Dividend Report Card: Diageo

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By

Todd Wenning

Published in Company Comment on 11 May 2011

Does the drinks giant's dividend pass the grade?

Last year, we began putting some of the FTSE's most popular dividend-paying stocks through the Dividend Report Card in an effort to better measure the health of a company's dividend.

Specifically, we wanted to answer three questions:

1. Over time, has this company steadily increased its payouts?

2. How sustainable is the dividend?

3. Does the company have room to further increase the dividend?

Some companies scored well, whilst others scored poorly. Today, we'll begin giving those companies a fresh look now that they've reported full-year earnings.

Today, we'll size up Diageo (LSE: DGE), which boasts a 3.0% yield. Here's a chart of its dividend per share and yield history over the past decade, ending March 2011.

Diageo dividend history

*Used with permission of Bloomberg Finance LP

Dividend history

Metric5-Year
Annualized
Growth Rate
Dividend per share5.3%

Data provided by Capital IQ, as of 11May 2011.

As the above chart shows, Diageo has an enviable track record of raising dividends, having boosted payouts each year for well over a decade, but the rolling five-year growth rate has declined from 6.9% in 2006 to 5.3% today.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Diageo scores a 3 of 5.

Sustainability

MetricTrailing
12 Months		Final Grade
Weighting		Report Card
Score
(out of 5)
Interest coverage3.410%3
EPS payout ratio52.5%10%4
FCFE payout ratio94.6%30%2

Data provided by Capital IQ, as of 11 May 2011.

Though dividend cover remains strong at 1.9 times, Diageo's free cash flow cover has slipped from two times in 2009 to just over one today. 

Free cash flow can be volatile, but the main culprits behind the deterioration are higher acquisition outlays and increased working capital investment. Whilst free cash cover could certainly improve this year, it is something for Diageo investors to keep an eye on.

Some Dividend Report Card readers have civilly argued that it isn't right to deduct acquisitions when calculating free cash flow, and that's a fair argument when we're analysing a company doesn't make frequent acquisitions; however, it is a prudent deduction when we're talking about serial acquirers like Diageo, as it is essentially a reinvestment cost and should be counted. 

Anyway, even if we didn't include acquisitions, Diageo's dividend cover would have been just 1.3 times.

The interest coverage ratio is still a little lower than I'd prefer, but Diageo has an "A-" credit rating from Standard & Poors and appears to have no problem paying its creditors.

Growth

MetricTrailing
12 Months		Final Grade
Weighting		Report Card
Score
(out of 5)
EPS payout ratio52.5%10%3
FCFE payout ratio94.6%20%2
Sustainable growth rate17.8%10%5

According to Bloomberg, the consensus analyst estimate for Diageo's dividend for the fiscal year 2014 is 52.5p, which would be a 38% increase from fiscal year 2010's 38.1p.

Could that come to pass? Sure, but the combination of low free cash cover and the declining dividend growth trend makes me less-than-confident about Diageo's ability to grow the payout at an expected 8.3% annualised pace in the coming four years.

Pencils down!

With all the numbers in, here's how Diageo's dividend scored:

WeightingCategoryCurrent
Grade
10%History3
10%Balance sheet3
10%Income statement4
30%Free cash flow2
10%Income statement3
20%Cash flow2
10%Sustainable growth5
100%Total Score (out of 5)2.8
 Final GradeC

Diageo's declining DRC score -- from "B+" last July to "B-" in January to "C" today -- leaves me with more questions than answers and more concern than comfort. 

There's no question that Diageo has a portfolio of top-notch brand names and a wide economic moat, but a bet on the shares today seems to be a bet that the global economic recovery will continue and that consumers will trade-up to its premium-priced offerings. In my mind, at least, that's anything but a sure bet.

> Todd Wenning is advisor of Motley Fool Dividend Edge. You can follow him on Twitter.

> If you'd like to learn more about dividend investing, why not download our special free report on how dividends can defend your portfolio.

