What Dividend Hunters Need To Know About Diageo plc

Today I am looking at whether beverages giant Diageo (LSE: DGE) (NYSE: DEO.US) is an appealing pick for those seeking chunky dividend income.

Emerging markets on the ropes

Diageo shocked the market earlier this month when it announced that intensifying sales weakness in developing regions pushed total net organic revenues 1.3% during January-March.

Most notably, sales in Asia Pacific slumped 19% during the period, and chief executive Ivan Menezes warned that “currency diageovolatility and caution about the outlook for GDP growth [in emerging markets] are negatively impacting business and consumer confidence.”

Still, Diageo saw sales in North America — the firm’s largest market and responsible for 40% of group profits — tick 1.2% higher in line with expectations. Meanwhile, the previously-bombed out regions of Europe are also showing signs of recovery, with sales there also rising 1.2% during the quarter.

Dividends set to run below market average

Diageo has been a reliable income pick for shareholders in recent times, the firm having consistently lifted the full-year dividend during each of the past five years.

And even though current problems in emerging markets are expected to result in the first earnings dip for many years during the 12 months concluding June 2014 — a 4% decline is forecast — the business is still expected to keep payouts ticking higher.

City analysts expect the drinks giant to lift the total dividend 4% during 2014 to 51.2p per share, with an additional 4% rise pencilled in to 55.5p next year. Still, predicted payments for this year and next only carry yields of 2.8% and 3% respectively, lagging a prospective average of 3.3% for the complete FTSE 100.

Shareholder payouts not a priority

Helped by an anticipated 9% earnings recovery next year, Diageo carries dividend coverage of 2 times forward earnings both this year and next, bang on the widely-regarded security benchmark.

However, investors cannot rely on a chunky cash pile to support solid dividend growth should earnings forecasts miss — indeed, Diageo saw free cash flow slump by more than half to £326m during July-December, mainly due to lower cash from operations and a vastly-higher tax bill.  

Besides, rewarding shareholders with large dividends falls below Diageo’s acquisition drive in the pecking order when it comes to dealing with surplus capital. Indeed, the firm announced plans to hike its stake in United Spirits to 54.8% in recent weeks by purchasing an additional 26% worth of shares for around $1.9bn, a move which will give it control of the Indian spirits manufacturer.

Investors should, of course, be concerned by Diageo’s rapidly declining fortunes in emerging markets, particularly as subsequent earnings constraints could pressure dividend growth. I am a believer in the long-term investment appeal of these regions, however, and am convinced that the firm’s rising exposure to these far-flung climes should deliver solid earnings growth in coming years.

But given Diageo’s current travails in developing regions — not to mention aggressive, and capital-sapping, expansion plans in such territories — I believe that more lucrative income stocks can be found elsewhere.

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Royston does not own shares in Diageo.