Three figures that show why Diageo is a great investment

It takes just three figures to show why The Coca-Cola Company (US:KO) is such a great business. They are: 14.9 times, 11 days and 27.9 per cent. Sure, the figures mean nothing in themselves; but, put into a context, they help explain why Warren Buffett loves Coca-Cola, the company, as much as he loves the eponymous fizzy drink. More important, the logic behind the numbers can help explain why the Sage of Omaha might focus more attention on the UK-headquartered global drinks group, Diageo (DGE), in which he has taken a small stake.

Start with 14.9 times. That’s the number of times Coca-Cola turned over its working capital in 2022. Working capital is roughly what it says on the can – the amount of capital tied up in the day-to-day running of a company. In a manufacturer, mostly that means funding inventories (from raw materials to finished goods) and the amounts owed by customers (receivables) but minus what the company owes to its own suppliers. Working capital is chiefly funded by short-term debt but, wherever it comes from, it costs. Therefore a company’s bosses have much incentive to use it as efficiently as possible. The measure of that efficiency is the number of times in an accounting period – usually a year – that working capital is turned into sales. So, in 2022, Coca-Cola, which produced $43bn £33.84bn) of sales, turned over its working capital 14.9 times.

No multiple of working capital to sales is necessarily good or bad and some companies get away without needing working capital (in effect, their suppliers and creditors provide the capital for them) so there is no multiple. Coca-Cola has been in that happy position itself in two of the past five years. However, the rule of thumb is that the less working capital needed – and therefore the higher the multiple – the better.

This is because managing working capital is the key part of a company’s ability to generate cash, which is quantified by its cash-conversion cycle, whereby sales are turned into cash. Fairly obviously, the speed of conversion depends on the nature of a business. A fast-food stall in a high-street market will operate on a daily basis, turning, say, its sales of cakes and currant buns (bought on credit from the baker) into cash there and then, and starting all over again the following day. At the opposite end of the scale, a company making bespoke capital goods on long-term contracts – such as, say, oil-services group Petrofac (PFC) – may have a lag of months before it turns work done into cash.

This ability to turn work into cash is quantified by the cash-conversion cycle, which says how many days, on average, it takes for work done to become cash. It is done by re-arranging balance-sheet data for inventories, receivables and payables so that these numbers become the equivalent of days held on the company’s books within a given accounting period. So, for example, in 2022 Coca-Cola turned over its average level of inventories 4.7 times (where ‘average’ is the mid-point between opening and closing inventory amounts). Divide 4.7 into a 365-day year and, on average, the group held its inventories for 77 days. Do the same exercise for its receivables and the answer is 30 days. Add together those two figures and in 2022 it was 107 days on average before Coke’s syrup was literally turned into cash.

But it can get better – and certainly does for Coca-Cola – because a company’s need for cash is reduced by its ability to preserve its own cash, which is best done by delaying payment to creditors. Using the same arithmetic as for inventories and debtors, the figure is 96 days for Coca-Cola’s average payables outstanding in 2022. So, deduct 96 days from the 106-day operating cycle and, in effect, the group’s cash-conversion cycle in 2022 took just 11 days, which is the second magical figure mentioned in the first paragraph. That was easily its shortest cycle in the past 11 years and barely a fifth of the group’s 52-day cycle in 2018. In the 11-year period, Coca-Cola has held inventory days fairly steady. They were 61 days in 2012, peaked at 90 days in 2020 and averaged 40 days overall. It was cutting the time it took to get debtors to pay but, especially, lengthening the time taken to pay its own creditors – from 61 days in 2016 to 96 days in 2002 – that dramatically speeded up cash conversion.

