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UK Quality: Diageo's Risks Are Manageable

A closer look at the brewing company

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Nov 04, 2021
Summary
  • After assessing at Diageo's moat and growth opportunities, I will look at its risks.
  • Changes in consumer preferences and brand image are key risks.
  • Increased debt levels are still manageable.
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Like the U.S. market, with SEC filings, the U.K. market has an excellent regulatory filing system. Issuers must file with a “Regulatory Information Service,” which get published on the London Stock Exchange’s website. The most popular service is London Stock Exchange’s own Regulatory News Service, so these releases often get called RNSs for short.

We can see Diageo PLC’s (

LSE:DGE, Financial) latest RNSs here.

Immediately, we can see many “Transaction in Own Shares” RNSs, which show Diageo, after pausing it, has resumed share buybacks. That’s a plus for investors.

If we go back to Aug. 20, we can see a prospectus for an issuance of debt instruments. In a prospectu,s there is a long section called “Risk Factors,” which usually list every possible risk a company faces.

These are broken down into six areas:

  1. Risks related to the business activities and industry of Diageo and its consolidated subsidiaries, which includes each of the Obligors.
  2. Risks related to the Diageo group’s financial situation.
  3. Legal and regulatory risk.
  4. Internal control risk.
  5. Environmental, social and governance risks.
  6. Risks related to the nature of the Instruments.

Parts 2 through 6 are fairly standard, though institutional investors are certainly paying more attention to the environmental, social and governance risks these days.

The business risks to Diageo are interesting, however: there are detailed notes on the Covid-19 pandemic and Brexit, of course, as well as the usual business risks related to economic and political headwinds. The two risks which I see as most important, however, are listed in its debt prospectus as:

  • “Demand for the Diageo group’s products may be adversely affected by many factors, including disruptive market forces, changes in consumer preferences and tastes and the adverse impacts of declining economies. ”
  • “The value of the Diageo group’s brands and its net sales may be negatively affected by its failure to maintain its brand image and corporate reputation or adapt to a changing media environment.”

As mentioned in a previous discussion, Diageo’s brand image is very important, so the risk is mainly around a celebrity scandal affecting advertising and brand by association. It seems to me that changes in consumer preferences are currently supportive of Diageo’s line of products.

But’s lets consider the downside risks.

A challenge to some extent for Diageo is that younger consumers have very different attitudes toward life than older generations. Let’s call it a more temperate mindset. This includes drinking less than older generations as a result of health trends and the fact that a large proportion of the younger market just don’t have the disposable income they once had due to the rising cost of living.

This trend has been accelerated by the pandemic. University College London’s Covid-19 Social Study demonstrated that 90% in the 18 to 29-year-old age bracket who were heavy drinkers in early 2020 were consuming less alcohol a year later.

Of course, this must be partly due to the closure of nightclubs and bars during lockdown. But it seems to me that along with the “build back better” mantra from governments, consumers are also more aware of their own health.

But are we going to stop drinking alcohol all together? That’s highly unlikely. In fact, a positive trend for Diageo is that when people drink less overall, they opt for higher-quality drinks when they do drink. So these trends might be problematic for certain beer brands, but Diageo’s premium portfolio net-net might even ultimately benefit from this development if it persists longer term.

Financials

One concern some investors may have is the group’s debt has risen sharply in recent years. The debt-to-equity ratio has risen from 1 in 2018 to 2.2 currently.

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But after adjusting for cash, the group currently has net debt-equity ratio of about 1.5, so this appears manageable. Diageo’s resumption of share buybacks in May could signal to investors that management is confident in the business and financial outlook.

I also like the fact that Diageo has a strong Altman Z-score of 3.4 and a very strong Piotroski F-Score of 8.

Diageo’s enterprise value-Ebitda ratio has risen in recent years also, reflecting a growing realization of the quality of its business.

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The group’s operating margin has been impressively over 25% since 2004, with the exception of Covid-19 hitting in 2020. Return on invested capital, which shows how well the business is creating profits from capital, has usually ranged between 10% and 15% for most of that time and seems to be returning to its normal level post its pandemic dip. Importantly, Diageo created 3 billion pounds ($4.05 billion) of free cash flow for 2020-21, up from 1.6 billion pounds in 2019-20.

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All this means is that Diageo has been able to increase the dividend consistently, even during the pandemic. The 2020-21 dividend payout of 72.2 pence was 4% higher than the prior year's payout. It seems safe to assume this trend will continue for the foreseeable future.

Diageo’s shares are not cheap. The GF Value indicator rates the stock as modestly overvalued, but its Shiller price-earnings ratio is 35 compared with rival Brown-Forman Corp. (

BF.B, Financial) at 43. As such, I believe Diageo’s strong moat, good growth prospects and healthy balance sheet mean the stock is worth considering as a long-term holding.

Disclosures

I am/we currently own positions in the stocks mentioned, and have NO plans to sell some or all of the positions in the stocks mentioned over the next 72 hours. Click for the complete disclosure
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