BalkansCat Diageo (NYSE:DEO, OTCPK:DGEAF) is the world’s leading producer of premium alcoholic beverages, with a portfolio of world-leading brands, including Guinness, Johnnie Walker, Smirnoff, Tanqueray, Baileys, and many more. Throughout the 21st century, Diageo has produced extremely consistent results, growing its dividend every single year, come rain, shine, global financial crises or pandemics. That’s impressive, but 2024 has not gone well, with falling sales in Latin America and weak growth elsewhere. Those weak results have knocked 35% off Diageo’s share price, leaving its shares trading at a far more attractive valuation. But is it attractive enough to make the shares a buy? Before diving into a full review of Diageo’s financial results, business model, competitive advantages, future prospects and valuation, here are a few key facts to set the scene: Size: Diageo is a member of the FTSE 100 and with its share price at £25.80, it has a market cap of £58 billion Industry: It operates in the defensive Consumer Staples industry, and within that, the Beverages sector Geography: It’s also a very international business, generating 39% of its revenues in North America, 21% in Europe (including 6% in the UK), 19% in Asia Pacific and 10% in Latin America & Caribbean A long track record of progressive dividend growth Diageo’s dividend has increased every year for more than 20 years, so it has an exceptional track record of progressive dividend growth. This is exactly what I’m looking for. Data source: SharePad Over those 20 years, Diageo’s dividend grew at a compound annual rate of almost 6%, which is far ahead of inflation and more than enough to keep most income investors happy. However, there is a problem. Diageo used to report its results and set its dividends in pounds, but from 2024, they’ll be calculated in dollars. This is sensible because Diageo generates most of its sales in North America and only 6% in the UK, but with its reporting currency switching to dollars, it also makes sense to review Diageo’s past results in dollar terms, rather than pounds. If we do that, then the company’s dividend record becomes far less impressive, for two reasons. First, random currency fluctuations mean that Diageo’s beautifully smooth dividend growth in pounds becomes notably less smooth when measured in dollars. This, of course, is excusable because management was focused on growing the dividend progressively in pounds, not dollars. You can see the impact of this in the next table. It shows that Diageo’s dividend, when measured in dollars, remained underwater for several years after the financial crisis in 2009 and after Brexit in 2016. In both cases, the pound lost value, so in dollar terms the dividend went down. However, if Diageo’s reporting currency had always been dollars, then it would almost certainly have paid a progressively growing dividend in that currency. On that basis, I think it’s sensible to analyse Diageo as if it had paid a progressively growing dollar dividend, and we can do that by adjusting its dividend so that it grows progressively from 51.1 cents in 2004 to 101.3 cents in 2023. There is also a second reason why the switch to dollars makes Diageo’s dividend appear less impressive and, once again, it relates to the weakness of the pound versus the dollar since 2009. When measured in pounds, Diageo’s dividend grew at an annualised rate of 5.8% between 2004 and 2023, but when measured in dollars at the prevailing exchange rate, its growth falls to 3.7%. A 20-year dividend growth rate of 3.7% is less impressive than 5.8%, but it’s still comfortably ahead of inflation and comfortably ahead of my minimum acceptable growth rate of 3%. Here’s what Diageo’s dividend would have looked like if it had grown progressively, in dollar terms, at a steady 3.7% every year. These are the figures I’ll use for the rest of this analysis. Reasonable overall growth, but shareholder equity is declining How to identify stocks with high-quality dividend growth Dividend growth doesn’t occur in a vacuum. Dividends are paid out of earnings, earnings are what’s left over after expenses are deducted from revenues and revenues are generated from productive assets like factories, machinery and inventory, which are funded by equity or debt. If a company’s dividend growth is to be sustainable, it needs to generate growth across all these levels. The good news is that Diageo’s dividend growth has been supported by earnings and revenue growth. Both have grown by 3-4% per year over the last ten years, broadly in line with dividend growth, so on that basis, Diageo’s dividend growth does seem to be sustainable. However, while revenues, earnings and dividends have all increased, shareholder equity has actually decreased over the last ten years, both in absolute terms and in per-share terms (and in dollar terms, which is the currency I’ll use for all of Diageo’s historical results from now on). Data source: SharePad Diageo’s