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Transcript : Diploma PLC, Q3 2022 Sales/ Trading Statement Call, Jul 21, 2022

21/07/2022 | 09:30

Presentation Operator Message
Operator (Operator)

Good day, and welcome to the Diploma's Q3 Trading Update Conference Call. For your information, this conference is being recorded. At this time, I would like to turn the conference over to Johnny Thomson, Chief Executive Officer of Diploma. Please go ahead, sir.

Presenter Speech
Jonathan Thomson (Executives)

Thank you very much. Good morning, everyone, and thank you for joining our call. I'm here as usual with Barbara Gibbes. I'm going to talk you through over the next few minutes the highlights of the quarter and the year so far. And then, of course, we'll do some Q&A at the end.

So I'll start with a quick reminder of our strategy, which is to build high-quality, scalable businesses for organic growth. We drive this organic growth through focused diversification of our business revenues. We positioned them behind structurally growing end markets. We penetrate further in core developed economies and we extend our product ranges to expand addressable markets. This drives organic growth, it builds scale and it increases our resilience.

Alongside this, we develop our value-added business model and our management structures and capability to sustain customer service and strong margins at scale. In this context, quarter 3 performance was strong. Organic growth, 13% in the quarter and year-to-date 15%. That's been driven by the organic revenue initiatives I've just mentioned, continued positive demand and some pricing. Growth, of course, has moderated slightly in the quarter against tougher comparators, but we're still seeing encouraging trends within the sectors very similar to the first half.

Reported revenue growth of 26% and reflects the contribution from a number of high-quality acquisitions. Acquisitions are, of course, critical to our future organic growth strategy. And a few words on 2 strategically significant ones that we did in the quarter, Accuscience and R&G Fluid Power, which we updated you on at the half year. R&G Fluid Power is a business with great organic growth potential, which gives us scale in the U.K. Seals and evolves our product capability. It also gives the opportunity to add growth through small bolt-on acquisitions. And we did 2 small ones at low multiples for GBP 4 million in quarter 3, as an example.

Secondly, Accuscience joined the group in May, a great business, which further builds out Life Sciences in Europe and increases exposure to the high-growth Diagnostics segment. More broadly, the M&A environment, there are some signs of cooling. Still a lot of money chasing quality assets. So more important than ever that we retain our discipline, which, of course, as you would expect, we are doing. That said, the pipeline remains very active.

Our operating margin is strong and as expected, driven by the benefits of our value-add service model and of course, lots of hard work on pricing. There are some pockets of improvement in supply chain that we see, but labor remains challenging. Inflation is still high, but probably more recently shifted from product inflation more towards labor inflation. Overall, we feel well positioned to continue to deliver our margin.

So to the outlook. We've had a great third quarter. We're not complacent. Of course, the trading environment is likely to become more challenging, but our business model is resilient and the strategy is only increasing that resilience. That resilience is built on 3 fundamental tenets: First of all, our revenue diversification that I mentioned at the start has resulted in increasingly shallower troughs through historic cycles, and that the strategy of revenue diversification will only make us more resilient; secondly, we continue to improve our value-add service model that drives customer loyalty, and therefore, retention stickiness, it also drives pricing power and therefore, margins, and again, through recent cycles, our margins have held up very well; and finally, on resilience, we have a strong cash flow generation and balance sheet. So we're not complacent, and we're certainly not immune. But we feel we're very well positioned for any tougher times ahead.

So concluding comments. We've got a strong performance in the first 9 months, and in meaning we're very confident in our full year guidance, which, as a reminder, is low double-digit organic growth and reported revenue growth over 20%, operating margin are on the top end of 18% to 19% range, strong cash generation to drive net debt-to-EBITDA of around 1.5x and that's it. I'll open it up now for questions.

Question and Answer Operator Message
Operator (Operator)

[Operator Instructions] And we are now taking the first question from David Brockton from Numis.

Question
David Brockton (Analysts)

Can I actually ask 3, please? The first question, I just wonder if you can give us a bit more of a feel for the sort of the split between pricing and volume benefit to the business through the period, given that the pricing has become a bigger part of distribution companies more broadly recently? That's the first question.

The second question just relates to some of the accelerating trends that seem to be within the business. I was just wondering if you can just touch on what's driven this, of the increase in International Controls? And again, also as we look into next year, what sort of backlog looks like in Life Sciences?

And then the third question just relates to R&G. You've done 2 small bolt-ons there. And I'm just sort of very intrigued to understand what the pipeline looks like. And does Diploma's ownership sort of help accelerate their plans?

