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Why I’d buy shares in this FTSE 100 giant despite falling profits

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Shares in the world’s largest spirits maker, Diageo (LSE: DGE), fell yesterday as it took a £1.3bn writedown. It was the latest drinks group to face impairment charges because of the coronavirus. Alongside this, the owner of brands such as Smirnoff and Guinness revealed pre-tax profit dropped 51.8% to £2bn on £11.8bn of net sales, down from £12.9bn the previous year.

Reason to buy Diageo shares

I bought Diageo shares as I believe it’s a quality business. An operating profit margin of 32%, which rose 0.8% between 2018 and 2019, shows Diageo is a good operator. One problem is that these impressive margins may be at risk in the short term, as the company said in its results: “Organic operating profit was down 14.4%, ahead of organic net sales, driven by volume declines, cost inflation and unabsorbed fixed costs that were partially offset by short term cost reductions and ongoing productivity benefits”.

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Diageo benefits from having a vast international footprint and scale. So although it’s currently struggling in countries like Nigeria and South Africa, tequila sales for example rose well in North America. It’s this kind of geographic diversification that I think gives Diageo room to keep growing. Diageo’s drinks are sold in over 180 countries.

In more usual times the company consistently grows profits year on year. Operating profit grew from £3.7bn to £4bn between 2018 and 2019. Basic earnings per share rose from 121.7p to 130.7p over the same period.

The fact it’s paying the same final dividend as last year to me shows some confidence by management in the business. Diageo is still profitable with high free cash flow. All in all, the setback looks temporary and related to Covid-19. As economies open back up I expect the shares to recover.

In a similar boat to others

Indeed, some rivals have upgraded expectations. France’s Pernod Ricard, which owns Jameson whiskey and Beefeater gin, last month upgraded its expectations for the full year. It still expects sales to fall, but the outlook was less gloomy than it had been earlier on in the pandemic.

Similarly, Rémy Cointreau also said last month that first-half sales would fall less than expected. This was because people were making cocktails at home, helping compensate for falling sales at bars. 

Diageo could also likely to be a beneficiary of the trend towards more drinking from home. The big question is whether this can truly offset the loss of trade from restaurants and bars. It seems like so far it hasn’t. But that trade is likely to pick up again.

Overall the share price in the short term will be tied to Covid-19. Longer term, Diageo remains a buy for me and I’ll likely to add to my holding because of the margins, incremental growth, and strong brands. For me, Diageo is a FTSE 100 company that combines growth and income potential and, for that reason, I like it a lot.

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Andy Ross owns shares in Diageo. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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