People who enjoy a good tipple may have experienced seeing things that turn out not to be there. Brewer and distiller Diageo (LSE: DGE) has had a great few decades as a business. But Diageo shares have fallen 32% in five years, as many investors are concerned about what the FTSE 100 business’s future commercial prospects are.
I think those prospects are bright and so I am happy hanging onto my Diageo shares. But could this be the sort of mirage that in fact turns out to be a value trap?
Great assets, but what next?
Diageo has been massively profitable for years.
That stems from a number of reasons. It has a large addressable market of end customers. It is a well-run firm that benefits from economies of scale. It also has a portfolio of unique, premium brands (many backed by iconic production facilities) that give it pricing power.
But the ground around Diageo’s feet has shifted.
The brands are still as powerful, in my view. Diageo’s recent performance has raised some questions about how well it is run, such as when some Guinness supplies ran low in the UK last year. But I think getting back to great management is doable and within the company’s control.
A much bigger long-term issue, that is largely outside Diageo’s control, is the future demand prospect for alcoholic drinks.
Diageo has pushed into non-alcoholic and low-alcohol products, but I think its future success will depend on its core market of booze.
This could be a value trap
That 32% decline in the value of Diageo shares gives me pause for thought as an investor in the company. After all, during the past five years, the wider FTSE 100 index has gone up 66%.
A value trap is a value trap precisely because it does not look like one.
A company with a storied history, excellent assets, and large customer base hits some hard times and the share price falls. Investors think they are getting a bargain, but that is because they are focused on the firm’s past, not what it might realistically achieve in the future.
Does that description apply to the Diageo of 2025?
I think it could. After all, younger generations of consumers are drinking less than their forebears did. That could see demand fall dramatically in decades to come.
I’m optimistic. Here’s why
Diageo’s premium brand portfolio might still perform strongly within the market, but if the market size shrinks dramatically then Diageo’s sales volumes will likely suffer.
It could use its pricing power to put up what it costs to buy a bottle of Talisker or Smirnoff, for example, taking a leaf out of the tobacco industry’s playbook on mitigating declining sales volumes. If the market shrinks enough, though, profits are bound to be hit sooner or later.
Still, while I see that as a risk, I continue to see value in Diageo shares at the current price. I believe they deserve to be higher.
Drinking trends come and go. This is far from the first time in history that some social groups have cut back on booze or cut it out altogether.
But I expect the long-term demand to stay high. On that basis, I see Diageo shares as potentially offering good value, rather than being a value trap.