Answer
Jonathan Thomson (Executives)

Okay, thank you. I'll take them in reverse order, if I may, David. Thanks for the questions. And I'll let Barbara answer on price and volume in a second.

Starting with R&G. Look, I mean, I think first of all, more broadly, the market for acquisitions as I said earlier, is probably valuations are cooling a little, I would say, from what we can see, which is obviously a good thing, and our pipeline looks very active. But as you can imagine, I'll just emphasize the fact that in an environment that we're in and with the prospects ahead, we're obviously being incredibly disciplined in the way we approach acquisitions.

R&G, more specifically, I think, is a great example of what I hope we can do more of. They have a great organic growth story and potential. And in fact, the organic growth since we joined the group has been fantastic. But they are also able to complement that with small regional product acquisitions that can complement that organic growth strategy in the future. And if they can do these roll-ups, then it adds great value to the Diploma Group.

So I mentioned, I think we've done now 5 since we bought them, 2 in this quarter of around GBP 4 million at a very, very low multiple, 3, 4x and complementing the organic growth strategy. So if they can continue to do that, roll these businesses up at very low multiples and drive future organic growth, I think that adds great value to the group. And actually, we can see that start to happen in maybe some of our other businesses, too. So that rollout strategy, I think, is an exciting part of our overall acquisition strategy in the future.

Your second question was about, I think, accelerating trends. Look, I think as you can see from the 9 months, we've had some great performances across sectors. International Controls, we've been working on diversifying for some time, and it's getting more into the renewable sustainability, into technology spaces, into infrastructure spaces. And that's helping to support organic growth, along with the recovery in civil aerospace, which has been pretty encouraging over the last 6 months or so. We continue, obviously, with International Controls, also to build out their geographical presence. We did some acquisitions in the U.S. for them in the last months. And indeed, they've been building out their European platform organically, too. So geographically, the trends in international sales are really encouraging. And they continue to add products as well.

So back to my 3 buckets of diversification and end market, geography and product, International Seals has been great. And Windy City, as you know, continues to be to be a fantastic story. Copper has moderated somewhat, the volume has still been very, very good, margins very good and performance excellence. So great performance from International Controls and Controls more broadly.

Seals, again, pretty exciting. We've seen acceleration in -- some acceleration in infrastructure investment, particularly in the U.S., which has been great. We've also seen the benefits of our new facility in Louisville continuing to sustain market share gains in North America and therefore, driving good growth. The R&G acquisition in International Seals is driving great organic growth. So there's some great trends across Seals, which we're really encouraged about as well, again, in my 3 buckets of end market, geography and product.

Life Sciences, obviously, is slightly softer this year as we've talked about before. There are some very short-term reasons for that, last year's ventilator sales. This year, health care systems are suffering from staff shortages, so that just held us back a little bit. We will be back into growth in quarter 4. We're confident of that. And more importantly, we're very, very excited about the future for Life Sciences.

I mean, I've said many times, we've got a big electrosurgical backlog, which one way or another, public and private health care systems are going to have to work through. We've got increased investment into diagnostics, which we can already see happening. So there's some great long-term trends there. And of course, on top of that, we can complement it with our own work on geographical and product extension, which we continue to do so.

Life Sciences is a bit softer in the year, but equally as exciting as the others for the future. I think obviously, we have to be aware of the outlook for next year. But clearly, the kind of underlying trends across all of our sectors are very, very encouraging. And I'll pass it over to Barbara to talk about price and volume.

Answer
Barbara Gibbes (Executives)

David, so our organic growth rate was 15% for the 9 months. And you can see that, that includes a moderating impact from the copper price as we are lapping year-on-year numbers, which are much closer to where they are now. And that means that our, sort of, remaining underlying organic revenue growth is double digit, which is primarily driven by volume. So there is price in there, but the main driver is the volume growth.

Question and Answer Operator Message
Operator (Operator)

And we take our next question from Thomas Truckle with Jefferies.

Question
Thomas Truckle (Analysts)

Yes. One question for me, which is really focusing on margins. Next year they're expected to decline slightly, and they appear very strong for this year. I was wondering if you could just talk about why the margins are going backwards there? I appreciate there is operating leverage, which should come through if there is indeed organic growth next year. And -- but as to behind that, is there any sort of investment that is causing that to go backwards beyond what the operational leverage should provide?

