Diageo: Not Overly Expensive

by The U.K. Income Investor

Alcohol giant Diageo (DGE) is one of the highest quality stocks listed in the United Kingdom. For one, its business is an absolute profit machine, with net margins running in excess of 20%. The company has earned a cumulative total of around £13,500m over the past half-decade, with around £7,500m of that paid out to shareholders via cash dividends. Your portfolio won’t go too wrong if it is full of businesses that constantly shower you with cash.

Most readers will know the business well, or at least its products, so I’ll keep the introduction brief. Firstly, a word on the the breadth of its drinks portfolio. The company has a hand in just about every product category you can think of. Whether it be rum or vodka, beer or whiskey, Diageo has it covered. It owns around a quarter of the world’s top one-hundred brands. Well-known brands in its stable include the likes of Smirnoff vodka, Gordon’s gin, Captain Morgan rum and Johnnie Walker scotch. It also owns famed beer brand Guinness. Sales of scotch account for around 25% of the company’s total, with beer and vodka representing another 16% and 11% respectively.

Second, its geographic breadth is similarly vast. Diageo operates all over the world, with North America currently responsible for around 45% to 50% of profit. Europe & Turkey accounts for another 25% or so, with Asia Pacific, Africa and Latin America making up the rest.

COVID-19

Typically, this one is a very stable business since alcohol sales don’t really depend on the wider economy. Of course, this is anything but a typical year for most firms. The company obviously sells its goods to bars, restaurants, nightclubs and so on, and this accounts for around a third of total sales. Diageo has withdrawn profit guidance for FY20 for obvious reasons.

On that note, I’m not sure it is worth talking too much about COVID-19. The above notwithstanding, I note that analysts still expect the company to make around £2,600m in net profit this year. That is on the back of revenue estimates of just under £12,000m. Diageo’s financial year ended in June, so most of it was not affected by the pandemic. Obviously that means the hangover will last well into its fiscal 2021.

Anyway, a quick look at its history implies COVID-19 only taking the firm back to FY17 levels of profit and revenue generation. Analysts also forecast higher profit next year, albeit still lower than before the pandemic. Any firm that is capable of posting positive retained earnings in this environment – which seems to be the case here – is probably a keeper.

Valuation

I’d bet that it is commonplace in financial media to see Diageo stock labeled as fairly expensive. On the face of it, it isn’t hard to see why. The shares currently change hands for 2,820 pence each, which is worth around 22x last year’s profit. If you look at the stock’s long-term history, then you’ll probably find that number is above average.

Now, before the pandemic the company was targeting mid-single-digit revenue growth with EBIT growth a point or so higher. COVID-19 obviously wrecks that, with analysts now expecting the company to only earn 120 pence per share in FY21. That puts the stock at 23.5x forward earnings. The current dividend yield works out to around 2.50% based on a TTM dividend of 69.9 pence.

That may look somewhat rich, but this does not factor in current interest rates. I mention the fixed income environment  nearly all of my articles now because it’s not really something that can be ignored. The 2.50% dividend yield that Diageo currently sports is hardly unattractive given ten-year UK government debt currently offers a yield of just 0.15%. The former can also grow each year, unlike the latter. This will keep Diageo stock from falling too much in my view.

Outlook

Longer-term, I don’t really see why the company won’t get back into the swing of things post-FY21. The company’s current plight remains largely a result of the unique public health situation. After that, Diageo reckons that 750m people in the developing world will soon be wealthy enough to afford its premium brands. North America and Europe – which currently account for most of profit – will remain a stable base.

Using the growth figures from above, it seems reasonable to assume that the stock can grow per-share profit in the 8% per annum region. The extra bump above EBIT growth comes from the long-term impact of stock buybacks funded largely from retained earnings. Add that onto our 2.50% dividend yield, and we are looking at a double-digit compounder. Factoring in some long-term multiple contraction – that is assuming that interest rates eventually rise – only knocks that down a point or so. For such a high quality business that strikes me as more than acceptable right now.

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