Diageo – Should this Dividend Stock be invited to the party?

Introduction

Diageo is undoubtedly, one of the world leaders when it comes to spirit drinks. I would be willing to bet you have heard (or even drank) some of their top brands.

Johnnie Walker whisky, Smirnoff vodka, Baileys liqueur, Captain Morgan rum, Tanqueray gin, and Guinness. These are instantly recognizable worldwide brands. Can you guess which one is top of my list?

Diageo sells more than 200 brands which is an impressive feat. But even more impressive is that 23 of those features in the top 100 Alcoholic beverage brands. And 2 brands in the top 5. Born in 1997, Diageo has over 27,000 employees from over 150 sites worldwide. Their products are also enjoyed in 180 countries worldwide. Most of their production companies are based in Europe. They also have distilleries in the USA, Africa, India, Australia and China. If you are ever in Ireland, I recommend a visit to the Guinness Storehouse.

Diageo operates within 3 main Operating Segments

1. Global which makes up 39% of net sales
2. Reserve which makes up 21% of net sales
3. Local which makes up 20% of net sales

Business Analysis

Our ambition is to be one of the best performing, most trusted and respected consumer products companies in the world.

Diageo’s business is built around its Global segment which is made up of 6 of its best brands. The combined retail sales of these 6 brands alone are over £16 Billion. This makes up just under 40% of all revenue. This strong brand power leaves $DGE in a strong position because it would take a new entrant lots of time and cash to try and copy what they do.

In developed markets such as Europe and the US, Diageo focus is on people who like to drink quality products. These people are willing to pay a premium for these products. In Emerging markets, the focus is more on Local brands. However as these markets mature, Diageo encourages trading up to more premium brands.

As mentioned above Diageo’s brand power and scale would make it hard for new entrants. Evidence of this can be seen in the income statement where gross margins of 60% show that they have significant pricing power.

With that in mind, there is high competition at a local level due to craft spirits which are becoming as popular as craft beer. To Diageo’s credit, they recognize this treat and have released their own craft versions of gin in the European markets.

Company Growth

Revenue has been steady since 2011 as can be seen in the chart below but there was a drop in 2020 of roughly £1 Bln. This is due to the effects of covid-19 as stated by the CEO . Over the last 10 years revenue has increased with a CAGR of 1.69% while earnings have grown with a CAGR of 3.67%.

2020 Annual Report

For the full year, net sales were down 8.7%, driven by a decline in organic net sales. North America was hardest hit with an 8.4% decline. Operating profit was down nearly 50% which included impairments in India due to a regulatory change. They also had impairments in Ethiopia, Korea, and Nigeria.

Not surprising but net sales were down across most brands and categories, with the exception of:

1. Tequilla which was up 8%
2. Canadian whisky, up 8%,
3. US whiskey, up 3%
4. ready to drink, up 8%.

Organic net sales of the global giant brands were down 13%, driven by declines in Johnnie Walker and Guinness. Below is a snippet of the main financial summary from the annual report.

Dividends

As a dividend growth investor, dividend safety is important for me. It is extremely concerning that the FCF payout ratio was over 100%. This means that they did not generate enough cash to pay dividends to us shareholders.

Looking at the Dividend payout history we can see that the company has historically floated above the 60% FCF payout ratio. There have been times where it has gone above or close to 100%. I am not immediately worried but I do have some concerns.

My main concern is that we do not know how long COVID will impact this industry. The company has stated they will keep future returns of capital, including dividends, under review through the year ending 2021. This is a red flag for me as if we have sustained closures and revenues and earnings fall further, there will be sustained pressure on the ability to pay the dividend. Of course, the company could borrow in a low-interest environment to pay the dividend but that is less than Ideal if you look at the current balance sheet.

Balance sheet

One way to determine if they can weather the storm is to look at the balance sheet. Another Red flag for me is that they have been increasing their debt to £14 Bln. Some of the debt has been used for share buybacks but they also issued bonds to increase liquidity which affected the interest coverage.

Liabilities make up 70% of all the balance sheet which is not so bad as we are currently in a low-interest environment.but what happens if the interest rates increase? As a high leveraged company, the balance sheet is not as strong as i would like and is another red flag for me.

Would I buy this company?

Please see my disclaimer before reading on. These are my thoughts and are not to be used as investment advice. I am simply outlining my thought process when deciding if I should buy a company or not. Please do your own due diligence and check all data for your self.

At this moment in time, I could not recommend Diageo as a buy at this moment. In fact, if I did hold them I would possibly consider selling them. If you would like to hear our thoughts on why we would not but I would recommend listening to our podcast. We discuss Diageo from minute 7.00 until minute 28.00 if you just want to skip to the correct section

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Thank you for reading this far and feel free to drop any comments below on what you think of Diageo.

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