DCC got to where it is — one of Ireland’s greatest stock market success stories — by keeping its head down and focusing on the numbers. 

It was always a bit mysterious, but it didn’t matter. DCC’s bottom line was exceptional, and for a long time, that was all investors needed to know. 

Donal Murphy was a big part of that success. Before being appointed CEO in 2017, he managed two of its three divisions, including its high-performing energy division. He has completed dozens of deals and travelled the world integrating businesses. 

Now, Murphy faces a new challenge. DCC is under pressure. It’s not under pressure because of its M&A pipeline, or its ability to generate returns. It’s under pressure because the market has soured on its oil and gas-heavy business model. Every euro of DCC earnings in 2021 was valued at a 72 per cent discount to those of the rest of the European stock market; whereas in 2018, the discount was 17 per cent.

Having returned a total of 244 per cent to shareholders between mid-2013 and the beginning of 2018; in the five years since it, has fallen by 50 per cent.

DCC makes 70 per cent of its profit from energy, so this is not an easy problem to solve. Having excelled at the nuts and bolts of building and running businesses, Murphy now has to figure out how to change investor sentiment. “At the moment, our focus is on selling the story”, he said.

At stake is DCC’s status as a public company. Because, if Murphy can’t win over public market investors, there’s always private equity. There are many private equity firms happy to make money from oil and gas. Especially when their target can be acquired cheaply.

In this interview, we cover:

Where DCC came from and how it makes money

DCC’s enviable financial metrics

The discount on DCC shares

The global rise of ESG investing

DCC and ESG

The debt decision

Private equity as a potential solution

What DCC does

DCC is a company that’s hard to understand – and that’s part of its problem. A question I hear is, “what does DCC actually do?” 

The answer is that DCC is a grab-bag of three unrelated businesses: energy, healthcare, and technology. It is a rare and interesting hybrid between an industrial company and an investment company. 

It got started in 1974 by Jim Flavin, who led it for 32 years. At first, it was, essentially, a venture capital firm. It invested in early-stage companies. The name DCC, which stands for Development Capital Corporation, is a vestige of the venture capital days. 

In 1994 it decided to change its model and become publicly listed. Part of that process meant tidying up its portfolio and focusing on a couple of key businesses. Its first annual report as a public company, from 1999, shows its operating profits divided roughly evenly between technology distribution, healthcare, energy, food, and other interests.

Now, DCC has three divisions: energy, healthcare, and technology. The following chart shows its income statement in its entirety.

The following chart shows how much operating profit each division contributed in 2021. Since then, LPG (liquified petroleum gas) and Oil and Gas have been merged to form the energy division. Note the difference between the share of revenue and operating profit of the healthcare and technology divisions – healthcare is much more profitable.

DCC started in Ireland and grew from there. "From 1977, we made our first investment in the energy sector, when we supported a couple of entrepreneurs to build an import terminal for LPG up in Drogheda to buy a truck, and that became Flogas. And today it has a 43 per cent share of the LPG market," Murphy tells me during our lengthy interview. 

"Having built the business here in Ireland, in 1984, we bought a tiny little business in Leicester to start replicating the same capability in the UK. Roll the clock forward and today we have a 33 per cent share of the UK LPG market with the same kind of approach: buy a business, buy a couple of bolt-on acquisitions, drive organic growth. 

"That model has worked really well: [we] built the business in the UK, then bought the Butagas business in France, the businesses in Holland and Belgium, bought the Statoil business in Norway and Sweden, started to build those businesses into the US," Murphy added.

For years, DCC’s diffuse nature wasn’t an issue. As an investor, all you really needed to know was its bottom line (excellent) and its total returns (also excellent). DCC kept its head down, delivered superior returns, and the market duly rewarded it.

Its bottom line is still great. But investors aren’t having it. Now it finds itself in a position of having to win investors around. Investors love a simple compelling story, and simple is not a word you’d use to describe DCC.

In this and the following section, I want to try to explain the rise of DCC: how it bolted together a multi-billion business and more than trebled shareholder returns between 2013 and 2018. 

There are three legs of the stool.

Capital allocation

Stock market investors like companies with focus: companies that are excellent at one thing and one thing only. This has a few benefits. First, they're easier for investors to analyse. Secondly, the company can get the right managers for their specific job. The CEO doesn't have to be a jack of all trades. Thirdly, different businesses appeal to different types of investors. One group of investors will prefer low-risk income, another will prefer growth. By tailoring the company, it can find a better match with specific investors and hopefully achieve a better share price. These are all the reasons why conglomerates — companies that do lots of things — are increasingly rare. 

