Diageo - the luxury spirits compounder

When we first started out a year ago, we discussed the goal to write one investment idea per month and ultimately getting to 30 ideas. Well time files and we are now at the 15th idea. This is a good one as can be seen in the numbers below (company has FY ending in Jun):

Simple Financials (Jun 2024 estimate, USD)

• Sales: 21.0bn 
• EBITDA: 7.2bn 
• Net income: 4.5bn 
• FCF: 3.2bn 
• Debt: 19bn, Mkt Cap 84bn

Financial Ratios

• ROIC: 13% and ROE: 40%! 
• EV/EBITDA 13.4x 
• PER 16.8x 
• Past margins: OPM 27-31% 
• FCF yield: 2.4-3.7%

This is another one of the highest quality companies amongst those we have discussed and therefore do not come cheap with average FCF yield in low single digits. It has not traded above 5% FCF yield in the last 10 years and the reason is in the world map below. The company has enjoyed good growth in most geographies (with the exception of North America and Russia), partially supercharged by the pandemic. It also operates in a consumer market segment that has a lot of pricing power as a result of strong brand marketing, the perceived glamour and luxury that comes with the consumption of its products and just strong global demand as the world normalizes from COVID-19.

The company we are discussing today is Diageo (DGE on the London Stock Exchange), the world’s largest spirits maker alongside China’s Kweichow Moutai by revenue but trading at less than half Moutai’s market cap. Diageo owns a few of the most recognizable alcoholic brands such as Johnnie Walker, Guinness, Smirnoff, Tanqueray, Bailey and Casamigos. Share price has compounded nicely over the last 20 years, up more than 4x from GBP6.9 to GBP30.6 today.

In the last few years, Diageo has enjoyed some strange and ironic growth. When the pandemic hit, it was thought that Diageo will be impacted negatively as on-premise drinking died down but revenue grew because people drank more at home! With nothing better to do during covid, they emptied their bottles of whiskies and tequilas and bought some more. Diageo’s revenue skyrocketed.

As air travel resumed, people started moving again and when they roamed the duty free shops at airports with spare foreign currencies they have to spend, they bought more spirits and so Diageo grew some more! Although we are seeing the backlash now and share price has corrected in the recent months.

1. Fundamentals

We have written about Diageo on the original infosite and the investment thesis has not changed much:

Diageo is a global leading spirits company with 200 brands and footprint in 180 countries that has compounded growth steadily since its inception in 1997. Its strong brands, coupled with good marketing, high market share and strong global distribution has enabled the firm to generate consistent, steady free cashflow (FCF) and high ROIC on the back of both pricing and volume growth. The stock has compounded well in the past and shareholders have benefited from both capital appreciation and dividend growth, an important aspect that management has focused on. Investors can expect Diageo to continue to compound at 5-7% going forward.

In the past, Diageo was synonymous with Johnnie Walker, its largest brand with the most amazing story and heritage. Scotch was c.25% of revenue but closer to 35-40% in terms of profit contribution. There is an old 6 min plus Youtube video taken in one shot casting Robert Carlyle who narrated the Johnnie Walker story brilliantly. Every Diageo current and future investor should watch the video. It is just fascinating! Since then, as depicted in the pic above, Diageo has successfully diversified its portfolio from Scotch over the last few years into other spirits.

Today, Diageo’s revenue breakdown is relatively simple to understand. The following pie chart from its latest annual report provides the breakdown which roughly works out to be 22% Scotch / Johnnie Walker, 18% Beer / Guinness, 16% Vodka / Smirnoff while Tequila, Rum and Gin makes up high single digits. Together, its spirits portfolio is the largest in the world and accounts for 70% of market share based on Diageo’s own measure of market segments it competes in. Of course, if we sliced it differently, the market share might be lower, but still, we cannot deny Diageo is dominant in spirits.

In terms of margins, Scotch enjoys one of the highest margins in the portfolio at 35-40% operating margin alongside Tequila and Vodka while Beer and Ready to drink are lower at 15-20%. Well, alcohol is just good business. As per the usual, let’s discuss the few positives on top of the fundamental thesis:

Positives

Growth in TAM via volume and premiumization: According to Diageo, the growth in the spirits addressable market is phenomenal and while Diageo has not grown in its North America region this year, the US market is resilient and I believe it also reflects the global growth opportunity for Diageo as 600m consumers come of age and look to drink better and are willing to pay up for that.