declining equity is slightly odd because a growing company will usually be growing its equity, as that’s the foundational source of funding upon which the rest of the business depends. In Diageo’s case, equity has fallen over the last ten years, so what exactly is going on? The answer is that Diageo has paid out more to shareholders through dividends and buybacks than it’s earned in profit. A good analogy for this is a savings account. If you have £100 in an account with a 10% interest rate, the account will earn £10 in interest. If you withdraw £15, you will have withdrawn the full £10 of interest as well as £5 of additional capital, leaving the account with only £95 instead of the original £100. This is effectively what Diageo has done over the last few years. In 2018, the company began buying back shares, and since then, it’s paid out a total of $25 billion to shareholders through dividends and buybacks while only earning $22 billion in profit. That’s largely why shareholder equity has declined by about $3 billion over the last few years. This means the company’s recent buybacks of around $2 billion per year are unsustainable at that level. Dividends, revenue and equity are all components of my Growth Rate metric (which measures the growth rate over ten years), so this decline in equity has a negative impact, reducing Diageo’s Growth Rate from 3.5% to 2.0%. I generally avoid companies where the Growth Rate is below 3% (which I classify as “bad”) and Diageo falls into that bucket. This is a Red Flag, but it doesn’t necessarily mean I wouldn’t invest. It just means I’d rather see Diageo cancel its buyback plan and use the surplus cash to reduce its debts and increase its equity instead (I’ll cover debt in more detail shortly). In addition to above-inflation growth, I’m also looking for consistent growth and here Diageo performs well, with revenues, earnings and dividends all increasing in most of the last ten years. But, once again, Diageo is held back by its declining equity, which shrank more often than it grew. This leaves Diageo with a Growth Quality score (which measures growth consistency across equity, revenues, earnings and dividends) of 69%, which is okay (66-75%) rather than good (75%+). Consistently good profitability is a sign of enduring competitive advantages Find quality dividend stocks using these profitability ratios Having somewhat lambasted Diageo for its uninspiring growth track record (with the exception of its excellent dividend growth record), the company’s profitability paints a much brighter picture. Net return on capital averaged 13% over ten years and without the pandemic, it would be north of 14%. I classify that as good (10%+) and it’s almost twice as profitable as most companies. Data source: SharePad This consistent and strong profitability is good evidence that Diageo has at least one enduring competitive advantage, and that’s a topic I’ll return to shortly. As for profit margins, although they don’t necessarily reflect any sort of competitive advantage (they tend to be driven more by the underlying industry than anything else), fat profit margins do provide a buffer that protects profits from falling revenues and rising expenses, so for a dividend investor, they’re still a nice-to-have. The good news is that Diageo’s profit margins are impressively plump, weighing in at an average of 21% (that’s above my “good” threshold of 10%). Debts have grown to where they’re almost excessive How to avoid dividend traps with excessive debts As I’ve already mentioned, in recent years, Diageo has paid out more to shareholders through dividends and buybacks than it earned in profit. This has inevitably led to a reduction in equity, but somehow, the company still managed to grow its revenues and earnings during this period. How can a company grow while reducing its equity? By taking on debt. In Diageo’s case, between 2014 and 2019, it carried somewhere between $12 billion and $16 billion of debt. Over the last ten years, its earnings averaged $3.6 billion, so its Debt Ratio (the ratio of debt to 10-year average earnings) during that period varied from around 3x to 5x. When the pandemic struck, Diageo took on even more debt to support the business and as a result, its Debt Ratio reached 6x in 2020. Of course, the pandemic is now over, but management chose to return cash through buybacks rather than paying down debt, so Diageo’s Debt Ratio remains elevated at 5.9 today. This is a borderline Red Flag because I usually avoid companies where the Debt Ratio is above 6x, as that’s where the risk of adding more debt usually begins to outweigh the benefit. You could argue that defensive companies can safely carry higher debt burdens than other companies, and I would agree. But I would still be happier if Diageo’s management stopped making such large buybacks and used some of its surplus cash to pay down its debt mountain instead. Despite my concerns, I don’t think Diageo’s debts are