Diageo (LSE: DGE) has long been a favourite defensive stock for me. When things are going well, people have a drink to celebrate. And when they’re going badly, it’s a wee dram to drown the sorrows. The closure of pubs and clubs hasn’t helped, mind, and the Diageo share price is down 19% so far in 2020.
But off-licences were deemed essential shops and remained open through the lockdown, and entertainment venues are opening up again.
Still, investors were unimpressed by August’s first-half figures, pushing the shares down on the day. With operating profit falling 47%, I can understand it. But it’s hardly a massive surprise. And the result is still actually a profit, of £2.1bn, when many major companies are struggling to avoid losses.
But I do have concerns over Diageo’s debt. At 30 June, net debt had reached £14bn, up from £12bn a year previously. To put that into some sort of meaningful measure, Diageo stated its adjusted net debt to adjusted EBITDA multiple (its leverage) at 3.3 times. That’s way above the firm’s target of 2.5 to 3 times, and the firm expects it to remain above that range through to June 2021. With that balance sheet outlook, I can understand why there’s pressure on the Diageo share price.
Shareholder returns
Diageo did lift its dividend by 2% for the full year. That gives me mixed signs. I’m a bit disturbed when a company pays dividends while shouldering heavy debt. But on the other hand, keeping dividend growth ahead of inflation does form an important bond with shareholders. I rate Diageo as an attractive income investment for retirement, and maintaining a level of confidence is an important priority.
The dividend was not the only capital return route, as Diageo had been buying back shares too. But the firm suspended its planned three-year return of capital in April 2020. It’s all because Diageo wants to get that leverage back within target, and won’t restart buybacks until it achieves it. I can see the Diageo share price remaining under pressure until that milestone is reached.
The suspension seems like an obviously sensible move, but does it go far enough? I generally don’t like to see companies effectively borrowing to pay shareholders, and a leverage in the range of 2.5 to 3 times still seems undesirably high to me.
Diageo share price still low
But then, debt financing can gear up earnings to a significant extent, if a company can generate strong margins while borrowing at low enough interest rates. Some companies are stable enough to do that over the long term. And if anyone is stable, it’s surely Diageo. Diageo’s list of worldwide alcoholic beverage brands is legendary.
We’re familiar with Johnnie Walker, Smirnoff, Captain Morgan, Gordon’s, Guinness, and many other brands here in the UK. But worldwide there are so many more, including such delights as Shui Jing Fang, Yeni Raki, and Ypióca. And who can forget Rumple Minze?
I see Diageo as the kind of company that can carry debt more profitably than most, with lenders always ready to oblige. It’s surely one of the least likely firms in the world to go bust. And in a year or two, when alcohol volumes are back up to normal, I expect we’ll look back on today’s Diageo share price and wonder how it ever dropped so low.
