As I write, Diageo (LSE: DGE) (NYSE: DEO.US) shares are within a whisker of 2,000p, and have now recovered all of this year’s losses.
The question for shareholders is whether the shares are worth more than 2,000p — or whether their recent outperformance is going to lead to a period of weakness. After all, Diageo’s earnings are expected to fall this year, currency effects are working against the firm, and the shares look pretty expensive.
Quality worth paying for?
The argument in favour of buying Diageo stock has long been that it’s worth paying a premium for quality. Diageo has a high 26% operating margin, and has delivered an average return on capital employed of 16.8% over the last five years, compared to just 9.3% for brewer SABMiller.
Despite their current weakness, emerging markets such as Latin America and China offer significant medium-term growth potential for Diageo, as does the US — historic trends suggest that drinkers tend to upgrade to spirits during periods of economic growth.
Although Diageo’s net gearing is a hefty 125%, highlighting how debt has been used to fund many of the firm’s successful acquisitions, Diageo’s high profit margins and strong cash generation mean that the firm’s $8.6bn net debt doesn’t concern me as much as it would at most other firms.
Yes, but it’s all in the price
Of course, you could argue that much of Diageo’s growth potential is already reflected in the firm’s share price: Diageo shares trade on a trailing P/E of 20 and a yield of 2.6%, compared to 15.4 and 3.5% for the FTSE 100.
What’s more, the firm’s adjusted earnings fell by 7.4% last year, and are expected to fall — or at best flatline — this year, before rising in 2015/16.
It’s also worth noting that Diageo has lagged the FTSE 100 over the last two years, gaining just 7% against the FTSE’s 20% rise. Could this be the beginning of a period of consolidation that will bring Diageo’s returns back into line with the FTSE average?
Will Diageo break 2,000p?
In my view, Diageo shares can, and will, break through the 2,000p barrier again.
However, I think that it will be some time before they deliver any meaningful gains above this level, and I wouldn’t be surprised to see a period of weakness in the meantime.
Overall, I rate Diageo as a hold.
