The alcoholic drinks market is battling through a recovery from the impact of the pandemic and dealing with a new industry landscape. Diageo (DGE) was badly hit by Covid-19 but looks set to prosper. The spirits-producing giant’s global reach, the strength of its brands and its supply agreements – its economic moat – give it distinct advantages. Its ability to take advantage of consumers’ growing preference for up-scale brands and opportunities in emerging markets mean the shares still offer significant long-term growth.
- Premium brand offering takes advantage of market trends
- Significant growth in emerging economies
- Wonderfully consistent dividend
- Debt levels are a concern
- Younger generation drinking less
Pandemic restrictions closed off revenue streams and hit profits. On-trade sales – revenues from hotels, restaurants, bars and pubs – dived as venues closed. Duty-free sales were battered with the lack of international travel. Net sales fell by 9 per cent and pre-tax profits by 52 per cent in the year to end-June 2020. A three-year programme to return £4.5bn of capital was paused and a £1.3bn impairment charge recorded due to the pandemic’s hit. [AC1]
While revenues and profits didn’t fully recover to pre-pandemic levels in 2020-21, the direction of travel was positive. In a recent trading update, Diageo reported organic net sales growth in all regions, with European operations outperforming expectations and the North American business performing well despite supply chain issues. Operating margins will “benefit from a further recovery in sales volumes, positive channel mix and premiumisation trends”, says management.
Long-term prospects look promising. Nick Train, manager of the Finsbury Growth & Income Trust (FGT), told Investors’ Chronicle that it is “the promise of sustained high profitability and pricing power over many decades to come that makes the company so undervalued”. As the world leaves the severest Covid-19 restrictions behind (hopefully permanently), Diageo looks neatly placed to benefit from a post-pandemic boom and its strong fundamentals provide a platform for long-term growth.
A moat-full of brands
Diageo operates a global and diversified business model. It trades in more than 180 countries and produces more than 200 brands. North America is the biggest revenue driver, contributing £5.2bn or 41 per cent of total net sales for 2020-21. Europe (including Turkey) and Asia Pacific are other key markets, contributing £2.6bn and £2.5bn of revenues respectively in the same period.
The group’s brands and assets mean competitors face high barriers to entry. Take a high-end Diageo whiskey. The group creates the product using a distillery and production chain it has built up over decades, which is obviously difficult to replicate. There is a long aging process – a good single malt needs at least a decade to mature. The 2021 accounts show £4.7bn of maturing inventories, a volume that can only be handled with Diageo’s scale. Any new market entrant faces significant initial costs with no immediate investment pay-off.
Brand equity is extremely strong. The group produces a range of leading brands including Smirnoff vodka, Guinness stout, Gordon’s gin and Captain Morgan rum. Premium brands, the highest-margin Diageo products, are of increasing importance. They drove almost half of total net sales growth in 2020-21 and 54 per cent of reported net sales were from premium-plus products. The group’s premium offering also includes Johnnie Walker Blue Label whiskey, Tanqueray No. TEN gin and Don Julio tequila.
Catching the new middle class
The move toward high-end and ‘superior quality’ products has been a consistent market trend over recent years. The growth of Fevertree (FEVR), which produces premium drink mixers, is a good example. So, too, are the premium prices that consumers pay for craft beers. IWSR research says the premium-spirits category outperformed general market growth by more than 100 per cent between 2015 and 2020. The drinks-market analyst also forecasts that the premium segment of the alcoholic drinks market will reach 13 per cent by 2024.
Finsbury’s Train says “the huge new wealth created by the digitisation of the global economy – most evident in the US and Asia – has resulted in many new customers sampling and enjoying premium and super-premium alcoholic beverages”. With its high-margin premium brand range, Diageo is well-placed to take advantage of this.
The prospect of significant growth in emerging markets also underpins the stock’s long-term potential. Diageo has developed a strong presence in markets such as China and India and is expanding market penetration. Consumers who could afford lower-price options are moving on to higher-end options as incomes increase and the middle class expands. The World Bank estimates that another 500m consumers will join the ‘middle class and above’ income range by 2031.