The benefit of a conglomerate structure is that it lets the managers easily move capital to wherever the returns are greatest. One year, DCC's healthcare division might have the best investment opportunities; the next year it might be energy. DCCs managers in Dublin can put capital wherever returns are highest.

Outside a conglomerate, if you want to move capital between businesses you have to sell shares, buy shares, pay tax in the process, and incur a bunch of other transaction costs.

The other benefit of the conglomerate structure is that it gives a wide range of options. The options, in themselves, are valuable. The market pays extra for companies with lots of options. 

The conglomerate structure, then, suits a specific type of company with a specific culture. It suits companies that are good at investing. The companies that think carefully about investment, and how to allocate capital, are the ones that can maximise the benefits of having lots of options over where to deploy their capital. Warren Buffett's Berkshire Hathaway is the ultimate example of a conglomerate that benefits from the investing nous of its leaders.

Investing is part of DCC's corporate DNA. It's a business that has always been good at finding new projects, funding them, and ruthlessly cutting the also-rans. 

The last part is hard. Leaders of companies are human, and they develop relationships with their colleagues. Division managers can be politically powerful within the company. For all these reasons, it can be hard to shrink or sell off a division. Food, for example, used to be one of DCC's biggest businesses. But, Murphy said: "We weren't in finding the opportunity to expand [food] geographically, it was a small part, three per cent, of group profits, so we decided to divest out of it

"We're pretty close to all the businesses, and we're close to the people within the businesses."

Later in our interview, he added: "If we don't see that a business can deliver high returns and capital and return substantially ahead of our cost of capital, then we've got to make calls on those investments."

Perhaps the best example of this is DCC's sale of 49 per cent of Manor Park, a homebuilder with a large land bank, at the peak of the Celtic Tiger in 2007 for €181 million. 

Decentralised operations

Investment is a part of DCC's DNA, but Murphy stresses they're more than investors. Murphy himself came to the business from AIB and worked his way up by operating DCC businesses. He was the first non-investor on the senior management team. 

"We're not an investment vehicle that just takes a punt on shares or businesses. We actually grow and develop all the businesses. So you've got to be able to identify good businesses, identify the trends, you've got to be able to motivate the management, you've got to be able to develop the management teams," he said.

Specifically, what's their formula for operating companies? A big part of it is that they don't try to manage everything from the centre. For a company with multiple divisions in multiple continents, this seems sensible. The Dublin office focuses on M&A, legal, integrating new businesses, and internal audit. The local offices are empowered to do the rest. 

The default model, according to Murphy, is "devolved, decentralised, close to the customer, and agile within markets." This, he says, is what has allowed their investments to flourish: "We bought lots of businesses over the years that big integrated energy groups were struggling to make decent returns out of. And we made really good returns."

"And it's not because we're rocket scientists. What we do is we make the business appropriate for the market, we put teams of people in place that are incentivised, motivated on their local market, that have the authority to grow their business," he added.

It goes back to the point about companies trying to focus on just one thing. Oil majors are good at digging oil out of the ground. Their culture and all their incentives are focused on that. But they're no good at running petrol stations. By handing over authority to the managers at ground level, DCC has been able to wring greater returns out of petrol stations and LPG distribution than the majors were.

M&A 

The third leg of the stool for DCC has been M&A. The company has made dozens of acquisitions across its divisions. It has a great track record of integrating them and using them to broaden its reach into new markets and new products. 

As we've seen, DCC has used M&A to expand into new countries. But there's another benefit, where acquiring a related business allows DCC to cross-sell to its existing customers, gives it more pricing power, and more leverage in negotiations with suppliers.

"It's a business model where acquiring a capability and integrating businesses delivers an awful lot of synergy. So if we buy a business and bolt it onto an existing business, we sell more products to more customers with less total capital employed. And that has been the driver of the high returns within our energy businesses," Murphy said.

"Having built a leadership position in the market, leverage the capability that you have to move geographically into a new market. Do the same again. Go into another market and into another market. And then as you expand those relationships, you become more important to your suppliers and more important to your customers."

A model business

By almost any financial metric you care to choose, DCC is a super business. Its north star is 'return on capital'. Return on capital is profit as a percentage of the funding that was required to generate it. 

A metric like return on capital is essential for DCC because it has multiple divisions. Its leaders are trying to work out how much capital to assign to each division. Return on capital provides the answer. It's an apples-to-apples number that tells management not just how much profit each division makes, relative to what could have been made at another division.

