Diageo – is it as good a business as people think it is?

Diageo is also a scarce business. Its enviable portfolio of brands has many loyal customers the world over. It also has a scale and global reach that are very difficult to copy. This has enabled it to have relatively stable and predictable profits and cash flows – the kind that investors have been willing to pay high valuations for in recent years.

Paying up for quality has proven to be a good long-term investment strategy. This only continues to work if the company concerned can retain its quality and, more importantly, keep on growing its sales, profits and cash flows by earning high returns on the money it invests.

This week, I am going to take a closer look at Diageo’s business to see if it has still got what it takes to continue offer rewarding returns to investors.

Business and strategy

Diageo’s business is based around a portfolio of iconic spirits and beer brands. Many of these are world leading such as Johnnie Walker whisky, Smirnoff vodka, Baileys liqueur, Captain Morgan rum, Tanqueray gin and Guinness beer. It also has a 34 per cent stake in Moet-Hennessy which adds champagne and cognac to its portfolio.

In 2018, Diageo derived over half of its sales from scotch, beer and vodka. Its full sales breakdown is shown in table 1.

1. Sales split

Source: Annual report

Most of the company’s production facilities are based in Europe where it has 29 distilleries in Scotland, a brewery in Dublin and a number of maturation and packaging facilities. It owns 10 production facilities in North America, 12 breweries in Africa, 20 manufacturing facilities in India as well as distilleries in China and Australia. In some emerging markets, some products are produced under licence by third parties.

These production assets are backed by a very large distribution network in order to sell its products to its end consumers. Diageo owns most of its own distribution companies in Europe, and distributes through third-party distributors to states in the US. It also sells direct to retailers in the UK. The company has a joint venture with Moet-Hennessy to sell in France and parts of Asia. It has stakes in spirits companies in India and China and uses distributors to sell its products in these key markets.

Diageo’s strategy is based around selling its products to consumers by understanding their habits and preferences and is focused on segmenting its brands into three distinct categories: Global, Reserve and Local.

2. Business model

Source: Annual report

The company has been changing its drinks portfolio in recent years in order to exploit the growing consumer trend of ‘premiumisation’. This has involved buying young premium brands in areas where it was under-represented such as tequila while selling off unwanted brands as was the case with its wine business and recently the sale of 19 brands to Sazerac, owner of the Southern Comfort whiskey brand.

In developed markets such as the US and Europe, people increasingly want to drink better quality products rather than more of them and are prepared to pay higher prices in order to do so. Diageo is playing this trend on the back of its six core global brands along with a growing portfolio of high-quality reserve brands such as Johnnie Walker Blue Label whisky, Bulleit bourbon, Don Julio tequila and Tanqueray Ten gin.

In emerging markets, there is a significant focus on local brands but also a lot of effort is placed on encouraging the growing middle class populations to trade up to more premium brands.

In addition to this selling strategy, the company is focusing on becoming more efficient and cutting costs. It is aiming to take out £700m of costs and reinvest two-thirds of the savings back into the business to drive sales growth.

Business performance

So how has Diageo been getting on? Back in 2014, the company looked as if it was losing its way as its Asia Pacific business started to shrink. There has also been a concern that Diageo’s North American business has been underachieving and lagging the performance of its competitors (see table 3).

3. Profit split

Source: Annual report

Fast forward to 2018, and while it’s fair to say that not everything is firing on all cylinders, things look much healthier.

Since 2016, organic sales growth (excluding the impact of changing exchange rates) has been on an upwards trend, particularly in Latin America and Asia. From a business that was not growing at all in 2015 to one that saw growth of 5 per cent in 2018 is a decent result. A gripe would be that its main competitors are currently growing faster.

4. Organic net sales growth by geography

Source: Annual reports

The other gripe is that North American underlying profits did not grow much in 2018. Given that this is Diageo’s most important market (47 per cent of total profits) this is a concern.

US net sales growth of 3 per cent was boosted by strong performance from Johnnie Walker, Baileys and Don Julio but Guinness sales were flat and vodka sales fell in a difficult and competitive market. Sales growth from its Bulleit bourbon was encouraging at 4 per cent.

Profit margins also fell as the company spent more money on marketing and had extra costs to bear due to hurricane damage at one of its production facilities as well as higher logistics costs.

Europe (26 per cent of profits) is doing well with profits growth of nearly 10 per cent in 2018. Diageo is riding the gin popularity boom in the UK very nicely with strong growth from Tanqueray and a successful launch of Gordon’s pink gin. Beer sales have also been very strong from Guinness and Hop House 13 lager. The Turkish business performed well, too.

Strong scotch sales in Latin America and Asia have been complemented by broader spirits sales growth. China has seen increasing sales of premium spirits while the cheaper white spirits business has also seen strong growth. Asia is also seeing Diageo benefit from a booming duty free market at airports.

Looking at performance on a brand basis, growth looks respectable with the exception of Smirnoff which is being hit by a combination of competition and changing consumer preferences in the US. Tanqueray’s performance should allay any concerns that Diageo cannot exploit the boom in gin popularity, particularly in markets such as the UK. Rapid growth of Don Julio tequila has contributed to a very strong performance from Diageo’s Reserve brands, which is an encouraging development (see table 5).

