Former Diageo (LSE: DGE) (NYSE: DEO.US) chief executive Paul Walsh transformed Diageo from a drifting food and drink company into a tightly focused, very profitable and very large global drinks firm, which owns brands such as Guinness, Captain Morgan, Johnnie Walker, Baileys and Smirnoff.
Although Walsh deserves full credit for his success, I’m concerned that Diageo investors have been dazzled by Walsh’s past achievements, and are not paying enough attention to the future.
As I write, Diageo is the 26th largest company in the FTSE 100, with a market capitalisation of £50bn.
Diageo shares have risen by 102% during the last five years, and currently trade on a trailing P/E of 21, with a dividend yield of just 2.3%. This makes them considerably more expensive than the FTSE 100 average of 17.5 and 3.0%.
Cash flow crunch?
Diageo’s constant expansion is beginning to place some pressure on its cash flow. The firm’s free cash flow per share has fallen for the last four years, while its capex per share has risen for each of the last six years.
If this continues, Diageo’s dividend may not be covered by free cash next year, and may be added to the firm’s £8.4bn net debt pile, which has risen by 30% since 2011, and gives Diageo net gearing of 118% — a little high for my liking.
Interest costs accounted for 13% of Diageo’s pre-tax profits last year, and if bond yields rise over the next few years, this proportion could increase.
How good is Diageo without Walsh?
I think Walsh’s departure may well mark the end of Diageo’s long run of trouble-free growth, and it’s possible that Paul Walsh does too. So far this year, the former CEO has banked profits of more than £14m by selling some of his Diageo shares.
Diageo’s board also seems to be nervous about letting Paul Walsh go. Although Walsh was replaced as CEO by Ivan Menezes on July 1, Walsh continues to receive a larger salary than CEO Menezes, and will remain employed as an advisor until next June, despite starting his new job as Chairman of catering giant Compass Group in February.
Although Diageo may be a hold for long-term income investors, I believe that anyone wanting to lock in their capital gains should consider following Paul Walsh’s example and selling their Diageo shares.
Finding the next Diageo
If you’ve already taken the plunge and sold your Diageo stock, you may be looking for high-quality blue chip companies that currently look cheap.
Buying such companies has worked well for top UK fund manager Neil Woodford. If you’d invested £10,000 into Mr Woodford’s High Income fund in 1988, it would have been worth £193,000 at the end of 2012 — a 1,830% increase!
> Roland does not own shares in any of the companies mentioned in this article.