We re-examine our investment case on Diageo (DEO), with shares down another 10% since our last review in June, and review FY20 results released last month.
Since our initial Buy rating in July 2019, the U.K.-listed Diageo shares have lost 22.0% (after 112.4p in dividends), underperforming the FTSE All-Share. Diageo has also materially underperformed global Spirits peers including Pernod Ricard (Buy-rated) (OTCPK:PDRDF) (down 10% in local currency), Rémy Cointreau (Buy-rated) (OTCPK:REMYF) (up 22%) and Brown-Forman (not covered) (BF.B) (up 27%):
Buy Case Recap
Our original Buy case last July predicted a 8-10% annualised return for investors, based on the following:
- Diageo benefits from the structural growth in the global spirits industry, including premiumization and rising emerging markets consumption
- Diageo also enjoys competitive advantages from its range of historic brands, and economies of scale in marketing, distribution and innovation
- Management targets a 4-6% p.a. organic Net Sales growth and a 5-7% organic EBIT growth in FY20-22, implying 6-8% p.a. in EPS growth:
- Together, these provide a 8-10% p.a. shareholder return, consisting of an approx. 2% Dividend Yield, a 6-8% p.a. EPS growth, and share price growing in line with EPS from stable valuation multiples, which at the time included a P/E of 26.9x and a Free Cash Flow (“FCF”) Yield of 3.4%
- Potential further upside from more shareholder distributions, with Net Debt / EBITDA at 2.3x at December 2018 vs. 2.5-3.0x targeted by management
Diageo was our preferred name within the spirits industry due to its more balanced growth profile. Approximately 65% of its FY19 EBIT was generated in North America and Europe, providing a solid base, while its operations in APAC (especially India and China) were expected to provide strong growth:
Since then, Diageo shares have suffered a substantial de-rating, with its valuation multiples (based on pre-COVID CY19 financials) worsening by approximately 30% to a P/E of 19.1x and a FCF Yield of 4.2%.
H2 FY20 P&L Headlines
Diageo suffers particularly during COVID-19 due to the large percentage of its sales from “on premise” consumption in all regions except North America; e-commerce is still only a low-single-digit percentage of group sales.
Diageo’s H2 and full-year FY20 P&L are shown below. For H2 FY20 (January-June), sales were down 23% and EBIT was down 42% year-on-year organically, leading to pre-exceptional EPS shrinking by 46.0%:
During H2 FY20, marketing costs were reduced 26.6% year-on-year, other operating expenses were reduced 7.0%, but the EBIT margin still shrank by a fifth from negative operational leverage. There were also £1.3bn in total impairments, primarily from businesses in India (£0.8bn) and Korea (£0.4bn), but also from those in Nigeria and Ethiopia.
For full-year FY20, sales were down 8.2% and EBIT was down 14.3% organically, and pre-exceptional EPS was down 16.4% – a sharp reverse from H1, when EPS grew 4.1% year-on-year.
H2 FY20 Regional Breakdown
A breakdown of Diageo’s sales and EBIT for H2 and full-year FY20 is below:
Diageo Net Sales & EBIT by Region (FY20 H2 & FY)
Source: Diageo company filings.
H2 FY20 saw a 30-40% organic sales decline in every region except North America, where the “on premise” trade was only 20% of FY19 sales:
- North America is primarily a spirits business, and sales was up as strong at-home demand more than offset lost “on premise” sales.
- Europe & Turkey previously had 50% of sales in the “on” trade, and beer was hit particularly hard by the lockdown, down 20% in full-year sales.
- Africa was also badly hit as an “on-trade oriented” market, including South Africa, which was in total lockdown for more than 2 months and has an ongoing alcohol sales ban.
- LATAM & Caribbean had “widespread on-trade closures”; Mexico and Brazil are now re-opening, but restrictions remain in “most countries”
- APAC saw China affected for much of H1, then a 6-week lockdown in India, where the “on” channel remains closed
Travel Retail sales was also badly hit, and Diageo is doing “virtually no” business there at present.
For the group, the sales decline was steepest in Q4 FY20 (March-June), when sales was down “closer to 40%” year-on-year organically.
The picture for EBIT was similar, with North America EBIT actually up year-on-year, but most other regions’ EBIT down 25-30%, and Africa’s EBIT was down 56% as lower volumes were compounded by excise increases.
Diageo is “not providing specific revenue and profit guidance” for FY21, due to the many uncertainties on COVID-19 and the global economy. Instead, management expects a sequential revenue improvement in Q1 and Q2, but with H1 revenue still being “significantly impacted” compared to the prior year. H1 FY21 margin is expected to show “some sequential improvement” vs. H2 FY20, but will likely still be “diluted” vs. the prior year, due to lower revenues and also increases in marketing costs in anticipation of a recovery.
Long-Term Structural Story Unchanged
While the near term is full of uncertainties, both in COVID-19 restrictions and in potential economic recessions globally or in key markets, there is no reason to question the long-term structural growth story in the global Spirits sector.