The chart below shows how spirits have grown 6% CAGR by taking share from beer and wine in the US and more importantly how the market has premiumised with the ultra premium and super premium categories growing rapidly. This phenomenon is likely global because as middle class consumers increase their income and spending, they seek out the best offering and will not hesitate to pay up to get. In the world of luxury handbags, our better halves only want the best and the most popular: Hermes and LV. Similarly in watches, it’s Patek and Rolex. In the Singapore food scene, it’s either Michelin star restaurant, or the longest queue in the hawker centre’s bak chor mee (minced pork dry noodle) store or Hainanese chicken rice store.

As such, Diageo, with the most recognizable whisky brand globally and a growing portfolio of desirable spirits and beer brands, has benefitted from having both the best and the most popular choices in the spirits space and will continue to do so. This is perhaps the key reason behind management’s confidence and promise to keep growing 5-7% annually.

Distribution prowess: With its long term track record in distribution prowess starting with ship captains more than 150 years ago to the current footprint in 180 countries, Diageo has insurmountable clout in putting its products across the globe in every imaginable shelf. We see Diageo’s spirits prominently in airports, supermarkets, convenient stores, bars, restaurants and online. Diageo tracks inventory at its distributors religiously and make sure its whole supply chain chugs along and delivers.

Strong Financial Metrics: The third positive for Diageo is reflected in the numbers. We have discussed the high OPMs in the various spirits segments. With scale, Diageo has been able to do businesses with less capex (c.5% capex to sales), generating high ROIC and extraordinarily high ROE. Diageo used to generate GBP1bn in FCF a decade ago but that has bumped up to GBP2-3bn.

Its return metrics are best in class with ROICs averaging teens while ROEs are in the 20-40% range with just modest use of leverage. Capex to sales has creeped up in the last two years to high single digit percentage. On average, this should be a mid single digit capex to sales business. The following shows its FCF generation capabilities and ROICs over the last 5 years.

Similar to Thai Beverage, the other alcoholic company we analyzed, the strengths of companies show through in numbers and Diageo’s margins, free cashflow generation, ROEs and ROICs speak for itself. This is a world class business and a classic compounder.

Management

Diageo was helmed by Ivan Menezes who built the company over the decade to 2023 but he unfortunately passed away this year. His legacy is passed to Debra Crew who was appointed Chief Executive this June and she seemed well-supported by a diversified team with varied experience to lead Diageo to greater heights.

Diageo exemplifies the future where corporates balance profitability and growth against environmental and social concerns. While selling alcohol, the company also advocates responsible drinking and is focusing on being a responsible employer for its 28,000 global staff.

Risks

Most investments have risks. That is how the game works. The only risk free investment is the first idea introduced - invest in Treasury bills which now gives 3.8%. This is risk free, as per textbooks’ definition. But it is predicated on the continuing existence of Singapore and our government. As such, nothing is without risk. For Diageo, two risks are tepid growth into 2024 and its geographical exposures.

Tepid growth: As discussed earlier, Diageo has enjoyed strong growth going into the pandemic and then going out of the pandemic as air travel resumed. Good times will always end and 2024 is now looking weak. We are seeing inventory piling up at its distributors and adjustment may well run a few quarters. Investors are ultimately short term minded and without growth, Diageo’s high valuation is not sustainable and hence we are seeing its share price correcting from its high at c.GBP40 to current GBP30.6 and looks like we may break that psychological barrier of GBP30.

Geographies: While Diageo is a global company, US ultimately drives revenue and earnings. The chart below shows how North America accounts for majority of sales and Operating Profit (OP) and needless to say, recession in the US will negatively impact Diageo. However, as market goes, hiccups in China, Africa and Latam will also affect share price when short-term investors look at large companies with exposures to these geographies and short them on sentiments.

2. Technicals

Diageo share price chart shows the nice compounding curve that we are familiar with and it recently hit its all-time high at GBP40 before correcting to the recent GBP30 level. At the pandemic low, it was at GBP25 which is, as previous ideas, a strong technical support.

The risk reward profile for Diageo as dictated by technicals is therefore 25/30 vs 40/30 which translates to c.20% downside vs c.30% upside. This means there is almost no skew either way which is usually the case for strong consumer names. It is worth noting though Diageo has had larger drawdowns at 25-30%. So it is not inconceivable that it drops closer to GBP18-20, which is the next strong technical support below GBP25. But let’s look at fundamental valuations for a better picture.

3. Valuations

Diageo trades at a slight discount to peers on PE but is right smack in peers’ average on EV/EBITDA and trades at a slight premium on FCF yield. Its OPM (blended at mid 20s) and ROIC (teens according to the company above) are inline with peers while ROE is exceptionally high. Overall, peer valuation comparison does not suggest Diageo is undervalued.

