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How Will Diageo plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

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To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at alcoholic beverage producer Diageo (LSE: DGE) (NYSE: DEO.US).

Track record

With the shares at 1986p, Diageo’s market cap. is £49,784 million.

This table summarises the firm’s recent financial record:

Year to June 2009 2010 2011 2012 2013
Revenue (£m) 12,283 12,958 13,232 14,594 15,487
Net cash from operations (£m) 1,619 2,298 2,183 2,093 2,048
Adjusted earnings per share 69.7p 72p 83.6p 94.2p 104.4p
Dividend per share 36.1p 38.1p 40.4p 43.5p 47.4p

1) Prospects

Diageo’s North American business delivered around 41% of operating profits during the company’s last financial year. The region delivers a bigger share of profits than any other, and a recent trading statement revealed sales grew about 5% there during the most recent quarter.

The firm’s North American business is a good one, driven mostly by spirit sales. However, up-and-coming markets collectively beat the contribution from America for the first time this year. Combined operating profit from Africa, Eastern Europe, Turkey, Latin America, the Caribbean and the Asia Pacific came in at about 42% in the last full-year results, demonstrating the escalating importance of such emerging markets.

The opportunity for expansion still seems on track. For example, a recent management update reported double-digit sales growth in Latin America and the Caribbean over the recent quarter. Meanwhile, sales in Western Europe remained static. That’s becoming less important as the percentage operating profit contribution from Western Europe declines in relation to growth elsewhere. The most recent full-year report showed the region delivering 17% of the firm’s total, down from about 22% a year ago.

2) Risks

The firm’s drink brands, such as Johnnie Walker, Bushmills, Smirnoff, Baileys and Captain Morgan in Britain, although strong, don’t sell themselves. Diageo spent £1,787 million on marketing last year, 11.5% of the value of sales. That’s a big commitment that needs to achieve increased sales, and there must be some risk of a particular advertising campaign failing to strike a chord with consumers.

Meanwhile, Diageo’s net debt is running at around 2.5 times operating profits, not huge, but big enough to keep a close eye on.

The latest management statement acknowledges weakness in some markets, and draws attention to headwinds in some emerging markets, including the effects of government policies in China. Overall, the firm expects a low single-digit sales decline for the current full year.

In terms of the investment proposition now, I think economic cycles affect Diageo shares as they move in and out of popularity. Investors tend to prize such firms for their defensive characteristics, which can drive P/E ratings up in troubled economic times, such as recently. When investors return to more risky investments, leaving the defensives, P/E compression can nullify the effects of business progress for investors holding companies like Diageo.  

3) Valuation

City analysts following Diageo expect earnings to advance about 5% during 2014. Meanwhile, those earnings twice cover a forward dividend, yielding about 2.6%.

The forward P/E rating is running at around 18, which looks ahead of earnings growth and yield expectations, to me.

Conclusion

Diageo is still growing sales and has opportunities to expand in emerging markets, but I’m uncomfortable with the premium price that potential is commanding at the current P/E rating, so Diageo can stay on my watch list for the time being.

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> Kevin does not own shares in Diageo.

 

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