businesses are double-digit growth and touching on 30-ish percent margin. So we think there's a bit of room in the margin as well, which makes us excited.

Our next question comes from Kean Marden of Jefferies.

You've already answered a few of mine, but just to sort of look back on some of this. So on the financials that you've disclosed, just to check, has TIE delivered all of this organically? Or has there been any sort of bolt-on M&A themselves in some of the numbers that you've mentioned? And then when we look at sort of how the organic is likely to trend here from all the points that you just mentioned, Johnny, it looks like it compounded at about 21% between fiscal '20 and '22. Look, if I read your narrative correct, I think it might be about 12% growth for fiscal '23. So I guess, why did it slow down a little bit in '23? And do you see trend here being more like fiscal '20 to '22 experience? And then a couple of quick ones. Just first of all, for your hurdle rate, what sort of post-tax WACC would you use for this type of transaction? And then secondly, just on the pipeline, in terms of just sort of constraints to converting that, do you have a net-debt-to-EBITDA ceiling in mind that you don't really want to go above? But also, how do you feel about operational management bandwidth to convert and to integrate?

Well, I'll take that last one, and then let Chris pick up some of the others on TIE and leverage, et cetera. Well, I mean, I think to answer -- I mean, as I'm sure most people know, we've got a leverage cap of 2x, and we don't feel this business should carry a lot of leverage. And therefore, that's one of the reasons why we're looking for a bit of shareholder support. I guess, eventually in time, as we get bigger and as our balance sheet grows up in line with our ambition and scale, then I would expect us to be self-funding. But at the moment, we're in that kind of transition, if you like, from small to medium to large, and that's part of this journey. I think your point on operational bandwidth is a really good one. But I think, I guess, I would widen this back 3 years, because it's not a question of now. It's a question of what we've been doing in the last 3 or 4 years. We've done quite a lot of M&A. The group has doubled in size in the last 3 years. And as many of you will know, I talk a lot about how we have and how we continue to focus on structure, capability, and culture to be able to sustain growth and scale over the long term. So we've been working on that very, very hard. When I started, we didn't have an executive team. We had myself as CFO and pretty much all the businesses reporting in. So we've built out an executive team. We've built out a layer of senior management as we've gone along. We continue to look forward on that, and we continue to add to that, constantly thinking forward about what comes next in terms of structure. We've got very significant internal development plans, which we call leadership at scale. We add, of course, the occasional new person into the structure as well. And the cultural progress that we make in joining up the group around common themes for common learning and common best practice helps everyone to make sure that we can execute at scale as well. So that is an ongoing journey that we've been on for the last 3 or 4 years, and that will continue to go on over the next 3. And I guess the last couple of points I would make on it are this. Where we are hasn't changed, the pace has not changed, if you like, over the next 12 or 18 months. We're not going to do all of this pipeline. Of course, we're not. Some of it will come down and be ugly and hairy. Some of it will come down the pipeline and be too expensive. So we'll do a proportion of it. And that will be great because we'll choose the high-quality ones, and they'll drive great growth and great returns. But if you look at that, therefore, over the last 3 years, we've done 30. So if we're only going to do a proportion of the 30 or so that we've got in the pipeline, then that tells you that it's a pace that's manageable for us. I'll just say one last point on it. Over the last 12 months, we've deliberately not done very much. We've done very, very small things. But since April last year, when we did a couple, Accuscience and R&G, we haven't really done that much, principally for valuation reasons. But one of the benefits, of course, has been that it's allowed us to settle and make sure the organization has breathing space and muscle for the next phase. So I feel very good about operational capabilities. Sorry, that was a long answer, but it's an important question. Chris...

Kean, look, the financials over a very short period are a bit noisy, because you've got a bit of COVID recovery in there in sort of 2021, or certainly in 2020. If we look at the last 8-year track record, i.e., during the ownership of the last owner, they grew organic revenue growth of about 7% or thereabouts pretty smoothly. And actually, if I take the last sort of pre-COVID data point, 2019, and look at growth from there to today, it's also in that same ZIP code, sort of 6%, 7% organic. They have bolted some things on in the past. They got into robotics through some bolt-on acquisitions, but that was earlier than those years. So they do have the muscle and the capability, and they've got a decent track record, but they've had a good organic run of late. And as for kind of -- I'm not going to give you a forecast under our ownership, but we would expect that to nudge up a bit. In terms of net-debt-to-EBITDA, look, nothing changes. As you know, our policy limit is kind of 2. We're comfortable anywhere between 1 and 2. We are -- the proposed equity placing is not around trying to drive a structural lower level. It is there more to, say, it effectively allows us to reload, rebase, and go again at the pipeline that we have open to us right now, but we would expect to settle back into somewhere between that 1x and 2x levered levels.

Very kind. And just the post-tax WACC?

Well, it's a very noisy number at the moment, Kean, isn't it. So it depends what month you ask me at. Seriously, I mean, it's all over the place at the moment, but 7 or 8.

Okay. That's quite like -- so this looks like a transaction that exceeds cost of capital after about 1 to 2 years then, if you're using 7 to 8...

