Value Investing Thesis - Diageo

Analysis of Diageo

I would buy Diageo (ticker symbol DGE on the London Stock Exchange) at a price of £5,5 or less per share because I understand Diageo; it’s good; and at £5,5 per share, it’s inexpensive. The company has performed well historically, has a fragmented customer and supplier base and is protected from competition through a portfolio of world-class brands. The company is also shareholder friendly and operates on a growing market. 

Diageo is a public limited company headquartered in London, operating in the alcoholic beverages industry. It was formed from a merger between Grand Metropolitan and Guinness in 1997. The Company is engaged in the production, importing, marketing, and selling of beverage alcohol with brands in spirits, beer and wine. Diageo’s customers are the businesses that distribute and retail their brands to consumers. The company operates globally as 21 geographically based markets around the world, with locally adapted route-to-market models and supply chains. The markets are designated either as import markets, import and third party production markets, or import and local production markets. As an alcoholic beverage company, Diageo is subject to heavy regulation and taxation across is local markets. Diageo also distributes products through joint venture and associate agreements. Diageo’s largest region is North America, which represents 32% of the net sales. Europe represents 24% of net sales, Africa 13%, Latin America and Caribbean 10% and Asia Pacific 21%. Merger and acquisitions have traditionally been an inherent part of the company strategy when expanding globally. The company owns an array of strong brands in the spirits, wine and beer categories. Spirits represented the largest category of total Diageo sales in 2014 with 76% of total net sales in 2014. Beer represented 20% and Wine 4%.  The brands span across categories and price points. Global giants (e.g. Smirnoff and Guinness) represent 39% of Diageo’s net sales, local stars (e.g. Bundaberg in Australia), 16% and Reserve brands (super premium brands 13% of net sales. Diageo is the leading companies in terms of spirit, with 26% of global spirit sales. Its global beer sales, its sales do however only amount to 1% of global sales. Despite its leading position, Diageo’s sales growth has underperformed in the two recent years, namely due to the consequences of the numerous (and hasty) acquisitions made by the former CEO Paul Walsh and also falling consumption in North America and Europe. The strategy has therefore shifted to consolidate the business and focus on its core – the premium spirits brand. Diageo has therefore sold off most of its wine business during the year, together with small beer brands, no longer deemed to be part of the core.

Historically, Diageo has performed very well. When calculating operating profit, I adjusted operating profit with the impact of exchange rate movements and acquisitions and disposals during the year, as I deemed these not to be part of the company’s core operations. I also adjusted for “exceptional operating items”, which items like included brand and tangible asset impairment, due to the same reason. Also, I chose not to adjust the operating income with JV and associate sales, since these only have made up approximately 2% of net sales throughout a five-year period.  In order to be prudent, I used the ROIC with cash (which was lower than ROIC without cash) The average ROIC, including cash, for the period 2011 to 2015 was 27% and the lowest ROIC during the period was 23% in 2012. As a business is generally perceived to be good when it generates RIC over 15%, Diageo performs very well on this metric. I calculated the FCF by subtracting the purchase of property, plant and equipment and computer software from net cash flow from operating activities. The average FCFROIC, with cash, for the same five year period was 13% and the lowest FCFROIC was 9% in 2014. This is well above the limit of 7%, which is demmed to be “good”.  The compounded annual growth rate (CAGR) per fully diluted share for Operating Earnings, Free Cash Flow, Book Value and Tangible Book Value are 2%, 2%, 10% and 28% respectively. The first two numbers are not very high, mainly due to stale growth in Diageo’s Western markets. However, considering that the average inflation rate in the world to be around 2%, it seems to be a good business. The high numbers for tangible book value growth can be attributable to the many acquisitions that Diageo undertakes, which involve high amounts of intangible assets in the form of brands and goodwill. The company had a liability to equity ratio of 159% in 2015, which is significant but not overwhelming. To sum up, the business seems to have performed well despite a slow-down the last two years.