Investors should drink to Diageo’s growth

Over the years investors have become very fond of global drinks giant Diageo’s (LSE: DGE) shares as well as its brands, which include Johnnie Walker, Gordon’s Gin and Guinness. A history of rising sales and dividends has kept the market happy.

But disruption from Covid-19 appears to have undermined Diageo’s reputation for reliability. The group’s annual results earlier this month left the market unimpressed and the shares down by over 10%.

It’s not just that the market was expecting better than the 8.4% fall in sales to £11.8bn for the year to June. The shortfall also appears to have prompted questions about whether Diageo is quite as resilient as widely assumed.

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It has long been an outperformer, earning its “premium” stockmarket valuation because its well-established and diverse drinks range is seen as strong in the face of economic ups and downs. But this year the shares have failed to shine compared with the FTSE 100 index; they have slid by 16%.

The nervousness seems overdone, however. Diageo may not have lived up to the expectations of a group of analysts on this occasion, but does it matter in the midst of a pandemic? Given none of them has ever before experienced a global economic shutdown, they are arguably just as clueless about the future as the rest of us. Any worries about Diageo’s resilience could prove short-lived as the recovery gains momentum around the world and the business gradually regains its footing.

A bold decision

A sign of Diageo’s own confidence that things will get back to normal is the bold decision to lift the dividend despite the difficult trading. Some commentators had cautioned that there could be a cut. The shares now yield over 2.7%, a strong draw for many investors seeking a progressive income that is well supported by cash flow and has been growing much faster than inflation (at more than 4% a year) over the past decade.

Certainly, before the lockdown it had been business as usual. The group talks of a “good, consistent performance” in the first half of its financial year, before Covid-19. And despite the pandemic, the North America business managed to lift sales 2% for the year as a whole, thanks largely to a 36% jump in tequila sales from its Don Julio and Casamigos labels, along with growth in pre-mixed drinks such as Smirnoff vodka fruit seltzers. However, sales in the region are heavily skewed towards supermarkets and stores. Diageo’s other markets depend more on bars and restaurants.

Meanwhile, early signs following the end of the financial year in June are positive. Chief financial officer Kathryn Mikells has spoken of an improvement in July compared with June and enough recovery in sales volumes coming through to make up for the economic downturn.

Drinks never go out of style

News from some of Diageo’s rivals also bodes well. In France, for example, both Pernod Ricard – which owns Beefeater gin – and Rémy Cointreau said the pandemic would affect their businesses less than originally believed.

Just as the pandemic is unique, there is scant knowledge of consumers’ psychology and behaviour after such lengthy, isolating lockdowns are eased. Some people say they enjoyed the tranquillity, while for others it has left scars. We’re in uncharted territory.

Pubs and restaurants are slowly gaining ground and while some cities might still be ghost towns, anecdotal evidence suggests suburban and village pubs are doing much better. Tourists, big sport and all manner of events will be back too. Drinks are key to social interaction, which will intensify as the pandemic eases, making Diageo a solid long-term bet on getting back to real life.

Diageo: a dependable and diversified giant

Valued at over £61.5bn, London-headquartered Diageo is a leading global alcoholic drinks business selling in 180 countries. It was created relatively recently, in 1997, emerging from the merger of two major players, Grand Metropolitan and Guinness.

Its history goes back much further: Haig Scotch whisky first appeared in 1627, for instance, while Arthur Guinness started brewing ale in Dublin in 1759. Diageo also has interests in established brands such as Hennessy Cognac, Moët & Chandon, Krug, Veuve Clicquot and Taylor’s Port. This is due to a joint venture with Moët Hennessy, which is owned by the global luxury group LVMH.

The portfolio of over 200 durable brands – this week it added Aviation American Gin to the mix – makes Diageo quite rare and is the foundation of its consistent long-term returns of around 10% annually over the past ten years.

While this may pale relative to the earnings growth of Microsoft or Visa, say, the steady growth and progressive dividend payout come together to offer an attractive total return for long-term investors.

Buttressing the strong brand foundations is the global spread of sales, with about 35% in North America, 23% in Europe and the remaining 42% in emerging markets.

It boasts a 36% market share in India and 23% in Latin America, for example. And the breadth of products, from aged Scotch whisky to stout, adds further diversification. The impact of lockdown has varied, depending on the region and the route the group’s products take to reach the market – whether through retailers or bars and restaurants. Early forecasts suggest a return to double-digit earnings growth next year, implying a price/earnings ratio of about 20. That represents a near-20% discount to its valuation over the last few years.

• Stephen Connolly writes on finance and business, and has worked in investment banking and asset management for over 25 years (sc@plainmoney.co.uk)