Disclaimer: This article by The Globetrotting Investor is general in nature. I aim to bring you long-term focused analysis driven by fundamental data, hence, providing you commentary based on historical data and analyst forecasts only using an unbiased methodology. This is not a buy/ sell recommendation, and it is solely for educational purposes. Please do your research before investing. Note that my analysis may not factor in the latest price-sensitive company announcements or qualitative material. Please read the full disclaimer here.
Last Updated: 26 Aug 2024
NYSE: DEO
GICS Sector: Consumer Defensive
Sub-industry: Beverages - Wineries & Distilleries
Management
CEO: Debra Crew
Tenure: 1.2 years
Debra Ann Crew, the current Chief Executive Officer of Diageo plc, brings a wealth of experience to the role. With a career spanning decades in the consumer goods industry, Crew has held leadership positions at some of the world's most prominent companies, including PepsiCo, Mars, and Reynolds American.
Prior to joining Diageo, Crew served as Chief Operating Officer of Reynolds American and President of PepsiCo North America Nutrition. Her experience in brand building, general management, product development, and innovation has equipped her to navigate the complexities of the alcoholic beverages industry.
Crew's tenure at Diageo has been relatively short, but her appointment as CEO reflects the company's confidence in her ability to lead the organization through a period of significant change and challenges. As Diageo continues to navigate a volatile external landscape, Crew's experience and leadership will be crucial in ensuring the company's long-term success.
Looking broadly at Diageo plc’s management team, it has an average tenure of 2.9 years. It is considered experienced.
Business Overview
Diageo plc is a global leader in producing, marketing, and selling a wide range of alcoholic beverages. The company's diverse portfolio includes well-known brands like Johnnie Walker, Smirnoff, Guinness, and Tanqueray, offering products such as scotch, gin, vodka, rum, tequila, whiskey, beer, and non-alcoholic options.
A commitment to sustainability and innovation is at the core of Diageo's business. The company sources high-quality raw materials from around the world, often working with local suppliers to ensure environmental responsibility. Diageo continually innovates by introducing new products and experiences that align with consumer trends and preferences, whether it's a new flavor, a convenient packaging option, or a non-alcoholic alternative.
Diageo’s global operations encompass the distillation, brewing, and bottling of its spirits and beer brands, maintaining the highest standards of quality and efficiency. The company strategically transports its products worldwide, ensuring they reach markets efficiently, whether from a local distillery or an international shipping point.
Sales and marketing are crucial to Diageo's success. The company works closely with its customers, leveraging data and digital tools to expand its reach and enhance its sales performance. Diageo invests heavily in world-class marketing, guided by a strict code of conduct, to build and maintain vibrant, resonant brands.
Trends, Competition, and Strategy Overview
Trends
Total Beverage Alcohol (TBA) remains an appealing and resilient consumer category with a steady growth rate. From 2013 to 2023, TBA grew at a compound annual growth rate (CAGR) of 4.4%, while the spirits segment outpaced this with a 5.1% CAGR, according to IWSR.
Diageo identifies a long-term shift as consumers increasingly opt for spirits over beer and wine. This trend is driven by favorable demographics, the expanding middle class in key global markets, and strong premiumization trends, and it is expected to persist.
Premiumization significantly contributes to spirits' value growth, as consumers prefer higher-quality drinks. Over the past decade, premium and above spirits increased from 26% to nearly 35% of category value. The super-premium plus price tier, in particular, has grown more than twice as fast as other tiers, capturing an additional 700 basis points of share in international spirits retail sales value since 2013.
Strategies
Diageo has set an ambitious goal to increase its total beverage alcohol (TBA) market share from 4% to 6% by 2030. To achieve this, the company has outlined a strategic framework focused on efficient growth, value creation, credibility, and employee engagement.
A central aspect of this strategy involves unleashing the full potential of Diageo's diverse brand portfolio. The company seeks to solidify its position as the global leader in whiskey and tequila by leveraging its rich heritage and capitalizing on significant growth opportunities. Emphasizing local relevance, Diageo aims to win with consumer-focused brands that resonate deeply within local cultures.
Furthermore, the company continues to drive growth for Guinness, including its non-alcoholic variant, through innovative and asset-light models. Illustrating this approach, Johnnie Walker has expanded its market share across various price points, with launches like Johnnie Walker Blonde boosting presence in Asia Pacific and Latin America. At the same time, premium offerings such as Johnnie Walker Blue Label have gained traction through innovations like Xordinaire and Umami.
Executing these strategies with operational excellence is crucial for Diageo's success. The company enhances its brand-building efforts by investing smartly in advertising and promotions, ensuring resources support the right brands, locations, and channels. Strengthening commercial capabilities involves building strong execution partnerships, advancing digital merchandising, and refining sales processes, with a particular focus on the on-trade channel for exceptional brand experiences.
Three key enablers support these strategies: digitization, talent transformation, and an evolved ESG approach.
The company invests in digitization initiatives to transform marketing, commercial execution, and productivity. It also prioritizes talent development to ensure its employees have the skills and capabilities to execute its strategy. Finally, Diageo is committed to its ESG approach, focusing on maximizing impact while protecting its license to operate and grow.
