Diploma (LSE:DPLM) is one of my favourite FTSE 100 stocks. Its capital-light business model, differentiated business, and growth prospects stand out to me as an investor.
The stock fell 6% last week, though, and it’s hard to know why. With no earnings report, no insider sales, and no changes in analyst ratings, is a lower share price a buying opportunity?
Cash generation
As a business, Diploma has a lot of the things I look for as an investor. One of these is the company’s exceptional cash-generating abilities.
Diploma is a distributor of industrial components. In 2023, the firm generated £237m in operating income. What really stands out though, is the fact that it did this using just £59m in property, plant, and equipment.
That means Diploma doesn’t have much to maintain in the way of machinery or buildings. So the cash it generates can be used for growth or dividends, rather than maintenance.
That’s why its free cash flow came in at £164m – almost 70% of its operating profit. That makes it a highly cash-generative business, which is something I like as an investor.
Differentiation
Generating cash is terrific, but it’s only part of why I like Diploma. I also think it’s one of the FTSE 100 companies that’s most difficult for competitors to disrupt.
This is partly due to the huge inventory it carries. That makes it quicker and more convenient for customers, who want to avoid downtime in their machinery as much as possible.
Another contributing factor is the bespoke service Diploma offers. For products that need to meet certain technical specifications, Diploma often has the know-how to provide this.
In other words, the company offers a service that adds value for its customers. That’s difficult for other distributors to match, giving it a strong competitive position — something else that stands out to me.
Growth and valuation
Diploma’s shares trade at a price-to-earnings (P/E) multiple of around 32 (according to the firm’s adjusted earnings per share figures). That’s high, compared to the FTSE 100 average.
As much as I admire the business, it will need to grow to justify that valuation. And the plan for this is to pursue acquisitions that can boost the company’s sales and profits over time.
Diploma has an outstanding record, but this approach is inevitably risky. It relies on there being enough opportunities available and management being able to evaluate them correctly.
The firm’s record since Johnny Thomson took over as CEO has been outstanding. But while the company is optimistic, even the best make mistakes when it comes to acquisitions.
Should I buy the stock?
In terms of a cash-generative business with a durable competitive advantage, I think Diploma is one of the FTSE 100’s finest. It’s no surprise to me that the stock has outperformed the wider index over the last five years.
If every stock in the index traded at what I consider to be its fair value, Diploma would be top of my buy list. But that isn’t how the market works — some shares are better value than others.
The latest drop makes the stock more attractive than it was before, but I think there are some unusually good opportunities elsewhere. I’m on the fence about whether this is the buying opportunity I’ve been looking for.
This post was originally published on Motley Fool
