Is Diageo plc A Promising Capital-Growth Investment?

DiageoAfter a jolly good run up from early 2009 alcoholic beverage producer Diageo’s (LSE: DGE) (NYSE: DEO.US) shares have been on the slide since the middle of 2013.

In the trading year to June 2014, earnings declined a bit, but forecasters expect a rebound in the current year. Last year’s earnings’ wobble could be driving what looks like downward valuation re-rating, but there could be more to the story.

Acquisitive growth

Trading is tough in emerging markets just now, reckons Diageo’s chief executive, but the firm sees its future in such up-and-coming areas, which is why it has made a string of acquisitions there recently.

Around 36% of operating profit came from fast-growing markets last year, so progress in newly affluent regions of the world is significant for Diageo shareholders. However, Diageo seems to be financing acquisitive growth with debt; relative to struggling cash flow, debt is on the rise:

  2010 2011 2012 2013 2014
Net cash from operations (£m) 2,298 2,183 2,093 2,048 1,790
Borrowings (£m) 8,764 8,195 8,629 10,091 9,214
Debt divided by cash flow 3.8 3.8 4.1 4.9 5.2

I wonder whether sluggish cash flow is driving Diageo’s valuation compression right now.

Until cash flow begins to grow, P/E compression could drag against capital-growth for Diageo investors, and there’s no short-term relief on the horizon. The catalysts for a near term recovery of consumer spend in the emerging markets are still weak, Diageo reckons, however the future growth drivers for the industry remain undiminished.

Indeed, with its powerful brands, all oozing with solid repeat-purchase potential, Diageo seems well placed to keep cash flowing. But how long will it be before names such as Johnnie Walker, Crown Royal, J&B, Buchanan’s, Windsor, Bushmills, Smirnoff, Ketel One Vodka, Ciroc, Captain Morgan, Baileys, Tanqueray and Guinness get that cash flow growing? It’s a crucial question for those timing an investment in Diageo now.

What next?

Diageo achieved higher cash flow in 2010 than in 2013, so a return to form seems essential if the firm is to deliver on capital growth for investors.

At today’s share price of 1,757p, Diageo trades on a forward P/E rating just over 17 for 2015 and the forward dividend yield is running around 3%. Given that the firm expects earnings to grow just 7% that year, the valuation still looks rich and it wouldn’t surprise me if the shares continue to drift down. Maybe a better bargain will emerge down the road enabling canny investors to lock in a bigger dividend yield to savour whilst waiting for a return to cash-flow growth.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool has no position in any shares mentioned.