Brexit results have come in just a few minutes back and there's probably going to be a lot of chatter around it for the coming weeks. I thought it would be a good time to take a look at the numbers and figure out if Diageo (NYSE:DEO), Britain's biggest spirit company, is worth buying as the drama unfolds.
We'll take a look at the current state of the company, discuss its new CEO, try to figure out the impact on its bottom line from a weaker sterling and, finally, run a DCF to see if we can pin down an intrinsic value.
Too Big To Grow (Organically)
A quick Google search is likely to show you just how massive Diageo is. If you drink, it's pretty likely they own a brand you recognize. Their portfolio includes Guinness, Ciroc, Smirnoff, Baileys, Captain Morgan and, of course, Johnny Walker. The company employs more than 33,000 people and sells products in 180 countries.
Under former-CEO Peter Walsh, the beverage company started building a consumer drinks empire. It succeeded, and is now the world's biggest spirit company by volume. That begs the question - is there room to grow?
The latest reports by the company show that its preferred metrics of growth are flattening. Organic growth is flat at 0% since 2014, while organic operating margins have improved by double-digit basis points every year. This means efficiency is improving, but sales are flat if you don't consider acquisitions.
Which is precisely why the management has been so focused on acquisitions over the past few years. The group is now so massive and owns so many well-known brands, that there's only one way to grow volumes and drive profits - buy emerging market brands.
One of the biggest recent acquisitions has been United Spirits (NYSEARCA:USL), India's largest spirits company. The company was acquired when its prolific founder, Vijay Mallya, ran into some trouble paying back corporate debt to banks in the country.
Much has been said about how big banks in India are affected by widespread defaults like this. But USL's founder offered an opportunity too hard to miss.
This strategy of buying big brands from around the world means 43% of the company's revenues now come from emerging markets. The focus on emerging markets seems justified. The strategy to boost growth abroad seems to be the only option for a company this size.
Diageo has traded organic growth for inorganic growth via acquisitions, which is not necessarily bad in any way.
But while volumes have improved in emerging markets, particularly in Asia, a bulk of the company's profits still come from Europe and America.
Source: Diageo Annual Report (2015)
Net sales in 2015 were pretty much equal between Europe and North America, while a bulk of the profits came from North America. That means the dollar has considerable impact on the bottom line for this British company.
For much of its history, sterling has been stable against the dollar. That changed today as Britain voted to leave the European Union and the pound plunged to a low not seen since the 1980's.
It's an unexpected day with a surprising result. For the moment we're only left with questions about the future of the UK and the pound.
Discerning the impact on Diageo's finances is just as difficult. While equity markets have gone into utter chaos, DGE, Diageo's London-listed shares, are flat. The FTSE 100 is down 10%, meanwhile.
Of course, a lower pound is good for British exporters and considering the fact that most of Diageo's profits come from abroad, it's reasonable to assume the weaker pound will benefit the company.
Revenues and profits are likely to be impacted positively, depending on how the company's hedge instruments are structured. But what about debt? Turns out there's good news there too.
A massive 2/3rd of the debt the company owes is denominated in GBP.
Source: Diageo Annual Report (2015)
Owing too much money in a foreign currency while the domestic one falls would be a risk. Management seems to have avoided this. Historically, the company has had limited exposure to the British economy, but it seems the borrowing has been very much domestic.
Betting on a company solely on the basis of a currency move is irrational, regardless of the size of the move.
So, a look at the fundamentals is justified. Here's what we know about Diageo:
- The company is massive and overall successful.
- It's more focused on foreign markets and has an enviable stake in emerging market growth.
- Brexit is likely to have a positive impact on its books.
- It has historically had a high dividend payout ratio.
In my opinion, there's two ways to measure the intrinsic value for a company like Diageo. A high payout ratio, positive free cash flows and low debt, coupled with lower rates of growth in volumes and barriers to further expansion, means this is a defensive value play.
So, a Gordon Growth Model for dividends seem to be appropriate measures for intrinsic value. Here are the assumptions:
Sustainable growth rate
ROE x Retention Rate
Required Return on Equity
(Dividend / Price) + growth rate
Annual dividend (2015)
Gordon Growth Model: $120
At the time of this writing pre-market trading indicates DEO will fall to $103. Over the coming weeks uncertainty is likely to push markets further down and this means the discount on Diageo is likely to grow bigger.
Diageo is a buy anywhere below $100, as the margin of safety expands to more than 20%. The unexpected Brexit is likely to have a positive impact on the company's bottom line and focus on emerging markets is justified.
The GGM, however, depends on the assumption of the sustainable growth rate and required return on equity. I have arrived at my estimates considering the current dividend payout ratio, the long term growth rate, the high levels of debt and the return on equity.
However, you may want to tweak the model based on your own assumptions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.