Diageo: A market leader with room to grow.
I like companies that are market leaders, I like companies that has plenty of growth ahead, and I like companies that are taking market shares. Diageo is a company that does all the above, while it also has a strong moat and should perform relatively well during a recession. It all sounds promising but is now the time to add Diageo to your portfolio? It is what I will investigate in this analysis.
This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should mention that at the time of writing this analysis, I do not own shares in Diageo. If you would like to copy my portfolio or see the stock in my portfolio, you can read about how to do so here. I don't own shares in any of their direct competitors either, but I have shares in Ambev, which is a Brazilian brewery. I should also mention that Diageo has been on my watch list for years, so it is a company that I like. Nonetheless, I will keep this analysis unbiased. Diageo is listed in both the United States and United Kingdom. In this analysis, the numbers and calculations will be in U.S. dollar because it is what eToro use, which is where I buy shares. Should I buy the shares though, I will buy the UK listed shares though, as there is no withholding tax on dividends.
Diageo was founded in 1997 from the merger of Guinness plc and Grand Metropolitan. It is headquartered in London, England, United Kingdom. It is a global leader in the beverage alcohol industry with more than 200 brands across spirits and beer. Their products are sold in more than 180 countries around the world. Their largest market is North America with 39,6 % of total net sales, followed by Europe (20,9 %), Asia Pacific (18,7 %), Africa (10,9 %), and Latin America & Caribbean (9,9 %). Diageo also has a joint venture with LVMH Moët Hennessy - Louis Vuitton in which they own 34 % of their share in the Moët Hennessy joint venture, which contributed with 10 % of their profits before taxes. Diageo has a strong brand moat, which is exemplified by owning two of the world's largest international spirits brands by retail sales value in Johnnie Walker and Smirnoff. Diageo also owns brands like Guinness, Baileys, Tanqueray, and Don Julio.
Their CEO is Sir Ivan Menezes. He joined Diageo in 1997, where he held various positions until becoming the CEO in 2013. Prior to joining Diageo, he worked across a variety of roles of sales, marketing and strategy roles for Whirlpool in Europe, Booz Allen & Hamilton in North America, and Nestlé in Asia. He has an MBA from Northwestern University's Kellog School of Management, a post-graduate degree from the Indian Institute of Management, Ahmedabad and a BA in Economics from St. Stephen's College, Delhi University. Besides being the CEO of Diageo, he also serves as a non-executive director at Tapestry, he is the Vice Chairman of the Scotch Whisky Association Council and sits on the Advisory Council of the China-Britain Business Council. Sir Ivan Menezes is regarding highly for his leadership, and author of the book "The Nine Types of Leader: How the Leaders of Tomorrow Can Learn from the Leaders of Today, James Ashton uses Sir Ivan Menezes as an example of good leadership in an interview as he said: "Look at Ivan Menezes who stripped out extraneous costs and thrown that money into marketing. At a certain point fixing just becomes good leadership". Sir Ivan Menezes has also been named the EMpower Executive Role Model in 2021, while he got knighted in 2023 for his services to business and equality. He scores an 83 employee rating at comparably, which is in the top 5% of similar sized companies. I feel very confident in Sir Ivan Menezes leading Diageo moving forward.
I believe that Diageo has a brand moat. Furthermore, I feel very confident with the management as well. Now let us investigate the numbers to see if Diageo lives up to our requirements for a strong moat. In case you want an explanation about what the numbers are, you can have a look at "MY STRATEGY" on the website.
The first number I will investigate is the return on investment capital, also known as ROIC. Ideally, you would like to see a ROIC above 10 % in all years. Diageo has delivered a solid ROIC above 10 % in all years except for 2020, which was during the heights of the pandemic. It doesn't concern me much that ROIC post-pandemic hasn't quite reached the levels of the ROIC pre-pandemic, as they are still above the required 10 %, and countries like China, which is 5 % of Diageo's net sales, has been on lockdowns through 2022. Personally, I'm very happy about seeing numbers like these when investing in a company. Later, in the analysis I will share the ROE, which is even more impressing.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. The equity has decreased since 2018 but it isn't something I'm worried about. The decrease since 2018 is because Diageo sold 19 brands to Sazerac Company. Besides that, we have also had a pandemic that has taken its toll on equity. I'm encouraged that Diageo seems to be back growing their equity post-pandemic.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. What springs to mind is that the free cash flow is not positive in all years, which is always nice to see. Furthermore, Diageo has delivered their highest free cash flow in the last two years. Free cash flow did decrease a bit from 2021 to 2022 but the yield is steady. I would like to see Diageo reaching a free cash flow yield above 4 % again at some point but all in all, I'm comfortable with these numbers.
Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years by calculation long-term debt to earnings. Doing the calculation on Diageo, I can see that Diageo has 4,46 years earnings in debt, which is above the limit of 3 %. It is a bit higher that I would like to see, and while it isn't alarming yet, it is something that needs to be monitored. The high debt affects the ROIC of Diageo. Below, you can see the ROE in the last 10 years, which will give you an idea of how the debt has affected ROIC.
