What’s Wrong With Diageo PLC And SABMiller PLC?

Lots has been said and written about Diageo (LSE: DGE) (NYSE: DEO.US) in recent weeks. Among other things: trading conditions are incredibly tough and growth sputters, especially in emerging markets; asset write-downs pose a serious threat to shareholder value; profitability will be under pressure for a very long time; finally, investment plans are too ambitious.

Most of these arguments hold true for SABMiller (LSE: SAB), too. Both companies are cutting costs to preserve margins, and are faced with a challenging late-cycle phase. The shares of Diageo and SAB, however, offer more upside than downside, in my view.

Strong Fundamentals

DiageoDiageo isn’t likely to grow at a terrific rate in the next couple of years, but even if its sales grew just in line with inflation, its operating profit margin would likely remain in the region of 30% as a result of cost cuts. The same applies to SAB’s profitability, although SAB is expected to grow sales at a faster rate.

Their relative valuations — as gauged by the enterprise value (EV) to earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio – don’t indicate “bargain territory”, but both companies boast strong fundamentals and emerging market exposure is essential to value creation in the long run.

It’s easy to forget that Diageo and SABMiller are resilient businesses, operating in a sector with high entry barriers, and generating a respectable net income margin above 20%. Their financials are sound, and debts are manageable. In normal market conditions, the shares of both companies should fetch a forward EBITDA multiple above 12x, yet they aren’t defensive right now. Why so?


SAB MillerWith an EV/EBITDA of 13.7x and 12.8x for 2015 and 2016, respectively, the shares of Diageo trade broadly in line with those of SAB, although the brewer’s stock has received a fillip from takeover rumours that have boosted its value by at least 5% in recent weeks. SAB and Diageo are not cheap, fair enough.

In fact, Diageo’s EBITDA is expected to grow at a normalised rate of just about 5% a year to the end of 2017. But keeping the trading multiple constant, Diageo stock hits 2,000p from its current level of 1,718p. Returns could be higher if investors switch to “risk off” trades during the investment period. 

For its part, SAB is expected to record a growth rate of about 10% for EBITDA, so the upside associated with its equity valuation may be greater, although I am convinced Diageo is a more defensive play, particularly if it shrinks its assets base. Both companies pay hefty dividends, their net leverage is expected to drop over time, and their prized assets appeal to buyers.

Do you still think I am wrong?


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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.