Competition
A focus on quality, price, and consumer engagement characterizes Diageo's competitive landscape. In the spirits market, the company competes primarily with global players like Pernod Ricard, Beam Suntory, Bacardi, and Brown-Forman. Additionally, Diageo faces competition from regional and local companies in various markets.
Diageo competes globally and regionally in the beer market with major players such as AB InBev, Molson Coors, Heineken, Constellation Brands, and Carlsberg.
Diageo plc Economic Moat
There are many ways to identify Diageo plc’s economic moat, but I focus on these 5 sources. The rating is purely subjective and is based on my in-depth understanding of the company.
Economic Moat: Narrow
Diageo establishes a narrow economic moat, fortified by its strong intangible assets, cost advantage, and efficient scale.
The company's portfolio includes iconic brands such as Johnnie Walker, Guinness, and Tanqueray, which have established a deep emotional connection with consumers. This brand equity allows Diageo to command premium pricing and creates a barrier against competitors, ensuring sustained customer loyalty. These brands' heritage and consistent quality, built over decades or even centuries, contribute to Diageo's competitive edge in the spirits industry.
One of Diageo’s most significant intangible assets is its portfolio of aged spirits. These products benefit from a scarcity value, as the aging process reduces the quantity available for sale while enhancing the quality of the final product. This scarcity and consumers’ perception that aging improves taste and texture allow Diageo to maintain pricing power.
Brand loyalty is particularly strong in the aged spirits category, with high perceived product differentiation. Diageo leverages this loyalty through its brand families, offering a range of price points within each brand to appeal to different consumer segments.
Diageo’s non-aged portfolio is also formidable, with leading global brands like Smirnoff, Guinness, Baileys, and Crown Royal. The presence of these brands under one umbrella provides a competitive advantage, especially in the on-trade market. Licensed premises benefit from simplifying their supply chain by sourcing multiple categories from a single vendor. Diageo’s broad portfolio makes it a preferred supplier, enabling the company to leverage sales across its entire range of products.
Economies of scale further enhance Diageo’s competitive position. The company’s ability to procure raw materials such as barley, maize, wheat, and grapes across multiple categories at a lower average cost than its competitors creates significant cost advantages.
Furthermore, the alcoholic beverages industry, especially spirits, is characterized by high barriers to entry.
Stringent regulations, capital intensity, and the time required to build brand recognition make it difficult for new players to compete effectively. Diageo's established presence in key markets and extensive distribution network create a natural barrier to entry. The company's ability to efficiently scale operations across diverse geographies reinforces its dominant position.
While switching costs for consumers in the alcoholic beverages industry are relatively low, Diageo mitigates this through brand loyalty and premium positioning. The psychological switching cost associated with abandoning a trusted brand can be significant, especially for high-end products where the brand experience is vital to the value proposition.
Diageo plc Performance
My quick performance checklist:
Has Diageo plc's revenue consistently grown year over year for the past five years? It grew from the fiscal year 2020 to 2022 but remained relatively flat after that.
Is the net income consistently increasing year over year for the past five years? It grew from the fiscal year 2020 to 2023 but dipped in 2024.
Has the cash flow from operating activities shown consistent year-over-year growth for the past five years? No, it is inconsistent.
Has the free cash flow remained positive for the past five years? Yes.
Is the gross margin % consistent or growing over the past five years? The gross margin has stayed consistent at around 60% over the past five years.
Has the EPS shown growth over the past five years? It grew from the fiscal year 2020 to 2023 but dipped in 2024.
Diageo's recent performance has been mixed. Despite successful price increases reflected in a positive price/mix, overall net sales declined due to unfavorable currency exchange rates, a small decrease in organic sales volume, and the impact of acquisitions and disposals.
The main culprit behind the decline in organic sales was a significant drop in Latin America and the Caribbean (LAC), fueled by a fast-changing consumer environment and high inventory levels. Weaker consumer spending and the effect of prior-year inventory build-up in North America further contributed to the slowdown. However, excluding LAC, organic sales grew slightly.
Despite the sales decline, Diageo's reported operating profit grew, primarily due to exceptional operating items. However, organic operating profit decreased, reflecting lower organic sales and increased investments in strategic capabilities. These investments focused on areas like digital marketing, strengthening distribution channels in the US, and overall marketing efforts.
Has free cash flow per share increased over the last five years? It is inconsistent.
Management Effectiveness
Has Diageo plc's ROE stayed within or above the 12%-15% range year over year for the past five years? Yes.
A stronger ROE relative to the industry suggests effective management. This implies the company is efficiently utilizing its resources to generate profits at a higher rate than competitors.
Has the ROIC stayed within or above the 12%-15% range year over year for the past five years? No.
When a company's ROIC is greater than its WACC, it signifies that the company is generating returns on its investments that are higher than the cost of financing those investments. In simpler terms, the company is making more money on its projects than it costs to fund them. This indicates efficient capital allocation and value creation for shareholders.
The trendline for the number of shares outstanding is declining, which would please an investor.
