DGEAF - Diageo: Why I Expect A Rebound For This SWAN Stock

2024-01-08 17:27:47 ET

Summary

• Diageo's share price has dropped during the last two years, making it cheaper than some of its most important peers.
• At the same time, the company is still steadily growing its revenue, earnings and dividend.
• Although there are risks and some problems with the market in Latin America and the Caribbean, these seem manageable.
• I believe Diageo is undervalued at this moment and its shares may have the potential for a 25% rebound.

Diageo ( DEO ) has been a part of my retirement fund for multiple years already, and it has been a steady and boring investment. The pandemic led to problems for the company, but it recovered rather quickly. But since a year or two, Diageo's stock seems to have lost steam and dropped quite a bit, leading to a more attractive valuation. In this article, I will try to investigate if Diageo has reached a valuation where buying (or adding to one's position, in my own case) could be prudent.

Portfolio and recent events

Diageo owns a premium selection of alcoholic brands, among which Johnny Walker, Guinness, Tanqueray, Bailey's, Smirnoff and Captain Morgan. This is a solid selection of brands, with the largest part of its portfolio consisting of premium brands.

Diageo has shown very steady growth of revenue, earnings and profit for quite a long time, with a hiccup during the pandemic. In the chart below you can see the last decade, and apart from this obvious downturn in 2020, it looks quite boring and stable.

Diageo is not a company of which you can expect spectacular performance. It's a slow grower: the company targets an organic net sales growth of 5 - 7% over the medium term. Almost the definition of a boring SWAN stock. High quality, a nice and growing dividend and a slow but steady growth. Up to now, what is not to like?

Also, Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) started a position in Diageo indirectly by taking over General Re Corp. Although this position basically represents no more than a rounding error in the grand scheme of things for Berkshire Hathaway, it is still notable.

But not all recent news about the company was good. Diageo cut its guidance due to lower-than-expected sales in Latin America and the Caribbean. This geographical segment is responsible for almost 11% of Diageo's sales, and the company expects it to decline by more than 20% year-on-year, which is a lot. Also, some of Diageo's brand are having a drag on the company's overall margins. This is likely why Diageo is considering offloading some of its beer brands.

It is likely that these recent press releases had a negative effect on the share price performance of Diageo, although I consider the offloading of some of its underperforming brands to not necessarily be bad news. As you can see in the graph below, Diageo's share price dropped by more than 35% since the start of 2022.

Risks

There are two risks to Diageo (and the general alcohol industry) that seem to have increased in importance lately:

The first risk is the increasing awareness of negative health effects of alcohol consumption. It is hard to measure objectively, but many parts of society are much more aware that alcohol consumption is unhealthy, especially when consumed in large quantities.

In the past, emphasis was often on the direct effects of alcohol like the risk of drunk driving, but nowadays it is well-known that alcohol consumption contributes to all kinds of diseases like cancer and cardiovascular illnesses. This awareness led to the introduction of voluntary abstinence like dry January, and it is possible that this movement will gain traction in many countries.

The second risk is GLP-1 , known for its weight-loss drugs such as Ozempic, Wegovy, produced by Novo Nordisk ( NVO ) and Zepbound and Mounjaro, produced by Eli Lilly ( LLY ). In a trial among patients used semaglutide, it was reported that this drug could help treating alcohol use disorder. The press was quick to identify this as a risk for alcohol companies, and it may well prove to be a large risk if the weight-loss drugs lead to a reduction to alcoholic cravings.

North America is the largest market for Diageo, closely followed by Europe and Asia. Quantitatively speaking, alcohol consumption is very concentrated among a limited number of people; in the US, only 10% of people account for well over half of all the alcohol consumed in any given year. In fact, 30% of American people do not drink at all.

If many heavy drinkers in the US gain access to GLP-1 and start drinking less, this will likely impact Diageo's bottom line. It is also not unthinkable that the press releases around GLP-1 contributed to the recent underperformance of Diageo and some of its peers.

