Do you fancy a swig of Diageo, the world's largest drinks company?
A very famous advertising slogan which dates back to the 1920s is "Guinness is good for you" Although its use was banned in Britain several decades ago, more recent research tells us that Guinness is probably good for you. So who makes Guinness and can we buy their shares?
Guinness is made by Diageo (LSE: DGE), the world's largest beer, wine and spirits producer and distributor which was formed back in 1997 when Guinness merged with Grand Metropolitan. Diageo's profits have grown significantly over the last decade and the company looks set to thrive despite the global recession. Diageo's shares could be a home for some funds for investors who are looking for a solid yet growing income.
Strong brands equals strong sales
Diageo possesses some extremely strong brands that are sold over the world. Many of these brands are household names and the likes of Guinness, Johnnie Walker, José Cuervo and Smirnoff are the best-selling products in the world in their respective categories. I'm a big fan of quality brands as they permit businesses to charge premium prices and give some protection against competition.
Diageo holds the largest share of the global spirits market, at 28% with France's Pernod-Ricard in second place at 16%. Since Diageo operates in so many countries it has far too many competitors to list, though arguably its biggest competition comes from other multinational brewers and distillers such as Anheuser-Busch InBev, Carlsberg, Heineken, and SAB Miller (LSE: SAB)
Competition in Britain also comes from smaller brewers such as Fuller Smith & Turner (LSE: FSTA), Greene King (LSE: GNK) and Marstons (LSE: MARS). Contrary to what some people think, Diageo has no pub interests although it does own the world famous Gleneagles hotel and golf course.
Check the numbers
The 2008 annual accounts showed diluted earnings per share (eps) of 57.9p, up from 49.9p in 2007, making Diageo's historic P/E ratio about 15.6. The 2008 dividend was 34.35p so Diageo's shares yield 3.8%. Diageo's P/E is higher than the FTSE100's P/E ratio of 10.5 but the shares deserves some sort of premium because of Diageo's quality brands and track record.
I'd argue that Diageo should be compared with the likes of Anheuser-Busch InBev, Pernod-Ricard and SAB Miller, all of which are on similar or higher P/E ratios, rather than the FTSE100 which is stuffed with oil companies, miners, telecom firms and banks.
Back in 2000, Diageo's eps was 37.2p and its dividend was 21p, so over the last eight years the respective growth has been 55% and 63%. Investors like to see steady growth in earnings and dividends and are prepared to pay a premium for such a company's shares, which is another reason for Diageo's above-average PE ratio.
Alcohol is a "recession resistant" business because customers will generally maintain their alcohol spending in a recession although they may switch to cheaper brands and spend more time drinking at home (and less in the pub). This is supported by Diageo's accounts for the six months to 31 December 2008 which show a 3% increase in like-for-like sales.
Adjusted eps for the same period was 43.4p, up by some 16% from 2007, with a 5.3% increase in the interim dividend to 13.9p. These figures demonstrate Diageo's quality and the defensive nature of the alcohol business
Accounting quirks
Some investors might be concerned about the level of Diageo's liabilities which are approximately equal to 74% of its assets. However, a big part of Diageo's assets are the value of its brands and accounting regulations only permit brands which have been purchased to be included in the balance sheet. So the accounting standard puts no value on a quality global brand like Guinness until someone buys it, whereupon value is mysteriously created out of nothing. That's a trick worthy of the finest quantum mechanic!
When looking at Diageo's accounts, as with many companies, you should consider that the headline eps contains exceptional items, profits from discontinued operations and tax equalisation adjustments. To get a clearer picture of the underlying business in my calculations above I've considered the earnings before these one-offs, using the figures for the continuing businesses. Thankfully Diageo makes it easy to identify these items, in contrast with some other companies who try to flatter their performance by passing one-off income receipts as being something which occurs every year.
Pension scheme deficits are a major concern of mine because too many pension schemes have become a major cost to the sponsoring employer and thus have a serious effect upon the company's profitability. Thankfully Diageo doesn't have this problem; its accounts show a total scheme deficit of only £170 million which is quite small in the context of a company with £3.6bn in scheme assets and £2.2bn of operating profits. Compare this to British Telecom (LSE: BT-A) whose recent 59% dividend cut which was blamed squarely on its pension scheme.
The future
Last year's growth in sales tells us that the recession is not deterring people from having a tipple, although anecdotal evidence tells us that they are drinking more at home. Diageo benefits from any increase in domestic consumption as it also supplies off licences and supermarkets. Any firm that can increase its earnings and dividends in the teeth of the worst global recession since the war must be doing something right.
One thing that makes some people wary of alcohol manufacturers is the possibility of stricter regulation. I don't think that there's too much to worry about here because alcohol generates huge amounts of tax and it's getting harder for governments to raise taxes elsewhere. Politicians, particularly here in the UK, tend to say one thing but do another when it comes to alcohol sales!
In summary, Diageo offers a combination of strong brands and a history of rising earnings and dividends but this means that it might be a touch too expensive for some investors.
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