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 £13.5bn over the past half-decade, with around £7.5bn 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 breadth of its drinks portfolio, which is massive. It owns around a quarter of the world’s top one-hundred brands: well-known names include the likes of Smirnoff vodka, Gordon’s gin, Captain Morgan rum and Johnnie Walker scotch. Diageo 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. The company sold 245 million units of booze across the globe in its last full fiscal year (one unit being the equivalent of a nine-litre case of spirit). North American operations currently generate around half of total profit, with its Europe & Turkey segment accounting for another 25% or so. Asia Pacific, Africa and Latin America & Caribbean make up the rest.
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 Diageo has withdrawn profit guidance for FY20 for obvious reasons.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, analysts still expect the company to make around £2.6bn in net profit this year. That is on the back of revenue estimates of just under £12bn. Diageo’s financial year ended in June, so most of it was not affected by COVID-19. Obviously that also means the hangover will last well into its fiscal 2021.
Before the pandemic, the company targeted mid-single-digit revenue growth and 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 per share.
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.
Longer-term, I don’t really see why the company won’t get back into the swing of things after FY21. After all, its current plight remains largely a result of a unique public health situation rather than anything intrinsic at the firm. Looking slightly further ahead, Diageo reckons that 750 million 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 internally 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. That strikes me as more than acceptable for such a stable and high quality business.