In recent years, Diageo’s dividend growth and capital gains have been outstanding.
But Diageo’s share price has already gained more than 200% since the financial crisis, so is it too late to jump on board?
In this blog post, I try to decide if Diageo is an attractive dividend growth stock by looking at:
1) Its financial past, 2) its susceptibility to common risks, 3) the strength of its competitive advantages and 4) whether the shares are cheap, fairly priced or expensive at their current price.
Dividend growth from a defensive drinks company
Diageo is one of the world’s largest alcoholic beverage companies. Even those who are one hundred percent teetotal have probably heard of its major brands, which include Johnny Walker, Smirnoff and Guinness.
Diageo was formed in 1997 from the merger of Guinness and Grand Metropolitan, a merger which created one of the world’s largest producers of spirits. Although the creation of Diageo was relatively recent, many of its brands and their underlying businesses can trace their origins back to the 18th century.
More recently, the company has been very successful. As the chart below shows, Diageo’s dividend growth rate has been rapid and consistent, although revenue and earnings growth has struggled somewhat in recent years:
Next, I’ll compare Diageo’s results with the FTSE 100. That’s a sensible thing to do since I’m trying to outperform the market in terms of dividend yield, dividend growth and capital gains.
- Share price:
- Diageo = 2325p
- FTSE 100 = 7525
- 10-yr dividend growth rate:
- Diageo = 7.5%
- FTSE 100 = 5.4%
- 10-yr overall growth rate:
- Diageo = 5.7%
- FTSE 100 = 2.4%
- 10-yr growth quality:
- Diageo = 79%
- FTSE 100 = 50%
- 10-yr average profitability:
- Diageo = 12.3%
- FTSE 100 = 10%
Diageo has good dividend growth at more than 7% per year on average, but overall growth is held back by weaker earnings and revenue growth.
Revenue growth is a particular area of concern because a company cannot grow its dividend long-term unless it can grow its revenues as well.
In this case, Diageo’s revenue growth rate is just 2.5% over a decade, which may turn out to be an upper limit for dividend growth in the future.
Slow revenue growth aside, Diageo has beaten the market in terms of overall growth rate, growth quality and profitability. This is a reasonably good sign that Diageo is a high-quality, relatively defensive business.
The company also easily sails through three of my main investment rules:
- Only invest in a company if its 10-yr growth rate is above 2%
- Only invest in a company if its 10-yr growth quality is above 50%
- Only invest in a company if its 10-yr average profitability is above 7%
So those are the headline results. Now we should have a look at what the company does to produce those results.
More specifically, we need to look for factors which could be a risk to the company’s future profits and dividends.
Is Diageo carrying hidden risks?
I like to look for hidden risks by asking a series of questions which relate to some common causes of corporate decline. These questions are a core part of my investment strategy.
Any negative answers to these questions could be cause for concern. More negative than positive answers is definitely a big red flag:
1. Does the company have a clear and consistent goal and strategy?
YES – Before 2014, Diageo did not have an explicit overall goal in its annual reports. Perhaps the goal was so obvious (maximising shareholder value?) that it did not need stating.
Since 2014, things have become clearer and more inspiring, with the company’s purpose now described in this way:
“Our purpose is to help our consumers celebrate life, every day, everywhere, and to do so responsibly.”
That goal is a bit woolly though, so the annual reports lay out the company’s strategy in more detail.
In short, the company strategy for helping consumers celebrate life is to get them to drink alcohol; preferably Diageo’s of course.
More specifically, Diageo’s strategy is to focus primarily on producing premium and luxury branded spirits and beers and then selling them to people across the world.
In terms of where Diageo is headed, its Performance Ambition is:
“To create one of the best performing, most trusted and respected consumer products companies in the world”
Management hopes to achieve this by prioritising investment in Diageo’s premium core global brands and its luxury brands.
Premium and luxury brands are the most profitable and they generate more than two-thirds of the company’s total sales.
Diageo does produce non-premium spirits and beers, but these are less important in terms of direct profits.
Instead, mid-market and value brands are used as a way to build scale and market share in new markets and to shape the drinking habits of the local population.
As people switch from, say, beer to mid-market spirits, the company hopes they will then drink premium spirits on special occasions, eventually leading to more people drinking Diageo’s premium spirits on any occasion.
