Diageo plc (ADR) (NYSE:DEO) is a leading player in the alcoholic beverages market. Up until the last few years, the company enjoyed great success.
However, consumer trends have started to shift in DEO’s most profitable region – North America. The company has struggled to grow volumes and is now in a bit of a transitional period in an effort to strengthen its long-term growth prospects.
For these reasons, the stock appears to be relatively cheap today and offers investors living off dividends in retirement a safe 3.2% dividend yield and mid-single digit dividend growth potential.
However, is now the time to buy the stock given some of its challenges?
At the end of September (the last reporting period), 25 funds from the Insider Monkey database reported holding shares of Diageo, down from 26 a quarter earlier. In addition, these funds held around $1.15 billion worth of the company’s stock, which represented 1.50% of the company at the end of September. Tom Russo’s Gardner Russo & Gardner, Tom Gayner’s Markel Gayner Asset Management, and Mario Gabelli’s GAMCO Investors are among the investors that reported long positions in Diageo in their last 13F filings.
Business Overview
DEO is the largest producer of spirits in the world and was formed in 1997 after the merger of Guinness and Grand Metropolitan. Some of DEO’s leading global brands include Smirnoff (#1 spirit brand by volume), Captain Morgan, Guinness, Johnnie Walker (#1 spirit brand by value), and Bailey’s. By beverage category, scotch (24% of revenue), beer (18%), and vodka (12%) are DEO’s largest categories (see below).
Source: Diageo’s 2015 Annual Report
By geography, over 40% of revenue comes from emerging markets. However, the United States (45% of operating profit) and Western Europe generate most of the company’s profits today.
Business Analysis
DEO’s key strengths are its global distribution network (products are sold in over 180 countries), well-known brands (many have hundreds of years of history behind them), broad portfolio (sells at every price tier of every category), dominant market share (see below), and large marketing budget (spent over $2.3 billion on marketing last fiscal year).
Source: Diageo’s 2015 Annual Report
With beer and spirits in its portfolio, DEO’s distribution network is massive and would take competitors decades of time and significant cost to replicate. This network allows the company to easily expand sales of its brands across numerous geographies. It also helps the company’s efforts to quickly introduce new or acquired products to the market to meet changing consumer preferences.
DEO has also made several strategic moves in recent years to position itself for stronger long-term growth and profitability. The previous management team relied on acquiring beverage companies across the spirits, beer, and wine markets.
The company is now taking a more focused approach in an effort to become more efficient, focus on its core strengths (e.g. premium spirits), and improve longer-term profitability. It has sold off several low-return wine businesses and beer brands like Red Stripe. Over 60% of the senior leadership team has also been replaced over the last two years.
Whether or not these changes can restore volume growth in North America remains to be seen. Longer-term, DEO’s size and strength should help the company adapt to consumers’ evolving tastes – through both product innovation and smarter brand marketing.
The company also stands to benefit from growth in emerging markets (43% of sales) as consumers in these regions see their incomes rise and are able to consume more spirits. DEO expects one billion new consumers will be able to afford its brands over the next decade and an additional 800 million consumers will reach levels of income where luxury brands are affordable.
All things considered, DEO seems to have many of the characteristics possessed by some of our favorite blue chip dividend stocks – a portfolio of leading brands with hundreds of years of history in some cases, strong and consistent profitability, participation in large and slow-changing markets, and a management team focused on the long term.
Follow Diageo Plc (NYSE:DEO)
Follow Diageo Plc (NYSE:DEO)
Key Risks
DEO’s stock has been a major disappoint over the last three years. It has compounded at an annual rate of 0.5%, significantly lagging the market’s 15% annualized return.
Not surprisingly, the company’s organic growth rate significantly decelerated over that period of time, coming in at 5% in 2011, 6% in 2012, 5% in 2013, 0.4% in 2014, and 0.0% in 2015.
Growth has slowed for several reasons. Scotch, beer, and premium core brands in North America account for about two thirds of DEO’s sales. Sales in this group declined by roughly 2% in fiscal year 2014 and 2015, driving the bulk of DEO’s underperformance.
Consumer preferences in the alcohol market have shifted over the last few years, hurting demand in the company’s scotch, vodka, and beer categories.
DEO’s Smirnoff vodka over expanded into too many flavored varieties, which have seen demand fade. Consumers have instead favored whiskey, tequila, bourbon, and craft spirits. In beer, the rise of new craft brewers has also dented demand for the big brands. Interest in Captain Morgan and scotch has also declined.
