Diageo: A Premium Sin-Stock

Background and summary:

Diageo produces alcohol – lots of it – hence a “sin-stock”. Tobacco and alcohol stocks have produced spectacular gains over the last century, and Diageo is not different: 12% CAGR since 2000.

Diageo is a result of the merger between the famous beer producer Guinness and Grand Metropolitan in 1997, which formed one of the biggest distillers company in the world. However, its origins can be traced back all the way back to the 17th century and the Haig family, the oldest family of Scotch whiskey distillers.

Being a “sin-stock”, the business model is pretty easy to understand and we can expect little variations in sales and profitability. Diageo is of course very profitable with high free cashflow conversion and margins. As of writing (April 2020) the forward PE is around 20. Due to the coronavirus the company has issued a profit-warning, but I expect the sales to return to normal within a few months to a year. All in all, I believe Diageo to be a pretty “safe” investment over the next decades. I’m long with a small position.

Its main listing is in London where it has the tickercode DGE, and its secondary listing is on the NYSE (DEO).

The brands:

Despite being the world’s largest distiller, Diageo might be an unknown name for many, but some of their brands are well known:

  • Johnnie Walker (ranked number one brand in value)
  • Smirnoff (ranked number one brand in volume)
  • Bailey’s
  • Tanqueray
  • Captain Morgan
  • Guinness
  • J&B

According to the company’s latest investor presentation, 20 of the world’s top 100 spirits brands belong to Diageo.

Scotch (whiskey) is the most important part of their business:

Segment % of sales
Scotch 25
Beer 16
Vodka 11
Canadian Whiskey 7
Rum 6
IMFL Whiskey 5
Liqueurs 5
Gin 4
Tequila 4
Other 17

The revenue is spread like this:

Region % of sales
Europe and Turkey 23
North America 35
Latin America and Caribbean 9
Africa 12
Asia Pacific 21

Emerging markets constitutes about 40 of sales, markets which are expected to grow faster than the developed markets.

The market is both concentrated and fragmented. The international market is dominated by just a few global players, Diageo being on of them, while the domestic and regional levels are more fragmented. M&A is in the DNA of Diageo and I expect to see more of if it in the future. Over the last years Diageo has divested the weaker brands with low margins to focus more on their premium brands which have higher margins. The wine business was exited in 2015/16. This strategy has paid off so far with organic growth higher than the industry.

Performance:

According to the authors of Triumph of the Optimists, alcohol has been the best sector in the UK stock market over the last 100 years with substantial outperformance. Since 2000 Diageo has compounded, with dividend reinvested, at 12% annually, way better than all international stock indices, even better than Berkshire Hathaway. Perhaps even better is that the rolling three-year CAGR has never been below minus 2% in this period. Of all the stocks I have looked at, this has only been achieved by a very few select growth stocks.

This table summarizes the most important key numbers:

Organic
operating
Organic margin Free
EPS in pence sales growth improvement cashflow ROIC
2010 70.9 2 -1 2114 14.7
2011 81.6 5 0 1801 15.9
2012 92.6 6 59 1657 16
2013 103.1 5 78 1452 16
2014 95.5 0.4 77 1235 13.7
2015 88.8 0 24 1963 12.3
2016 89.4 2.8 19 2097 12.1
2017 108.5 4.3 37 2663 13.8
2018 118.6 5 78 2523 14.3
2019 130.8 6.1 83 2608 15.1

EPS has grown at 6.1% since 2010, lower than the share price. Thus, multiple expansion has been one of the main drivers of share performance, and this tailwind can of course not continue endlessly.

The dividend, buybacks and stewardship:

Many own Diageo because of the dividend. However, I believe this is the wrong approach because you can sell shares to generate “income”. Focus should be on total returns. The aim of paying a steady rising dividend has the potential of attracting a bunch of shareholders that only care about the dividend and not so much about generating high total returns. It simply makes the capital allocation process very sticky and inflexible.

The dividend has grown at a rate of 6.1% since 1999, more or less the same growth as the EPS, and the payout ratio is between 45 to 60%.