The company also has six performance drivers which steer its activities:
- Strengthen and accelerate the growth of premium core brands
- Win with luxury brands in every market
- Innovate at scale to meet new consumer needs (e.g. Guinness Black Lager)
- Build and then constantly extend our advantage in route to customer
- Drive out costs to invest in profitable growth (current goal of £500m of productivity savings)
- Ensure we have the talent to deliver our Performance Ambition
2. Does the company have an obvious and dominant core business?
YES – Diageo’s core business is to produce and sell spirits and beers.
3. Do the company’s key performance indicators (KPIs) focus on indicators beyond growth, such as profitability, leverage and investment?
YES – Profitability is a KPI and is measured using both operating margin and return on invested capital.
There are no headline KPIs for leverage or capex, but free cash flow is an unusual and welcome core metric.
4. Is the company in the leading group in terms of market share within its chosen markets?
YES – Diageo describes itself as “a global leader in beverage alcohol”.
In terms of individual brands, many are world number one, such as Johnny Walker, Guinness and Baileys.
5. Has the company had the same core business for many years?
YES – Diageo’s core business can be traced back to the 18th century for Guinness and other major brands.
6. Is the company free of very large projects which, if they failed, could push it into a major crisis?
YES – There are no bet-the-company projects as far as I can see.
7. Has the company avoided dangerously large capital expenditures (capex)?
YES – Capital-intensive companies can be more cyclical than other companies, so the amount of investment required in capital assets (long-life assets such as buildings or machinery) is an important risk factor to consider.
Over the last ten years, Diageo’s total capital expenses have amounted to just 24% of its total post-tax profits. That’s less than the average for FTSE 100 companies, where average capex is around 50% of profits.
I also like to compare capex to depreciation.
This can highlight when a company is over-investing in capital assets, which can eventually lead to over-supply of its products, which leads to declines in prices and profits.
When capital expenses are consistently more than two-times depreciation, I start to get worried.
In this case I’m not particularly concerned.
Diageo’s total capex over the last ten years came to 124% of total depreciation.
This means its capital base is expanding in order to allow the business to grow, but does not appear to be growing too quickly.
8. Are revenues generated through a large number of small sales rather than a small number of large sales?
YES – Diageo sells its spirits and beers mostly to wholesalers and distributors in relatively small and frequent batches.
9. Has the company avoided mergers or large acquisitions which have little to do with its core business?
YES – For me, a large acquisition occurs when a company spends more on acquisitions in a single year than it made in profits.
In the case of Diageo, there have been no years out of the last ten in which acquisitions exceeded profits.
2012 came close though.
The amount paid out for acquisitions in 2012 reached 77% of profits, with most of the money going towards the acquisition of three drinks companies: Mey İçki (Turkey), Zacapa (Central America) and Meta (Ethiopia).
However, these are all drinks companies so they are similar to Diageo’s core business. As a result I wouldn’t expect the integration of these acquisitions to be particularly destabilising.
10. Does the company operate in defensive markets?
YES – Alcoholic beverages are relatively defensive products because people like to drink, and a recession or two isn’t going to stop them.
Averaged across an entire country or the entire globe, any reduction in alcohol consumption as a result of economic woes is likely to be small and short-lived.
11. Does the company operate in markets where the pattern of demand is unlikely to be disrupted?
YES – As far as I can see, the beverage sector is not particularly prone to disruption or rapid change.
Guinness today is probably not enormously different to the Guinness of the 18th century, and the way it is consumed is probably not enormously different either.
However, one possible source of disruption is startup brands. With the advent of micro-breweries, plus social media and other forms of viral marketing, new drinks can quickly scale up into significant businesses.
To defend itself against these threats, Diageo runs an incubator and accelerator. It’s called Distill Ventures. It invests in, helps and learns from tiny competitors so that Diageo can own a slice of the most successful new brands and learn how to improve its own brand creation process.
Having said that, my gut feeling is that startup brands will not be a significant disruptor.
12. Does the company operate in markets where demand is expected to grow?
YES – In the developed western markets, the total value of alcohol consumed is expected to grow in line with population growth (or decline as may be the case in Europe) and income per person.
In developing markets such as Latin America and Asia Pacific, demand is expected to grow more quickly along with the rapid growth of a consumption-oriented middle class who can afford Diageo’s products.
13. Does the company generate most of its profits from products or contracts that do not need to be replaced in the next 10 years?
