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2011 Year in Review

"In 2011, revenues increased by 26% to £230.6m... operating margins hit record level of 19.6%"

Business model

The Group comprises a number of high quality, specialised businesses supplying technical products and services to customers in the Life Sciences, Seals and Controls industries. The Group's business model is designed to achieve the twin objectives of stable organic revenue growth and sustainable attractive margins. Growth is then accelerated through carefully selected, value-enhancing acquisitions which fit the Group's business model and offer entry into new strategic markets.

We aim to achieve these objectives by focusing on businesses which supply essential products and services which are funded by the customers' operating rather than their capital budgets, providing recurring income and stable revenue growth. Our businesses then design their individual business models to closely meet the requirements of their customers, offering a blend of high quality customer service, deep technical support and value adding activities. By supplying essential solutions, not just products, we build strong long-term relationships with our customers and suppliers, which support attractive and sustainable margins. Finally we encourage an entrepreneurial culture in our businesses through our decentralised management structure. We want our managers to feel that they have the freedom to run their own businesses, while being able to draw on the support and resources of a larger group. These essential values ensure that decisions are made close to the customer and that the businesses are agile and responsive to changes in the market and the competitive environment.

The Group's business model has been closely tested over the last three years. The businesses proved their resilience through the 2009 global downturn with Group revenues growing by 2% (albeit a decline on an underlying basis) and operating margins held at a creditable 16% of revenue. As markets have slowly recovered following the recession, the Group has moved forward strongly, posting seven quarters of growth in revenues and profits since the recovery started in early 2010 and outperforming economic and market benchmarks. This level of relative performance confirms that the operating businesses have succeeded in further penetrating their markets by maintaining high customer service levels and adding product lines through the downturn.

Operating performance

In 2011, revenues increased by 26% to £230.6m (2010: £183.5m) with underlying growth of 17% after adjusting for currency effects and acquisitions. As revenues have increased, the businesses have continued to manage costs carefully in view of continuing uncertainty over the sustainability of the recovery. With the resulting benefits of operational leverage, adjusted operating margins have increased to 19.6% of revenue (2010: 17.5%).

The operating margins achieved this year are well above the three year average of ca. 18% of revenue. It is likely that over time operating margins will gradually trend back towards this average, as resources will need to be increased to support higher levels of revenue. In addition, there will be increased investment in fixed assets to ensure that the IT environment and the facilities in the businesses provide a robust foundation for further growth; this investment will result in higher operating costs and depreciation. In 2012, for example, three of the businesses will be moving into new facilities at a total cost of ca. £1m – the IS-Group in Swindon, RT Dygert in Minneapolis and Vantage Endoscopy in Toronto.

Free cash flow in 2011 has again been strong at £25.0m against a very strong prior year comparative (2010: £29.8m), which had been boosted by the proceeds from the sale of the Anachem businesses, as well as by a reduction in working capital across the Group. During 2010, working capital had fallen to the level of 15.4% of revenue as suppliers struggled to keep pace with increasing demand for their products. By the end of the 2011 financial year, working capital had moved back to a more normal level of 16.1% of revenue, with an additional investment of £7.4m.

During the year, £28.2m was invested in acquisitions, principally in the Canadian Healthcare business. Return on trading capital employed ("ROTCE") has increased to 25.4% (2010: 22.1%) principally driven by the improved operating margins.

Sector developments

The Group's strategic objective is to build more substantial, broader based businesses in each of its chosen sectors through a combination of organic growth and acquisition. Good progress was made in the year in executing this strategy in each of the three sectors and the key developments this year are summarised below.

Life Sciences

The Life Sciences businesses increased revenues in 2011 by 34%, boosted by the contribution from the acquisition in December 2010 of CMI and also modest currency translation benefits. Underlying sector revenues increased by 12% after adjusting for the acquisition and currency effects. Operating margins increased by 150 basis points to 23.0% (2010: 21.5%), mainly driven by improved profitability in the Environmental business.

The Group's Healthcare businesses in Canada and now Australia ("Diploma Healthcare Group" or "DHG"), account for almost 80% of the Life Sciences sector revenues. They operate in healthcare markets which are largely public sector funded and where the demand from growing, aging and well-educated patient populations drives a steady growth in funding (on average 6–7% p.a. growth over 15 years in Canada). Within these markets, the DHG businesses supply specialised products which are used in the pathology laboratories, operating rooms ("OR") and endoscopy suites of the hospitals as well as private clinics. During the recession there were initiatives to control costs including limits imposed on the number and cost of specific medical procedures and diagnostic tests and extended tender processes for capital equipment. However, overall Healthcare expenditure has continued to grow steadily in real terms and there has been some evidence of an easing of capital approvals.

