Is Diageo plc An Annuity Alternative?

Annuity giant Legal & General expects the UK annuity market to halve in size following the changes announced to pension rules in this year’s Budget.

That means that annual annuity sales of £12bn could fall to £6bn or less — leaving an extra £6bn per year in the hands of investors, many of whom I believe are likely to invest the bulk of their pensions in dividend stocks.

In my view, George Osborne’s decision to liberate pension funds could end up giving the stock market a boost — in particular, large cap dividend stocks like Diageo (LSE: DGE) (NYSE: DEO.US), which have the ability to deliver long-term growth.

Taking the long view

Diageo’s 2.6% prospective yield isn’t the highest in the market, but what the firm does offer is a market-beating record of dividend growth. Diageo has increased its dividend every year since 1999, during which time the firm’s payout has risen by 150%.

Over the last seven years, Diageo’s dividend has grown by an average of 6.7% per year, meaning that income investors have received an above-inflation pay rise every year. This kind of dividend growth means that it can be worth accepting a lower initial yield, especially if you are still a few years away from retirement, and don’t yet need the income.

Can Diageo sustain its growth?

Diageo’s earnings per share have grown by an average of around 11% per year since 2008. I don’t expect this rate of growth to continue indefinitely, but it doesn’t need to.

A portfolio of global brands, such as Guinness, Johnnie Walker and Smirnoff, means that Diageo enjoys strong pricing power in all of its markets, and boasts an operating margin of 30%. As a result, Diageo’s cash flow is very strong, and its dividend has been covered by free cash flow every year for the last six — a record that many of the firm’s FTSE 100 peers might envy.

Even if Diageo’s growth slows, this profitability should be sustainable, as the firm’s brands create a barrier to entry for smaller competitors, most of which are forced to compete on price.

Buy Diageo today?

Diageo shares currently trade on 18 times forecast earnings, so they aren’t cheap. Although Diageo’s share price is 9% lower than it was a year ago, there’s no way of knowing whether this gradual decline will continue, or whether the firm’s shares will take off again.

I believe Diageo is an ideal stock for a regular investing strategy, which will average out fluctuations in price, and capture the benefit of the rising dividend.

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Roland does not own shares in any of the companies mentioned in this article.