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Visible Alpha

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Today's episode focuses on Diploma, a UK-listed value-added distributor. They supply essential products to engineering and industrial companies across sectors such as aerospace, life sciences, and a broad range of other industrial markets in Europe, the UK, and now the US. It's somewhat similar to Fastenal's core business, but without the vending machines they have at customer sites. With 1.5 billion in revenue and 18% operating margins, it has compounded EBIT or EBIT plus amortization at roughly 20% for a couple of decades. It's one of our favorite UK listed companies in terms of enduring quality. We've been studying the business in detail for the last few months. They've hired a new CEO in recent years who is performing very well, but also significantly changing the business in terms of structure and M&A strategy, which we believe is worth exploring in more detail. As always, please conduct your own research. Nothing here is investment advice.

How did you come across Diploma? Why are we focusing on it?

I was looking for every listed value-added distributor I could find, which is how I discovered Diploma. I was originally studying Fastenal, which led me to Watsco and Pool Corp, and other B2B distributors that have performed well, trying to understand why. Then I found Diploma in the UK, along with other companies like Bunzl and Electrical Components, which is now the RS Group. Diploma caught my attention due to its stability and durability. One thing I consider when evaluating these companies, or any company for that matter, is the stability of the gross margin. I use it as a proxy for the value they're adding to the customer. A stable gross margin suggests a stable industry or market structure, no increased competition in pricing, and a consistent and stable value add. This means that the costs and the price charged to the customer are very stable. Diploma's standard deviation of the gross margin, which I calculated using 20 to 30 years of their financials, is one of the lowest. In fact, it's one of the lowest I've seen among most companies. They've maintained a gross margin of around 35% to 36% for 25 to 30 years. I wanted to understand why and realized it's a pretty interesting company. Let's delve into a brief history.

Let's discuss a bit about their origins and what they do.

Interestingly, there was a former consultant who took over the business in 1998 and transformed it into a value-added distributor selling essential products. In simple terms, they sell critical components to large industrial companies, aerospace firms, military businesses, manufacturers, and pharmaceutical industries. Their product range includes seals, hydraulic components, controls, sensors, and they also have a life sciences business in Canada.

If you recall, we discussed Bergman & Beving a few weeks ago, and they have Luna who sell items like hats and gloves. However, Diploma sells components that are integral to machinery. For instance, if a digger or a Caterpillar machine has a faulty hydraulic component or seal, the machine becomes inoperable. In such cases, construction companies would rely on Diploma for these critical components.

Diploma offers what you would expect from a typical distributor, such as high product availability, quick delivery, and a wide range of products in store. They are a one-stop shop providing excellent service and pricing, but their key selling point is the critical components they offer. If you remember our discussion on Bergman& Beving, their return on capital is low because they are not selling critical components and they get disintermediated in the value chain.

Interestingly, the person who transformed Diploma is named Bruce Thompson, and his successor is Johnny Thomson, although they are not related. Bruce focused on critical components, sold off ineffective parts of the business, and pursued accretive M&A for 25 years. As a result, the company's stock has compounded free cash flows at 19% a year. It didn't issue much equity until Johnny took over. It's been one of the best performing companies, and I believe it's one of the best businesses in the UK.

Could you elaborate more on that and explain the framework that led you to this conclusion?

Companies like Diploma and some Swedish firms operate in very niche markets, selling critical and often highly technical components. Diploma's business, for instance, sells somewhat technical cable harnessing products. These are low-cost, high-benefit, or mission-critical products that customers can't operate their manufacturing facilities without. Therefore, they pay a premium to Diploma to get these components quickly, as it saves them more in the cost of the product. It's a similar situation to TransDigm, but without the excessive pricing.

Diploma's customers, like airlines that can't operate without AmSafe seatbelts, can't function without some of their components. Diploma also has an aftermarket business in industrial MRO and a business called Hercules, which operates similarly to TransDigm.