5. Brands’ organic growth

Source: Annual report

A revival in sales growth and cost-cutting has seen Diageo grow its profits strongly since 2016 at the same time as maintaining its high profit margins and return on capital employed (ROCE) (see table 6).

6. Business performance

Source: Annual report/my calculations

Return on operating capital employed (ROOCE) where goodwill on acquisitions is stripped out has seen a very healthy improvement since 2016.

That said, Diageo has spent significant amounts of money on acquisitions over the last five years that have not added much – or any – additional value for shareholders because of the high prices it has paid for businesses.

It paid £1.8bn for a 54 per cent stake in United Spirits in India which is not coming anywhere close to making a decent return at the moment. The same can be said for the 2017 purchase for US tequila brand Casamigos where profits are very small yet Diageo paid $700m, potentially rising to $1bn for this business.

While Diageo is maintaining its high rates of profitability, there has been a step change in its cash-flow performance over the last five years.

7. Cash flow

Source: Annual report/my calculations

The increase in trading profits has been pretty much matched by an improvement in operating cash flows. Despite having significant working capital requirements – namely the maturing of spirits stocks and selling on credit – the cash requirement for it has been well controlled. The same goes for capital expenditure which has declined significantly as a percentage of operating cash flow.

As a result of these developments, Diageo’s free cash flow has more than doubled since 2014. Its free cash-flow margin is more than 20 per cent which is the hallmark of a very profitable and high-quality business.

Diageo’s business performance looks pretty good on most measures compared with other listed spirits companies. In terms of profit margin and ROCE, only Brown-Former – the owner of Jack Daniel’s – could possibly claim to be performing better.

Critics could point to Diageo’s inferior organic sales growth performance even though it has been accelerating. It’s worth noting that Remy Cointreau’s sales growth has had a significant boost from a shortage of premium cognac (selling for over $50 per bottle) on the market.

8. Spirits companies’ financial performance

Source: Annual reports/my calculations

How strong is Diageo’s competitive moat?

There’s no doubt that a new entrant would find it impossible to replicate Diageo’s business. To create a business of the same scale would cost billions of pounds in production and distribution assets and would need to have significant amounts of money reinvested in marketing and advertising to maintain and grow the sales of brands. The big spirits companies spend a sizeable proportion of their sales on advertising and marketing.

9. Brands in 2018

Source:Annual reports

Working capital requirements are also high. To be classified as scotch, a whisky has to be matured for at least three years. Premium single malts require maturation periods of 10 years or more. This maturing stock needs to be financed. This is less of a barrier to entry in white spirits such as gin.

While barriers to entry are high for someone wanting to create a significant global spirits business, there is a serious competitive threat in the form of craft spirits.

Just as we have seen with craft beers, there is a growing demand for craft spirits which have played a big role in the premiumisation of the sector. The popularity of local spirits made from quality natural ingredients has led to a boom in the number of independent gin and whisky distilleries in recent years, particularly in the UK. The products typically sell at premium prices to mainstream branded gins.

Craft spirit brands such as SippSmith have seen rapid growth in recent years which has led to it being bought by Beam-Suntory. But are these craft distillers a meaningful competitive threat to Diageo’s business and growth prospects?

Possibly at the margin, is my view. It would be concerning if Diageo had been complacent and not made any effort to innovate to capitalise on these trends but it has not been as far as I can see.

As far as gin is concerned, Diageo is doing more than fine given the growth rates of Tanqueray and the successful launch of Gordon’s Pink. Baileys has introduced new flavours and complemented this with a marketing campaign to create recipes and new occasions to drink it. Ketel One vodka is based on an innovative recipe of new botanicals, while the launch of Bulleit bourbon and a range of Johnnie Walker reserve brands have gone down well with consumers.

It also should not be forgotten that Diageo has huge amounts of market intelligence to exploit trends around the world. While by its own admission it could be doing better on some fronts, it seems to be holding its own against competitive threats quite well.

Forecasts and valuation

Being a truly global business means that Diageo’s sales and profits are influenced by changes in exchange rates. This can work for and against it. At the moment, weaknesses in emerging markets currencies are expected to lead to a small reduction in profit forecasts for the year to June 2019. The disposal of brands to Sazerac will dilute EPS.

That said, the company confirmed in its recent trading statement that it was still on track to deliver organic sales growth in the range of 4 to 6 per cent for 2019. A further £2bn share buyback (plus a further £340m from the Sazerac disposal) is also supportive to EPS growth. The large buyback is possible as debt remains at a manageable level while the financial position of the final salary pension fund has recently moved into surplus.

Source: SharePad

Throw in some more margin improvements from cost-cutting and the near-term outlook looks very reasonable for Diageo.

10. Spirits companies’ valuation

Source:SharePad

Spirits companies are highly valued by the stock market. On the basis of the estimates of the next year’s EPS, Diageo is trading on a one year forecast rolling PE ratio of 21.6 times which is significantly cheaper than Brown-Forman and Remy Cointreau on a relative basis.

On an absolute basis, this valuation does not look too stretched from the perspective of a patient long-term investor in a business that should be able to keep on earning high returns while continuing to grow. With demand for premium spirits increasing, Diageo looks every inch as good as many quality investors think it is. Granted, areas such as India and US spirits need to up their game, but I’d be fairly happy to own a slice of this business for the next decade.

Click here to read Phil's Alpha shares round-up 23 November.