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Can investors still raise a toast to Diageo shares?

The spirits group is rightly seen as a very good business. It has served long-term investors well, but will the coronavirus change this for good?
Can investors still raise a toast to Diageo shares?

Diageo shares have been very popular with investors. Its strong portfolio of leading spirits brands has created a very profitable business that has served them well. Yet, as with many businesses it has not escaped unscathed from the economic impact of the coronavirus. I’ve decided to revisit its investment case and ask whether it can continue to prosper in a changing world.

 

Business model and strategy

Diageo is the world’s leading spirits business. Its strategy is based around a portfolio of leading 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 stout. It also has a 34 per cent stake in Moet-Hennessy, which adds champagne and cognac to its portfolio.

These global brands are backed up by local brands targeted to individual markets and a stable of reserve brands aimed at the more expensive luxury end of the spirits market.

Johnnie Walker and Smirnoff are amongst the top five global drinks brands, with Diageo also owning 23 of the top 100 brands. It sells more than 200 brands in total.

In the six months to December 2020, Diageo derived over half of its sales from scotch, beer and vodka. Its full sales breakdown is shown in the table. In 2019, it sold 245.9m nine-litre cases of drinks.

 

Diageo: sales breakdown 6 months to Dec 2019

Category

Net sales %

Scotch

26

Vodka

11

Canadian Whisky

7

Rum

6

Liqueurs

6

IMFL

5

Gin

4

Tequila

4

US Whiskey

2

Beer

15

Ready to Drink

6

Source: Annual report. IMFL = Indian made foreign liquor.

 

The business has a global footprint, with extensive production facilities and distribution networks across the world.

Most of the company’s production facilities are based in Europe – it has 29 distilleries in Scotland, a brewery in Dublin and a number of maturation and packaging facilities. It owns nine 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.

 

Diageo: segments & brands

Segment

Brands

% net sales

Global

Johnnie Walker, Smirnoff, Baileys, Captain Morgan, Tanqueray, Guinness

41

Reserve

Bulleit, Don Julio, Tanqueray Ten, Ketel One, The Singleton, JW Blue

19

Local

J&B, Yen Raki, Ypioca, Bundaberg, Shui Jing Fang, Grand Old Parr

19

Source: Annual report

 

In developed markets such as the US and Europe, people increasingly want to drink better quality products rather than more of them and have been prepared to pay higher prices in order to do so. Diageo is trying to exploit 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, Tanqueray Ten gin and a selection of Scottish single malt whiskies.

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. Its Indian business is a significant producer of whisky for local markets. The company has also established a tequila distillery and bottling plants in Mexico.

 

Competitive positioning

Diageo has a very strong competitive position in the global spirits market. It certainly has what investors like to refer to as a economic moat. Its business assets are so vast that a new entrant would need lots of time and lots of money to copy it.

The company has spent nearly £7.5bn on its production facilities and fixtures and fittings according to its accounts, but this ignores the fact that many of them have been in existence for decades and would cost a great deal more money to build now from scratch.

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, with some maturing for 30 years. Rum, tequila and Chinese white spirits also need to be laid down for periods of time before they can be bottled and sold. 

This maturing stock needs to be financed and Diageo had over £4.3bn of maturing stock at the end of June 2019, with £3.4bn of it being stored for longer than a year. Maturing stock is less of a barrier to entry in white spirits such as gin, but when you take into account stocks of finished goods and the need to hold supplies of raw ingredients, the size of stocks or inventories is a significant barrier to competition.

Stocks have been consistently over 40 per cent of annual revenues at Diageo in recent years. You need to be a business of significant financial strength to support this kind of scale.

As well as financing stock, brands need a significant amount of marketing support to retain and win customers. This is another significant barrier to entry to anyone looking to compete on a global scale. Diageo has been ploughing 15 per cent of its revenues into marketing to keep its revenues growing.

Given that the financial requirements of operating a global spirits business are so high, it is not a surprise that the market is quite concentrated, with only a few major global players competing with Diageo. These include Pernod Ricard, Suntory-Beam, Remy-Cointreau and Brown Forman.

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 in local markets.

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 consumer goods sector has woken up to the threat posed by a growing consumer preference for local brands made from quality natural ingredients, as has been seen with the boom in the number of independent gin and whisky distilleries in recent years, particularly in the UK. The products typically sell at higher prices than mainstream branded gins and are something that all spirits companies want to tap into.

This means that the pressure on the big players to innovate and keep their brands and products relevant in the eyes of consumers has arguably never been higher. Diageo seems to have stepped up to the challenge it faces reasonably well. In gin it has released innovative versions of Gordon’s and Tanqueray as well as launching Villa Ascenti, an Italian ultra premium gin for European markets. 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 has gone down well with consumers. A limited edition of 'White Walker by Johnnie Walker' has been a hit with younger consumers due to its association with the TV series Game of Thrones.

