Diageo: P/E at 20x Again Ahead of FY23 Results

Company Update (DGE LN) (Buy)

Highlights

• Diageo shares are at 20.4x CY22 EPS and 24.5x FY19 EPS

• We believe CY22 may have over-earned but only modestly

• FY23 should show resilient demand but also prior-year restocking

• Recent results at peers are mixed as each company is different

• We see 56% total return (16.3% p.a.) by June 2026. Buy

Introduction

We revisit our Diageo investment case ahead of FY23 results scheduled on August 1, based on Q1 CY23 results among its peer group as well as Diageo management’s comments at an investor event in June.

Diageo is likely to achieve a high-single-digits EPS CAGR over time, but currently has a P/E of just 20.4x relative to CY22 (and 24.5x relative to FY19). The company may have over-earned in CY22 due to COVID-19’s boost to demand and retailers restocking, but we believe only modestly. In general the U.S. consumer appears to remain resilient; there is some volume pressure in the market, but Diageo growth should be more resilient thanks to its focus on premium brands. Results at peers show a mixed pattern, as quarterly growth rates often follow company-specific dynamics. We expect Diageo will show weak growth in H2 FY23 but solid growth for the full year. The real test may come if/when the U.S. enters a recession, but we are confident in its long-term growth drivers.

Our updated forecasts indicate a total return of 56% (16.3% annualized) by June 2026. Buy.

As this is our first Substack article on Diageo, we start with a longer recap of its investment case. Readers familiar with our research can jump one section ahead to “Diageo Share Price & Rating History”.

Diageo Buy Case Recap

Diageo is the global #1 player in Spirits, with a diversified portfolio of categories, brands and regions:

Diageo Net Sales & EBIT by Region (FY22)

Source: Diageo results release (FY22).

Our investment case is based on the structural volume and value growth in global spirits, and Diageo’s ability to take advantage of this growth:

• The global spirits industry is benefiting from structural increases in the population of drinkers, penetration rates (including share gains from wine and beer) and premiumisation. In 2010-21, total Retail Sales Value of spirits grew at a CAGR of 4.1%, with Premium spirits growing at 8.1% and Super Premium+ spirits growing at 14.8%

Global Spirits Retail Sales Value Growth (2010-21)

NB. TBA = Total Beverage Alcohol, RTD = Ready To Drink.

Source: Diageo results presentation (FY22).

• Diageo can grow sales faster than the spirits market thanks to its over-indexation to premium+ brands (57% of its net sales by FY22), as well as its strong brands, scale, and capabilities in innovation, marketing and distribution

• Diageo can continue to expand its operating margin, from a combination of pricing, positive mix shift, operational leverage and cost efficiencies

At its November 2021 investor day, Diageo set out long-term targets to increase its share of the global Total Beverage Alcohol market from 4.0% to 6.0% by 2030. For FY23-25, management is targeting, on annual basis:

• A “consistent” 5-7% organic net sales growth

• A “sustainable” 6-9% organic EBIT growth

In a typical year, Diageo’s modest financial leverage (targeting Net Debt / EBITDA of 2.5-3.0x) tends to add 0.5% to Net Income growth (on top of EBIT growth), while buybacks have added 1.6% to EPS growth on average in FY18-22. We believe Diageo’s medium-term targets are achievable, and we expect a long-term EPS growth of 9%.

Diageo Share Price & Rating History

Diageo’s share price is roughly flat from its level just before COVID-19 in January 2020, having fallen by 16% since 2021 year-end:

Diageo Share Price (Last 5 Years)

Source: Google Finance (03-Jul-23).

The picture is similar for the price of its American Depository Receipts (“ADRs”) in U.S. dollars, but with an even larger decline of 21% from 2021 year-end, as the GBP/USD rate has fallen from 1.35 to 1.27 approximately in this period.

We have followed Diageo for the past few years and first published our research online with a Buy rating in July 2019. At current prices, Diageo shares have gained only 4.4% in GBP since our initiation, with dividends offsetting a slightly lower share price. We believe the stock is at a cyclical low and offer an attractive opportunity for long-term investors.

Diageo Valuation: 20.4x CY22 EPS

At 3,394.0p, relative to CY22 financials, Diageo shares have a cheap 20.4x P/E and a 2.5% Free Cash Flow (“FCF”) Yield; relative to pre-COVID FY19, shares have a reasonable 24.5x P/E and a 3.2% FCF Yield:

Diageo Earnings, Cashflows & Valuation (FY19-CY22)

NB. FY21 £290m dividends received included £161m for CY19 and £128m for CY20.