Return on capital disciplines the company. Without it, a company could be tempted to over-invest. Aryzta is a good example of a company that acquired a lot of other businesses, without paying much attention to return on capital. That's how it came a cropper.

DCC would say its conglomerate structure gives it lots of investing options, which in turn results in high returns on capital. Either way, it's hard to argue with the result. The following chart shows DCC's return on capital compared to the average of the European oil and gas distribution industry.

Return on capital measures profits over all forms of funding — in terms of debt plus equity, in other words. It shows how efficiently the business turns funding into profits. 

Another way of thinking about the same concept is 'return on equity'. Return on equity is simply net income over net equity. It shows profits as a percentage of shareholders' funding. This one shows how much profit the business generates for shareholders, as a percentage of the capital they have tied up in the business. By this metric, too, DCC is in great shape. The following chart compares DCC's return on equity to that of the European oil distributors.

To be sure, DCC isn't just an oil distributor. It made 30 per cent of its operating profit from Healthcare and Technology last year. But nonetheless, the European oil distributors are the best comparator for it.

Not all its divisions are created equal. Both in terms of total profits and return on capital, energy has been the star performer. Healthcare performs well too. Technology is the runt of the litter.

Energy and healthcare are both hard to break into. Oil and gas distribution takes big upfront investments in tanks and other physical infrastructure. Healthcare is heavily regulated. That means the companies that are already operating in those industries can charge more and earn higher profits. 

The technology division, by comparison, has relatively low barriers to entry. The name is a bit of a misnomer. The business is mainly about storing appliances and gadgets in warehouses and trucking them around. Not as lucrative as oil and gas distribution. 

If healthcare is so profitable on a return on capital basis, why is it so much smaller than energy? An issue is that it's been much easier to buy and sell energy companies. The deals are cheaper. M&A in healthcare, by contrast, is expensive. That has limited its growth. 

Another impressive part of DCC's financials is its free cash conversion. Return on capital refers to profits, but profits are known to sometimes overstate the amount of money an investor can call on. Free cash flow is the profit-like number that says how much cash is left over after all the spending needed to keep the business going. It's the one investors watch. 

Bad businesses fail to convert all their profits to free cash. DCC by contrast converted 138 per cent of its profits to free cash last year. This means there's plenty of cash to reinvest internally, buy a new business, or pay back to shareholders. 

This is why DCC has been able to pay generous dividends. It's currently yielding 4.1 per cent. And the dividend has grown by around 10 per cent per year.

DCC's mysterious discount 

If DCC is such a model company, what explains the share's performance since 2018? 

The first thing to say is that it's not about earnings. After a wobble in 2019, earnings per share are up 29 per cent in the last three years.

The problem comes from the market's rating of the business. The following chart is important. It shows the multiple the market has attached to DCC earnings, European stocks' earnings, and the European oil and gas distribution industry. What it shows is that in 2019, DCC was modestly discounted, relative to the rest of the stock market. Over time that discount has widened so that a given euro of DCC earnings is now worth 72 per cent less than the European market. 

The question is, what happened?

It's impossible to say with certainty, but there are a few potential explanations. One is that the business is usually complex, which makes it hard for analysts and investors to get to grips with. This is true as it goes, but it has always been true, so it doesn't explain the widening DCC discount.

Another explanation is the drop in earnings per share between 2018 and 2020. This is surely part of it. After years of steady growth in earnings, the setback will have signalled to investors that they shouldn't expect the same growth trajectory in the future. But this doesn't explain why the DCC discount failed to close in the last two years, with earnings growing strongly.

Donal Murphy pointed to the problems of the UK stock market: "We're listed in the UK, where there's a government that's imploding. The capital has gone [out of the market], and not gone [into it]. It's a tough environment." 

While it's true that the UK market has struggled, it's not true that UK earnings multiples have dropped. The FTSE 250, which includes more UK-based companies than the FTSE 100, has seen its average PE ratio rise from about 15 in 2018 to 40 today, according to data from the FT. 

That leaves one obvious candidate: the rise of ESG investing. 

DCC's ESG problem

Is that what has happened to DCC — has the rise of ESG investing pushed investors away, given that it made 70 per cent of its operating profits in 2021 from oil and gas?

It looks likely that ESG is a big part of the problem. The rise of ESG investing in the last three years coincides with the deepening of DCC's discount. 

Though Morningstar, a data provider, gives DCC an ESG score of 3/5 (the same as it gives to the overall market), Refinitiv, another big data provider, score it at 21.7, relative to the Eurostoxx 600 index of European stocks' score of 65.8. 

