DGEAF - Diageo: LatAm Recovery And Destocking Activities Make This A Strong Buy

2023-12-15 11:30:47 ET

Summary

• Diageo's potential disposal of its non-Guinness beer brands could lead to a margin potential re-rating and increase in EBITDA margins.
• The completion of Diageo's buyback program and a potential 10% dividend per share hike support our downside protection.
• A solid track record of innovation, higher growth rate than peers, and destocking activities coming to an end make Diageo a buy.

Following our positive update on Heineken called The Worst Is Behind , today we are back to analyze Diageo plc ( DEO , DGEAF ). This year, we have already deep-dived into the beverage alcohol sector, also commenting on Davide Campari . On a high level, we see this recent stock price underperformance as an opportunity to increase Diageo's investment based on best-in-class organic revenue growth and a quality portfolio with margin potential thanks to premiumization . Overall, in our view, we believe that Wall Street is concerned about the spirits industry's growth normalization. However, even if there might be some short-term topline sales pressure due to phasing/comparatives, here at the Lab, we continue to expect solid US sell-out trends to support a re-rating compared to peers. Aside from the upside on premiumization, we have a favorable view supported by Diageo's increasing market penetration and scale across the Globe .

New Upside: Disposal optionality, destocking, and LatAm recovery

1. A week ago, there were rumors and concerns about Diageo's optionality to sell its beer portfolio. In our forward-thinking analysis, our internal team does not rule out the company's potential disposal. However, we believe certain non-Guinness beer brands might be sold. The media release highlighted that Diageo seeks to divest the beer portfolio on margin concerns. Looking at the number, Diageo beer accounts for approximately 15% of the group's total sales ($3.1 billion). Here at the Lab, we believe that the Guinness division is about 65% of the company's portfolio. Excluding Guinness, this assumes sales of $1 billion. Assuming a 20% EBITDA margin, this would imply an EBITDA of $200 million. Using an EV/EBITDA multiple of 10x, in line with European players, this would potentially be a transaction of $2 billion. It would increase Diageo's EBITDA margins by 80 basis points, given the fact that the company's group margin is at 35.7%. Therefore, this disposal might lead to a margin potential re-rating. Even if we are not speculating on that, we believe this strategy follows Diageo's increasingly asset-light approach held in Africa. Indeed, in 2022, the spirits giant announced the sale of Guinness Cameroon, and in Q1 2022, the company also sold its Ethiopian business. Diageo is investing and looking at the highest business return; therefore, we won't be surprised if the company might dispose of Tanzania, Kenya, and Nigeria. In addition, scotch, vodka, and tequila are the three largest growth categories in 2023, and the African spirits segment is gaining traction. Diageo's Africa sales are up by 24% in 2023, and we believe the growth rate is expected to be higher than beer over the medium-term horizon. In addition, Diageo is the number one player in spirits in the region thanks to its international premium products;

2. Diageo only executed approximately 40% of the $1 billion share repurchase program, and we assume a buyback completion in Fiscal Year 2024. Therefore, this should support the company's total yield considering its dividend (its current dividend yield is at 2.85%). In our forward numbers, we estimate at least a 10% DPS hike from the 2023 level;

3. Even if investors have concerns about the lack of an inflection catalyst, Diageo's top management can draw a line under LatAm destocking. In addition, the company has a solid track record of innovation. Therefore, we are not changing our medium-term organic revenue guidance of 6/7% (2025). In addition, even if it may take time, the US plan to tequila and to further innovate Crown Royal sounds rational and supportive.

Changes in Estimates and Valuation

Here at the Lab, we have changed Diageo's new reporting to US dollars in line with the company. With the warming on 10th November and the Capital Marker Day presentation at the end of November, we are now lowering our H1 sales forecast to +0.6% with a core operating profit margin of -4.6% to $3.56 billion. This implied a margin drop of 170 basis points and a lower EPS of -8%. This is also impacted by unfavorable currency development and lower associate income. Diageo disclosed that LatAm sales will likely fall by more than 20% due to lower consumer demand and destocking activities.

Our internal team forecasts the fiscal year 2024 and 2025 fully diluted earnings per share at $1.87 and $1.99, respectively. Historical P/E was 20.5x; however, with an improving trend starting from H2 2024 and short-term challenge, we value Diageo on an 18.5x forward P/E multiple with no premium to consumer staples. Despite that, we maintain a buy rating with a £34.50 price target ($172 in ADR) from £38.50 per share . Our valuation is also supported by an EV/EBITDA of 14.5x. Downside risks in our target price include a slower recovery in the US, unfavorable FX development with a £ appreciation, regulatory risks given the nature of the spirits industry nature, and ESG concerns.

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