The low competition, low relative cost, and high relative benefit of the product make it attractive. The previous management team's excellent capital allocation and their rigorous and diligent approach to acquiring companies at good valuations and allowing them to run decentralized also add to its appeal. It's an interesting asset, and that's why I've been studying it over the last year or so. Bruce retired in 2018, and they hired someone who didn't work out and was quickly let go. They then brought in a new guy from Compass, Johnny Thomson, who is not related to Bruce.

Johnny has been on a roll, buying up assets. This is what makes it quite interesting. It reminds me of Halma in the early days when Andrew Williams took over.

There's an intriguing aspect here, as everyone seeks owner-operators. This is the owner-operator who started the business. It's rare to find individuals who are compounding in the style of Buffett at 20%, 30, 40 years down the line. Take Diploma for instance, Bruce took over in 1998 and retired in 2018, a span of 20 years. He's not the founder per se, but he is the pioneer of the modern Diploma. Then we have a younger successor, probably in his mid to late 40s, Johnny. A significant part of Diploma's value addition is through accretive M&A. Capital allocation is crucial for these businesses as they generate a lot of cash. They pay some dividends, but primarily, they make acquisitions.

Identifying a transition period between the old management and the new one can be an opportunity, albeit a difficult one. The market and equity investors may not know how to react when Bruce leaves. It wasn't just Bruce, but also Nigel and Ian, who were part of the team that pioneered and executed all the M&A and due diligence. They all retired between 2018 and 2019, leaving a new team to manage these assets. None of them are on the board now. A similar situation occurred when Andrew Williams took over Halma in 2005 and he killed Halma.

Bruce, for instance, was set in his ways for 20 years, from 1998 to 2018, and wasn't acquiring much. One could argue that he was being too conservative. But he was also operating based on the business that started with 30 to 40 million in revenue and now generates a billion. So, a new structure was needed. It's interesting to observe these transition periods. If you can find these assets, like Judges will possibly go through one soon, and understand how these new management teams operate, their approach, their culture, it could be beneficial.

The hardest part is determining how good Johnny really is at allocating capital. You won't know until there's a track record, which is why the equity typically trades down or is in limbo when the original management team retires. There are many examples of management messing it up, but Johnny seems to be doing well.

There are legitimate reasons to be interested in this business. How have you considered implementing primary research to reveal insights about how this business creates value and where the story goes from here?

Covering companies with a decentralized structure can be quite challenging. They often have a small headquarters, similar to Berkshire Hathaway. You don't get to interact directly with the top executives like Buffett or Charlie Munger.

In a similar vein, under Bruce Thompson's leadership at Diploma, most of the current management team, including Johnny Thomson, are still in place. Only a handful of people, perhaps six to eight, were closely involved in understanding the capital allocation, business acquisition strategies, unit economics of the group, and so on. We managed to find and interview four to five of them privately. These interviews provided insights into Bruce's leadership, the evolution of Diploma, and the character of Johnny, who was hired by one of the interviewees. We explored what motivates Johnny and his plans for Diploma.

This research primarily focused on understanding the group's evolution at the HQ level, the M&A strategy, and how Johnny's approach to M&A differs from Bruce's. We also sought character references.

We have lined up a few interviews with the operating companies. Diploma's decentralized structure makes it challenging to identify a single company that significantly impacts the group. While interviewing people at the operating companies can provide insights into the assets they acquire, it doesn't significantly affect the group if it only contributes to 5% of the revenue.

However, Johnny has been acquiring large companies. In the last three years, he has spent 800 million on acquisitions, which is three to four times the amount Bruce spent in 20 years. He even purchased an asset for around 450 million. This is a significant change, and while it's too early to tell if it's successful, it's certainly a different approach.

Our research now focuses on understanding the quality of the assets Johnny is acquiring. We plan to conduct interviews on Windy City Wire, a major asset purchased for 450 million, and other companies acquired for 50 to 75 million. We hope to wrap up this research over the next few weeks, with the first piece expected this week.

That sounds interesting.

Yes, it certainly is. I'm also planning to attend an investor day later this month to see what Johnny is up to. He's definitely not taking things lightly.

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