Diploma Plc - Enough To Seal The Deal?

Summary

• Another under the radar UK stock with impressive dividend growth.
• Member of the FTSE 250 with a market cap just above £1bn.
• 16% p.a average dividend growth over the past 10 years, coupled with 18-years of consecutive dividends.

In line with my previous articles looking at UK focused companies, I want to focus on Diploma PLC (OTC:DPMAF) here and the opportunities and challenges that face it going forward.

Introduction:

Diploma is not a household name in the UK, incorporated in 1931 and listed in 1960 the firm has undergone various changes in its core area of expertise mainly driven by acquisitions. During the 1970-80's the key elements of the business were Steel, building products and electronic components. These are highly cyclical sectors and ones in which the UK was losing its competitive advantage (as with most non-technical manufactured sectors), the ensuing economic downturn in the late 1990's led aspects of the company relating to these industries being sold off and that capital reinvested into new ventures. Diploma today stands as an amalgamation of the different smaller businesses that they have acquired.

The three sectors in which it now operates are life sciences, seals and controls. The share of revenue between the functions is 28%, 43% and 29%. The entry into these new markets was largely driven by a acquisitions of smaller companies both within the UK and increasingly in other markets. Diploma makes a point to celebrate the range and scope of acquisitions that it has made in the past 25 years, with a cumulative spend of £296m and a high of £38m being spent in 2015 expanding the product offering.

The diversity in products is also matched by the diversity in geography with Diploma having shifted from being focused solely on the UK to gaining traction in three main markets in Europe, North America and Australasia. This spread in geographic location has allowed the UK to become only 1/5th of group revenues. The breadth of Diploma's operations is presented below in the figure from the groups website.

_{Source: https://www.diplomaplc.com/our-businesses/group-at-a-glance/}

Going forward Diploma has identified the following KPI's; double digit EPS growth over the business cycle, total shareholder return in the top 25% of the FTSE 250 and (the most important in my eyes) deliver progress dividend growth with at least two times dividend cover.

In order to achieve these objectives the business strategy that has been taken is one that is non-cyclical and provide products which are essential to the functioning of their clients. The business operates with a motto of :

Our business model is designed to make us essential to our customers.

Diploma uses the essential aspects of this statement to break up how it seeks to offer essential solutions, products and values. While not glamorous this approach is one that is attractive in today's environment. The strategy of acquiring other firms and growing and developing their product offering is one that Diploma sees as being successful and has outlined this approach will continue into the future.

Financial metrics:

With the overview of the groups activities presented, analysis on the financial metric of diploma will now be conducted. First of all looking at the share price over the past ten years presents a positive picture, as shown in the chart below:

_{Source:https://www.diplomaplc.com/investors/share-price/share-price-chart/}

In the years from 2008 onwards the share price has gone from a low of 109p in 2009 to a high of 1300p at the tail-end of 2017. This is in the context of a Bull market and in the latter years stronger industrial production in the core seals and controls markets. The increase in price was also accelerated in 2016 with Brexit and the devaluing of the pound, which owing to 78% of group revenues coming from non-pound domiciled countries, increased repatriated earnings. In line with the total shareholder return being in the top quartile of the FTSE 250, diploma has achieved an annual compounded rate of 21% TSR. This as shown in the chart below well outpaces the overall performance of the index.

_{Source:https://www.diplomaplc.com/investors/share-price/tsr-chart/}

A large factor in the strong TSR is the dividend growth that has underpinned this stock over the past 10 years. As mentioned at the beginning of the article the company has had a very impressive dividend growth history in the past 10 years, this is shown in the chart below which includes the most recent increase of 16%:

^{Source: Diploma PLC. Authors own chart.}

The yield at current levels is 1.99% and expectations for the coming financial year are that the dividend per share increase will be low double-digits. This level is slightly below the 5-year average and this could be attributed to recent run-up in the 2016-2017 period. However the weakness in the recent trading update at the end of March has provided some downward pressure on the share price and it is down ~8% YTD.

Throughout this period Diploma has been able to keep to one of their key goals in keeping dividend cover at 2 or more. In the most recent financial year the company had EPS growth which was larger than the increase in dividend and the coverage ratio increased to 2.2. This has been driven by very successful years in terms of EPS as it has increased from just over 16p in 2008 to 49p in 2017. There was only one year in which EPS fell and that was between 2008-09, which was the height of the financial crisis and EPS only fell from 16p to 14.8p and swiftly the following year.

This policy of having a constant dividend cover ratio is one that may not appeal to all DGI followers as it does not preclude dividends being cut in bad years. The previous 10 years have been good in terms of economic growth and may not accurately represent how Diploma would fare in a sustained downturn but the increased diversification and move away from cyclical goods offers good protection for revenues. However the stock is currently trading at a P/E ratio of 28, which is above both the FTSE 250 average and the industrial sector average of 15. On reflection in spite of its impressive recent growth, it is hard to justify a PE ratio almost double that of its peers.

Risks:

As noted above the weakness in the pound following the Brexit referendum was a tailwind of Diploma due to the % of foreign earnings. However in recent months the pound has gained some bullish momentum and stabilised around the $1.40 level and with the Bank of England potentially raising rates in May, there could be more upside ahead. This has the consequence of potentially undoing the benefits Diploma experienced in the past couple of years. The first sign of this was reported in the March trading update in which the company reported that currency adjusted revenues for the FY 2018 would only increase by 8% (10% was previously stated) and that non-currency adjusted results were on track to increase by 12% boosted by strong North American industrial activity. While the underlining message is good, the fact that one of the firms key revenue drivers is subject to the currency pressures could be detrimental longer term.

In tandem with this is the recent rhetoric in the United States of a trade war and the impact that it could have on industrial activity. The intricacies of international trade law are not an area I am well versed in but from my economic understanding trade tariffs and protectionism is on the whole damaging to the global economy and the ramifications could be large if both the US and China decide to butt heads and not give any ground. As the seals range of products for Diploma is experiencing strong growth in the US aftermarket, the reduction in the level of industrial activity due to increased import costs could be very damaging. The worst possible outcome would be the degradation of relations and a global recession. Despite Diploma's corporate language suggesting that the company has moved away from cyclical goods only the life sciences division appears to be well insulated from the longer term effects of negative economic growth. The other two sectors I believe would struggle in an environment in which there is less industrial activity. As presented in the 2017 annual report a large majority of Diploma's products are consumable and not purchased through capital spending.

Time will tell how the trade saga develops and whether it is the beginning of a prolonged recession or a blip on the continued run of economic prosperity. Diploma despite its small market cap has a beta of 0.62 which does offer some protection from the volatility in markets that could ensue.

Conclusion:

To conclude and provide a recommendation on the value of Diploma, dividend discount analysis will be presented to see whether today's price of £11.33 represents good value. For some comparison Simply Wall St use a DCF model in order to calculate the value of Diploma and using analysts estimated earnings out to 2022 they value it at £8.31. This represents a 29% fall from the closing price on Friday the 6th of April.

Using a DDM approach to look at the intrinsic value of diploma with a discount rate of 10%, the intrinsic value is £9.10. This would result in a yield of 2.5% and a price 22% lower than at the last close. This may be underestimating the growth potential of the firm but in the 9th year of a positive economic growth and the chances of trade wars increasing it is prudent to understate the upside in the short term. Longer term I believe that Diploma is well managed and continues to create growth in new areas through target acquisitions that position it better in both the markets it operates it and ones in which it see synergies going forward. I like the potential of the firm and have a target price of £9-9.50 and hoping to enter a position on any pullback. The firm reports it's next set of results in May and I will use that to reassess my position.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DPMAF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.