As a result of shifting consumer tastes and an increasing number of brand choices, DEO’s U.S. market share declined every year between 2011 and 2014 (and likely 2015 as well). It is challenging to say if, when, and how these trends will evolve over the coming years.
Beyond North America, DEO has also been impacted by China’s crackdown on government corruption, which has reduced demand in the company’s premium spirits business in Asia. The company even had to write down some of its Chinese assets. Once again, it’s difficult to know how long it might take for this situation to play out.
Finally, it’s worth nothing that DEO is also under investigation by the Securities Exchange Commission (SEC) for potentially shipping too much inventory to distributors in order to boost near-term financial results.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. DEO’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
DEO’s dividend Safety Score of 58 suggests that its dividend is safer than most other dividend stocks in the market.
In its most recent fiscal year, DEO’s earnings payout ratio was 54%, which is a very safe level for such a consistent business.
Longer-term, we can see that DEO’s EPS payout ratio has remained very stable around 50%, indicating that its dividend growth has been driven by earnings growth. A stable payout ratio can also be a sign of a business that generates predictable earnings each year.
Source: Simply Safe Dividends
DEO’s business performed fairly well during the financial crisis. While DEO’s sales fell by 15% in 2008, its earnings only decreased by 11%. The stock ultimately returned -32% in 2008, modestly outperforming the S&P 500. The business appears to be more recession-resistant than many other companies because consumers will continue to drink alcoholic beverages in most economic environments.
Source: Simply Safe Dividends
From a profitability perspective, we can see that DEO has maintained high and stable operating margins, which is often the sign of an economic moat. In this case, DEO’s strong brands, pricing power, and economies of scale have helped it maintain excellent margins.
Source: Simply Safe Dividends
Not surprisingly, these same factors have helped DEO generate strong free cash flow every year. Free cash flow generation is very important because it allows a company to comfortably reinvest and return capital to shareholders without the assistance of capital markets.
Source: Simply Safe Dividends
Diageo plc (ADR) (NYSE:DEO) maintains a lot of debt on its balance sheet relative to its cash on hand, but the strong and stable nature of its cash flow mitigates much of this risk. Morningstar and Fitch have given the company an A- credit rating.
Source: Simply Safe Dividends
All things considered, we believe DEO’s dividend is very safe.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
DEO’s dividend Growth Score of 55 is slightly above average. The company’s low payout ratio and strong cash flow generation support its score.
DEO has increased its dividend for more than 10 consecutive years (excluding foreign currency fluctuations) and hiked its dividend by 9% during its last fiscal year. While DEO is not a member of the S&P 500, disqualifying it from ever being included on the list of U.S. dividend aristocrats, we think the company can continue raising its dividend by at least 3-6% per year over the long term.
As seen below, the company’s historical dividend growth rate in U.S. dollars has been in the mid-single digits.
Source: Simply Safe Dividends
Valuation
DEO trades at about 20x forward earnings, which is a meaningful discount compared to beverage companies Brown-Forman (Forward P/E 28.8x), Molson Coors Brewing Co. (24.6x), and Anheuser Busch (25x). The stock’s dividend yield is also 3.2%, which is meaningfully above its five year average dividend yield of 2.8%.
DEO clearly needs to show improving growth trends in its most profitable region (North America) to close the valuation gap.
If the company can get back on track, it looks cheap. A high-single digit earnings growth rate wouldn’t be out of the question (DEO’s 5-year earnings per share compound annual growth rate is 7.5%) and would potentially result in an annual total return of about 10%.
Conclusion
Diageo plc (ADR) (NYSE:DEO) is experiencing several challenges at the moment. Some appear to be controllable (e.g. better marketing / innovation / management of North American division), while others are more uncertain (e.g. consumers shifting away from big brands in favor of craft distilleries; flavored vodka losing share to whiskey and bourbon; strong U.S. dollar).
DEO has the marketing budget, brand strength, distribution channels, and global reach to get back on track, but the size of its struggling businesses means that a turnaround could take some time. The SEC’s investigation (DEO might have been shipping excess inventory to distributors to boost results) is another mark against the company, but it doesn’t necessarily impair the company’s long-term earnings and dividend growth potential.
Either way, we don’t see a rush to jump into the stock despite its stable cash flows and 3.2% dividend yield. However, if DEO traded down below $100, it would be hard not to give it more serious consideration for our Top 20 Dividend Stocks portfolio.
Disclosure: None