Next we look at Diageo’s valuations based on the usual three metrics: Free cashflow (FCF), EV/EBITDA and Price Earnings Ratio (PER). The Earnings row is simply FCF (GBP 3bn), EBITDA (GBP 6bn) and Net Income (GBP4bn) respectively and if we apply the appropriate multiples, we get to Intrinsic Values (IV) between GBP33.3 to 35.6 which suggest that Diageo has some upside to its IV but not by a whole lot. There is no big margin of safety buying today.

This corroborates with both peer valuation comparison and technicals and hence it may be prudent to wait for a better opportunity to buy, perhaps closer to GBP25. However, this high quality name rarely gives a big open window for investors to buy a lot at the price we want. If we can establish that GBP25 is a screaming buy, so do other investors and hence it won’t get there. One other angle to look at is dividends. Diageo is considered a UK Dividend Aristocrat, a small group of stocks listed on LSE with increasing or stable dividend for the last 10 years. The following bullet points provide more details:

Diageo's dividends 

• Track record of increasing dividend since 2001 and in the last few years, consistent dividend growth between GBp1.5-3.8 annually 
• Enhanced shareholder return with further share buybacks 
• Paid out c.GBP5 in dividends over the last 7 years which accounts 16% of today’s share price 
• Current dividend yield of GBP 0.8/30.6 = 2.6%

With that in mind, I would ascribe the higher IV of GBP36 for Diageo which implies high teens upside but would look to buy more closer at GBP25.

Huat Ah!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

Covid, Consumerism and Diageo

2020 will go down in history as one of the craziest year ever. A microscopic organism wreaked havoc causing millions of deaths. A US President who refuse to concede defeat and handover after losing the election. Meanwhile, in the midst of all these, Chinese spend USD74bn on a single day buying stuff, almost doubling what they bought last year on the same day. That's also 10x more than what's sold in the similar event in the world's largest economy - US Black Friday sales in 2019. 

Intuitively, Covid and consumerism should not go together. We are still in the midst of a pandemic and millions of people are suffering from the loss of jobs and deaths of loved ones. But Covid has shown that we are so used to consumerism and our way of lives that we cannot help it. E-commerce sales went through the roof. Where tourism is again possible in parts of the world like China, people travel and spend. In fact, they spent more than usual. There is even a term for it - revenge tourism.

As such, a stock like Diageo is strangely, doing well despite less on-premise drinking in pubs, restaurants and events. Alongside other alcohol names like Moutai and Heineken but doing less well versus LVMH, the world's most powerful marketing machine. Diageo means day (dia) and the world (geo) in Latin, referencing to its global footprint (it operates in 180 countries) and encouraging people all over the planet to seize the day. Unsurprisingly, its company slogan is "Celebrating Lives, Every Day, Everywhere." 

There is a lot of history with this company which is fascinating and insightful but for our purposes let's stick to what is important for investors. Diageo is the world's second largest distiller after Moutai and owns a portfolio of high quality liquor brands including Johnnie Walker, Smirnoff and Guinness. Its full suite of brands are listed above.

Its investment thesis is as follows: Diageo is a global leading spirits company that has compounded growth steadily since its inception in 1997. Its strong brands, coupled with good marketing, high market share and strong global distribution has enabled the firm to generate consistent, steady free cashflow (FCF) and high ROIC. Covid presents an opportunity to be able to buy it at a slight discount. At market cap of GBP67bn and projecting a strong recovery in FCF to GBP3bn in the future, its FCF yield is c.4.5%.

Diageo is also laser focused on shareholders. In its annual report, it listed its top three financial targets: free cashflow, return on invested capital and total shareholder return (see below). Diageo has done pretty well in all three and importantly, these are the exact metrics that investors are now looking at. Price earnings ratio (PER) and Return on Equity (ROE) are still important but they no longer tell the full story as well. 

PER has been the preferred metric for decades but as companies learnt to manipulate earnings and manage this number, it became less and less reliable. As for ROE, it can be artificially inflated simply by raising debt and as such ROIC became a better return metric over time. PER and ROE has also become less meaningful with global QE. Cheap money means lower cost of equity demanded by investors and cheap debt. The former is the reason why we can no longer buy good companies at teens PER.

As we can see from Diageo's numbers above. It has consistently generated both strong FCF and high ROIC. What is impressive is that is has managed 12.4% ROIC despite Covid's negative impact. This goes back to the conundrum we presented earlier. Why are people spending and drinking during Covid? Are we just so consumed by consumerism that not even a pandemic can change our behaviors? Perhaps so. Single's Day crazy buying and Diageo's performance have validated this theory.