high enough to completely undermine the investment case. Given the scale of its buybacks, if its debts did become a problem, it could easily suspend its buybacks and use the cash (about $2 billion per year) to reduce its $21 billion debt mountain at a fairly rapid pace. Even so, Diageo’s high debts are still a negative feature that I will have to factor into my valuation. Decent cash generation and mostly organic growth As a dividend investor, I want to see profits convert into cash at a high rate because dividends are obviously paid in cold hard cash. That’s why I try to avoid companies with large capital expenses (capex) because capital expenses cause cash flows to reduce relative to profit. In my experience, cash flow issues often arise when capex is consistently higher than profit, but this isn’t the case with Diageo. It’s a relatively capital-light business and, over the last ten years, its capital expenses averaged a mere 26% of earnings. This is good because it means that Diageo’s dividend should be sustainable, especially as the company usually maintains a high level of dividend cover of around two times. I also have a strong preference for organic compounders. These are companies that like to grow organically rather than by acquiring other businesses because they want to avoid the operational and cultural disruption that often comes with large or numerous acquisitions. In this case, Diageo has a low Acquisition Ratio (the ten-year ratio of acquisitions to earnings) of 16%, which means that most of its recent growth has been organic, rather than acquisitive. A narrowly focused and highly stable core business How to find quality dividend stocks with enduring core businesses Diageo is the world’s leading premium drinks business, which means it makes, sells and markets branded alcoholic beverages, many of which are global market leaders. Diageo’s core brands include Baileys, Guinness, Johnnie Walker, Smirnoff and Tanqueray, all of which are global best-sellers in their category. Diageo’s basic business model is fairly simple: Buy raw materials (grain, etc) Use sometimes centuries-old recipes and processes to turn those raw materials into unmissably superior alcoholic beverages Transport the finished product to wholesalers and other customers all over the world Market those branded drinks to consumers Gather feedback from customers and consumers to help improve existing products and to develop new products Repeat that cycle, over and over again It’s also helpful to think of Diageo in terms of what it sells, at what price point and in what country. In terms of its 2023 net sales (net of alcohol duty), Diageo has the following profile: Category: Scotch 25%, beer 15%, vodka 10%, tequila 10%, others (eg rum and gin) 40% Price point: Super-premium+ 27%, premium 36%, standard 29%, value 8% Region: North America 39%, Europe 21%, Asia Pacific 19%, Latin America 10%, Africa 10% Across each of these dimensions, Diageo is more diverse than any of its global peers, and that’s a potential competitive advantage I’ll return to shortly. This narrowly focused core business has also been very stable over time, having barely changed since the merger of Guinness and Grand Metropolitan created Diageo in 1997. Together, those two companies owned most of the brands that remain central to Diageo’s success today, and most of those brands and the businesses behind them have existed for many decades and in some cases, centuries. The only material change to Diageo’s business model over the last 20 years relates to its previous ownership of food brands, including Burger King, Häagen-Dazs and Pillsbury. These were sold off in the early 2000s and since then, Diageo has been, very sensibly in my opinion, focused exclusively on being the world’s leading producer of premium branded alcoholic drinks. A simple and consistent growth strategy Diageo’s strategy for producing consistent, sustainable revenue growth, expanding profit margins and progressive dividend growth has stayed largely unchanged over the last 20 years. Of course, different CEOs have focused on different aspects of the business where they saw a particular need for improvement, but in my opinion, the core strategy has remained the same: (1) Expand existing brands in existing and new geographies The default route to growth is to just run the business model and sell more Guinness, Smirnoff and other established brands to more people in more countries. (2) Introduce new variants of existing brands This broadens the appeal of existing brands through new flavours, more expensive or affordable sub-brands and zero-alcohol alternatives. (3) Drive premiumisation Consumers are buying smaller quantities of higher quality drinks, with spirits outgrowing beer and premium spirits outgrowing value spirits. Diageo has taken advantage of this by actively tilting its portfolio towards premium and super-premium price points, which have grown from 53% of developed market sales in 