Compare Coca-Cola’s cash-conversion cycle with others in the table and it is by far the shortest. True, we should expect nothing less given the nature of a producer of syrup for soda water compared with groups that make beer and, particularly, spirits, which need a long maturity. For example, on Diageo’s 2022 balance sheet, as part of its £7.1bn-worth of inventories were £5.3bn of maturing stocks, £3.7bn of which would not be ready for more than a year. Arguably, that £3.7bn-worth should be shuffled away from current assets. Put them elsewhere on the balance sheet and Diageo’s cash-conversion cycle would shrink appreciably.

However, what’s really remarkable about Coca-Cola is that it runs on the cash-conversion cycle of, say, a supermarkets’ operator – businesses that get by on profit margins of 4 per cent or so if they’re lucky – yet it generates the profit margins of the spirits makers with which it is compared in the table. Its margin was 27.9 per cent in 2022, that third figure from the first paragraph.

In a way, it shouldn’t be like that. Spirits makers need their fat profit margins largely to compensate for the amount of working capital they must tie up in their operations. Without those margins, they wouldn’t generate an acceptable return on the capital they employ. But Coca-Cola could happily get by on skinny margins and that’s what makes it brilliant – the combination of the cash-conversion cycle of a food retailer while producing the profit margins of a spirits maker. No wonder Warren Buffett says he’ll never sell the stock.

But the topical question is whether Buffett – or, specifically, the Berkshire Hathaway (BRK.B:US) conglomerate he runs – will buy more Diageo shares? And that’s another way of asking if the shares – currently priced at £34.19 – are good value? Could be. Based on the data in the table, Diageo compares well with similar international spirits groups. The ratio of sales to working capital for the maker of Johnnie Walker whisky and Guinness stout is twice that of its closest rivals, Brown-Forman (BF.A:US), the maker of Jack Daniel’s whiskey, and Pernod Ricard (RI:FR), maker of Pernod pastis and Beefeater gin.

Similarly, Diageo’s cash-conversion cycle – 342 days in 2022 – is better than those two by more than 100 days, as is the case for the 10-year average of their cycles. Likewise, its latest profit margin is the best of the three, though it falls short of the margin at Constellation Brands (STZ:US), which is chiefly an importer of beer into the US. For the 10-year average of margins, Brown-Forman also bettered Diageo’s, as it did for return on equity (RoE); though in the past four years Brown-Forman’s RoE has been falling while Diageo’s has been rising.

Given all this, it might be surprising that Diageo’s share rating – based on the ratio of its price to forecast earnings – is consistently lower than Brown-Forman’s and, especially, that it has dropped below the multiple for the S&P 500 Beverages sector of US listed shares. It’s not as if Diageo should be unfamiliar to US institutional investors. The US is the group’s biggest market – 37 per cent of sales in 2022 compared with just 6 per cent in the UK – and there is a sponsored Diageo depository receipt (ADR) listed on the New York Stock Exchange, where one ADR is equivalent to four ordinary shares.

Sure, today’s exercise is just the financial-analysis equivalent of a 10-minute sketch. Even so, it points to financial characteristics of Diageo that would particularly appeal to Buffett. His appreciation of other aspects of Diageo could be presumed since Berkshire Hathaway had held a stake in one of its predecessor companies, Guinness, and – incidentally – lost money. Meanwhile, Diageo is an archetype of the companies that Buffett likes, where barriers against competition are high thanks to strong brand names buttressed by heavy marketing spending.

True, Berkshire’s arrival on Diageo’s share register has done nothing to stop its share price drifting away and the price is now 14 per cent off its 12-month high. Other factors are at work. Something approaching global recession must be bad news for a group that likes consumers’ discretionary spending to be on the carefree side and higher interest rates must erode the value of its annuity-style revenues.

Yet it is feasible to see a takeover premium creeping into the share price. There is no chance of Berkshire making a hostile offer, that’s not its style. Yet Diageo, for all its $100bn or so of equity value, is just a big bite for Berkshire (market capitalisation $750bn) rather than a heavy meal. Much the same would be true for a private-equity consortium intent on carving up Diageo. From distinct components it came. Back into distinct components it could go. One to watch.

bearbull@ft.com