Diageo PLC – LSE:DGE

Company Background

Diageo is a global leader in alcoholic drinks with an outstanding collection of brands across spirits and beer. It was formed in 1997 from the merger of Guinness and Grand Metropolitan, and it has its headquarters in London. 

The company sells around 200 brands of alcoholic beverages in more than 180 countries across the world.  Diageo has renowned brands such as Guinness, Tanqueray, Smirnoff, Johnnie Walker or Baileys. The US is its primary market, along with Europe and Pacific Asia. The vast majority of its distilleries are in Europe where it has 29 in Scotland. It owns ten production facilities in North America, 12 breweries in Africa, 20 manufacturing facilities in India as well as distilleries in China and Australia.

Diageo is a company which has increased its dividend during the last 30 years. 

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Description automatically generated
Company data (17/04/20)
 Market Capitalization$62 Bill
Revenue FY19$12’867 Mill
EBITDA$4’490 Mill
Debt$14’333 Mill
P/E21

What is the business of the company?

Diageo’s business is based around a portfolio of iconic spirits and beer brands. It has an enviable collection of brands with many loyal customers around the world. 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. Scotch represents around 25% of its sales, beer 16% and Vodka more than 10%. 

Diageo uses its distribution network to sell in Europe and in the US. That approach varies when tackling emerging markets, where it trusts on third parties to produce and commercialise its brands.

Diageo’s strategy is focused on understanding their customer habits and preferences. Based on that understanding, Diageo has segmented its brands into three distinct categories: Global, Reserve and Local. In the US and Europe, people increasingly want to drink better quality products, and they are ready to pay higher prices to do so. Consequently, Diageo tries to take advantage of this trend by positioning its Reserve brands in those markets. In emerging markets, there is a significant focus on local brands, but also much effort is placed on encouraging the growing middle-class populations to trade up to more premium brands.

Diageo is constantly developing analysing the consumer habits in order to improve its portfolio, either by creating a new collection of its most trending gin adding new flavours or pursuing new opportunities to enter in new markets as wine.

Investment Thesis

Diageo is a company with a high MOAT due to the fact that its distribution network and brands are difficult to replicate. In addition to that, the company can maintain a 4-5% organic growth/year due to the increment of people who have access to its brands and the increase of drinking awareness, which make people to choose its renowned brands instead of choosing others. Diageo is well-positioned in developing countries, where this trend is increasing the most. Diageo’s net margin is close to 25%, which shows the easiness that the company has to transform 1 pound of revenue into profits for the shareholders. Moreover, it is a stable company which has reasonable debt rates (1.72%)

Markets overreacted to COVID-19 as Diageo has continued obtaining revenues due to the high volume of sales due to retail consumption. This bring us the opportunity of buying a high-quality and stable business much cheaper than its fair price. It is a fact that the business which are able to obtain a higher ROCE, people are willing to pay higher P/E rates. Diageo has a competitive advantage which is going to allow it to maintain its previous cash-flows in the future, as a consequence of:

  • The loyalty of its customers towards its brands, 
  • The increment of retail sales 
  • The increment of population in developing countries

Catalysts 

  • Diageo is a defensive stock due to its ability to continue selling its brands even in spite of being suffering COVID-19. (People depressed/sad drink more alcohol)
  • Diageo is established in developing countries which are facing a vast increment in their population size
  • Growing awareness, people prefer to buy renowned brands instead of drinking others
  • Growing in wine 
  • It is carrying out a buyback program until 2022

Valuation

  • It is forecasted a diminution of 20% in its revenue for 2020 and a three-year recovery to reach 2019’s revenues
  • Working capital requirements are also high. To be classified as scotch, a whisky has to be matured for at least three years
  • Capex investment around 600 Mill next 10 years (as it has been the last 5)
  • Increments in working capital similar to the last 5 years
  • Assumption of 2% long-term growth 
  • WACC 5.19%
  • Taxes 22.37%
  • Diageo’s Beta (0.68), Beta applied in the DCF model (0.75)
  • Sterling rate against dollar constant at 1.25 ; Sterling against Euro 0.88

Risks: 

  • Competitors can make Diageo lose market share 
  • Health concerns
  • Regulatory framework in developing countries
  • Increasing competition in draft beers 
  • Currencies (Diageo has presence in more than 180 countries)

Results:

We find that. Diageo is a stable company within a sector which is expanding and where it is one of the main players. It is difficult to forecast a revalorization of more than 50% in the next five years due to its size and current organic growth of 4%. However, we believe that Diageo has a potential growth of 23%, taking into account the current price of 26.16. Level of risk – standard

Annex:

Property of Diageo
Property of seeking Alpha

Disclaimer: This analysis is not a buy recommendation. This is only my point of view about the expected FCF of the company in the future with the information I have.