Diageo has seen its organic EBIT growth accelerated in FY16-19, and it remained positive in H1 FY20 (June-December of 2019):
Diageo EBIT Growth by Component (FY09-20A)
NB. EBIT is before exceptional items. Source: Diageo company filings.
Diago’s EBIT growth has been broad-based by geography, with a large contribution from APAC, but also positive growth in the core markets of the U.S. and Europe:
Diageo EBIT Growth by Region (FY09-20A)
NB. EBIT is before exceptional items. Source: Diageo company filings.
Anecdotally, where there have been re-openings in the U.S. and in Europe, consumers have flocked to entertainment and sports venues enthusiastically and in large numbers. We expect the COVID-19 outbreak to be over eventually, and alcohol consumption to return to pre-COVID levels thereafter.
At 2,568.5p, on pre-COVID CY19 financials, shares are trading at a 19.1x P/E and a 4.2% FCF Yield; on FY20 financials, the figures are 23.6x and 2.7%:
Diageo Earnings, Cashflows & Valuation (FY16-20)
Source: Diageo company filings.
On either CY19 or FY20 financials, Diageo has de-rated significantly from last July, when the P/E was 26.9x and the FCF Yield was 3.4% (with respect to CY18 financials).
Dividends Likely to Continue
Diageo’s total Dividend Yield is 2.7% (69.88p per share), after management kept the final dividend flat year-on-year.
As shown above, the FY20 dividend was just covered by the company’s FCF during the year, which did not have the usual dividend payment from Diageo’s Moët Hennessy 34/66 joint venture with LVMH (OTCPK:LVMHF) (Diageo believes it is due £166m); the issue is currently in arbitration.
We believe the dividend is likely to be just covered by FY21 FCF as well, as we expect FY21 earnings to be only a low-single-digit percent down year-on-year.
Our expectation of continuing dividend payments is supported by management comments on the FY20 earnings call, which refer to Diageo’s £3.3bn cash balance, its £5.3bn in standby credit facilities and a willingness to exceed the leverage target temporarily:
“We’re maintaining our final dividend flat … when we get to interims and report at that period of time, we’ll be reporting a leverage ratio off of our 12-month trailing EBITDA … that will have been fully impacted by COVID. As a result, I expect our leverage ratio is going to peak at that point … we will see improvements as we go into the second half of fiscal 2021 and into fiscal 2022 …
We do have real financial strength. We’re an A-rated company … We’ve got £5.3bn of standby credit facilities. We ended the year with £3.3bn in cash. So I think we’re in a quite good position to continue to make balanced decisions … with regard to shareholder returns [and] ongoing investment”
Kathy Mikells, Diageo CFO (FY20 Earnings Call)
Diageo’s Net Debt / EBITDA rose to 3.3x at FY20 year-end, from 2.5x a year ago and higher than the targeted 2.5-3.0x. Buybacks have been suspended since April 2020 and will remain so “until leverage is back within our target range”. Moreever, the company was confident enough to announce the $610m acquisition of Aviation Gin (including $275m in earn-outs) in August.
Illustrative Returns Forecasts
Our illustrative returns forecasts are below, and are based on the following assumptions:
- H1 FY21 Net Income to be down 30% year-on-year
- H2 FY21 Net Income to be 10% lower than H2 FY19
- FY22 Net Income to be 5% below FY19, representing our expectation of lingering economic weakness in key markets
- Thereafter Net Income grows at 6.5% each year, representing the mid-point of management’s 5-7% EBIT CAGR target plus financial leverage
- Share count to be flat in FY21 as buybacks remain suspended, then falls by 1.5% each year; this drives post-FY22 EPS growth to 8.1%
- Dividend to be flat in FY21, then grows with EPS on a 50% payout ratio, the mid-point of management’s 1.8-2.2x dividend cover target
- FY24 year-end P/E of 24.0x, roughly flat from the current level and below the near-27x level in July 2019 (before COVID-19)
- The exit P/E of 24.0x is appropriate for one of the few “quality” U.K. stocks, and implies a Dividend Yield of 2.1%
With shares currently at 2,568.5p, the exit price of 3,637.1p and dividends imply returns of 12.1% annualised and 53% in total over the next 3.5 years:
Illustrative Diageo Returns Forecasts
Source: Librarian Capital estimates.
Diageo shares have lost 22% since last July when we initiated a Buy rating, due to COVID-19’s effect on “on premise” consumption.
H2 FY20 results (January-June) showed the full impact of the lockdown, with sales down 23% and EBIT down 42% year-on-year organically.
However, the final dividend was maintained (implying a 2.7% total Dividend Yield), and management comments support continuing payments.
Diageo’s earnings growth has been healthy up to H1 FY20, and the long-term structural growth story in the global Spirits sector has not changed.
At 2,568.5p, shares can deliver an annualized return of 12.1% and a total return of 53% in the next 3.5 years. We reiterate our Buy rating.
Note: A track record of my past recommendations can be found here.
Disclosure: I am/we are long DEO,PDRDF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.