Will Diageo plc Be Forced To Slash The Dividend?

Today I am looking at why Diageo (LSE: DGE) (NYSE: DEO.US) could leave income investors with a nasty hangover.Diageo

A proud payout history…

A backdrop of near-consistent earnings growth has enabled drinks giant Diageo to keep shareholder payouts trucking higher during the past five years, with dividends rising at a strong compound annual growth rate of 7.9% since 2010.

And recent forecasts suggest that Diageo is poised to lift the payment once more for the year concluding June 2015, with a further 5.8% hike, to 54.7p per share, currently pencilled in.

However, I believe that a backcloth of worsening trading conditions in key markets could put the kibosh on the company’s history of generous payout rises, at least in the immediate term.

… but trading difficulties could herald downturn

On the plus side, Diageo still has plenty of firepower with which to keep payouts rolling due to its cash-generative qualities. Indeed, free cash flow came in at a hefty £1.24bn as of June, albeit down from £1.45bn at the same point in 2013 due to lower cash from operating activities.

Still, Diageo is having to keep pumping the cash into marketing, product innovation and acquisitions in order to mitigate the effect of declining global sales. As a result the business saw net borrowings leap by almost £2bn from June to £10.85bn as of the end of September thanks to the purchase of an additional 26% stake in India’s United Spirits.

And signs are that the beverages firm will have to keep hitting the chequebook in order to just stand still, as highlighted by last week’s disappointing interims. Diageo saw organic net sales dive 1.5% during July-September, with turnover in Asia Pacific sliding 7.4% due to curbs on extravagant purchases in China. Sales in Europe, and Latin America and the Caribbean, both dived 1.4%.

Only North America — the company’s largest market and responsible for around half of total operating profit — posted sales growth during the period, although a paltry 0.1% improvement in organic net sales hardly steadies the nerves.

City brokers suggest that Diageo is poised to recover from last year’s 7% earnings decline with a tentative 1% advance in fiscal 2015, to 96.6p per share.

However, this projection creates substandard dividend coverage — a reading of 1.8 times predicted earnings, although hardly catastrophic, falls short of the widely-regarded security benchmark of 2 times or above.

Given the top-line travails that Diageo faces in the near-term, and huge capital expenditure required to resuscitate growth, I believe that the chunky dividend increases seen previously could be consigned to history.

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Royston Wild 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.