I last covered alcohol giant Diageo (DGE) back in July. The Johnnie Walker and Guinness owner traded for around 2,820p then, a circa 11% drop on where it started the year. Now, what I like most about this firm is its ability to shower shareholders with cash. It can do that without sacrificing growth relative to the average company. Selling world-leading spirit brands across multiple product categories, plus certain other advantages, affords it the high quality profits it needs to pull that feat off. On that basis, a 2020 price-earnings ratio of 25x did not strike me as particularly expensive at the time, but more on that later.
Of course, the earnings underpinning that multiple have been hit hard by COVID. I mean, the firm generates a big chunk of its sales from the on-trade. With restaurants and clubs heavily disrupted by the virus, it stands to reason that Diageo is also taking a hit. Its travel retail activity has also fared badly as passenger traffic has collapsed. The only real bright spot is in North America. On-premise activity does not make up a big slice of total business there – only around 20% compared to 50% in Europe. That led to £4.6B in FY20 net sales across the region, a 2% rise in organic terms compared to FY19. North American operating profit rose 4% before exceptional items to just over £2B.
Other than that, the numbers look pretty grim. Total volume sold clocked in at 217m units in FY20, down 11% from 245m in 2019. Organic net sales declines registered anywhere between 12% and 16% in its other operating geographies. Those are Europe & Turkey, Latin America and the Caribbean, Asia Pacific, and Africa. That led to total FY20 sales of £11.75B, a circa 8.4% drop in organic terms year-on-year. Operating profit (EBIT) slumped even further, falling by a reported 47% to £2.1B. That came largely as a result of a £1.4B impairment charge spread across businesses in India, South Korea and Africa. EBIT fell circa 15% to £3.5B excluding exceptional items. EPS excluding exceptional items clocked in at 109.4p, a 16% drop year-on-year.
As a result of its July-June calendar, only around half of the firm’s fiscal 2020 fell victim to COVID. That also means that the hangover will persist well into fiscal 2021. We can expect a pretty poor 1H21 on that basis, though hopefully better than the 40% EBIT slump in 2H20. The second half of its fiscal 2021 looks set to coincide with the gradual reopening of battered sectors of the global economy. That, of course, will go hand-in-hand with global vaccination programs.
That tentatively sets the stage for a recovery here in fiscal 2022. I have analyst estimates of FY22 profit at circa 129p per share, implying a full recovery to FY19 levels. That said, the firm may experience some sustained softness – the premium nature of its brands giving it a slightly more cyclical angle than certain other fast-moving consumer goods stocks. Normal service with respect to growth will hopefully resume thereafter – and that implies circa 5% organic revenue growth based on its pre-COVID performance.
In Plain Sight
The stock closed the week just below the 2,945p per share mark. Some quick maths puts that at around 22.8x FY22 earnings estimates. That may not look like much to get excited about, but that brings us nicely back to the opening paragraph: a firm that sports high quality profits should trade at an elevated valuation, all other things equal. That also means that not all price-earnings ratios are created equally. A business that can send more cash to shareholders is more valuable, and should command a premium. Indeed, Diageo spent around £11.8B on dividends and buybacks over the 5-year period between FY15 and FY19. Cumulative net income in that period came in at £13.3B, while organic EBIT growth still came in at 5% per annum on average. So although the stock may look fairly expensive, it actually isn’t, hence the title of the post.
The key question then: can the company sustain at least average growth levels going forward? Call that EBIT growth in the 5% range, roughly comparable to global GDP growth and the stock market average. If it can, then the stock can quite easily justify the current premium based on FY22 estimated profit. As to the answer to that question, management certainly seems to think so. Indeed, on page 32 of its Form 20-F it states that “notwithstanding COVID-19, the long-term trends for our industry remain extremely attractive”. It sees 750 million new middle-class customers by 2030 helping to justify that positive outlook. The firm only generates 35% of its profit outside of North America and Europe, so it has plenty of scope to grow.
For those reasons, the assumptions set out in July’s article remain intact. That is to say, annual top line growth in the 5% area with EBIT growth running a point or so higher. The cumulative impact of stock buybacks can nudge EPS growth toward the 8% per annum area. Combined with a current dividend yield of 2.4%, I see that leading to double-digit returns – with low interest rates and a deserved premium to the wider market supporting the stock’s current valuation.
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