One of Diageo’s key competitive strengths is that it has huge amounts of market intelligence to exploit changing consumer trends around the world. This doesn’t mean that it is guaranteed to produce new winning products, but it's nice to have nonetheless.

 

Business performance

The strength of branded consumer products is that they have become very dependable in the eyes of consumers and also investors. That doesn’t mean it is easy for the makers of them to sell more of them, as we have seen with UK-listed global consumer staples companies such as Unilever and Reckitt Benckiser.

I’d say Diageo’s organic sales record has been reasonable in recent years, but not generally outstanding. Its three biggest categories of scotch, vodka and beer were not showing much growth at the end of 2019, but things look better within its key brands.

 

Diageo: Organic net sales growth in key categories (%)

Net organic sales growth 

2015

2016

2017

2018

2019

H1 20

Scotch

-5

0

5

2

6

0

Vodka

1

1

-4

-1

2

-1

Rum

-3

3

4

1

-2

2

Liqueurs

-4

3

3

6

4

7

Gin

5

8

8

16

22

7

Tequila

14

8

26

40

29

31

Beer

4

6

2

4

3

2

Ready to drink

-1

3

5

5

7

4

Source: Diageo

 

Scotch, its biggest category, has had a patchy record, with reasonable growth between 2017-19 but that growth come to a halt in the six months to December 2019. Vodka has been disappointing for some time now, but beer has been a steady performer. Liqueurs have been very strong over the past couple of years.

The star performers have been gin and tequila, but both only account for 4 per cent of Diageo’s net sales at the moment.

Looking at the performance by brand:

 

Diageo: Global brands organic net sales growth (%)

Global brands

2015

2016

2017

2018

2019

H1 20

Johnnie Walker

-9

1

6

5

7

-4

Smirnoff

-2

2

-1

-2

3

1

Baileys

-4

4

5

6

4

8

Captain Morgan

-4

3

6

2

-2

5

Tanqueray

5

12

9

15

19

13

Guinness

0

4

0

3

2

1

Source: Diageo

 

Johnnie Walker has been solid, with a slowdown in the first half of 2020 reflecting a very strong performance in 2019. Smirnoff has been poor, while Baileys has been good. Captain Morgan had picked up in the first half of 2020, while Guinness has been quite weak. Tanqueray has ridden the boom in gin drinking very well.

 

Diageo: Reserve brands organic net sales growth (%)

Reserve Brands

2015

2016

2017

2018

2019

H1 20

Scotch malts

11

7

2

1

12

17

Ciroc Vodka

6

-3

-12

-2

-8

-9

Ketel One

-3

4

-5

-1

10

-1

Don Julio

8

18

25

39

26

25

Bulleit

34

29

24

11

7

4

Source: Diageo

 

Of the Reserve brands, the performance of Ciroc vodka has been poor, while Ketel One has been very up and down. Single malts have seen impressive rates of growth over the past year or so, but the star has been Don Julio tequila. Bulleit bourbon has also been an impressive performer, although growth slowed in the first half of 2020. Diageo is investing $130m to expand the Bulleit distillery in the US.

In terms of its businesses by geography, Diageo has been doing very well in the US – the world’s biggest spirits market, accounting for 45 per cent of its total profits.

 

Diageo: North America (£m)

North America

2015

2016

2017

2018

2019

H1 20

Sales

3,455

3,565

4,161

4,116

4,460

4,604

Operating profit

1,448

1,551

1,890

1,882

1,948

1,967

Margin

41.9%

43.5%

45.4%

45.7%

43.7%

42.7%

Source: Diageo/Investors Chronicle

 

The business has been a beneficiary of the devaluation of the pound from 2016 onwards, but in recent years has seen a decent uplift in revenues driven by increased marketing spend. Tequila and Crown Royal whiskey sales were strong in the first half of 2020, as were Smirnoff ready-to-drink products. The division continues to earn impressive profit margins.

Profits in Europe have stagnated but Latin America and Asia-Pacific were growing nicely until the coronavirus hit.

 

Financial performance

Based on its most recent results to December 2019, Diageo remained a very impressive business on key financial performance measures such as operating margin, return on capital employed (ROCE) and free cash flow margins, although it had been increasing its debt levels to buy back shares.