Diageo is a  also superb marketing company. One of the first slides on its investor presentation deck showcases its efforts during Covid to help disrupted lives. It sent out 10m bottles of hand sanitizers and spent $100m to help poorer communities. This is both noble and smart. The company is also acutely aware of global issues. Inspired by the #MeToo campaign perhaps, it launched a Jane Walker campaign in 2018 to support the fairer sex. Geez, just looking at it makes one want to buy a set of two! One for John and one for Jane.

Over time, we shall delve deeper into the business, its positives and risks! Keep walking. 

Huat ah!

Great Scot! Brexit?

It's been three weeks into Brexit and the financial world now think that maybe it was never an issue at all? US S&P is back near all time high, the FTSE 100 bounced back with a vengeance and hit its high for 2016. Even the STI is now close to 3,000. Brexit? Nah. Let's Move On! That's market short-termism for you.

For most people, it was actually more disappointing that in the same week, England was knocked out of the Euro Finals. By Iceland. Ouch! People asked, "What happened?" This was the Great Britain, we were talking about the most powerful empire of the 19th century! First, it took a big retreat on globalization with Brexit, then it lost its prowess in football. To rub it in, even the British Gentleman spirit was lost when Michael Gove, a former Secretary of State for Education backstab his political ally Boris Johnson to announce that he would run for Prime Minister, and not support Johnson instead. It was one of the darkest days for the UK in recent history. May God not just save the Queen but the Empire on which the sun never sets.

English Football

Okay, things really looked bad. This could be it for the UK, literally, now that Scotland might want to seek another referendum for independence since the Scots really wanted to be part of EU. Great Scot! How are we gonna ship enough Johnnie Walkers if we are not part of the EU! If Scotland leaves UK, then what about Ireland? It would mean breakup of the United Kingdom. This further implied the same fate could await the EU and other alliance (ASEAN, NATO etc). This is MAJOR. Globalization has been the big trend of our lives and now the people of UK voted and demanded that they didn't want more. It was a vote that the common man said, "Enough is enough." It could be the beginning of the Great Class Divide, the elite vs non-elite. This is the rebellion against capitalism. It had already started in some ways. ISIS, random bombing and shooting, refugees, Donald Trump, even going back earlier in Singapore: Worker's Party winning Aljunied GRC!

Okay, breathe.

For now, let's drill a little deeper on the financial markets, what are the really big implications for Brexit? Where's the catch and most importantly where's the big money making opportunity? As markets become more and more short term, most market participants had already failed as long term thinkers, most simply prefer to trade. Brexit went from "Not Gonna Happen" to "Oh Shit" and to "Nah, it doesn't matter" in three weeks! It really showed something about the intellectual depth of the markets i.e. really shallow. Brexit has big long term implications that wouldn't have changed in three weeks, if what is described in the previous paragraph unfolds, this could ultimately lead to WW3, or some global anarchy, maybe we might evolve into the human society depicted in the Divergent Series. This is really big deal. Ok, hope everyone got the idea. Here's the three biggest deals today:

1. Currencies

2. Financials and F4

3. UK stocks

Needless to say, currencies saw the most volatility with the British pound or GBP collapsing to its 30 year low. In one fell swoop, the GBP fell from 1.5 against the dollar to 1.3. It was said that we might see parity. That has never happened since the pound and dollar exchange rate was recorded in 1791. The closest it ever got to was GBPUSD of 1.1 in 1985. Against the SGD, it also fell to an all time low of 1.77. Singaporeans are now rushing to change pounds and buy UK properties but alas no money changer would be dumb enough to effect that transaction now and banks are also unwilling to support the purchase of London condominiums. No easy lobang bros!

GBPSGD exchange rate

Meanwhile, the second order impact on currencies was even more significant. As the pound lost its status, the other currencies benefited. Obviously the dollar and Swiss Franc rose. In Asia, the yen strengthening much more than expected, negating the effects of Abenomics causing the Nikkei to plunge. The Chinese government took the opportunity to weaken against all other currencies in order to boost its exports, it was called a stealth devaluation, but this would cause further capital outflow. The Chinese simply couldn't have their cake and eat it. 

