Is Diageo plc Dependent On Debt?

Are debt levels at Diageo plc (LON: DGE) becoming unaffordable and detrimental to the company’s future prospects?

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2014 has proved to be a disappointing year for shareholders in Diageo (LSE: DGE) (NYSE: DEO.US). Indeed, shares in the global alcoholic beverage company are currently down 6%, while the FTSE 100 is up around 1% (at the time of writing).

The reason for this appears to be Diageo’s exposure to emerging markets, with the company ‘looking east’ for much of its future growth and focusing resources and capital on emerging economies, such as China. Therefore, with the FTSE 100 having had a ‘wobble’ in the last two months concerning the sustainability of the emerging market growth story, it seems understandable that Diageo may have been hit harder than the average listed company.

However, the reason for Diageo’s underperformance could be an aspect of the company itself. Indeed, with high levels of financial gearing, is the market beginning to question the finances of Diageo? In other words, is it dependent on debt?

Excessive debt?

With a debt to equity ratio of 125%, Diageo lives with a very high level of financial gearing. Certainly, there is a benefit to this, in the form of increased returns to shareholders (since being financed by debt means less equity is required, in theory). However, due to the relatively stable revenue stream that Diageo enjoys, debt levels may not be as excessive as they first appear.

That’s because people tend to drink alcohol in the good and bad times, meaning that Diageo’s revenues are very defensive. Therefore, it can afford to accommodate higher amounts of debt than if it were a cyclical company, whose revenue fluctuated depending on economic circumstances, for instance.

In addition, Diageo remains highly profitable and can easily afford its debts. With an interest coverage ratio of 8, Diageo should also be in a comfortable position (with adequate headroom) when interest rates do eventually increase.

Looking ahead

Although Diageo’s exposure to the developing world may have held its shares back of late, it should prove to be highly beneficial in the long run. With a population that is growing in wealth and demanding more luxury goods, Diageo’s stable of high-end brands should prove popular in future. With a comfortable debt position and the potential for impressive growth rates in emerging markets, 2014 could yet prove to be a strong year for Diageo.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Peter does not own shares in Diageo.

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