YES – One of Diageo’s core strengths is the fact that its products do not need to be constantly changed or improved. In fact their unchanging nature is one of the things that makes them attractive.
For example, when I buy a pint of Guinness I want it to taste the same as it did ten or twenty years ago.
This means that although Diageo does invest in research and development, it does not have to constantly come up with new and better products in the same way that, say, consumer electronics companies do.
14. Does the company sell differentiated products that do not compete purely on price?
YES – This is another main driver of Diageo’s attractive levels of profitability.
Not only does it not have to spend much money on improving its best-selling products, it can also price them at a premium relative to less well-known brands.
Using Guinness as an example again, I would rather pay an extra few pence or so for a pint of Guinness rather than buy a slightly cheaper stout which I had never heard of.
This, of course, leads to wider profit margins and higher profits.
15. Is the company relatively immune to commodity price movements?
YES – Diageo is not particularly affected by commodity price movements.
16. Does the company have an expected rate of return on investment (ROCE or similar) of more than 10%?
NO – Diageo has return on invested capital (ROIC) as a KPI, but there are no explicit targets for it as far as I can see.
However, the company’s profitability is generally quite good, averaging slightly over 12% post-tax return on capital employed.
17. Are the company’s debts conservative enough given these various risk factors?
YES -At the last annual results, Diageo had debts of £10.7 billion. That’s 4.4-times its recent average profits of £2.4 billion.
I think that’s quite high, although it still manages to squeeze past my debt-related investment rule:
- Only invest in a defensive company if its debts are less than five-times its recent average profits
However, Diageo also has a defined benefit pension deficit of £1.2 billion which – if you assume this is a debt (which it effectively is) – takes Diageo’s debt ratio to 4.9.
So Diageo’s debts are right on the limit of how much debt I would be willing to accept. This warrants a moment more thought.
Diageo is very defensive, even among defensive companies, so higher levels of debt are not necessarily a problem.
That’s because its profits are unlikely to decline dramatically, leaving the company unable to pay the interest on its debts.
In fact the company has had a ratio of debts to profits of around five for most of the last decade. That period includes the financial crisis, so I think it’s reasonable to say that Diageo can (probably) handle this amount of debt in good times and bad.
18. Is the company free from serious risks today?
YES – I cannot see any obvious and serious risks which are affecting Diageo today, or are likely to affect it in the near future.
In the last five years or so, revenue growth has been virtually non-existent. But this has to do with various one-of factors, such as exchange rate movements and new “anti-extravagance” laws in China. I think such factors are unlikely to hold back revenue growth over the longer-term.
In its most recent interim results (published in January), Diageo seems to be ticking along nicely, with revenues, earnings and dividends up by around 5% (excluding benefits from the fall in the value of the pound).
Diageo is not a risky business
Having worked through those questions, it should be clear that Diageo is not a very risky business. In fact, it is about as defensive a business as you could hope to find.
Out of 18 questions, only one resulted in a negative answer, which is about as good as I’ve ever seen.
Having looked at risks, let’s turn now to look at something more positive: competitive advantages.
After that I’ll work out whether Diageo’s current share price is cheap, fair or expensive.
What are Diageo’s competitive advantages?
Any company which hopes to succeed over the long-term must have some sort of durable competitive advantage. So what is Daigeo’s edge over its competitors:
1. Does the company have any intangible asset advantages (e.g. brand names that command pricing power; patents; regulatory barriers)?
YES – Diageo’s main intangible asset advantage is its brands. These are unique assets that are embedded in the minds of millions (perhaps even billions) of people across the world.
As a typically unadventurous drinker, if I walk into a pub which offers Guinness and The Dogs Eyeball (not sure if that’s a real drink) then I’m going to buy a pint of Guinness. That is a massive advantage for Diageo.
2. Is it difficult for customers to switch to another supplier (e.g. bank accounts or computer operating systems)?
NO – Although I may prefer to drink Guinness, I can easily drink something else if it isn’t available at a particular pub.
3. Does the company have a network effect, i.e. do its products or services become better as more people use them (e.g. Facebook, eBay)?
NO – Guinness does not taste better just because millions of other people drink it.
4. Does the company have any durable cost advantages (e.g. unique location, unique low cost source of raw materials, greater scale)?
YES – As one of the largest drinks companies in the world, Diageo has economies of scale advantages over its smaller competitors.