Answer
Barbara Gibbes (Executives)

Tom, so the margins are very strong, as you say, in the current financial year, and we expect those to come out in the top end of the 18% to 19% range that we have given. Now at this trading update, I wasn't going to go out with our full year expectations for '23, but you also may want to bear in mind that some of our acquisitions, there's some mix impact in that. R&G is quite material. That's in Seals and that will have some impact. And we obviously like to have the flexibility to invest something in margin in order to accelerate our organic growth. But we're not giving sort of fundamental guidance for the '23 outlook at this update.

Question
Thomas Truckle (Analysts)

Okay. And sorry, just a follow-up on that. Are you able to say where that investment will be directed? Will that be in headcount or otherwise? Or is it too early to say?

Answer
Jonathan Thomson (Executives)

Look, overall, as we've talked about, we continue to develop our value-add business model for scale. And that means continuous investments over time, incremental investments over time in talent, in technology, in upgraded facilities, et cetera. And that happens around the group incrementally over time. And there will no doubt continue to be a little bit of that going into next year.

I think you're getting a bit hung up on decimal points on a margin a year out from now. And quite frankly, our margins are incredibly strong. They're well above our financial model. And the kind of guidance that's out there at the moment suggests that next year will be too. So let's not get too hung up about a few decimal points here and there. Overall, I think our margins are in good shape.

Question and Answer Operator Message
Operator (Operator)

And we take our next question from Henry Carver with Peel Hunt.

Question
Henry Carver (Analysts)

Just a quick one on the sort of organic revenue initiatives, and obviously they're bearing fruit this year. I just wondered how they evolve going forward. Is that something where you're picking relatively low-hanging fruit now, and we could expect them not to play a sort of significant part in future years? Or is it something that is a continuous improvement project or gathers pace even as we go forward? Just any color on that would be great.

Answer
Jonathan Thomson (Executives)

Yes. I mean the more time goes on, Henry -- as your question, the more time goes on, actually, the more excited I get about it because. The opportunities are not tactical or limited in any way, they are structural and long term. You could think about -- sorry about that, everyone. -- fire alarm here. So yes, I was just saying that I think the revenue diversification initiatives are structural and longer term.

Look at the end markets type of exposure we're trying to get more involved with, whether it be infrastructure investment over decades, I guess, in places like the U.S. data center, digital antenna rollouts, electrification rollout, these are long, long-term trends. Diagnostics investment, they're long, long-term trends. And there's many more of these type of end market exposures that our businesses are getting involved with at a detailed level, which I'm really excited about.

Geographically, I still think we're really, really small in the bigger markets. And that has no -- I don't see any medium-term horizon on that, whether it's the U.S., whether it's Germany and France where we got practically nothing, there's still massive potential for us there in core home economies. And products, again, there's matters of scope. We've done some work on extending strategically into product ranges like specialty adhesives or with R&G, pneumatics and hydraulics. But we look at things and we write down lists of product groupings that we think are suitable for us, and it's a long list.

So I feel really, really excited about whether it's end market, whether it's geography or whether it's products, all of our businesses have fantastic opportunities across all 3. And I think this is a real long-term sustainable organic growth story.

Question and Answer Operator Message
Operator (Operator)

And we take our next question from James Rose with Barclays.

Question
James Rosenthal (Analysts)

I've got 2, please. Which businesses do you have more forward visibility in? And are you seeing any pockets of slowdown anywhere at all? And then secondly, the moderation you've seen in copper, given the recent copper price move, does it become more of a drag in the fourth quarter and going into next year? Is it a potential drag on pricing or can -- will you simply hold on to it? .

Answer
Jonathan Thomson (Executives)

Okay. I'll let Barbara do copper in a second. Where do we have most visibility? Generalizing what do I look at, I look at some businesses on their run rates, perhaps slightly more transactional value-add businesses, Windy City or North American fields aftermarket. We look at their daily run rates to see trends.

I guess, on the other side, I also looked at order books in our, I guess, more OEM-based businesses or even Life Sciences, longer-term contract type businesses. So these are the 2 kind of main data points that I look at. Obviously, the order books in OEM and Life Sciences give us a bit further visibility further out.

I look through January, through the end of the quarter we just reported, things were very, very strong. And as we come into July, there's nothing that we're seeing that's of note that materially changes that. Now it doesn't mean we're complacent. Of course, at some point, I would expect that things will slow a fraction, the mood music would suggest. So -- but at the moment, we continue to see decent trends across the business.

And as I've just been talking about with Henry's question, we can continue to drive organic growth through our own diversification initiatives, too. So no immediate size as yet. Not complacent about future markets, but very positive about what we can do into the next year. Barbara?