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Comments

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F958B 11 May 2011 , 12:12pm

I like DGE as a business, but the shares are too richly priced for my liking, given the fundamentals.
Fairly valued around £11.50 in current market conditions.

They remain on my "wish list", but I would not want to be paying more than about £10.50, to allow for a margin of safety and dealing costs.

When they stumble - as even the best companies do, from time to time - I'll be there waiting to scoop up a truckload for a long-term-buy-and-hold.

XMFPhila100 11 May 2011 , 12:15pm

Hi F958B,

I think that's a very fair way to approach Diageo at the moment.

Foolish best,

Todd Wenning

jackdaww 11 May 2011 , 1:17pm

F958B

i got mine at £9.30 2 years ago.

would be very interested how you arrive at a fair current value of around £11 - just a rough idea.

thanks

F958B 11 May 2011 , 1:36pm

jackdaww

I arrive at my valuation by what I call my:
"Theory of relativity".

I take the fundamentals of about 20 similar companies, including likely growth and future risks.
I then weight the fundamentals/growth/risk of one company against another, and relative to the current share price, the broader FTSE100 and the longer-term trends in the company's of the market's valuation.

It involves a large Excel spreadsheet with numerous interlinked cells that run calculations.

At the moment, without going into detailed numders, some of the most important characteristics of DGE relative to the average "defensive" type of company in the FTSE:

Forward P/E somewhat worse than average.
Forward dividend yield slightly worse average.
Expected growth about average.
Financial strength about average.
Risk (e.g. litigation, regulatory etc) slightly better than average for a defensive company.

DGE have nothing special *relative* to similar companies.
On the other hand, if we take TSCO:

Forward P/E slightly better than average.
Forward dividend yield about average.
Expected growth slightly above average.
Financial strength about average.
Risk slightly better than average.

Tesco wins, offering, on balance of many features, about 20% better value-for-money than DGE at yesterday's closing prices.

F958B 11 May 2011 , 1:41pm

It's somewhat similar to Todd's "dividend report card" system, but with my own "customised" variables.
I've been using this system, with minor tweaks, for many years.

TonyTwoTimes 11 May 2011 , 3:15pm

Diageo invariably looks expensive when compared to Tesco.

I've owned Diageo shares for donkey's years and can't remember any time when people said that they were really cheap, not even during 2008.

The key factor is that virtually all of Diageo's products are luxury goods. In contrast Tesco's product mix includes a lot of normal and inferior goods (luxury, normal and inferior as per the economists definition).

So as incomes around the world rise Diageo's profits should, in the long term, increase at a faster rate than the likes of Tesco. Which is why it's on a higher PE ratio

F958B 11 May 2011 , 3:43pm

What if we - or emerging nations - don't get significantly richer?
Emerging nations have been highly dependend on our over-consumption and could suffer badly if "the West" has a long, slow slump (which is what I expect).
What if rising inflation erodes any gains in earnings, as has been happening in recent years?

As many food/beverage/household companies have found recently: commodity prices can be crippling.
ABF, ULVR, BVIC and others have all given profits warnings over input costs.
Brand names may count for something, but, as the dairies found out: the supermarkets have considerable power and can price the goods at whatever they wish.
In troubled times, there may be some element of "trading-down".
As examples: tobacco has seen a significant increase in (cheaper) "roll your own" and the discount stores (ALDI/LIDL etc) have had some outstanding increases in revenues.

.....................

On the subject of DGE outgrowing TSCO, the historical evidence suggests that DGE promise a great deal, but actually deliver less than you'd think..

Last reported earnings for TSCO: 35.9p (14.46p divi)
Five-years-previous reported earnings: 22.36p (9.64p divi)
Change over last five years:
EPS: 1.61x
divi: 1.50x

TSCO Forecast EPS growth: +9% (FY2011), +11% (FY2012)
Forecast divi growth: +9%

Last reported earnings for DGE: 74.2p (38.1p divi)
Five-years-previous reported earnings: 67.2p (31.1p divi)
Change over last five years:
EPS 1.10x
divi: 1.23x

DGE forecast EPS growth: +7% (FY2011), +9% (FY2012)
Forecast divi growth: +7%

.....................