Source: Diageo company filings.

CY22 FCF was atypically low due to working capital, with creditors returning to pre-COVID norms (worth about £500m), higher inventories (£150m) and maturing stock (not quantified), as well as a higher tax payment (£258m).

Diageo paid total dividends of 77.65p in CY22, implying a Dividend Yield of 2.3%.

Pernod Ricard has a similar P/E of 21.3x relative to CY22, while Brown-Forman and Rémy Cointreau have P/E multiples of 36.3x and 25.2x respectively relative to their FY23 (which end on April 30 and March 31 respectively).

CY22 Earnings Likely Modestly Elevated

Diageo’s CY22 earnings may be elevated due to COVID-19’s boost to demand and shipments exceeding depletions.

Spirits consumption grew faster during the pandemic years due to a number of factors, including people spending more time at home, absence of other consumption opportunities especially travel, and government stimulus payments. We believe much of the sales growth is permanent, especially in price/mix (due to both inflation and habit changes).

For Diageo, between H1 FY19 (January-December 2018) and H1 FY23 (January-December 2022), group Net Sales grew at a CAGR of 8% across the group, including a CAGR of 3% from volume, with relatively similar growth rates across all regions except LATAM (likely due to the rising popularity of Scotch and higher inflation there):

Diageo Net Sales Growth By Region (H1 FY19 to H1 FY23)

Source: Diageo results presentation (H1 FY23).

Diageo’s North America region had a Net Sales CAGR of 8% in this period, same as the group figure, and higher than the U.S. market’s historic long-term growth of mid-single-digits; this was supported by a 2% volume CAGR. We do not believe this is excessive given Diageo’s premium focus and record in gaining market share over time.

CY22 earnings also benefited from shipments exceeding depletions, as retailers restocke., as management described on that half-year’s earnings call:

“US Spirits shipments were ahead of depletions, with a benefit of approximately three percentage points from the replenishment of stock levels by distributors, recovering from lower levels during COVID‐19.”

Most of the benefit occurred in January-June 2022 (H2 FY22), given North America shipments were described as “in line with depletion” in H1 FY22 and 1 ppt behind depletions in H1 FY23. We believe this means year-on-year growth in North America will be the lowest in H2 FY23, after which it will return to its normal trajectory.

U.S. Demand is Still Resilient

In general the U.S. consumer appears to have remained resilient, thanks to a strong employment market and excess savings that were built up during the COVID-19 years and are still substantial:

JPMorgan’s co-head of Consumer & Community Banking, Jennifer Piepszak, said at an investor conference on June 13 that:

“The consumer continues to be very resilient ... Cash buffers still remain above pre-pandemic levels. So for us on the median cash buffer is still about 20% above pre-pandemic levels and it's even higher at lower income segments”

Similarly, Bank of America’s President of Preferred Banking, Aron Levine, said at the same conference that:

"Our clients still, as we sit today, just generally across the board, have about 30% more in their checking accounts than they did pre-pandemic ... it's still 30% higher than it was and across every cohort ... the lowest cohort, it's up about 34% … Our client base is healthy.”

In the U.S. Spirits market, there is some volume pressure, but Diageo’s growth should be more resilient thanks to its focus on premium brands, as their CEO Debra Crew said at their Scotch investor event on June 1:

“If you look at the industry overall, we're feeling pretty good about how it's normalizing out. It really is getting back toward mid-single digits … It's being driven by importantly this super premium plus part of the category. So, luxury, the growth is moderating there, although still growing. Below premium, there is a lot of price competition and that's really where you're seeing this sort of weaker consumer environment. But remember, most of our portfolio really is about this super premium plus area.”

Similarly, Brown-Forman CEO Lawson Whiting said at their Q4 FY23 earnings call on June 7 that:

“The U.S. is the one people seem to go at the most … the important thing is that the super-premium and the ultra-premium price points continue to grow at a faster rate than, say, standard or just premium. So, that has been true for a long time. The gap has closed a little bit, but still premiumization is live and well in the U.S. business.

While there will inevitably be a U.S. recession at some point and it will be temporary, it is not a factor at present.

Peers’ Q1 CY23 Results Were Mixed

Diageo only reports every 6 months, while most of its peers report quarterly, but such results for the most recent quarter (typically Q1 CY23) show only a mixed pattern, as growth rates often follow company-specific dynamics.

