DEO - Diageo: What Can We Learn From One Of Berkshire Hathaway's Smallest Positions?

2023-05-19 17:09:27 ET

Summary

• DEO appears to have a substantial moat, given expanding revenues on a growing portfolio of classic labels and new favorites.
• DEO pays a consistent and well-supported dividend, with a current forward yield of 2%.
• However, cash flow and debt appear to be a concern, especially because interest expenses are currently 30% of operating cash flow.

Background

I recently re-watched one of my very favorite Warren Buffett clips. If you haven't seen Warren Buffett and Charlie Munger share their collective insights while eating Dairy Queen Dilly Bars, you are missing out on not only golden wisdom but also exceptional wit. By the way, gesturing with ice cream on a stick is a surprisingly effective means to emphasize a point.

The most recent 13F filing from Berkshire Hathaway Inc. ( BRK.A ) ( BRK.B ) reported 277,750 shares of Diageo plc ( DEO ) formerly reportable by subsidiary Gen Re. Although Berkshire wholly owns Dairy Queen partially because Buffett likes ice cream, I doubt Berkshire continues to hold DEO simply because Buffett's throat gets dry occasionally. I suspect DEO displays many of the same fundamental qualities of Berkshire's larger and more well known positions. Because I'm a fan and a student, each section of the following analysis of DEO will begin with and revolve around a quote from Warren Buffett or Charlie Munger.

"In business, I look for economic castles protected by unreachable moats." - WB

DEO is an international distiller with a portfolio of perennially popular brands including Johnnie Walker, Guinness, Tanqueray, Baileys, Smirnoff, Captain Morgan, Crown Royal, and others. The continuing appeal of these brands serves as a moat protecting DEO's earnings and revenue.

DEO Earnings & Revenue

Over the last ten years, yearly revenue has generally been consistent while growing 19% to over $20B. Over the same period, EPS has been similarly consistent while growing over 27% to $1.88. I don't doubt that consumers will continue to purchase and enjoy DEO's premium brands, providing enviable support for future earnings and revenue.

"Above all, dividend policy should always be clear, consistent and rational" - WB

In 2023, Berkshire is expected to collect about $5.7 billion from the well-known dividend stocks including ( CVX ), ( BAC ), ( AAPL ), ( KO ), and ( KHC ). Unsurprisingly, DEO is also a dividend payer, with 10 years of dividends detailed below.

DEO Dividends & Payout Ratio

DEO's most recent semi-annual dividends of $1.54 and $1.10 represent a forward yield of 2%. Over the last ten years, the average semi-annual dividend was $1.70 with a sustainable average payout ratio of just 62%.

"Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent." - WB

Over the last twelve months, DEO has generated over $4.3B of operating cash, with ten years of cash flows detailed below.

DEO Cash Flow

Cash from operations (black line) and levered free cash flow (dashed black line) are plotted over the last ten years. Over the period, DEO has consistently plowed a substantial fraction of operating cash flows back into CapEx and other net investments, including substantial acquisitions. DEO has also consistently rewarded shareholders beyond dividends with share buybacks. Over the last ten years, DEO has repurchased almost 10% of outstanding shares.

The last major components of cash flow are interest expenses and changes in net debt.

DEO Interest Expense & Net Debt

Interest expenses consumed almost 30% of operating cash flows over the last twelve months. I am also a little surprised to see net debt increasing over the last ten years. Net debt has increased partly on several recent acquisitions , including Don Papa Rum, a premium dark rum from the Philippines) and Balcones Distilling (a Texas craft distiller of American Single Malt Whiskies).

I would like to see growing cash flows and decreased net debt from recent acquisitions before DEO considers any more acquisitions as it appears that leverage is already excessive.

"Price is what you pay. Value is what you get." - WB

Seven distiller and vintner peers were selected for a relative valuation based on peers' average EV/Sales.

Relative Valuation

Peers' average EV/Sales ratio was 5.17 vs DEO's current value of 5.86 while analysts' estimated FY 23 revenue was about 7% greater than revenue TTM. Based on these two figures DEO stock value was estimated at $166.02 suggesting about a 6% downside vs. the current share price.

No wise pilot, no matter how great his talent and experience, fails to use a checklist. - CM

Warren Buffett often gives Charlie Munger the last word, and it seemed appropriate to follow his example here. DEO earnings and revenue are trending higher on a growing portfolio of classic labels and newer favorites. At the same time, DEO consistently pays a modest but well-supported dividend.

However, cash flow, debt, and valuation appear to be concerns. DEO operating cash flows have trended up over the last ten years, but recently levered free cash flows have turned sharply lower on increased CapEx and acquisitions. Decreased cash flows are particularly concerning given increased debt and interest expenses; nearly 30% of operating cash flows are currently consumed by interest expenses.

Lastly, DEO appears slightly overvalued with modest downside based on estimated value on peers' average EV/Sales. I was expecting to be a little more impressed, but based on my review, I can only rate DEO at hold. Perhaps readers better understand why Berkshire continues to hold DEO and will let me know what I'm missing.

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