Diageo: A Longer Historical Perspective

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About: Diageo plc (DEO)
by: Blue Sky Capital
Summary

Diageo is widely considered to be a high-quality business, and its strong performance in the last few years has inspired faith among investors.

However, over a longer period, the company's earnings and share price are more volatile, with a prolonged period of poor performance in 2014-16.

Problems included weak emerging market currencies, poor eurozone macro, political events in China and India, and even a shrinking U.S.

On balance, we believe this confluence of problems seen in 2014-16 will not happen again, and Diageo can deliver its 5-7% EBIT growth target.

At 3,438.5p, Diageo shares trade at a well-deserved premium valuation but can still deliver 8-10% annual return. We recommend Buy.

Introduction

Diageo (DEO) is widely considered to be a high-quality business with sizeable structural growth drivers and deep-rooted competitive advantages. Its performance in the last few years has been impressive, delivering double-digit total shareholder returns each year in FY16-18, inspiring an almost faith-like confidence among many investors.

However, viewed over a longer period, the company's earnings and share price are more volatile, with a prolonged period of poor performance in 2014-16. As shown below, Diageo EPS shrunk in both FY14 and FY15, and was basically flat in FY16; total shareholder return was a measly 2% in both FY14 and FY15:

Diageo - Earnings Per Share Growth (FY14-18)

NB: FY ends 30th Jun.

Source: Diageo Investor Day (CFO section) (May-19)

Diageo - Total Shareholder Return (FY14-18)

NB: FY ends 30th Jun.

Source: Diageo Investor Day (CFO section) (May-19)

In fact, holders of both Diageo stock (DGE LN) and its American Deposit Receipts would have seen little return from the start of 2013 to mid-2016 (as shown below). In this article, we review the reasons behind this prolonged period of poor performance and assess if it will happen again.

Diageo Share Price Since 2013

Source: Yahoo Finance (10th Jul, 19)

Company Overview

Diageo is a global alcohol beverages company active in all regions and involved in a variety of spirits, beers and wines. Scotch is its most important category, with 25% of FY18 net sales; other whiskeys add up to 14%, beer is at 16% and vodka is at 11%. In each category, Diageo operates a diverse range of brands catering to different tastes and price points. (It estimates 18% of its net sales are from super-premium, 32% premium, 40% standard and 10% value.)

North America is its most important region, with 47.3% of EBIT, followed by Europe & Turkey (35.1%) and APAC (22.7%), as shown below:

Diageo Volume, Net Sales and EBIT by Region (FY18A)

Source: Diageo results press release (FY18)

Diageo's global competitors include Pernod Ricard (OTCPK:PDRDF), Rémy Cointreau (OTCPK:REMYF), Brown-Forman Corp. (BF.B), Campari (OTCPK:DVDCF), Beam Suntory (part of Suntory Beverage & Food (OTCPK:STBFY)) and Barcadi (private). It also competes with a number of smaller, more regional players.

EBIT Decline During FY14-16

A geographic breakdown of Diageo’s EBIT for the past decade is shown below - EBIT (as reported in GBP) fell substantially during FY14-16, which led to the EPS declines and poor share returns mentioned above.

Diageo EBIT by Region (FY09-18A)

NB. EBIT is before exceptional items. Source: Diageo company filings

The company's EBIT growth from different components is shown below - the decline during FY14-16 was primarily caused by currency moves, though weak organic growth also played a key part. We will review the currency moves and weak organic growth (by region) in turn below.

Diageo EBIT Growth by Component (FY09-18A)

NB. EBIT is before exceptional items. Source: Diageo company filings

Emerging Markets Currency Exposure

The negative currency impact on Diageo's EBIT during FY14-16 was primarily from LATAM and Africa, as shown below. Key LATAM and African currencies depreciated significantly in these years, amid wider emerging markets weakness, which was linked to falling commodity prices.

