Around four years have passed since our last teasing story on Diageo, when we were broadly negative following a succession of unprofitable reported results. That hangover seems to be well behind with a healthy recovery since mid 2016. While the competition rages on between the group and Pernod Ricard (to a lesser extent, Remy Cointreau too), Diageo clearly leads the European spirits industry and confirms it is by far the most shareholder friendly. This comes with a price, i.e. a modest 7% upside potential.
Its global presence, both in developed and emerging markets, is Diageo’s strength. It implies continuously adapting its strategy to consumer trends, which obviously vary from one country to another. Innovation and portfolio reshaping are essential planks of Diageo’s strategy to keep its margin premium over rivals. It works as can be inferred from the following chart.
Compared EBIT margins. Diageo in pink
Raising the mix through the launch of premium spirits is expected to combine with volume growth at c.2%. The H2 operating margin nevertheless is seen as muted due to rising operating costs across the board especially marketing costs (9% in H1). We are still confident that Diageo will hit its goal to increase margin by 175bp by year-end.
Acquired top-line growth will be funded by two-thirds of its current £700m cost savings programme, i.e. will be modest. Discussing with management about future opportunities, it said that it is “happy” with the portfolio at the moment but is still on the lookout for attractive and complementary small brands. Ergo, this is not quite the time for industry reshaping big acquisitions. Floated ideas like going for Pernod are likely to remain investment bankers toying about. The ideal course of action would be to buy from LVMH (Add, France) its 66% in Moet Hennessy but this is a three decades old ideal that would come with a c.€20bn price tag.
Premiumisation driving North America and Asia Pacific
Diageo’s North American sales growth will henceforth be driven by a premium and above brands portfolio, in a clear shift away from the low end of the market. Diageo has shown its hand last November with the sale of nineteen low range brands for an aggregate consideration of $500m. Accounting for a third of Diageo’s sales and nearly half of its operating profit, North America remains the biggest market for premium drinks. With net sales growing by 8% over last H1 results, it seems that going further upmarket is paying off.
Asia Pacific also reported significant sales growth of +13%, pushed by the Indian market, with a strong start of the year. Indian net sales were up +12%, thanks to significant performances from the “prestige and above brands”, which grew by +17%. A slowdown is, however, expected in H2 due to the 2019 Indian general elections.
Forgotten but useful beer
Diageo’s beer segment accounts only for 8% of global volume, but nevertheless generates 15% of the group’s net sales. This activity has continued to grow in H1 by 5%, obviously driven by the iconic Guinness brand, whose net sales were up 4% with a strong performance in Europe. Beer is Diageo’s beach-head to African markets with Africa accounting for more than half of beer revenues. The group’s spirit brands are expected to piggy-back on beer penetration.
The group now expects mid single-digit organic sales growth in FY19 and a 175bp organic EBIT margin expansion in the three years ending FY19 (implying 60bp expansion in FY19). This means only an 7% upside potential left on AlphaValue’s valuation metrics but this is not the point. The point is about the group’s capacity to deliver high total shareholder returns which does not seem to be remotely at risk. The chart below plugs Diageo’s superior pay-outs (in €m) and financial performance (ROCE ) vs. Pernod’s.
Diageo vs. Pernod: dividends payments and ROCE – 2013-20
With a £600m buy-back in progress and a 2.7% yield, Diageo is good to pay another £3.0bn. Cash in the pocket speaks for itself, while it is hard to find a weakness in what Diageo does. Buy to hold obviously.