The DHG business model is built on the supply, on an exclusive basis, of high quality, manufacturer branded products secured by long-term distribution agreements. Strong customer relationships are forged through high levels of customer service, with highly qualified and experienced technical sales and product application staff working closely with the surgeons, OR nurses and laboratory technologists. A large proportion (over 60%) of DHG's revenues are secured under multi-year customer contracts.

During the year, DHG expanded its business in Canada through the acquisition of CMI, a supplier of medical devices, consumables and service to GI Endoscopy suites in hospitals and clinics across Canada. CMI shares a common customer base with the endoscopy business within our existing AMT company and the products are very complementary with few overlaps. With effect from the start of the new financial year, the businesses were combined under a single management team, with the new name of Vantage Endoscopy("Vantage") and with plans to relocate to a new facility in the first half of the year. Vantage is now able to offer to its GI Endoscopy customers, the most complete range of products, including endoscopic imaging and reprocessing systems, therapeutic technologies and devices and other essential accessories and service support.

There are now three similar sized, growing DHG businesses in Canada, the Somagen clinical diagnostics business, AMT's core electrosurgery business and Vantage. Each of these businesses has good potential for further growth by continuing to penetrate core markets, as well as by adding new product lines and suppliers. In Australia, BGS is a smaller version of AMT which was acquired towards the end of 2010. During the year investment was made to generate stronger growth by employing direct sales staff to replace sub-distributors in Victoria, Queensland, South Australia and New Zealand.

The remaining 20% of the sector revenues are generated by the a1-group of Environmental businesses in Europe, which supply a range of products used in Environmental Testing and Health & Safety applications. The market demand is largely driven by regulation which ensures steady demand for the essential consumable products, though customers do defer capital expenditure during economic downturns.

The a1-envirosciences group, following its restructuring in 2010, now has its principal operations in Germany and Switzerland with other Northern European markets served through sales and service staff. The benefits of the restructuring have been seen this year in the improvement in operating margins. The CBISS business in the UK has seen good growth in its sales of emissions monitoring systems, both in replacement systems for traditional power stations and new systems for alternative power plants (e.g. waste, biofuels, syngas). Demand for gas detection products has also been strong.

Seals

The Seals sector businesses increased revenues in 2011 by 33%, boosted by a full year contribution from All Seals, acquired in September 2010, and despite modest currency translation losses. Underlying sector revenues increased by 26% after adjusting for the acquisition and currency effects. Operating margins increased by 380 basis points to 18.6% (2010: 14.8%), demonstrating the effects of operational leverage in this business, as increases in operating costs lagged the strong increase in revenue.

Currently just over 60% of Seals sector revenues are generated from the Aftermarket businesses of HFPG (Hercules, Bulldog and HKX) and FPE. Own brand sealing products, sourced from the same seal manufacturers who supply to the original equipment OEMs, are supplied to a broad range of mobile machinery applications in heavy construction, logging, mining, agriculture, material handling and refuse collection. The principal market drivers are therefore the growth in the general industrial economy and in particular heavy construction.

In the core Aftermarket business in North America, the key to success is the ability to provide a next day delivery service from inventory, for seals and seal kits used in a broad range of different manufacturers' machinery and different applications. Typically the first three years of equipment life is controlled by the OEMs through product warranty and lease terms. However, after the equipment is sold into the pre-used market or moves out of warranty, Hercules has a very compelling offering to customers by providing a responsive, next day delivery service for these time critical items.

The Aftermarket business was insulated from the worst of the 2009 recession, by its focus on customers' operational rather than capital budgets. As a result, it rebounded less strongly in 2010. In 2011, however, revenues increased by over 25% which suggests a significant increase in market share driven by the high level of customer service levels maintained during the downturn.

Outside North America, the main focus for development has been in Europe where good progress has been made in both direct sales in the UK and Benelux countries as well as the appointment of sub-distributors to distribute Hercules seal kits in other mainland European countries. Initiatives are also being developed to increase penetration in other developing markets in Asia Pacific and South America.