Stickiness of the product

But alcohol consumption seems to be very concentrated in the US compared to other countries: The share of adult people who regularly consume alcohol is much higher in Europe and in Australia, with Europe being specifically notorious when it comes to number of liters of alcohol consumer per capita. For example, in France (where 88% of the adult population regularly consumes alcohol) there was a recent political row about 'dry January', with some people arguing that 'it's not French culture to not have wine'.

All these figures and statistics show that alcohol use is sticky, maybe even more so in Europe than in the US. For some people it might be an addiction, but when people are considering alcohol use to be a part of the national culture, it is likely that also non-addicted people will be an important part of the market in the near and more distant future.

A brief intermezzo about ethics and my personal stance

Ok, I know we are here to make money and to seek alpha, but I am also aware that some investors avoid investing in alcohol producers for ethical or religious reasons. I am avoiding some companies and some industries out of ethical considerations myself as well, but alcohol is not one of them.

I am very aware that alcohol is bad for people's health in general and I experienced first-hand that it can be addictive. During my university education I drank a lot, usually ending up in a bar around 3 to 4 times a week. After some heavy weeks of drinking, it did happen that I was simply not feeling too well being sober, and while I didn't consider myself to be a 'problem drinker', the number of drinks I have per week might have suggested otherwise. But in the end, after I graduated my alcohol use quickly decreased, and nowadays I only drink very moderate amounts at parties or in restaurants, usually no more than 1 or two drinks a week.

As long as the alcohol industry promotes responsible use, I do not have large problems with investing in alcohol producers. Of course, the use of it in traffic should be banished and I do not wish to have negative encounters with drunk people. I can understand that some investors want to avoid investing in alcohol companies as they do with tobacco, but I am still investing in alcohol-producing companies. I sometimes have my doubts though when I see statistics like 10% of the adult US population having an average of 73.85 drinks a week, which shows that there are likely many addicted drinkers.

Valuation

Well, back to Diageo. Compared to many of its peers, Diageo looks cheap, especially considering its brand portfolio. Anheuser-Busch InBev ( BUD ), the only company that comes close to Diageo with regard to its forward PE ratio, mainly sells beer, which Diageo is considering ditching (partly) because of the negative effect on its overall margins.

Compared to Constellation Brands ( STZ ) (which is also much more exposed to the lower-margin beer market compared to Diageo) and especially Brown-Forman ( BF.B ) Diageo simply looks cheap. Note however that the PE ratio of most of the companies in my graph decreased considerably over that last three years. It does not surprise me that the PE ratio of Diageo came down, it does surprise me that it is trading all the way down this list of companies.

Let us look at another factor underlining the rock-solid nature of Diageo: its dividend.

Dividend hikes

Diageo has, throughout the years, increased its dividend in a meaningful way. This has by no means been explosive growth, but as you can see in the table below, which I created using data from its own website , the company has doubled its dividend over the last 12 years. Diageo isn't a very quick dividend grower, but as you can see, annual dividend increases have all been around 5% or higher (with the only exceptions being 2020 and 2021, but those years were burdened with uncertainty due to the pandemic, so I forgive the company for that). Note: numbers in the table are in UK pence.

Again, with the notable exception of the pandemic, Diageo's payout ratio has hovered between 60 and 40 percent, and is quite reassuring at 47.19 percent at this moment:

Takeaway

Diageo is a solid company with decent growth expectations, a very dependable dividend and a premium portfolio. At the same time, it is trading for a seemingly depressed valuation. I would expect Diageo to trade for a slightly higher valuation than peers like Anheuser-Busch or Constellation Brands. The way I see it, Diageo has room to reach a forward PE ratio of around 22, which would be at a share price of around $175. This would mean that there is room for a rebound of almost 25% from current levels.

Since Diageo is a relatively low risk stock, this kind of potential short term increase looks quite attractive. Also, I consider the downside to be relatively limited. The risk-reward ratio of Diageo seems very favorable at these levels, and while I did not pull the trigger yet myself, I am planning on adding shares to my position as soon as I can find some dry powder.

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