The FTSE 100 stock I’m looking at now has fallen by 40% since hitting record highs in early 2022.
The company is drinks giant Diageo (LSE: DGE). This £50bn firm owns brands including Johnnie Walker, Guinness and Smirnoff, plus many high-end whisky and tequila brands.
Drinkers poured doubles during the pandemic and spent more money on premium spirits. Diageo reported record profits in its 2022/23 financial year.
However, the party’s now come to an end. Long-term shareholders have been left with a serious hangover. Diageo’s share price has fallen from a 2022 high of £41 to less than £25, at the time of writing.
Cutting back on booze
After three years of high inflation, cash-strapped consumers are buying fewer bottles of spirits and they’re choosing cheaper brands.
Diageo’s results for the year to 30 June showed a 4% reduction in volumes last year. Within this, sales of its value brands rose by 5.4%, while sales of its super-premium brands fell by 6.7%.
The worst falls were seen in the Latin America and Caribbean region, where a stock overhang triggered a profit warning last year. Another potential risk is the US market, where there are growing signs of a consumer slowdown.
Why I think Diageo could be cheap
Diageo has a broad portfolio of brands and is able to adapt to changing consumer tastes. I think spending will recover, over time. Indeed, as a long-term investor, I think the current weakness is more likely to be a buying opportunity.
Companies with Diageo’s quality metrics are often very expensive. Last year’s results showed an operating profit margin of 29% and a return on capital employed of just under 17%.
These above-average figures highlight the company’s ability to generate value for shareholders, while still investing in growth.
In my view, Diageo’s strong profitability’s probably the main reason why the shares have beaten the FTSE 100 over the last 10 years, despite the share price slump over the last 18 months.
Looking ahead, Diageo shares are trading on a 24/25 forecast price-to-earnings (P/E) ratio of 16 with a dividend yield of 3.4%. That’s relatively cheap for a business of this kind, in my experience.
What could go wrong?
Diageo reported net debt of three times EBITDA (a measure of profits) at the end of June. That’s slightly above my comfort zone. I’d prefer to see leverage between 2x and 2.5x. However, it wouldn’t stop me investing, given Diageo’s high profit margins.
The other risk I can see is that a recovery could take longer than expected. This could carry an opportunity cost – maybe I could make more money investing elsewhere?
What I’m doing
I think Diageo’s likely to remain a high-quality business with strong brands and good cash generation. At current levels, the shares look good value to me and the 3.4% dividend yield’s within my buying range for this kind of business.
I haven’t made a final decision yet. But Diageo’s certainly on my shortlist to consider as a possible addition to my long-term income portfolio.