From my perspective, DGE give an illusion of greater prospects than TSCO, while actually delivering inferior returns.

I rest my case that TSCO offer about 20% better value for money at current prices.

.........

eccyman 11 May 2011 , 5:38pm

Couple points

#1 Diageo drinks are premium, but not luxury. For most people a bottle of spirits is an occaisonal treat, I only buy about four bottles a year and normally go for Diageo type brands - it's not like smokers who spend a large part of their disposable income on their habit.

#2 Don't see input costs as too big an issue as most of the cost of their product is tax.

TonyTwoTimes 11 May 2011 , 5:56pm

hi eccyman,

I'm using "luxury good" in the economics' sense, i.e. an increase in consumers' income of 1% causes their spending on the luxury good to increase by more than 1% (for "normal goods" it's 1% for 1% and for "inferior goods" the increase is less than 1%).

Alcohol, particularly spirits, is a luxury good. The trading down will have been from premium to non-premium brands (which are cheaper luxury goods)

This is where the argument comes in about rising incomes in the developing world. This should translate into faster rising sales there (particularly in India).

As F958B has pointed out, Tesco has done better in the last five years. But I'd argue that we've been through the biggest global recession in the last five years so sales of luxury goods will have been hit harder than the typical mix that Tesco sells.

eccyman 11 May 2011 , 6:14pm

Presumably is Diageo were to call in McKinsey, they'd be advised to cut the divi and instead buy back their own shares - then be given a hefty bill for these wise words.

F958B 11 May 2011 , 7:13pm

Tony 2x

Don't get me wrong: I like DGE and I would like to be a long-term shareholder (at the right price).
Yes, perhaps TSCO are flattered by the recent recession, but I see a long, difficult road ahead for the economies of the West, with yet another deep/prolonged recession a few years down the line.

The developing nations seem like a bit of a wild card.
Do they depend too greatly on Western demand for their economic wellbeing, or will they be able to self-sustain if the developed world's extreme debt problems causes us to catch "Japanese disease"?

When "the West" double-dips due to us simply having kicked the can down the road (actually more like "double crashes") in a few years time (2013-14 is my guess), I think that emerging nations could be hit very hard when Western demand disappears again.

Additionally, many emerging nations have a long history of currency devaluations and inflation. Brazil, Russia etc.
While these devaluations keep the nations competitive, it also reduces the value of overseas earnings generated in those currencies. I remember UU making a significant write-down of their Argentine water assets about ten years ago, after the Argentine default.

It used to be quite common that investing in the Dow was frustrating because as the Dow went up, the Dollar declined (actually a weak Dollar pushed up the Dow) and the currency weakness significantly offset an equity gain with a currency loss.

In summary: I treat emerging nations with caution, but appreciate a company that has a diverse spread of currencies represented in its geographical spread.

TonyTwoTimes 11 May 2011 , 8:54pm

Hi F958B,

Yes, it's difficult to picture what's going to happen with the developing nations.

I take the view that India and Brazil are better bets than China, mostly because they are democracies, albeit flawed ones.

DGE gives worldwide exposure. Tesco doesn't to the same extent, but I'm sure it will in twenty or thirty years time (especially if they can crack India, which is a nightmare due to its regulations regarding retail outlets)

Clitheroekid 12 May 2011 , 6:36pm

F958B

I was interested by your approach to valuation.

If you don't mind telling me, what other companies is your valuation method showing as good value?

CK

F958B 12 May 2011 , 7:24pm

Clitheroekid

I track closely about twenty companies from the FTSE100, which have relatively stable revenues and better-than-average dependability.
My investment philosophy - like my chess strategy - is to play a solid defensive game, with damage limitation a high priority.
If the downside is covered, the upside usually takes care of itself.

It may surprise people that such "stodgy" companies tend to do better-than-average in the long term, due to their stable earnings and steady but unexciting performance. Their shares tend to only be two-thirds as volatile as the average FTSE share. You can verify this by their Beta values of 0.5-0.75 and the extent of their declines in the 2007-9 bear market.
It's the downturns that kill businesses, so the ideal business is one that is resistant to downturns.

