Forever Investor

Diageo, by any metrics, is a high quality company that keeps a lot of people happy. With its consistently high return on capital employed (never below 30% in the last five years) and solid dividend record (16 years of increasing dividends, currently yielding 3%) it has plenty to offer investors; but with its stable of market-leading brands, such as, Guinness, Smirnoff, and Johnnie Walker, it can expand around the world fully confident in the knowledge that, after investing in marketing, local drinkers will also succumb to its charms.

Not only does it have a great, nearly recession-proof product, but it has been a well-run company for a long time. Paul Walsh was the brains behind the operation we know today and built the company by successfully identifying where it could lead (premium drinks) and then focusing all of its resources towards that goal. Originally a consumer goods company, Walsh sold off assets that did not fit the new model; this led to the sale of Pillsbury to General Mills in 2001 and Burger King to the Texas Pacific Group. Diageo instead invested in premium drinks brands and has grown steadily, while paying increasing dividends, over the last decade or so. Historically, growth has been at a rate of about 8% a year and is expected to come, increasingly, from emerging markets where middle-class consumers are discovering the unquestioned delights of a long cold glass of something strong after a day sitting in front of a computer monitor. Although Walsh is no longer at the helm, Diageo shareholders will be hoping that his successor fares better than Terry Leahy’s hapless successor at Tesco.

However, it does look as if Walsh might have picked a good time to leave with Diageo experiencing an uncharacteristically troubled year. The Chinese government’s unsociable crackdown on gift giving has largely been responsible for a fall in the value of its stake in spirits maker Shui Jing Fang (Chinese civil servants should switch to pints of Guinness instead), which has been written down by £264 million. In common with other big British multi-nationals, the strong pound has also hurt its numbers. Both factors contributed to a fall in operating profits of £2.7 billion for the year to the end of June.

Nevertheless, there was strong double digit net sales growth in India, where Diageo has recently taken control of United Spirits. United Spirits will provide it access to local delivery routes, as well as USL’s portfolio of nectars. There was also growth in the US, which as Diageo’s biggest and most profitable markets, should give increasing support to profits as the United Statues continues its recovery from the Great Recession/Financial Crisis. Rightly or wrongly, I am not really worried about currency swings, but the growth in emerging markets, in particular, should create lifelong customers, which is something much more enduring.

Debt

The dreaded “d” word must be mentioned here, because Diageo does carry quite a bit of the stuff. Its net gearing is at about 125%, but with those steady drinkers as customers, its revenues are, at least, relatively reliable (tempting fate). It has an interest coverage ratio of about 5.5, so there is a comfortable margin to allow for interest rate rises (if they ever happen).

Price

Diageo’s share price has drifted downwards by more than 10% over the last year and it stands today at about 1740p. Sadly, it is definitely not cheap and has a P/E of about 18.

What does Ben Graham’s intrinsic value formula say about Diageo?

Intrinsic Value = (95.5 X (8.5 + (2 X 5.1) X 4.4) / 2.75 = 2857.36(p)

Where: 95.5 is the most recent EPS (reported end July 2014)
5.1 is the expected growth rate (Morningstar’s five-year growth forecast of 6%, less 15% to allow for analyst over-exuberance)
4.4 was the average yield of high-grade corporate bonds in 1962, the year the formula was introduced
2.75 is the current year on AAA corporate bonds.

Value (2857.36) / Price (1750) = 1.63
Verdict = Undervalued

Changing the denumerator to a more normal corporate bond yield, would obviously gives a lower intrinsic value. For example, with a bond yield of 4% (surely only a matter of time), the intrinsic value drops to 1964p, which does still leave a small margin of safety.

I definitely do not think Diageo is cheap but, to me, it looks reasonably priced for such a high class operator that is is yielding 3.0% (with a recent dividend increase of 9%). It is also a forever company, which I can tuck away for a very long time (tempting fate again). If emerging markets pick up and sterling weakens, then I think that it will do well. At current prices, I am happy to add it and wait for events to turn in its favour. In fact, I might just add a few more this morning.

Slainte!

Disclosure: Long DGE.
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.