ESG matters more in Europe than elsewhere. 80 per cent of European institutional investors have signed up to climate principles, compared to 55 per cent of Asian ones and 45 per cent of American ones.

Though Murphy pushes back on the idea that ESG is a drag, the company has made a big effort to talk up its environmental plans this year. It rebranded its old Oil and Gas and LPG divisions as Energy and spent €80 million on green energy businesses. A competitor in France, Rubis, did something similar last year.

DCC's new plan is to leverage its close relationships with customers, and its existing assets like petrol station forecourts, to sell environmentally friendly energy products such as heat pumps, solar panels and electric car rechargers. 

Murphy said DCC is well positioned to take advantage of the energy transition because it's close to end users of energy. "People say, 'you're an energy business, you're selling lots of oil products and gas products. That's bad news for you.' It's anything but. It's really good news for us because what's going to happen as part of the energy transition is going to be an acceleration of the decentralisation of the production of energy, energy is going to get produced closer to customers," he tells me.

The plan was unveiled to investors last summer. At the event, DCC promised to reduce emissions by 15 per cent by 2030 while maintaining high returns on capital and profit growth. "Certainly, post the energy event we had last May, I think our energy transition story is really well understood by the market," said Murphy. 

On the day of the event, the stock dropped six per cent in an overall flat market. In the following two days, it dropped another six per cent, with the market dropping two per cent. 

The debt decision

I’ve said DCC is a well-run company, despite the market’s sceptical view of it. But could there be one foible? 

DCC’s balance sheet is very strong. This is a good thing, you might say. It helps DCC’s dealings with suppliers and customers. And it helps it do deals quickly. 

But the cost of a stronger balance sheet is weaker returns for shareholders. A business with low debt will be more robust, but also less profitable. 

Here’s what I mean. The following chart shows DCC’s debt relative to its competitors in the European oil and gas distribution business. It shows debt as a percentage of total capital.

This is a strategic decision on DCC’s part. It has decided to sacrifice returns for stability. Bear in mind that about a quarter of DCC’s profits don’t come from oil and gas. Though healthcare in particular tends to have lower leverage than oil and gas, DCC’s diversification among the three businesses should in theory make it a candidate for higher debt.

The riskier play would be to borrow a couple of hundred million and use it to buy back shares. That would instantly boost earnings per share and return on equity. Admittedly debt isn’t as cheap as it was last year. But DCC shares, too, are dirt-cheap. 

Donal Murphy isn’t keen on the idea: “Could we improve our [earnings per share] tomorrow by going out and buying a load of shares? Of course we could. But what does that do in terms of the next five years of growth, and the shape of the group? Are we better deploying capital into businesses that will accelerate our growth? Are we better deploying the capital into the existing business that we have today?”

A falling stock price increases the hurdle rate of return for DCC investments. So Murphy is betting DCC shareholders will do better if DCC invests in green energy, than they will if it invests in its own shares at a PE of 8. I'll go into this decision in more detail in a separate piece tomorrow.

Murphy made the case for conservatism: “If you're sitting where we're sitting today, with a very strong balance sheet, with lots of capital to put to work, in a market where interest rates are going up, where private equity might find it a little bit more difficult to get the returns that they were getting over the last number of years, in a [higher] interest rate environment. That’s a great place to be."

Another answer?

If the story of DCC is as follows: DCC has a strong underlying business with good growth prospects and returns on capital; but it's being undervalued by stock market investors mainly for ESG reasons; and it's under-levered relative to its peers. 

If that's the story, one potential solution suggests itself: DCC could sell itself to a private equity buyer. 

Two things about private equity buyers: plenty of them don't care about ESG. And they like businesses they can put more debt onto. That being true they have an opportunity to buy a strong business on the cheap, have it borrow €200 million, and pay themselves a special dividend. Brookfield is one example of a private equity firm targeting the oil and gas industry. It raised a $7 billion fund for that purpose in 2021. 

Murphy insists that the problem isn't the public markets: "We've been a public company for 28 years. There have been lots of periods over that time where we weren't happy with the share price." 

"But [there are benefits] in terms of recruiting people into the organisation, in terms of the ability to attract businesses that we might want to acquire.

"Of course, I'm frustrated with where the share price is. Have we created value? We've created huge value in this group over the last number of years. Is our business model working? Our business model is working. Are our returns very strong? Our returns are very strong. Is our cash flow very strong? Our cash flow is very strong. The market will catch up."