Pernod Ricard is Diageo’s closest peer, albeit less weighted towards the U.S. and more weighted towards APAC / Rest of the World. Pernod Ricard reported an organic Net Sales decline of -2.2% in January-March 2023 (their Q3 FY23), down from growth of 11.8% and 11.2% in the two preceding quarters, with Americas in particular reversing into an organic Net Sales decline of -9.7% after growth of 9% and 6% in the two preceding quarters:

Pernod Ricard Organic Net Sales Growth by Quarter (Since CY20)

Source: Pernod Ricard company filings.

Brown-Forman is similar to Diageo in having about 50% of its Net Sales in North America, but is different in having most of its non-U.S. sales in Developed Markets like Germany and the UK, and in being less diversified by category (with Whiskey contributing 79% of its FY22 sales). Brown-Forman reported organic Net Sales growth of 4.0% in February-April 2023 (their Q4 FY23), on top of total organic growth of 36% in the past 3 years, though quarterly year-on-year growth rates have been volatile due to prior-year supply chain shortages and retailer inventory movements:

Brown-Forman Organic Net Sales Growth by Quarter (Since CY20)

NB. Brown-Forman fiscal year ends on 28-Apr.

Source: Brown-Forman company filings.

Rémy Cointreau is the least similar to Diageo, with 72% of its FY22 Net Sales from Cognac, as well as being more weighted towards APAC and less towards Europe. Rémy Cointreau reported an organic sales growth of 10.2% in January-March 2023 (their Q4 FY23), but on the back of a prior-year organic sales decline of 9.4%, the latter attributed to strategic inventory control ahead of a price increase as well as a 4 ppt calendar effect from the Chinese New Year (which took place on February 1 in 2022, compared to February 12 in 2021):

Rémy Cointreau Organic Net Sales Growth by Quarter (Since CY20)

Source: Rémy Cointreau company filings.

Diageo’s own Net Sales showed a total CY20-22 organic growth of 33% for H1 CY22 and 32% for H2. We believe Diageo’s results are likely to resemble those at Pernod Ricard, with weak or negative growth in H2 FY23.

The Next U.S. Recession & Worst-Case Scenario

The real test for Diageo may come if/when the U.S. enters a recession, with the worst scenario being a multi-year period of zero to low-single-digits EBIT growth similar to FY14-16:

Diageo EBIT Growth by Component (FY09-22)

NB. EBIT is before exceptional items. Source: Diageo company filings.

Diageo’s organic Net Sales growth was only 0.4% in FY14 and zero in FY15, with a positive price/mix offset by volume declines; volume growth returned to positive in FY16 while price/mix has continued to be positive every year:

Diageo Net Sales Growth by Component (FY14-22)

Source: Diageo company filings.

A U.S. recession alone will likely not be enough to cause a repeat of FY14-16. Weak growth during FY14-16 was due to a confluence of headwinds, including weakness in Emerging Market currencies, the bursting of a bubble in U.S. vodka sales, “demonetization” and a ban on the sale of alcohol near highways in India, and an “anti-corruption” drive in China. We believe such a confluence is unlikely to recur. Diageo is also a better business today, with more diversification across categories, a higher mix of premium sales and better inventory control (so less destocking in a downturn).

Spirits is ultimately a discretionary category and demand will be impacted by a recession, and a repeat of the FY14-16 slowdown cannot be ruled out entirely. However, we are confident about the structural drivers behind Diageo’s earnings growth and believe that, regardless of short-term cycles, these will help generate positive shareholder returns over time.

Illustrative Diageo Stock Forecasts

We reduce our FY23 and FY24 forecasts but keep most other assumptions the same.

Our assumptions now include:

• FY23 Net Income growth to be 5.0% (was 11.0%), implying zero year-on-year H2 growth

• FY24 Net Income growth to be 3.0% (was 8.0%), partly reflect a higher tax rate

• Thereafter, Net Income grows at 8.0 % annually (unchanged)

• Dividends to be based on a 50% Payout Ratio (unchanged)

• FY23 share count to be down 2.0% (was 1.0%)

• Thereafter, share count to fall by 1.0% annually (unchanged)

• FY26 year-end P/E of 25.0x (unchanged)

Our new FY26 EPS of 200.8p is 9% lower than before (220.4p):

Illustrative Diageo Return Forecasts

Source: Librarian Capital estimates.

With shares at 3,394.0p, we expect an exit price of 5,021p and a total return of 56% (16.3% annualized) by June 2026.

We reiterate our Buy rating on Diageo.

Ends

Stocks mentioned: DEO 0.00%↑ $RI $RCO $BF.B. We are long Diageo and Rémy Cointreau.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.