When I think of alcoholic beverage producer Diageo (LSE: DGE) (NYSE: DEO.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.
1) Debt
Diageo’s drink brands, such as Johnnie Walker, Bushmills, Smirnoff, Baileys and Captain Morgan, although robust, don’t sell into new territories without marketing ‘push’. The firm spent £1,787 million on marketing last year, 11.5% of the value of sales.
Marketing is one of many costs. For example, high intangible-asset figures on the balance sheet suggest that the firm can put a lot of growth down to acquisition. Diageo has partly financed its ascendancy to the premier league of worldwide companies with debt. The firm’s net debt figure is running at around 2.4 times operating profits, not huge, but big enough to keep a close eye on.
Thanks to rising operating profits, the ratio of debt to operating profit has been coming down, but the absolute level of net debt has been going up:
| Year to June | 2009 | 2010 | 2011 | 2012 | 2013 |
|---|---|---|---|---|---|
| Net debt | 7,661 | 7,311 | 6,611 | 7,553 | 8,319 |
| Operating profit | 2,418 | 2,574 | 2,595 | 3,158 | 3,431 |
| Debt divided by profit | 3.2 | 2.8 | 2.5 | 2.4 | 2.4 |
2) P/E cyclicality
Investors tend to go for businesses with resilient cash flows in times of economic turmoil. Take the credit crunch and recession we’ve recently experienced, the ‘defensives’ such as Diageo were popular and the shares of such companies have been in a long bull run, which has driven up P/E ratings.
As more favourable general economic conditions return, the risk is that investors shift to ‘sexy’ growth companies, adopting a ‘risk on’ attitude and leaving the ‘defensives’ behind. The result could be P/E compression for stalwarts like Diageo, which could drag against the firm’s operational progress in terms of investor total returns. As such, the P/E rating of ‘defensives’ such as Diageo could prove to be counter-cyclical to the wider macro-economic cycle.
What now?
Despite such concerns, Diageo’s emerging-market presence combines with its consumer-product credentials to create an attractive business model.