In summary then, I think Diageo’s main advantages are its powerful brands and its massive scale.
Combined, they allow it to grow in new markets with keenly-priced value and mid-market products, upon whose backs (and distribution networks) the more profitable premium and luxury brands can then ride.
Diageo is a worthy investment, at the right price
I think Diageo is an excellent company and one in which I would be very happy to invest.
However, there is of course the question of price.
As a value investor (albeit a defensive and dividend-focused one) I am not going to buy an excellent company at any price.
The price must represent good value for money, although I realise that the price may be high relative to less exceptional companies.
Here are Diageo’s current valuation multiples , relative to the FTSE 100:
- Share price:
- Diageo = 2325p
- FTSE 100 = 7525
- Dividend yield:
- Diageo = 2.5%
- FTSE 100 = 3.7%
- PE10:
- Diageo = 27.6
- FTSE 100 = 17.4
- PD10:
- Diageo = 51.4
- FTSE 100 = 34.5
Note: PE10 and PD10 are just cyclically-adjusted valuation ratios which use 10-year average earnings and dividends instead of just last years.
By every measure, Diageo is more expensive than the market, with a lower dividend yield and higher PE10 and PD10 multiples.
But as I mentioned, this is potentially reasonable given the company’s above average growth rate, growth quality and profitability.
What we need to do is take into account both the quality and price of the company at the same time.
And that’s exactly what my stock screen does.
It ranks all eligible FTSE All-Share companies by each factor in turn and then combines those rankings into a single overall rank.
Diageo’s overall rank on my stock screen is currently 116 out of 225 dividend-paying FTSE All-Share companies.
116 is very close to the stock screen’s mid-point of 112, so by that measure Diageo, at 2325p, is very close to fair value.
Fair value means fair returns, and intuitively I think that sounds about right.
Combine Diageo’s current dividend yield of 2.5% with future dividend growth of say 5%, and you might reasonably expect total returns of about 7.5% per year over the longer-term.
That’s a decent expected return, but it’s only equal to the expected return from a passive index-tracking strategy.
I don’t know about you, but I want better returns than a passive index tracker and preferably better than 10% per year, so I don’t find Diageo attractive at its current price.
For me, attractive shares are those that (at the very least) rank in the top 50 of my stock screen.
For Diageo to be a top 50 stock its shares would have to fall below 1700p.
That’s a decline of more than 25%, so the company would probably have to run into some sort of minor problems in order to fall that far out of favour with investors.
But that’s okay; as a value investor you have to be willing to buy when others are pessimistic and sell when others are optimistic.
If Diageo does fall out of favour this year and if its shares do fall below 1700p then its dividend yield would increase to 3.5%, and I think 3.5% is a more reasonable yield from a company with a mid-single digit growth rate.
With a 3.5% dividend yield, Diageo’s long-term annual returns (assuming 5% annual dividend growth) would be 8.5%.
That still isn’t in the 10%-plus range that I would like, but at 1700p there would be much more room for an upwards re-rating if the market became more optimistic again, and that could produce the double-digit returns I’m after.
Of course Diageo’s shares may never fall back to 1700p, but that isn’t a problem.
There are plenty of other good companies out there that are attractively priced, and I would rather buy one of them than buy Diageo at too high a price.
So for now I think Diageo is a good dividend growth company, but not a particularly attractive dividend growth stock at its current price.
Note: The recent fall in the value of the pound means that Diageo’s (mostly international) sales and profits are going to receive a one-off boost this year into double digit territory. However, this does not change the longer-term expectation of mid-single digit growth, which management reaffirmed in their latest results and recent investor conference.
I suppose we have different metrics. I use the P/FCF5 or the averaged inverse of the free cash flow yield, as I find this is less susceptible to creative accounting. On this basis I have Diageo as 50% discount to what I would regard as fair value. Its a similar metric to the one Terry Smith uses (although he doesn’t say if he averages over 5 years) and I note it’s in his portfolio too.
Hi Andrew, yes different metrics will produce different results. I don’t look directly at free cash flow, so if that’s your key metric then I’m not surprised we come to different conclusions.
Just out of interest, and if you don’t mind, I’d be interested to know what sort of expected return you have for Diageo. I.e. do you have some sort of FCF + growth metric for total returns?
