Investors seeking a high-quality consumer staple that is currently on sale should consider buying Diageo (DGE), the world’s largest premium spirits company which is growing its market share around the globe. Shares in the premium drinks maker behind iconic brands Johnnie Walker whisky, Smirnoff vodka and Guinness stout are down 20% over one year. This reflects disappointment around its performance in the Latin America and Caribbean (LAC) region, and concerns over China’s slower than anticipated post-Covid recovery and a cautious consumer environment in North America.
The sell-off has left the shares looking cheap relative to their historical average and it feels as though the point of maximum pessimism has now passed with a margin of safety built into the stock. Admittedly, recent news flow from Diageo has been downbeat, but the company is delivering productivity savings and CEO Debra Crew is confident that ‘when the consumer environment improves, organic net sales growth will return’. Diageo could even be a takeover candidate for a bidder looking to snap up an industry giant at a big discount.
DISTILLING DIAGEO’S STRENGTHS
Guided by Crew, successor to the late Ivan Menezes, Diageo is a veritable beverages behemoth whose unrivalled portfolio of brands span the likes of Captain Morgan rum, Tanqueray premium gin, Baileys cream liqueur, the Don Julio and Casamigos tequila labels and Chinese white spirit Shui Jing Fang.
This formidable strong portfolio confers pricing power on the business, which is key during inflationary periods, while the drinks giant’s myriad strengths also include its worldwide distribution footprint, massive marketing clout and a cash generative business model that has enabled the FTSE 100 group to establish an enviable dividend growth record, while investing in the organic growth opportunities and acquisitions and returning additional capital to shareholders through earnings-enhancing share buybacks. Diageo also has scope to expand its operating margin thanks to ‘premiumisation’, the consumer trend towards quality over quantity and drinking better, not more.
DOWNGRADES LEAVE SOUR TASTE
Diageo’s shares are still nursing a hangover from a surprise November 2023 profit warning followed by downbeat results for the year ended 30 June 2024, which undershot consensus expectations with group sales declining for the first time since the pandemic.
The company was unable to give an indication when its current period of poor trading will end, again given the difficult outlook for consumer spending, and reported an operating profit decline in four out of its five operating regions, while organic net sales were down 3% in North America, which accounts for 40% of the group’s global sales. Nevertheless, Crew noted that excluding LAC, organic net sales grew by 1.8%, driven by ‘resilient growth’ in the Africa, Asia Pacific and Europe regions, and the company ended the year with 75% of its brands gaining or holding market share.
Encouragingly, two of Diageo’s big long-term growth drivers, Guinness and Tequila outside the United States, grew their revenues at a double-digit clip. Bears will flag that spirits consumption is down among younger, more health-conscious drinkers, but Diageo has a secret weapon in Guinness Zero, which is selling hand over fist including to those who aren’t traditionally Guinness drinkers.
Despite facing numerous challenges, Diageo’s free cash flow jumped 18% to $2.6 billion last year, which allowed the company to increase the annual dividend by 5% to $1.0348 per share and complete a $1 billion share buyback programme. Having always traded on a price to earnings comfortably above 20 times, Stockopedia data shows Diageo’s shares currently swapping hands for 18.7 times forecast 2025 EPS (earnings per share), falling to below 18 times for fiscal 2026.
One fund manager convinced the shares are undervalued is Nick Train, who holds Diageo in the Finsbury Growth & Income Trust (FGT). Train has long held the view that ‘a company with brands of Diageo’s calibre and, crucially, half of its earnings generated in the world’s biggest, and most dynamic economy, the United States, could be valued on up to 33 times EPS, for an earnings yield of 3%.
‘Or put differently, we would not even consider selling out of an asset as advantaged as Diageo at anything less than a 30 times or more multiple.’
One sticking point to a bid is the fact such a takeover deal would require a significant cash outlay, even if the bidder got a bargain price, since Diageo is currently worth the best part of £56 billion. One route might involve breaking up Diageo, with a beer company taking on Guinness and another company taking on the spirits brands.
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