The drinks giant has withstood the recession, but resilience comes at a price.
Diageo (LSE: DGE) was one of the biggest fallers on Thursday, and I'm not surprised.
The share price of the £24 billion spirit maker -- one of the biggest 20 companies in the FTSE 100 -- has boomed in the past three months, coming within a whisker of £10 this week as investors bet it would report it's shrugged off the economic slowdown.
And it has -- to a point.
While Diageo sold 3% less liquor in the 12 months to 30 June 2009, net sales still rose 15% to £9.3 billion, while operating profit before exceptionals was up 13% to £2.6 billion.
Earnings per share rose 10% to 65.2p, and the final dividend is up 5%, for a total payout for the year of 35.9p.
At 960p, Diageo is yielding just over 3.7% -- not the highest in the FTSE 100 or the fastest growing, but surely among the most secure.
Glass half empty
Drinks all around then? Well, that depends on whether you're a glass half-empty or half-full kind of investor.
Let's start with net sales, where nearly all that increase -- £1.1 billion to be precise -- is down to exchange rate movements.
As for profits, take into account exceptional costs of £170 million – mainly resulting from restructuring that is costing jobs and making headlines in Scotland – and operating profit drops to £2.4 billion.
Knock off finance charges of £592 million (almost double last year) and add back the £164 million earned by associate operations (mainly Diageo's 34% interest in Moet Hennesey) and profit before tax actually fell nearly 4% to £2 billion.
How then have earnings per share risen 10%?
Digging into the results, it's seemingly because Diageo's tax on profits has fallen by 44% to £292 million, partly because of an exceptional £155 million tax credit. As a result, profit after tax increased 9.8% to just over £1.7 billion.
It's not clear to me whether Diageo will continue to benefit from this favourable tax treatment, but without it there'd have been no earnings per share growth.
Something that isn't going away is debt. Long-term borrowings of £7.7 billion are manageable for a cash cow on Diageo's scale, but the interest bill is still hefty at £516 million -- and up from £341 million.
The currency effects already mentioned were the main reason borrowing costs rose, but another is that Diageo has been borrowing to buy its own shares -- it spent £1 billion in buybacks in 2008, and £354 million last year.
I prefer dividends, but I can see the logic of buying back shares using excess income. Borrowing for buybacks to boost earnings per share though is another matter -- corporate engineering that to my mind increases risk just to flatter the growth picture.
Worse, Diageo's management proved they should stick to distilling -- they suspended buybacks shortly before the shares fell towards 700p in March's lows.
Further long-term liabilities dog the balance sheet in the £1.4 billion pension deficit, up a shocking £975 million.
Glass half full
Diageo is on a P/E rating of 14.7, which seems pretty high in current market conditions.
But the reason investors will pay a premium for Diageo's shares (and banks will happily lend it billions) is the same reason its sales have held steady during the recession: brands.
John Walker, Smirnoff, Captain Morgan, Bushmills, Archer's, Pimms and many more -- Diageo's cabinet is a barfly's wet dream. Unite these labels with a global sales machine that can put super-premium whiskey and tequila into American's top clubs while distributing Guinness to shacks in the Caribbean and Africa and you have one of the world's great consumer giants.
This year highlighted Diageo's touch once again. Having paid £450 million for a 50% stake in trendy Dutch Ketel One last June, the brand is already contributing £150 million in profits, so the acquisition will soon pay for itself.
The strength of these brands is both fascinating and amusing. For instance, Diageo is shifting the production of its 150-year old Johnnie Walker whiskey from its historic birthplace in Kilmarnock to a vast industrial distillery on the Morayshire coast. There's been outcry in Scotland from politicians, but I doubt the world's Scotch drinkers will notice.
This restructuring -- which is creating as well as costing jobs -- is best done in a recession. Diageo can ramp up volumes when growth returns, when future headlines about record profits won't sit awkwardly with trade disputes.
Another round?
Diageo is a world-class company that British investors should be proud of, and there's much to recommend it.
As the global economy recovers, travellers will start buying fancy bottles at airports again while workers will regain that Friday feeling and have an extra double. Margins should rise; Diageo has been holding down prices to retain market share. And in the longer term there's huge potential in South East Asia, given Diageo owns most of the premium Western spirits.
What price we should pay today is another matter, however.
That P/E of around 15 looks expensive to me, given the company has warned it only expects 'single digit' profit growth – a PEG of around 2 on forecast earnings.
Diageo's management may seem overly gloomy given recent talk of economic recovery, but manufacturing inventory bounces and cash-for-clunkers schemes won't sell more whiskey. With unemployment still rising in Europe and the US, it's probably right they're cautious.
Diageo will probably never be a cheap growth share, but I think there will be better times to get in given the stodgy outlook.
I'd buy for long-term income at around 850p a share, compared to today's 960p, which would see Diageo on a P/E of 13 and a yield of around 4.25%.
Until then I'll stick to Pimms and lemonade.
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