Diageo successfully executed its share buyback program during the fiscal year ending 30 Jun 2024. The company repurchased 28 million ordinary shares, representing approximately 1.1% of its issued share capital, at an average price of 2918 pence per share, for a total cost of $987 million, including transaction fees. The shares purchased were subsequently canceled.
This buyback program was part of a broader capital return initiative, which also included the return of $0.6 billion to shareholders in the previous fiscal year.
Diageo's ordinary shares are primarily traded on the London Stock Exchange, while its ADSs are listed on the New York Stock Exchange. One ADR is equivalent to four ordinary shares.
Diageo plc Financial Health
Current Ratio: 1.5 (pass my requirement of >1.0, but <3.0)
I use the current ratio instead of the quick ratio to analyze the company’s liquidity. This is because I want a general overview of financial health and the company’s inventory is a significant asset and easily be converted to cash.
A declining ratio suggests the company has fewer current assets relative to its current liabilities. This could make it harder to pay off bills on time.
When compared to its industry, Diageo plc's current ratio is worse, as it is below the industry median of 1.7.
Debt-to-EBITDA: 3.1 (fail my requirement of <3.0)
This ratio measures a company's ability to pay off its debt with its operating income. A higher ratio may indicate higher financial risk, while a lower ratio suggests more manageable debt levels relative to earnings.
I use the debt-to-EBITDA ratio instead of the net debt-to-EBITDA ratio because I want a straightforward view of the company's gross leverage, focusing on the total debt burden without accounting for cash reserves.
Debt-to-EBITDA can present a more conservative view of a company's financial risk by not considering cash. It is useful for me to understand the worst-case scenario regarding the company's ability to service its debt. Also, it helps that every company has different cash management strategies.
Diageo plc’s debt-to-EBITDA ratio has decreased over the past five years. The decrease was due to higher EBITDA, which is usually a good sign.
A lower ratio makes the company a more attractive borrower to lenders. This could translate into better loan terms and lower interest rates in the future.
As the ratio decreases because EBITDA has increased, it reflects the company’s improved profitability and operational efficiency.
When compared to its industry, Diageo plc's debt-to-EBITDA ratio is worse, as it is above the industry median of 1.7.
Interest Coverage: 5.3 (pass my requirement of >3.0)
Debt Servicing Ratio: 27.6% (pass my requirement of <30.0%)
Diageo plc Intrinsic Valuation
Estimated intrinsic value: USD $57.04
Value is calculated using the discounted cash flow method (considering their cash and debt) and scenario planning.
Average free cash flow used: USD $2,800M
Projected growth rate: 5%
Beta: 0.6
Discount rate: 6.0%
Ideal margin of safety: 50% (Uncertainty: High)
Price range after the margin of safety: <USD $29.00
Date of calculation: 26 Aug 2024
I use the past 5 years' free cash flow and apply a weighted average, giving more focus on the recent years. I then round the average to the nearest tens. In some instances, I use a more realistic number to represent the free cash flow.
The total debt and cash and short-term investments are the last quarter figures that are rounded to the nearest tens. In some instances, I use more realistic numbers to represent them.
Diageo plc Relative Valuation
My Concerns
Like any global business, Diageo faces a range of risks that could impact its operations and financial performance. Geopolitical forces and macroeconomic volatility primarily drive these risks.
Geopolitical events, such as ongoing conflicts in Europe and the Middle East, can create instability and disrupt supply chains. Furthermore, global inflation, debt crises, and energy price shocks can put pressure on public finances, leading to tax increases that could negatively affect consumer spending. Public health concerns may also restrict alcohol marketing or sales, while trade tensions and fiscal pressures could lead to trade barriers or disproportionate tax increases.
To mitigate these risks, Diageo has increased its advocacy efforts to challenge ineffective and discriminatory tax policies. The company also actively engages with international organizations to promote positive drinking practices while avoiding discriminatory policies against its products.
Beyond geopolitical factors, macroeconomic stress can increase the likelihood of domestic and international tensions, disputes, and unrest. A significant disruption to Diageo's business due to external events, such as a pandemic, war, or natural hazard, could restrict access to its products, negatively affect operations and brands, or pose a threat to employee safety. These disruptions could have a detrimental impact on the company's performance.
Supply chain disruptions are another critical risk factor for Diageo. These disruptions can stem from demand volatility, geopolitical tensions, severe weather events, macroeconomic conditions, cybersecurity threats, supplier failures, and regulatory changes.
Although the global supply chains have become more resilient since the pandemic, the potential for material shortages and supplier insolvency remains a concern. Such issues could lead to longer transit times and negatively affect Diageo’s ability to maintain its commercial and financial stability.
Consumer demand for alcoholic beverages is also subject to uncertainty. Short-term demand can be impacted by macroeconomic volatility, such as inflation and cost-of-living crises, which can adversely affect consumer priorities and spending power. Longer-term demand is being shaped by factors like digitalization, changing social habits, health and lifestyle priorities, new competitive adjacencies, and a growing desire for moderation. Diageo's ability to adapt its products and processes to these evolving market forces will be crucial to maintaining its market position.
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