Is Diageo plc A Safe Dividend Investment?

DiageoI can understand why investors go for alcoholic beverage producer Diageo (LSE: DGE) (NYSE: DEO.US) when they are looking for an income stream. After all, at today’s share price of 1852p, the forward dividend yield is running at about 3% for 2015 and City analysts expect underlying earnings to cover the payout almost twice that year.

What’s more, the firm’s brands such as Johnnie Walker, Crown Royal, J&B, Buchanan’s, Windsor, Bushmills, Smirnoff, Ketel One Vodka, Ciroc, Captain Morgan, Baileys, Tanqueray and Guinness have ironclad repeat-purchase credentials that will power cash flow for years to come, right?

Well, yes, but…

How is that dividend paid?

The thing to remember about dividends is that cash pays them. If a company doesn’t have the cash, it can’t pay the dividend so, by extension, a company paying a dividend is showing that its cash flow cuts the mustard, right? 

Wrong. Companies seem to pay dividends for all sorts of reasons, even if they don’t have enough cash coming in, and that’s exactly what Diageo did recently. When you look at the firm’s cash flow statement is seems clear that the Diageo financed its dividends during the 2013 and 2012 trading years by taking on new debt and by raiding the company piggy bank!

In an ideal scenario, companies will use cash flow to spend on maintenance capex and what’s left over can go to fund captial investment for expansion. Any cash flow remaining after those investments can then be used to reward investors. In 2013, though, Diageo had about £789 million of cash flow left over for shareholder returns after funding maintenance capex and buying new businesses, yet it spent around £1236 million rewarding shareholders with dividends and share repurchases. That’s an overspend of £647million. In 2012, the overspend was even bigger at £1019 million. How were the books balanced? By taking on more debt, that’s how.

Gearing up to finance growth

Essentially, Diageo seems to be financing acquisitive growth with debt: it’s gearing up. Which begs the question, should the firm be paying dividends it can’t afford? Smaller growth companies typically don’t pay dividends if it means borrowing money to do so, and that’s a jolly good idea.

Diageo enjoys stellar cash flow, but I’d be happier if it decided how to spend it rather than spending it on everything and running up its debts. The situation is a downer on an otherwise decent dividend growth story. Running up debts adds risk as even consumer firms can suffer a downturn in trade, which could cause debt to drag on investor returns in the future.

This is what the debt record looks like:

  2009 2010 2011 2012 2013
Borrowings (£m) 8575 8764 8195 8629 10,091
Debt divided by cash flow 5.3 3.8 3.8 4.1 4.9

Debt is on the rise and it’s worth keeping a close eye on going forward.

Flat cash flow

Diageo has been driving up its adjusted earnings-per-share and dividend-per-share figures but cash flow looks flat. That’s another reason to be cautious, here. In its pursuit of untold emerging-market riches is the firm pulling too hard on the throttle, racing ahead with debt-fuelled expansion and leaving the cash-flow pillion passenger standing by the road side? Here are the figures:

  2009 2010 2011 2012 2013
Net cash from operations (£m) 1619 2298 2183 2093 2048
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

Ultimately, there’s no point in debt-financed expansion if cash flow doesn’t improve. Comparing the absolute debt level to the absolute cash-flow level suggests cash flow needs to step up. After all, Diageo achieved higher cash flow in 2010 than in 2013, even though debt increased by more than 15% by 2013. As I’ve argued, in the context of cash flow, you could say that the extra debt has just financed dividend payments, which makes the firm seem less appealing as a dividend payer.

What now?

Diageo might not be the best dividend proposition on the block, as it doesn’t seem able to finance both acquisitive growth and dividend payments from flat cash flow without taking on debt.

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Kevin Godbold has no position in any shares mentioned.