2023 to 71% today. (4) Create or acquire new brands In some cases, Diageo won’t have an existing brand that fits a particular niche, so creating or acquiring brands that can be scaled up rapidly by plugging their operations into its world-class infrastructure is another sensible route to growth. (5) Exit brands with weak growth or profitability Not all brands are successful. Those that aren’t are usually sold, with the proceeds used to fund the growth or acquisition of other brands. If you’re familiar with other branded consumer goods companies, you’ll recognise this as a fairly cookie-cutter strategy that most of them use. That isn’t a criticism. It’s an effective strategy that has worked for many companies over many years and, as the saying goes: if it ain’t broke, don’t fix it. Durable competitive advantages from market-leading brands and (perhaps) scale Diageo is far and away the largest premium spirits producer in the world. Its market share is about 1.4 times its nearest competitor, and it’s larger than four of its top ten competitors combined. It also has global leadership in scotch, vodka, rum, tequila and gin. Scale is an advantage because the market leader can spend more than its peers in a variety of areas such as R&D, marketing, talent and technology. It can also help to increase efficiency and negotiating clout with suppliers, and it can reduce risk through greater diversity. It’s also useful for closing big sales deals because, as the saying goes, “nobody ever got fired for buying IBM”. Diageo does have these advantages, but it doesn’t quite meet my threshold for market dominance. For a company to gain a durable competitive advantage from scale, it needs to dominate its peers and that, for me, means it has to be at least twice as big as its nearest competitor. Diageo is only 1.4 times larger than its nearest competitor, and although that is an advantage, it’s an advantage that could be wiped out if two of its nearest rivals decide to merge. While its market-leading scale is perhaps a durable competitive advantage, a far more powerful and enduring competitive advantage comes from its famous brands, which are valuable, unique and impossible (or at least illegal) to copy. Owning popular brands is an advantage because most people are willing to pay a small premium to buy branded goods they’re familiar with, especially when price isn’t the most important factor. For example, if I’m buying a bar of soap, I’ll usually go for Dove or Imperial Leather because I’ve used them before, I like them, they do the job and I don’t care if they cost 50p or £1 more than Sainsbury’s own-brand soap. The same logic applies to most consumer products that go onto or into your body (clothing, grooming products, food, drink, medicine, etc). This competitive advantage tends to become more durable over time, so very old brands like Guinness and Smirnoff are much more likely to outlast newer brands and retain their pricing power for many decades and perhaps even centuries to come. This is known as the Lindy Effect, where the expected future lifetime of a non-perishable entity (like a religion, a piece of music, a brand or a company) is directly related to its current age. If I’d written this review a year or so ago, I would also have mentioned Diageo’s home-grown CEOs as a potential competitive advantage. It can be an advantage because long-term owners (typically founders and their families) and long-term managers (typically internally hired CEOs who have already been with the company for more than a decade) are willing and able to protect the company from the short-sighted demands of short-term investors. In Diageo’s case, its first two CEOs were insiders who joined Guinness and Grand Metropolitan more than ten years before becoming CEO, and they each remained as CEO for at least another ten years. Unfortunately, Diageo’s current CEO is an outsider who only joined the business in 2019 as a non-executive director. Perhaps she will prove to be Diageo’s greatest CEO yet, but I still think this is a step in the wrong direction. Being able to home-grow successful leaders is a key attribute of enduringly great businesses, and Diageo has (hopefully temporarily) strayed from that path. Short-term headwinds and attractive long-term prospects Over the last two years, Diageo’s share price has fallen by more than 35%. This is a clear sign that investors are worried about something, and they seem to be worried (quite understandably) that Diageo won’t hit its ambitious medium-term growth targets. Things started to go wrong in Q1 of 2024, when sales in LAC (Latin America & Caribbean) were down 20% thanks to weak demand and excess stock. At the half-year, weak performances in LAC and elsewhere drove sales down by 1%, causing management to reduce its growth targets. The medium-term organic net sales growth target was maintained at 5-7% annualised, but the operating profit target was reduced from 6-9% to 5-7% annualised. But, with