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I was right about Diageo shares in April. Here’s what I’m doing now

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Shelves holding drinks bottles
Image source: Getty Images.

High quality defensive stocks selling branded consumer goods have (mostly) outperformed the market this year. Not so drinks group Diageo (LSE: DGE), whose share price is down by 15% so far in 2020.

Back in April, I said I thought Diageo was “an excellent business with great prospects,” but I couldn’t get comfortable with the valuation. In the six months since then, Diageo shares have lagged the FTSE 100 and fallen slightly lower. Has my view changed?

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Do I need to be worried?

Of course, there are good reasons why its shares have underperformed. The widespread closure of bars and restaurants all over the world has hit sales, despite a rise in at-home drinking.

The loss of travel sales from duty-free shops has also caused a problem. Although there are signs of improvement, the company says it thinks, over time, hospitality and travel sales will recover.

What worries me more is that growth might be slowing in emerging markets. Diageo’s latest results included a £1.3bn impairment charge relating to operations in India, Nigeria, Ethiopia, and Korea. This (non-cash) charge means management believes growth rates and business disposal values in these markets are likely to be lower than previously expected.

Sales might bounce back post-Covid, but I think any slowdown in emerging market growth could be a serious concern. These less mature markets have long been a key part of the group’s growth story.

Still one of the best

Don’t get me wrong. I still think Diageo is a great business with a good long-term future. The group’s portfolio of brands — including Johnnie Walker, Tanqueray and Guinness — is unique and I believe it’ll have enduring appeal for generations to come.

If I held the stock I wouldn’t sell and, if I bought today, I’d expect positive returns over time. But I prefer to buy at fair value or, preferably, when they’re cheap, and Diageo’s valuation metrics just don’t say that to me.

Diageo share price: still too high?

This is a stock I’d like to own, but I still can’t get comfortable with the share price. There are a couple of reasons for this. Although Diageo stock is down by 25% from the all-time high of £36 seen in September 2019, the business still trades on 24 times 2020/21 forecast earnings, with a dividend yield of just 2.6%.

I might be happy with that if the group’s debt levels hadn’t risen so much in recent years. Diageo’s net debt rose from £12.1bn to £14bn last year, leaving the group with a net debt/EBITDA leverage multiple of 3.3x. That’s well above my preferred maximum of 2.0x-2.5x.

At the end of September, chief executive Ivan Menezes warned that the pace of recovery in emerging markets is expected to be “gradual.” Menezes said that both sales profit margins are expected to fall this year. That could mean another year of weak profits before any recovery begins.

The combination of slowing growth, rising leverage, and a high equity valuation makes me cautious. Although I’d like to own Diageo shares, I’m going to stay on the sidelines for now.

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Roland Head has no position in any of the shares mentioned. 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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