The Industrial OEM businesses now represent close to 40% of sector revenues following the addition of All Seals to the RT Dygert and M Seals businesses. These companies supply seals, O-rings and custom moulded and machined parts to a range of specialised Industrial OEM customers. Applications include spray painting guns, water filtration, wind power mills, hearing aids and medical devices. On a like-for-like basis, these businesses have increased revenues by 25% in 2011 and are experiencing demand well ahead of pre-recession levels.

The acquisition of All Seals has extended the Group's coverage in the US, with its strong position in California and the South Western States complementing RT Dygert's strength in the Mid-western States. M Seals has further penetrated its core Scandinavian markets from its operations in Denmark and Sweden and has established a wholly owned foreign enterprise ("WOFE") in Tianjin to trade directly with wind power customers in China.

Controls

The Controls sector businesses increased revenues in 2011 by 12% in both UK sterling and constant currency terms. Operating margins increased by 70 basis points to 17.3% (2010: 16.6%).

The IS-Group (UK), Sommer and Filcon businesses supply high performance wiring, connectors, fasteners and control devices used in a range of technically demanding applications. The businesses offer high quality, manufacturer branded products sourced under the terms of long-term exclusive distribution agreements. Strong customer relationships are based on ex-stock availability of product, responsiveness, technical advice on product applications and a range of value added services.

The largest end user sector is Defence & Aerospace. Here, the businesses do not typically supply to major platform OEMs and Tier 1 suppliers, who are mostly served direct by the manufacturers. Rather, the businesses supply into repair, refurbishment and upgrade programmes, as well as supplying to Tier 2 electronics customers, where ex-stock availability and responsiveness are important. The businesses therefore are less exposed to cutbacks and postponements in major defence programmes as a result of the Strategic Defence Reviews in the UK and Germany; though inevitably there will be some impact longer term at the sub-contractor and component supply level. In Commercial Aerospace, the businesses supply products principally for the initial installation and subsequent upgrades of aircraft interiors. After falling back in 2009, demand picked up in 2010 and as passenger numbers continue to recover, the sector appears to be returning to its long-term projected growth rate of ca. 5% p.a.

The businesses also supply to a range of specialised technical applications in the General Industrial market. The underlying market drivers are the growth of the industrial economies in Europe (in particular the UK and Germany), but demand tends to be more stable in the specialised sub-sectors in which we operate. In Motorsport, activity increased sharply with a successful F1 racing season and growth in the Indycar and Nascar series in the US, the DTM series in Germany and the World Rally Championship. Medical Equipment is another specialised market where demand has been stable and in Energy, there has been strong demand from the manufacturers of electrical generators and commercial batteries. The closure of the older nuclear plants in Germany will also require infrastructure investment in the power distribution network.

Hawco serves the Commercial Refrigeration market in the UK which continues to be buoyant, driven by investment by the major food retailers in new convenience stores and in energy saving technologies when refurbishing existing outlets.

Acquisition activity

Over the last five years, the Group has invested ca. £91m in acquisitions across the sectors and geographies – an average of ca. £18m p.a. The success in financial terms can be measured broadly by the profit return on the total investment which currently stands at over 20%. In 2011, a total of £28.2m was invested, mainly in the Canadian Healthcare business in the acquisition of CMI and the purchase of the 25% minority shareholdings in AMT.

While the time and effort invested in the acquisition programme is a sustained activity, the results can be more irregular. We find that most success tends to come at times when the business cycle is changing and creating uncertainty. For example, when markets are slowing down after an extended period of growth, this may encourage owners to sell ahead of a market downturn. Alternatively, in the early stages of recovery, when confidence is building in future projections, owners who have delayed selling during a downturn may come back to the table. With the performance of many businesses having recovered since the 2009 recession, but uncertainty remaining as to the sustainability of the recovery, we believe that there will continue to be good opportunities for value adding acquisitions.

Summary and outlook

The continued strong performance of the Group and the resilience shown over the last five years gives us confidence that we can maintain the "GDP plus" levels of underlying revenue growth over the business cycle. The Group is well diversified by geography and business area and the business model supports stable revenue growth and sustainable, attractive margins. Although general economic uncertainty over the strength of global markets continues to grow, we see good opportunities for future development, both organically and through acquisition.

Bruce Thompson

Chief Executive Officer

21 November 2011