Diageo Currency Impact on EBIT by Region (FY14-17)

NB. EBIT is before exceptional items. Source: Diageo company filings

However, such currency headwinds would have less impact on the company today, as emerging markets have become a much smaller part of its earnings. As shown below, in FY13, regions outside North America and Western Europe were 42% of Diageo's total segment EBIT; in FY18, the equivalent figure (for regions outside North America and Europe & Turkey) has fallen to less than 27%. (Europe accounts for about 90% of "Europe & Turkey".)

Diageo EBIT by Region (FY13A)

Source: Diageo company filings

Diageo EBIT by Region (FY18A)

Source: Diageo company filings

Compared to the years before FY13, Diageo's EBIT growth has been more balanced in recent years, with a higher contribution from developed markets. In particular, the contribution from LATAM and Africa, more vulnerable to external economic shocks, contributed a far lower share of organic growth in FY16-18 than in the years before FY13, as shown below:

Diageo Organic EBIT Growth by Region (FY09-18A)

NB. “International” segment is Africa and LATAM. EBIT is before exceptional items.

Source: Diageo company filings

Organic Growth - Regional View

Europe, North America and APAC together contributing 87.5% of the company's total segment EBIT. We review each of these regions' performance during FY14-16 below, to assess if the same weakness then could occur again.

North America

North America includes the U.S. and Canada, and is predominantly a spirits business for Diageo, with a small amount of beer exposure:

Diageo Net Sales Breakdown - North America (FY18A)

Source: Diageo results press release (FY18)

The organic net sales and EBIT growth rates for its North America business are shown below - North America is a solid market, with only a small decline in FY15 and healthy net sales and EBIT growth in recent years:

Diageo Organic Net Sales & EBIT Growth - North America (FY09-18A)

Source: Diageo company filings

We believe the 2% organic EBIT decline in FY15 is unlikely to be repeated. It was the result of a 3% decline in volume that year, mostly due to a reversal in flavoured vodka sales after a boom in the preceding years. Management stated they have learnt from this experience and now pursue more sustainable growth and manage stock levels in their channels better.

Also of note is how EBIT growth is higher than net sales growth in most years - with margin expansion resulting from natural operational leverage, even with North America already being Diageo's highest-margin region. (FY18 EBIT growth was reduced by higher marketing spend, as well as logistics costs, inflation and hurricanes.)

Europe & Turkey

Europe & Turkey is about 90% Europe (including Russia). It is mostly a spirits market, but beer is about ¼ of net sales:

Diageo Net Sales Breakdown – Europe & Turkey (FY18A)

Source: Diageo results press release (FY18)

Europe & Turkey net sales growth was weak until FY16, due to economic weakness in the eurozone, especially in the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain). Growth has since returned (as shown below) as the eurozone economies have stabilised and the weaker markets (Iberia, Greece and Italy) have shrunk to just 3% of group sales by FY13:

Diageo Organic Net Sales & EBIT Growth - Europe & Turkey (FY09-18A)

NB. Reporting regions have changed over time; most equivalent regions used.

Source: Diageo company filings

In recent years, Europe & Turkey organic net sales has been at or near 5%, with margin expansion helping EBIT to grow even faster. Growth is helped by innovations (such as gin and botanicals), which play to Diageo’s strengths.

We expect Europe & Turkey to continue to deliver solid growth.

APAC

APAC includes key growth markets like India, China and Southeast Asia, and also developed markets like Australia, Japan and Korea. It is predominantly a spirits market, though this includes IMFL (Indian-made foreign liquor) spirits in India and white spirits (baijiu) in China:

Diageo Net Sales Breakdown - APAC (FY18A)

Source: Diageo results press release (FY18)

Diageo's APAC business shrank in FY14, and also had relatively low growth in FY15 and FY17 (though still near or above 5%), as shown below:

Diageo Organic Net Sales & EBIT Growth - APAC (FY09-18A)

Source: Diageo company filings

The weakness in FY14-16 was largely the consequence of an anti-corruption campaign in China that started in FY13H2. Weak numbers in FY14 were also before the consolidation of United Spirits Limited in India in FY15, which increased regional net sales by 70% and provided more diversified growth.

FY17 was impacted by the India government's surprise "demonetisation” exercise, as well as its ban on the sale of alcohol near highways, but the region still showed positive growth that year.