 

Diageo: Key financial performance measures

Diageo (£m)

2015

2016

2017

2018

2019

TTM

Revenue

10,813

10,485

12,050

12,163

12,867

13,159

Operating profit

2,972

3,062

3,868

4,000

4,356

4,526

Profit after tax

2,467

2,362

2,827

3,144

3,377

3,244

Capital employed

22,435

24,362

24,674

25,183

26,652

26,261

Operating capital employed

19,914

21,663

21,951

22,505

23,970

23,579

Capex

638

506

518

584

671

730

Free cash flow

1,841

1,941

2,531

2,420

2,465

2,090

Total debt

9,838

10,129

9,042

9,902

12,555

13,472

Cash

472

1,089

1,191

874

932

950

Dividend paid

1,341

1,443

1,515

1,581

1,623

1,636

Share buybacks

8

1

41

1,507

2,775

2,615

       

Operating margin

27.5%

29.2%

32.1%

32.9%

33.9%

34.4%

ROCE

13.2%

12.6%

15.7%

15.9%

16.3%

17.2%

ROOCE

14.9%

14.1%

17.6%

17.8%

18.2%

19.2%

FCF margin

17.0%

18.5%

21.0%

19.9%

19.2%

15.9%

FCF conv

74.6%

82.2%

89.5%

77.0%

73.0%

64.4%

Debt to FCF

5.3

5.2

3.6

4.1

5.1

6.4

Dividends as % FCF

72.8%

74.3%

59.9%

65.3%

65.8%

78.3%

Div & BB as % of FCF

73.3%

74.4%

61.5%

127.6%

178.4%

203.4%

Capex to Sales

5.90%

4.83%

4.30%

4.80%

5.21%

5.55%

Source: Annual Reports/Investors Chronicle

 

Diageo and the coronavirus

Diageo remains a very good business with reasonable prospects in a world without the coronavirus. It has brands that have stood the test of time and ones that you can easily envisage people drinking in 20, 30 or even 50 years’ time. 

It seems to be well placed to exploit the trend in rising premiumisation with its reserve brands, while the continued shift away from beers and wines to spirits does it no harm either.

Before the coronavirus hit, the company was bullish about its prospects out to 2022. It was targeting 5-7 per cent growth in organic operating profit and looking to boost earnings per share (EPS) growth with buybacks.

That outlook has gone. An update in February showed how much damage was being done to revenues and profits just due to Chinese bars and hotels being closed for a short period of time. They are now slowly opening up again, but the lockdowns have spread to the rest of the world and Diageo’s key markets.

The closure of bars and restaurants, added to the decline in travel retail, is going to have a big negative impact on Diageo’s profits. On-trade sales (pubs, bars, restaurants and hotels) account for 20 per cent of its US spirits sales and 50 per cent of its European sales and sales have collapsed. Some of the damage has been limited by sales in supermarkets, but the company has no idea how long this will last.

Its United Spirits business in India will also see a big hit as both on- and off-trade has been shut down. 

Diageo is cutting back on advertising, investment and keeping a tight control on its working capital position, but the bottom line is that profits are probably going to be a lot lower in 2020.

Most investors have accepted this. The key questions are what happens when things get back to normal and how long it will take. The big worry must be that the virus stays around for months or even years. This would mean that bars, restaurants, hotels and air travel are not going to be getting back to 2019 levels of activity very quickly and nor will Diageo’s or its competitors’ profits.

The trouble is that no-one has any idea what short-term profits are going to be for global spirits companies. You have to take a view on long-term profitability. Do you think that profits will be higher than the past 12 months’ in five or 10 years’ time?

 

Diageo: Key performance indicators & valuation vs global peers

Company

Price

Mkt Cap bn

TTM FCF yield %

TTM PE

op margin

FCF margin

ROOCE

Sales growth LTM

Diageo

2884p

£66.10

2.9

22

34.40%

15.90%

19.20%

4.90%

Pernod-Ricard

€133.75

€35.50

3.1

24.3

28.70%

13.70%

11.70%

4.20%

Remy-Cointreau

€102.70

€5.10

1.8

32.5

23.50%

10.20%

5.60%

1.20%

Brown-Forman

$67.99

$31.1

1.9

37.4

32.50%

18.10%

26.90%

2.20%

Source: FactSet

 

Without the coronavirus I’d not hesitate in saying that I believe profits will be higher and perhaps quite a lot higher. With it, there has to be some doubt as the business models of its key customers may have to change significantly and that may not be helpful in selling more alcoholic drinks.

All this leaves investors in a difficult spot. If you’re an optimist, based on its past 12 months’ profits, Diageo looks like the best trade-off between profitability, growth and valuation in the global spirits space to me. Having said that, none of the shares in this sector can be considered to be outstanding value, which given the cloudy outlook for their profits suggests that now is not the right time to buy in.