The takeover of SAB Miller is set to leave only one beverages company left in the FTSE 100. Diageo should, though, be more than capable of holding the fort given its portfolio of global brands. The company is the world’s largest producer of spirits and saw volume growth return in the six months to December 2015.
In the fable of The Tortoise and the Hare the overconfident hare takes a nap during the race and fails to wake up on time. This enables the plodding tortoise to win despite being much slower than its competitor.
The consumer staples sector – tobacco, food, beverages, home & personal care – matches the performance of the tortoise. Volume growth for these everyday consumer items is modest but they continued to be bought in difficult times.
Over the long-term the consumer staples sector has outperformed the other nine sectors (What Works on Wall Street). Racier areas - such as banking, mining and energy - have occasionally suffered from significant value destruction.
Within this context it is notable that the six FTSE 100 consumer staple groups have all outperformed the index. Clearly it pays to invest in companies that “plod along” and hold their own over the long-term.
Diageo is one of the UK’s leading consumer staple companies and is globally diversified. The bulk of revenue comes from spirits with a quarter of net sales in the first half from Scotch – whiskey made in Scotland.
Scotch makes up a quarter of Diageo’s net sales
Source: Diageo investor presentation
The trouble for Diageo is that organic volumes fell back in the two years to June 2015. However, the group returned to organic volume growth in the six months to December 2015 on the back of emerging market demand.
Selling Scotch to China, India and Latin America should be a winning formula over the long-term. Diageo’s key brand should also serve it well and include Smirnoff, Captain Morgan, Baileys, Tanqueray and Guinness.
Diageo profile
The most important market for Diageo is North America with it generating 45% of operating profit in the first half. This was followed by Europe, Russia & Turkey at 25% while Asia Pacific was only 13%.
Diageo’s profile: six months to December 2015
Source: Diageo investor presentation
There is therefore plenty of scope for Diageo to grow its presence in key markets like India. Diageo has a 54.78% stake in the Indian group United Spirits and has listed subsidiaries in a number of emerging markets.
In terms of the product portfolio and Scotch was the largest contributor at a quarter of net sales in the first half. The rest of the portfolio is mainly made up of a diverse range of spirits that include Tequila, Rum, Gin, Liquor and Vodka.
Diageo by drinks
Source: Diageo report
The group recently sold some of its wine interests because wine no longer considered part of its core portfolio. The most recent large acquisition was for Tequila Don Julio which is a premium tequila brand produced in Mexico.
Volumes start to recover
Recent trading at Diageo has been tough with earnings per share hitting a peak of 104.4p seen in the year to June 2013. In the year to June 2014 earnings per share came in at 95.5p and in the year to June 2014 they were 88.80.
Organic volume (the amount of spirits sold) fell back in the year to June 2014 and the year to June 2015. However, we have started to see this turnaround with a 1% increase in organic volumes in the six months to December 2015.
Returning to growth in the six months to December 2015
Source: Diageo investor presentation
Organic net sales showed a 1.8% improvement in the first half of the current year versus a flat performance in the year to June 2015. This was driven by emerging markets which saw a 4.4% jump in organic net sales in the first half.
This is likely to remain a feature of the results going forward given the relative maturity of developed markets. However, Diageo has robust brands and so will continue to deliver strong operating margins in mature markets.
Source: Diageo investor presentation
Diageo’s financial performance
The turnaround in organic sales volumes in the first half wasn’t accompanied by an improvement in earnings per share (EPS). Foreign exchange headwinds and business disposals meant that EPS fell by 4% in the first half to 51.3p.
The organic operating margin also improved by 16 basis points to 30.63% excluding the foreign exchange impact. The return on invested capital fell to 13.9% to 14.6% last year due to disposals and the FX headwind.
Diageo was confident enough to increase its interim dividend by 5% to 22.6p (ex-dividend 25th February). The group also saw net debt fall to £9.2bn at December 2015, from £10.7bn at the start of the year, due to business disposals.
Summary and valuation
Diageo’s shares hit a high of £21.36 in August 2013 and today trade at around £19. This weakness is understandable given falling organic sales volumes and earnings per share over the last couple of years.
In our view, there is evidence that Diageo is now turning a corner with a return to organic sales growth in the first half. However, the foreign exchange headwind is likely to remain in place for some time to come.
Looking at the valuation and for the year to June 2017 the forecast P/E is 19.8X while the dividend yield is forecast at 3.3% (1.5X covered). The forecast P/E is expected to fall to 15.2X by the year to June 2020.
Whether this expensive or not is debatable but the quality of the consumer staples sector is hard to dispute. In our view, Diageo will outperform over the long-term given its market-leading portfolio of global spirit brands.
This report was produced by Fat Prophets Senior Analyst, Andrew Latto