Like every other investment there are risks when investing in Diageo. One risk is macroeconomics. In his letter to shareholders, Chairman of the Board, Javier Ferrán mentions that their supply chain has been impacted by inflationary pressures as high energy costs affects their suppliers and operations. While CEO Ivan Menezes in his letter to shareholders mentions that the operating environment is challenging with headwinds from inflation, supply chain and geopolitical events. Hence, challenging macroeconomics may affect the results of Diageo. Another risk is the debt. Diageo's higher than desired debt has affected the return on invested capital, as we saw previously. High debt is a big deal,
in his book Rule # 1 investing, Phil Town mentions the following on debt: "A business that is carrying a lot of debt relative to its income has an unpredictable financial future. If there are any problems with the economy, a business with a lot of loans might be in big trouble". I think that Diageo will do just fine but debt is something that needs to be monitored. another risk is Competition. In their annual report Diageo mentions that they are facing substantial competition from several international companies as well as regional and local companies. They particularly mentions that there has been a recent increase in competition for distribution channels, most notably e-commerce channels, and that these trends may lead to stronger competition as it could negatively impact Diageo's distribution network.
There are also a lot of potential for Diageo moving forward. A growing addressable market. Diageo expects that by 2032 an additional 600 million consumers are expected to come of age to buy their products. Furthermore, according to Diageo, the growth of the middle class and above income bracket should enable another 600 million customers to purchase their brands by 2032. Finally, spirits penetration with current customers remains low and in the United States, which is their largest market, only 50 % of the households purchase spirits every year. A higher penetration rate, a growing middle class, and more people should significantly increase Diageo's addressable market. Winning market shares. Diageo is growing larger than the alcohol beverage market in both developed and emerging markets. It is due to the premiumization trend, as the highest price tiers growing more than double the overall international spirit's market. Diageo has the largest premium-plus business within international spirits, and the segment now comprises over half of their net sales. Currently Diageo has a 4,6 % market share of the global total alcohol beverage industry, and management has set a goal that the market share should reach 6 % by 2030. Should do fine during inflation. Diageo should perform relatively well during inflation due to their pricing power. Their last reported fiscal year ended 30th June 2022, and Diageo managed to grow their gross profit margin from 60,4 % the year before to 61,3 %. It means that their strong brand recognition means that they can pass on extra costs to their consumers. Hence, higher costs can be passed on to the consumers, so Diageo can keep their margins and profitability in place.
All right, we have gone through the numbers, potential and risk regarding Diageo, and now it is time for us to calculate a price for Diageo. To calculate price, we will need numbers that I have explained in the "MY STRATEGY" section of the website. I do not want to go through the whole calculation here. I chose to use an EPS at 5,59 which is the one from fiscal 2022. I chose an Estimated future EPS growth rate of 12,5 % (which is the consensus the analysists expected growth rate from Finbox), Estimated future PE 16 (which the double of the growth rate, as the historically PE for Diageo has been higher) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY", we come up with the sticker price (some call it fair value or intrinsic value) of $112,18, and we want to have a margin of safety on 50 % , so we will divide it by 2 meaning that we want to buy Diageo at price of $56,09 (or lower obviously), if we use the Margin of Safety price.
Our second way to calculate a buy price is the TEN CAP price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. The Operating Cash Flow last year was 3.935. The Capital Expenditures was 1.097. I tried to look through their annual report to see, how much of the capital expenditures were used on maintenance. I couldn't find it though, so as a rule of thumb, you expect 70 % of the capital expenditures to be used on maintenance, meaning we will use 767,9 in our further calculations. The Tax Provision was 1.049. We have 2.279 outstanding shares. Hence, the calculation will be like this: (3.935- 767,9 + 1.049) / 2.279 x 10 = $18,50 in TEN CAP price.
The last calculation is the PAYBACK TIME. I also described in "MY STRATEGY". With the Free Cash Flow Per Share at 4,75 and a growth rate of 12,5 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $62,21.
Diageo is an interesting company. They have a high moat, a good management, is winning market shares, and their addressable market seems to be growing much larger. They are facing some short-term risks when it comes to macroeconomics. While I think that competition is a more long-term risk when it comes to their beer segment, as craft beer is a trend I don't see reversing. The beer segment is 15 % of their net sales. Nonetheless, I would love to add Diageo to my portfolio, as I believe it could be a long-term compounder that I would feel comfortable holding for many years. I don't think it will be realistic to ever get to buy Diageo at a 50 % discount to intrinsic value. Personally, I will give Diageo a look if it reaches the intrinsic value of my highest calculation. Currently, it is the PAYBACK TIME price, where the intrinsic value is $124,42. How big a discount you want to have, is up to you.
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