Spirit sales in China account for approximately 12 per cent of total global alcohol retail sales, according to a recent estimate. Diageo currently records only about 5 per cent of its net sales in the country and last month management said Diageo will open an R&D centre in Shanghai “to further its product innovation and development ambitions”. The centre will focus on developing premium products and is an encouraging sign for the group’s expansion in east Asia.
Yet expansion is not limited to emerging markets. A £185m investment to improve visitors’ trips to its Scottish whisky distilleries has come on stream. The centrepiece of the plan is the newly-opened Johnnie Walker Experience in Edinburgh.
The risks and the fundamentals
A threat to Diageo is the well-established trend of a more temperate mindset amongst younger consumers. The data show that they are drinking less than older generations, driven by health concerns and the impact of regular drinking on disposable income. The pandemic has also highlighted changing drinking habits amongst the young. University College London’s ‘Covid-19 Social Study’ found that nine in 10 of those aged 18-29 who drank heavily in early 2020 reported drinking less a year later.
This was undoubtedly affected by the closure of nightclubs and bars, but it would be foolish to assume drinking levels among this age group will automatically revert to pre-pandemic norms over the long term. That said, when people drink less they tend to drink higher-quality products. So, with its broad and high-margin premium product range, Diageo might ultimately benefit even from this trend.
Another concern is the level of debt the group has taken on in recent times. The 2021 full-year results revealed net debt at about 150 per cent of shareholders’ funds and a ratio of enterprise value to Ebitda of 22.4. The positive news is that Diageo’s underlying financial metrics suggest the group can deal with this. The resumption of the return-of-capital programme in May suggests that management thinks so.A range of benchmarks reveals a fundamentally solid business. The operating margin has been robust at over 25 per cent year by year. Return on invested capital, a measure that shows how well the business is creating profits from capital, is on the way to returning to the high teens after a pandemic dip. The group generated £3bn of free cash flow for 2020-21, up by £1.4bn from 2019-20.
These underlying strengths mean Diageo has been able to raise its dividend steadily, a trend that was even maintained over the pandemic period. The 2020-21 payout of 72.2p was 4 per cent up on 2019-20’s distribution. City analysts assume that trend will continue this year and next (see table).
Granted, Diageo’s shares look highly rated. Analysts’ average forecasts have the shares trading on a 12-month forward PE ratio of 27 times, although this is lower than competitors such as Brown-Forman. We think that rating is justified by Diageo’s reliable growth prospects, underpinned by its economic moat, premium-brand offering and emerging-market opportunities; a long-term holding if ever there was one.
| Company Details | Name | Mkt Cap | Price | 52-Wk Hi/Lo |
| Diageo (DGE) | £84.8bn | 3,640p | 3,666p / 2,474p | |
| Size/Debt | NAV per share* | Net Cash / Debt(-) | Net Debt / Ebitda | Op Cash/ Ebitda |
| 362p | -£12.2bn | N/A | 120% | |
| Valuation | Fwd PE (+12mths) | Fwd DY (+12mths) | FCF yld (+12mths) | CAPE |
| 27 | 2.1% | 3.0% | - | |
| Quality/ Growth | Ebit Margin | ROCE | 5yr Sales CAGR | 5yr EPS CAGR |
| 29.6% | 16.4% | 4.0% | 4.9% | |
| Forecasts/ Momentum | Fwd EPS grth NTM | Fwd EPS grth STM | 3-mth Mom | 3-mth Fwd EPS change% |
| N/A | 11% | 4.8% | 6.0% | |
| Year End 30 Jun | Sales (£bn) | Profit before tax (£bn) | EPS (p) | DPS (p) |
| 2019 | 12.9 | 4.15 | 130 | 68.6 |
| 2020 | 11.8 | 3.42 | 109 | 69.0 |
| 2021 | 12.7 | 3.71 | 117 | 72.2 |
| f'cst 2022 | 13.8 | 4.20 | 133 | 75.6 |
| f'cst 2023 | 14.7 | 4.63 | 147 | 79.9 |
| chg (%) | +7 | +10 | +11 | +6 |
| source: FactSet, adjusted PTP and EPS figures | ||||
| NTM = Next Twelve Months | ||||
| STM = Second Twelve Months (ie one year from now) | ||||
| *includes intangibles of £2.3bn, or 462p per share | ||||