Answer
Barbara Gibbes (Executives)

on copper, James, as you know, we've seen impact of the movement of the year-on-year cost price as a tailwind to organic throughout this year, which we've been very transparent about and called it out. And that is now really moderating because those prices year-on-year are pretty close to each other.

It's important to remember that Windy City is a high gross margin business with a strong value add and that's what drives the pricing power with another copper trader. It's a part of their input cost, but not the majority at all. They have discretion as to how they come on their pricing and the timing of that. So the recent volatility doesn't mean the prices get put up and down.

What we've been calling out in terms of our organic growth rate is the year-on-year movement. So if that stays within certain time lines, it's not going to be very material on our group numbers at all. And what's important to remember is what's driving the impressive profit performance of Windy City is that volume growth and their value add and the posting double-digit volume growth for the 9 months to date and seeing strong trends.

Question and Answer Operator Message
Operator (Operator)

[Operator Instructions] And we are taking our next question from Oscar Val with JPMorgan.

Question
Oscar Val Mas (Analysts)

Johnny and Barbara, I have 2 quick questions. The first one on cost inflation and wage inflation. Could you quantify the level of wage inflation you're seeing in the business and how that's trended during the 9 months?

And then the second question is, again, a bit more color on Windy City. You've just talked about seeing double-digit volume trends. Could you talk about the outlook you see in Windy City? And if we think about a slowdown in some end markets in the U.S. around construction, how you see Windy City from here?

Answer
Jonathan Thomson (Executives)

I'll answer that question on Windy City. And then Barbara, do you want to do the cost inflation one? That would be great. Barbara just mentioned that the growth in Windy City in the first 9 months has been exceptional. In fact, the growth over the last 2 years has been exceptional. And even if you strip out the effect of copper pricing, their volume growth has been well into double digits. So it's been way better than we could have expected.

They're -- first of all, they're behind some great structurally growing end markets, technology data centers, digital antenna, as I said, and that supports their growth. They've got a great value proposition to customers, which differentiates them and drives market share gains. And on top of that, I think in the last 6, 12 months, although it's difficult to quantify, I think their control of their supply chain has also driven market share gains against a competitor set who largely import from the Far East. So I have no doubt there's been some benefits from that, too.

As we look forward, we can't expect them to continue to grow at these phenomenal rates. I mean that's just crazy on the size of business. So of course, it's -- stripping out copper again, it will moderate naturally. However, don't forget the fact that they are in structurally growing end markets. While some construction might slow, a lot of work that they do is actually refurbishment as well: Office refurbishment, building automation upgrades, et cetera. So it's not always about construction for them. So you've got the digital antenna data center bit. You've got refurbishments versus construction. And then finally, you've got their value proposition and their differentiated position in the market.

So will they grow at the rate they've been growing in the last year or 2? Probably not. But I'm very sure that they're going to grow more than most. And I feel confident about the way that they'll deliver in a tougher environment next year, if indeed that's what happens.

Answer
Barbara Gibbes (Executives)

And the labor cost inflation offset, we did certainly see labor cost inflation over the last few months, and we continue to see it and that's across all of the businesses and their geographies. I guess what's really important is that the value-add model and the pricing power that we have, I mean that doesn't just cover input costs, but it also covers what we're seeing in our admin costs. And hence, we continue to deliver, and we're confident that we can can continue to deliver strong margins going forward.

From a margin perspective, it's taken into account. But what's even more important is that we look after our workforce properly. Labor shortages are very, very important. And we have high employee engagement. We make sure that the comp is right at the right time, and that's what's really important to deliver our growth plans going forward.

Question
Oscar Val Mas (Analysts)

Okay. Great. That's very useful color. So you can't quantify the level of kind of cost inflation you're seeing. .

Answer
Barbara Gibbes (Executives)

It differs. I mean it's a little bit higher in the U.S. than it will be in Europe.

Question and Answer Operator Message
Operator (Operator)

As we have no further questions at this time. I would like to turn the call back over to the speakers today for any additional and closing remarks. Thank you.

Answer
Jonathan Thomson (Executives)

Thank you, everyone, for joining. We're pleased with the performance so far this year. We're making good strategic progress and driving future organic growth. And if markets do get tougher, we believe we've got a resilient business model to support us through the coming months and years. Thank you very much for joining us, and we'll see you soon.

Question and Answer Operator Message
Operator (Operator)

Thank you. And that will conclude today's conference call. Thank you for your participation. Ladies and gentlemen, you may now disconnect.

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