The dividend is paid twice a year: A smaller interim dividend and a bigger final dividend. At today’s price of 25 GBP, the dividend yield is 2.7%, the highest since early 2017. Because of multiple expansion, the yield was consistently over 3% prior to 2016. Currently there is no withholding taxes on UK dividends.

Buybacks are moderate as the dividend is made a priority over buybacks. A buyback plan was initiated in 2018 and the share count has been reduced from 630 million to about 595 million since then. Unfortunately, most managers are not good at capital allocation, and so far the buybacks have been done at multiples higher than the current one. In April 2020 they temporarily stopped the buybacks, at a time when the stock is down 20-25% from its peak.

I believe the stewardship to be pretty standard. Diageo has been involved in many M&A and most of them seems to be done at acceptable multiples, except for some “unlucky” deals in China. This is not an owner-operated company, and thus we can expect to have issues with the agency problem: the board and management have minimum ownership in the business.  All in all, I believe Diageo is one of the companies that can manage decent returns even with a mediocre management because of it’s sticky products.

Moat?

Investing in a stock that has the ability to resist competitive threats and generate abnormal profits are what all investors are looking for. Such a stock can compound investment returns at consistently above-average rates over the long term. Unfortunately, these stocks are far between and many of them sooner or later reverse fortunes. Two industries that have stood the test of times are tobacco and alcohol, so-called sin stocks.

Diageo has high rates of free cashlow (about 20%) and high return on invested capital (ROIC – 14% average).

  • Alcohol is unlikely to go out of fashion.
  • Brands – intangible assets.
  • Wide distribution network, sales in 190 countries.
  • Less disruption from online sales due to age verification requirements.
  • Cost advantage: according to Morningstar Diageo’s market share gives them bargaining power for raw materials (27% share). However, the whiskey and distiller market competes on differentiation and taste. Smaller distillers can have a premium simply because some consumers prefer that product, and many small distillers have the same margins as Diageo.

The balance sheet and debt:

The current corunavirus crisis shows the importance of having moderate levels of debt and the importance of low leverage to ensure investor confidence. Diageo strives to have a rating of A+ or better by keeping EBITDA/total debt to about 35%, which is investment grade, and ensures low borrowing costs and confidence. This keeps the interest coverage ratio at between 5 and 8.

Runway:

The company is already market leader in many of its brands. Despite this, I believe there is future runway because markets are still fragmented in many of its brands. It’s a mature market that grows slowly, around 1-2% annually. This means market share and consolidation is needed to sustain the growth of the past. About 40% of sales come from emerging markets, which of course are expected to grow faster than developed markets over the next decades.

Risk:

Diageo issued a profit warning in 1Q 2020 because of reduced sales in China during the lockdown, showing even alcohol gets disrupted. In addition, as of writing this article, a press release confirms it’s halting its stock buyback program and suspending its financial guidance. However, the interim dividend due in April goes as planned. In mainland China, Diageo said it’s beginning to see a very slow return of consumption, while most bars are shut in the U.S. and in Europe. However, retail stores have offset some of the loss from bars.

No doubt alcohol is costing society overall a lot of indirect problems and costs, and thus governments increase excise taxes and regulation. The effects of increased regulation was recently seen in China where the government scrutinized gifts to government officials and subsequently lower demand for scotch (!). According to Morningstar, distilled spirits are more cyclical than some other consumer staples, including brewing, and more correlated to general economic cycles: spirits and GDP are correlated 0.8 while beer brewers only 0.3.

Conclusion:

Diageo is now selling at the lowest multiples since Brexit in 2016. It’s not cheap nor a bargain, but Diageo rarely is, bar a major crisis. As long as the interest rates are at all time low Diageo will trade at PE above 20 as a “normal” multiple.

What rate of return can you expect in Diageo over the next decade? I like to keep things simple and use late John Bogle’s very simple formula of calculating future returns over the next decade (or longer):

Dividend yield + earnings growth + multiple expansion = annual growth.

If we expect the same growth as over the last two decades, which is about 6%, and the same valuation in ten years’ time, we can expect around 9% (6 + 2.7). Clearly, it will not set the world on fire, but I expect lower returns in the main stock indices, thus I believe it will continue to outperform. An added bonus is multiple expansion.

I currently have no position in Diageo.

 

Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

(This article was published on the 9th of April 2020.)

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