The other big impact would be on the global financials. The key cities that controlled the global financial markets were always New York in the States, London in Europe and the three Asian contenders: Hong Kong, Singapore and Tokyo. With Brexit, what does it mean for the financial gateway into Europe that was the UK and the hub that was London? If Brexit meant that UK loses its privileges as a EU country, perhaps a new hub might be needed. There is already talk of a F4 alliance (more on this later). This major stress strained on the global banks. JPM, HSBC and Standard Chartered fell 5-10% immediately but had since recovered. Again, vultures targeted the weakest links, such as the Italian banks and Deutsche Bank, now trading at 0.28x book. Investors are saying 72% of the largest German bank's book is worthless. As we had seen over the last few years, there is an increasingly discerning power amongst investors. Good stuff stays good. There was that 5-10% drop in the solid banks but that was it - the minuscule, small window to buy. In a week, everything good rallied. Junks though collapsed and stay cheap. 

F4 in Taiwan

Then there's F4. Sorry, no, not the Taiwanese boy band. Sorry. This is different. This is another gamechanger. Shortly after Brexit, the Swiss Bankers' Association took the chance of a lifetime and ran with it. They proposed forming an alliance by the same name F4 which comprises of four new financial hubs in Switzerland, UK, Hong Kong and Singapore as a counterweight against new possible emerging hubs in the EU: Paris, Frankfurt, Brussels etc. If this succeeds it would bring about a new force as the Swiss controls a quarter of global asset management business. It was proposed that the F4 alliance would coordinate positions on global financial regulations and create new international standards as well. This could even rival the US and make them conform to global standards rather than letting Uncle Sam always writing his own rules. It's a very interesting development to say the least and our beloved motherland is part of it!

The last point would be on UK stocks. So everyone was expecting UK stocks to be hit badly with Brexit and there might be opportunities to buy on cheap. Alas, the window was just one day - the day of the Brexit announcement. Then the stocks took off and never looked back. As said, investors are becoming very discerning when it comes to premium good stuff. Global powerhouses listed in UK like Unilever, Reckitt, Diageo (yeah Johnnie Walker) and even Royal Dutch Shell share prices jumped as the pound fell. This was because their business was global. While the stocks were denominated in pounds, since the earnings were global, a cheap pound meant that the share price should rally. This is an important point as most investors tend to only think about which currency their stock is denominated in, believing they would earn in that currency. But in reality, it doesn't matter! A rose by any other name will smell as sweet. A good stock denominated in ringgit would simply compound faster. Diageo's share price above showed as much. The stock did nothing for three years and rallied 20% mirroring the fall in the pound.

Diageo's share price

Diageo had been mentioned previously but it might worth reiterating that this might be one of the best stocks to own globally. Diageo is the world's largest spirits company with megabrands such as Johnnie Walker, Smirnoff, Guinness and Bailey amongst others. It has 40% value share in Scotch (whisky from Scotland) and is the world's largest producer of vodka. 40% of its earnings comes from the emerging markets while it continues to enjoy pricing premium in developed world with its key brands, It also has an unparalleled global distribution built over the last 180 years that ensure its products reach every corner of Earth. Pirates robbing East India Company's ships in Singapore were after crates of Johnnie Walker whisky in 1819. 

Diageo's Portfolio

Okay, fast forward to today, Diageo, with 20% of its earnings from Johnnie Walker, has been a cashflow generating machine given its business of selling highly priced beautiful bottles of alcohol to rich men and high end bars in the last few decades. It churns out GBP 2bn in FCF globally (soon to be GBP 2.5bn with the collapse in pounds) and this is expected to grow at a 5-6% clip annually. This means that Diageo's FCF doubles every 11-12 years and it had indeed been the case so far. Its FCF in 1999 was GBP 0.5bn and it grew to GBP 1.3bn in 2006 and now almost doubling to GBP 2.5bn in 2017. Of course the market knew this and bought it up since three years ago. Today, as was three years ago, Diageo trades at high multiples: 22x PE forward in two years, EV/EBITDA of 17x and FCF to market cap at a whopping 26x. It fell around 5% during Brexit to teens PE before rallying 20%. Now the ship had sailed.   

In conclusion, Brexit was a lesson about market's short-termism, the world's populace dismay at globalization and the wealth discrepancy it created, the possible emergence of a new financial order led by F4 (no, no, again it's not the boy band) and the power of great companies with strong business moats. On the last point, it was a reminder that we should simply buy a portfolio of these stocks and sleep soundly, not worrying over the whims and fancies of global markets.

Well, maybe Brexit won't really happen, it would take at least two years just to iron out the exit road map (and ten years to fully exit). Let's hope England do better in the 2018 World Cup and God Save the Queen!

PS: This writer owns Diageo.