With India and China both being strong growth markets, and other growing economies in Southeast Asia, we expect the APAC region's strong growth to continue.

Future Growth Prospects

To sum up the above, the confluence of negative issues that impacted Diageo in FY14-16 will most likely not happen again, because:

  • Any LATAM and Africa currency depreciation would affect Diageo less, given the regions' now lower share of profits.
  • The North American market will remain strong, driven by the healthy U.S. economy and Diageo's more sustainable growth and stock management.
  • Eurozone economies have stabilised, and the weaker Southern Europe markets are now a smaller part of the business.
  • APAC is now driven by multiple growth engines; the Chinese anti-corruption drive and the Indian "demonetisation" exercise were both one-offs.

We thus believe that the growth rates achieved since FY17 are more representative of the company's future than the stagnation of FY14-16.

Moreover, management believes changes to Diageo's distribution and inventory management processes in FY14-15 would reduce future volatility:

“The single biggest change in these two years has been the focus we now bring to sell out... the move to sell out and the destock in key channels has achieved 4 things. Sustainable growth with less volatility. A better relationship with customers and a closer understanding of consumer trends. Reduced working capital and higher free cash flow. And productivity in trade terms, in marketing spent, and the supply chain.

We are now putting less volume into distributors at the outset and focusing instead on those innovations which are gaining traction... When the brand really started to take off our supply chain acted to replenish stocks quickly. This replenishment approach will allow us to better direct marketing and sales activities at launch and reduce the volatility inherent in launching innovations.”

Ivan Menezes, Diageo CEO (FY15 earnings call)

The company's medium-term guidance is for a “consistent” 4-6% organic net sales growth and a sustainable 5-7% organic EBIT growth:

Diageo Medium-Term Guidance

Source: Diageo Investor Day (CFO section) (May-19)

We believe these are realistic targets for the following structural reasons:

  • Strong secular growth from rising spending on alcohol, including global premiumisation and emerging markets volume growth.
  • Spirits as a category continues to gain share from beer and wine, with premium international whisky growing fast.
  • Diageo has deep-rooted competitive advantages from its historic brands, economies of scale in marketing, distribution and innovation.
  • The company's geographic and product diversification helps smooth out regional economic volatility and gives it time to adapt to local taste changes.

Global Alcohol Volume Share by Category

Source: Diageo Investor Day (CEO section) (May-19)

International Whisky Market (2017 vs. 2013)

Source: Diageo Investor Day (Scotch section) (May-19)

FY19H1 Results

FY19H1 results (for the 6 months ending December '18) were again strong, and management now guides to full-year organic growth being “towards the upper end” of the 4-6% range:

Diageo FY19H1 Results - Key Financials

Source: Diageo results press release (FY19H1)

Valuation

On last twelve-month (CY18) financials, Diageo is trading on 26.9x P/E and 3.4% FCF Yield; its annualised dividend (66.5p) gives an 1.9% yield:

Diageo Earnings, Cash Flows & Valuation (FY14-19H1)

Source: Diageo company filings

These figures are likely underestimates, as the pound has depreciated further, falling from an average £/$ rate of 1.35 during FY18 to 1.25 now.

Management has promised to return any excess capital, so the 3.4% FCF yield implies another 1-1.5% of shares being repurchased. Net debt / EBITDA, at 2.3x as of December 18, is below management's 2.5x-3.0x target, which implies additional capital returns.

Conclusion

Diageo’s period of weak earnings and share price in FY14-16 was due to a confluence of negative events; the chance of this happening again is low.

Management's medium-term guidance of 4-6% organic net sales growth and 5-7% organic EBIT growth is likely to be achievable.

Diageo is one of highest-quality names in the FTSE All-Share index and will retain its premium valuation during Brexit-related uncertainties.

At 3,438.5p, shares should deliver an annualised return of 8-10%, from a dividend yield of 1.9% and a stock price growing 6-8% (EBIT growing 5-7%, EPS growing from this and another 1% from buybacks, P/E multiple staying flat). We recommend the stock as a Buy.

Disclosure: I am/we are long DEO. 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.