This is a -- I think it's straight off the bat, exceeds cost of capital. Yes. No, it's...

I think it's worth just stating at this point. I mean the acquisition itself does exceed the cost of capital straight off the bat. But also, I think I should have also mentioned earlier that this acquisition plus our proposed placing is marginally earnings accretive from year 1. And of course, as we deploy this on the pipeline, that accretion will build over the next 12 to 18 months. But straight off the bat, we are earnings accretive on the placing.

That's very helpful.

Next we hear from Daniel Cowan of HSBC.

Two questions. One is on -- and they probably are 2 unfair questions, but I'm going to ask them anyway and see what you say. One is on, I guess, the pipeline you've identified. You mentioned it short term. What sort of time frame should we sort of think about that for those sort of 35 targets and what you sort of mentioned as that sort of nearer-term pipeline. And the second one is on organic growth. For some time, you've been buying businesses that have faster organic growth and that take you into the structural growth markets. Your medium-term guidance is still around about 5% organic growth. At some point, might that 5% be more like 6%, 7% or higher, are you sort of prepared to sort of start thinking about moving that organic growth number for the medium term up a little?

I don't think they're unfair questions at all. I think they're very good questions, and I'll take them in reverse order. Look, I mean the more time goes on, the more difficult it gets for us to save 5%, doesn't it? And our excitement around organic growth potential continues and continues to build. So it kind of becomes, I guess, more difficult for us to hang on to the 5%. You can understand why we're not jumping too quickly to put a noose around our necks. But I think over the next few months and into June, when we do a seminar, it's potentially something that we can talk about a little bit more. But whether we state 5% or whether we don't as part of the financial model, the bottom line here is we've got tremendous white space and fantastic opportunity. And internally, if not externally, we're obviously targeting to do a lot better than 5%. The first question was on the pipeline. Yes, I mean, I think it's 12 to 18 months sort of a time period. I think you'll understand when I say, we're going to spend it wisely, not quickly. So if it's not completely deployed within 18 months, fair enough. It's because we've made the right decisions. I would be surprised, given the quality and the size of the pipeline, if we haven't done. But there'll be good reasons if we haven't. My hunch, if I can say that, would be that we would have spent it certainly within 18 months.

[Operator Instructions] Next, we'll hear from Oscar Val of JPMorgan.

Johnny and Chris. Just a few questions from my side that haven't been asked. The first one, going back on the business itself. Just to clarify, could you just run through how much of the business is own brand? And then the second part on the acquisition, is there an earnout or not? I just wasn't sure from the release. And then the final question is going back on the pipeline. Is it fair to say that valuations have come down already? Or do you expect them to come down over time?

Yes, I'll take the last one, and then Chris can take the first 2 on TIE. Yes, valuations have come down. I guess, I think I said a bit earlier to Kean's question that over the course of 2022, we didn't actually do that much of any size. And one of the main reasons for that was the valuations had become a bit crazy during the middle part of last year, post-COVID earnings and cheap debt, et cetera. So we were very, very careful and cautious during that period and stayed away. I guess what we're seeing now is -- I guess, I'm somewhat -- compared to where it was 4 or 5 months ago, I think I said this on the quarter 1 call, we've been quite pleasantly surprised that the small and medium-sized deals seem to be unaffected by the debt situation, if you like. The deal flow is still very strong, as you can see from the pipeline, and that's been great to see. Private equity, who are normally our main competitors, are still there. But the great thing is that they have become infinitely more rational than they were, say, 9 or 12 months ago. And that means that, I guess, I can generalize our evaluations have come back towards a norm from being a bit silly last year. And I certainly think that something like TIE, we wouldn't have got for, what is it, 9.5, 9.7, whatever it is, times multiple. We wouldn't have got it for anything like that 6, 9 months ago. So I think valuations have returned to more sensible levels. I would also just add, though, you don't get good businesses on the cheap either. So we're not expecting to get materially cheaper deals, but we can definitely be much more competitive and retain our strong returns criteria.

Yes. And Oscar, it's not really an own brand business. It's supplying used reconditioned or new Fanuc parts or ABB parts or Mitsubishi parts or Siemens parts. But the core is that kind of used or reconditioned. So it's supplying very, very hard to acquire, very hard to acquire parts that then keep these machines running for a long period of time. And these are machines that are licensed to operate. And therefore, there is a big benefit for the end consumers to keep an aged CNC machine running, especially in end markets like aerospace, where it takes quite some time to get a new machine licensed. It's not really an earn-out sort of a deal. Obviously, we bought from private equity, we bought over the management team, who were great, by the way, and are very, very happy to be part of our structure. But we've got them on sort of short, medium, long-term, "LTIP" if you like. So it's not an earn-out, but clearly, there is -- we're incentivizing the right performance.

And it appears there are no further questions at this time. I'll turn the call back over to Johnny for any additional or closing comments.

I'd just like to say thanks again to everyone for joining us at such short notice. As I said at the beginning, we feel really, really positive and optimistic about where we are right now and about our prospects, both organically and through the pipeline. And we're excited about the prospects of being able to continue on our journey of delivering great compounding long-term earnings growth at fantastic returns. And thank you again for your time.