sales falling rather than rising, there are serious doubts about whether any of that is remotely achievable. Here’s the key question: Is weak demand and excessive inventory in LAC in 2024 likely to damage Diageo’s long-term prospects? I don’t think they are. Instead, I think they’re run-of-the-mill business issues that investors will barely remember ten years from now. This is good news because it means that Diageo’s 35% share price decline may be excessive. Looking beyond these short-term headwinds, Diageo still operates in a very large and growing market. The total beverage alcohol market is expected to grow by around 4% per year through the rest of this decade, with the spirits market growing faster at around 5% year, driven by an increasingly large and wealthy global population. There is also a lot of room for Diageo to grow its market share which, despite its market-leading scale, is still below 5%. And although the world seems to change at an ever-increasing pace, I don’t see anything obvious that would disrupt the time-honoured tradition of consuming alcohol to make life that little bit more enjoyable. Diageo’s yield is okay but is it trading at a discount to fair value? How to Value Shares with a Dividend Discount Model Having reviewed Diageo in some detail, I do think it’s a quality dividend stock and I would gladly add it to my UK Dividend Stocks Portfolio. But, I would only do that if the dividend yield is acceptable and if there is at least a 33% discount between the share price and a realistic and conservative estimate of the company’s fair value (also known as its intrinsic value). Starting with the dividend yield, with its share price at £25.80, Diageo has a yield of 3.1%. That just about exceeds my minimum acceptable yield of 3%, but I certainly wouldn’t call Diageo a high-yield stock. As for the discount (or premium) to fair value, I’m a dividend investor, so I base my fair value estimates on expected future dividends. In other words, an investment is only worth the cash you can get out of it, so fair value is the present value of all future dividends discounted by a “fair” annualised rate of return. Diageo’s management hopes to grow the company’s earnings (and I assume dividends) by 5-7% per year in the medium term and 6-9% over the longer term. However, I don’t think it would be conservative to use those growth targets to estimate Diageo’s future dividends as the company’s historical long-term growth rate has been closer to 3-5%. Instead of relying on management’s targets, here are the conservative and realistic assumptions I’ve used to estimate Diageo’s future dividends and fair value: Diageo’s net return on capital is maintained at a historically average 14% Cash previously returned through buybacks is returned as dividends instead and at a more conservative level than in the past. This causes the dividend to jump from $1.01 in 2023 to $1.38 in 2024 and because of that, dividend cover falls to 1.4, where it remains indefinitely This enables Diageo to retain enough earnings to grow by 4% per year without increasing its debts Diageo maintains a 4% growth rate over the long term, thanks to rising global wealth Under those assumptions, and using a discount rate (ie the target fair rate of return) of 7% per year, we get the following model: It’s important to remember that this isn’t a prediction or a forecast. It’s just a simple but hopefully realistic and conservative model of what might happen, under the above assumptions. It’s also focused on the long term, rather than trying to be overly accurate about what happens in the next year or two. In essence, the model says that if Diageo does pay precisely the above dividends, an investor could pay anything up to £36.62 per share and get a 7% annualised return or better. For context, Diageo’s share price has previously exceed £40 in 2021 and 2022, so this estimate is in line with the company’s historical share price range. With Diageo’s share price currently at £25.80, it’s trading at a 29% discount to that fair value estimate. That isn’t bad, but it isn’t low enough for me to press the buy button today because it doesn’t meet my 33% discount threshold. However, if I needed to add a defensive stock to my portfolio for diversification purposes, then yes, I might buy Diageo at today’s price. And if I already held Diageo, then I would be happy to continue holding at anything up to £36.62. In other words, here are my personal buy, hold and sell prices for Diageo: BUY: Ideally, I would like to buy Diageo below £24.17 per share, as that would give me my minimum discount of 33% to the fair value price of £36.62 HOLD: If I already owned Diageo, then I would be happy to hold it at anything up to £36.62 SELL: If I owned Diageo and its share price rose above £36.62 within the next year, I would start thinking about selling Original Post Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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