For comparison, my guesstimate for long-term returns is dividend yield plus dividend growth. So for Diageo that’s about 2.5% yield plus 5% growth, for a total return estimate of 7.5% per year.
Or a very optimistic person’s estimate might be 2.5% yield plus 10% dividend growth, for a total return estimate of 12.5%. But I think 10% dividend growth ad infinitum is a tad unlikely to be honest.
I have tried DCF, Graham, EPV and the Gordon Dividend Discount model you describe. I haven’t found any of them particularly useful because of the number of assumptions necessary.
Instead I monitor the FCF yield and sell when it drops under 1-2%. From where we are now, as 1-2% is the best cash interest rate available. I would expect a 150% return for Diageo assuming nothing changes and it continues to generate Returns of Capital Employed (ROCE) above its Weighted Average Cost of Capita (WACC)l. So I keep a close eye on this ratio (ROCE/WACC), as I suspect you do too. Hope that answers your question.
Thanks Andrew. Interesting that you compare FCF to cash. I guess in that case you must be looking at the most defensive companies only.
I do look at ROCE, but not WACC. I just compare ROCE from one company against all the other FTSE All-Share companies. As long as ROCE is above 7% I’m happy, but obviously higher is better.
John – Strangely enough, I started buying Diageo at 17xx and added at 18xx and close to 1900 in 2014-15.
It’s now 4.57% of my portfolio and to be honest I think I’m underweight on this. If you sectored off the individual brands and formed companies around singles or groups of them, the value would be above the current Diageo valuation by some margin – my estimate of course based on seeing the prices of other brands/companies sold recently within the drinks industry.
As Andrew pointed out using the FCF yield it looks conservatively valued.
Terry Smith must have this close to 3% of his portfolio – Nick Train has it at over 10%. Not a measure of valuation of course and Pearson is an example of belief in something that can go terribly wrong, but I wouldn’t put Diageo’s business or risk factors in anything like the same camp as a technology disrupted Pearson.
Your comments on emerging craft brands is a real worry – it’s not just beer crafts (less important for Diageo) but many of the more popular competitors in Gin-Vodka and Malt Whisky that are the threat. Let’s hope Diageo can use it’s weight to swallow some of these and not get too drunk on debt in the process.
My yield is well over 3% and I’m happy to hold this for the long term. I wish I had other companies quite so stable as DGE.
LR
Hi LR, Diageo is definitely a favourite among long-term buy and hold investors like Smith and Train. Personally, I can’t quite see where the outsize returns are going to come from at its current price.
I’m sure I’ll revisit Diageo in a year or two and then we’ll have a better idea of who was right!
John, Complete change of plan – sold the full holding. Since this article was wriiten the decision to pay close to $1Bn for a tequila branded by George Clooney seems utter madness.
28% over 2 years + a fine collection ofdividends is enough — I redeployed some of it into IG Group, which turned out quite fortuitous as the results were well recieved and it’s up 13.6% as I type.
They do say the harder you work, the luckier you get.
LR
Love the format, John! BTW, the number of questions need answering is insane! Appreciate your effort!
On the Company’s objective
I won’t blame a drinks company for trying to inspire investors. The company’s purpose can be taken out of context: “Our purpose is to help our consumers celebrate life, every day, everywhere, and to do so responsibly.”
So, does Diageo wants to encourage drinking? Or, if people do drink responsibly, does that mean fewer sales?
Just my thoughts.
My Opinion
Diageo is a great company and I agree that valuation is an issue when P/E is near 30 times and growing at single-digits. But, I tend to focus on the company’s historical valuation levels rather than the FTSE 100 because each business is different.
On that basis, is Diageo always has a historically high valuation or, are they at peak valuation historically?
Hi Walter, thanks.
I think the official line is that they want people to drink “better”, rather than more units. I guess that means a) more of Diageo’s drinks per person up to some “responsible” limit, and b) more people in total following point a.
Diageo has always had a somewhat premium rating, and deservedly so. But now it is higher than it’s been for more than 15 years. CAPE is almost 27, but it was 13 in 2002 and 2009. Average CAPE before 2010 (when bond-proxies became all the rage) was mid-teens. Post 2010 it’s been above 20. There is no reason why Diageo and the other bond-proxies can’t fall out of fashion again and return to their earlier and much lower ratings.
At which point of course, I would happily buy it.
Thanks for the info.