ABOUT DIPLOMA PLC

STRATEGIC RISKS

Downturn in major markets

Adverse changes in the major markets in which the businesses operate can have a significant impact on performance. The effects will either be seen in terms of slowing revenue growth, due to reduced or delayed demand for products and services, or pressure on margins due to increased competitive pressures.

A number of characteristics of the Group's businesses moderate the impact of economic and business cycles on the Group as a whole:

• The Group's businesses operate in three different sectors with different cyclical characteristics and across a number of geographic markets, as set out in the 2011 Annual Report.
• The businesses offer specialised products and services; this offers a degree of protection against customers quickly switching business to achieve a better price.
• A high proportion of the Group's sales comprise consumable products and service contracts which are purchased as part of customers' operating expenditure, rather than through capital budgets.
• In the majority of cases the products are used in repair, maintenance and refurbishment applications, rather than original equipment manufacture.

Mitigation

The businesses identify key market drivers and monitor the trends and forecasts, as well as maintaining close relationships with key customers who may give an early warning of slowing demand. Changes to cost levels and inventories can then be made in a measured way to mitigate the effects.

Loss of key supplier(s)

For manufacturer-branded products, there are risks to the business if a major supplier decides to cancel the distribution agreement or if the supplier is acquired by a company which has its own distribution channels in the relevant market. There is also the risk of a supplier taking away exclusivity and either setting up direct operations or establishing another distributor.

In times of rapid economic expansion in activity, such as after a global recession, the lead times to supply key product can become very long.

No supplier represents more than 15% of Group revenue and only five suppliers represent more than 2% each of Group revenue.

Relationships with suppliers have normally been built up over many years and a strong degree of interdependence has been established. The average length of the principal supplier relationships in each of the sectors is over ten years.

Strength of relationship with supplier and volume of activity generally ensures continuity of supply when there is shortage of product.

Mitigation

Actions to mitigate the risks include:

• Long term, multi-year exclusive contracts signed with suppliers with change of control clauses, where possible, included in contracts for protection or compensation in the event of acquisition.
• Collaborative projects and relationships maintained with individuals at many levels of the supplier organisation, together with regular review meetings and adherence to contractual terms.
• Regular review of inventory levels.
• Bundling and kitting of products and provision of added value services.
• Periodic research of alternative suppliers as part of contingency planning.

Loss of major customer(s)

The loss of one or more major customers can be a material risk.

The nature of the Group's businesses is such that there is not a high level of dependence on any individual customers and no customer represents more than 5% of sector revenue or more than 2% of total Group revenue.

Mitigation

Specific large customers are important to individual operating businesses and a high level of effort is invested in ensuring that these customers are retained and encouraged not to switch to another supplier.

In addition to providing high levels of customer service, close integration is established where possible with customers' systems and processes.

Product liability

There is a risk that products supplied by a Group business may fail in service, which could lead to a claim under product liability. The businesses, in their Terms and Conditions of sale with customers, will typically mirror the Terms and Conditions of sale from the suppliers. In this way the liability can be limited and subrogated to the supplier.

However, if a legal claim is made it will typically draw in our business as a party to the claim and the business may be exposed to legal costs and potential damages if the claim succeeds and the supplier fails to meet its liabilities for whatever reason. Product liability insurance can be limited in terms of its scope of insurable events, such as product recall.

During 2011, the Group settled a small claim received from a customer in respect of product failure which it was unable to recover from the supplier. However, there have been no similar claims during the past ten years.

Mitigation

Technically qualified personnel and control systems are in place to ensure products meet quality requirements. The Group has also established Group-wide product liability insurance which provides worldwide umbrella insurance cover of £10m in all sectors.

The Group's businesses may also elect not to supply products if they are not fully confident that the products will meet the demands of the operating environment.

Loss of key personnel

The success of the Group is built upon strong, self‑standing management teams in the operating businesses, committed to the success of their respective businesses. As a result, the loss of key personnel can have a significant impact on performance, at least for a time.

Average age of our senior managers making up the self-standing management teams in the operating businesses is 43 with an average length of service of ten years.

As set in the 2011 Annual Report, the average length of service for all personnel in the Group is over five years.

Mitigation

Contractual terms such as notice periods and noncompete clauses can mitigate the risk in the short term. However, more successful initiatives focus on ensuring a challenging work environment with appropriate reward systems. The Group places very high importance on planning the development, motivation and reward for key managers in the operating businesses such as:

• Ensuring a challenging working environment where managers feel they have control over, and responsibility for their businesses.
• Establishing management development programmes to ensure a broad base of talented managers.
• Offering a balanced and competitive compensation package with a combination of salary, annual bonus and long-term cash incentive plans targeted at the individual business level.
• Giving the freedom, encouragement, financial resources and strategic support for managers to pursue ambitious growth plans.