As of tonight's close, I rate them as follows:

Extremely undervalued:
AstraZeneca

Moderately undervalued:
Scottish & Southern Energy, Vodafone.

Slightly undervalued:
Centrica, GlaxoSmithKline, National Grid, Sainsbury, Tesco, Morrison's.

Fairly valued:
Brit.American Tobacco, BT, Imperial Tobacco, Reckitt Benckiser, Unilever.

Slightly overvalued:
Diageo, Severn Trent, United Utilities.

Moderately overvalued:
AB Foods, SAB Miller

...............

Many of the above shares have had a great run in recent weeks, since commodities took a tumble. This recent price jump and ongoing market correction puts them at increased risk of profit taking, so maybe don't go piling in with too much too soon, unless you can ride-out a potential 10% correction.

.............

I hold shares in AZN, GSK, IMT, MRW, NG., SSE, TSCO, VOD.
Despite CNA and SBRY being slightly cheap, I consider that I already have both sectors well-covered, with my holdings in SSE, NG, TSCO and MRW.

.............

If you have a specific company in mind that I haven't listed, I can input its vital stats. But bear in mind that it takes time to seek-out the accounts and strip them of the information necessary, so it is not quick, which is why I specialise in 20 of the FTSE's finest and ignore the rest.

HstG 13 May 2011 , 11:18am

Lots of interesting & informed comments here.
My twopence worth is (I regret to say) somewhat on the negative side, in that it questions one's ability to reach a conclusion based on a co.s a/cs - which we would all agree is a fairly fundamental source obf information.
We would all accept that any Footsie Co.s set of a/cs are over long & too technical for the avearge non-professional investor (with an aveargely full life) to wish to wade through. Even where they have done so, there are so many dodges available within acceptable GAAS, which accountants are expected to operate, to massage figs. (both up & down - depending on the driver in any partic. case) & these strategies change from one accountant to another that.
i woukld just make 2 points here. As an illustration, I discovered quite recently that my employer changed its chargng method on one of its products. There is an upfront fee & an annual fee. Normally these are charged together in the first year. To make our product appear cheaper than that of the oposition, we switched the initial fee for the service to be invoiced on the 364th day of the 1st period thereby making it appear cheaper in the 1st year, but it would make no difference to the annual accounts. Nowhere could you discover this little dodge from our co. accounts - accept in the adverse impact on the cash flow statement, which would seem to be a negative but in fact due to the positive marketing effect it should be viewed in a positive light.
Second, it is interesting how many of us are happy to buy into (or short) other companies but do not choose to to do either with our own employer's shares. If value is a reflection of facts then we should be more confident in doing so than have to relky on the flawed (historical) published accounts & such like public information. We should have a more comprehensive understanding of our employer's profitability (or otherwise) & that one should be able to forsee 'problems' & successes long before it is factored into the market price.

kvet 15 May 2011 , 7:09pm

Well, F958B, I agree with all your valuations-with the possible exception of AstraZeneca, which I don't think is as undervalued as you do. Anyone who has invested in 'sin' shares over the last 30 years will have done v. well.- I bought Gallagher in the early 80's on a P/E ratio of 2!- incredibly cheap. Imps and BATS are still quite reasonably priced, I think. Keep up your interesting posts.

ini1 17 May 2011 , 12:51am

Guys whats do you think the future holds for CEY?

Excel35 20 May 2011 , 11:40pm

F958B what do you think of Compass Group? Maybe Pearson?
Bigger market caps than Morrisions.

Do you ever feel tempted to spread your net slightly wider?

Do you feel your portfolio is diversified enough. Limiting youself to 20 stocks to observe, of which many are considered to high to buy.

Long term I would like to hold BATS and IMT.
Im also interested in SSE, NG, ULVR

By coincidence all these stocks have risen fairly significantly over the last 3 months of so.
Taking the long term view, or the "Time to buy is Now" view would you consider these stocks buys at current prices?

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