Diageo: Shares Fell Again After FY23 Results, Cheap at 20x P/E

Company Update (DGE LN) (Buy)

Highlights

• Diageo shares have now fallen 18% since 2021 year-end

• FY23 results showed solid growth in sales and earnings

• U.S. inventories have normalized; demand is healthy

• Adjusted EBIT should grow at 6-9% annually as targeted

• We see 62% total return (19.1% p.a.) by June 2026. Buy

Introduction

Diageo shares have fallen another 3.8% (in GBP in London, and by 5.4% in USD with its American Depository Receipts) since FY23 results were released on August 1, and are down 19% since the end of 2021:

Diageo Share Price (Last 5 Years)

Source: Google Finance (28-Aug-23).

Diageo shares are at 20.1x FY23 earnings. FY23 results were better than we expected, with organic growth of 6.3% in sales and 6.7% in Adjusted EBIT (10.7% and 9.5% respectively in GBP). We believe Diageo did not materially over-earned in FY23. In the U.S., distributor inventories have now normalized and consumer demand remains healthy; in China, sales are down but represent less than 5% of group sales. The main negative is a slight loss in U.S. market share, after the growth of low-value Ready-to-Drink spirits and supply shortages in Canadian Whisky, but we see the impact as modest and temporary. We believe Diageo has a good chance of growing Adjusted EBIT at 6-9% organically on average in FY23-25 as targeted. The current Dividend Yield is 2.4%, backed by a 3.1% normalized Free Cash Flow (“FCF”) Yield, and buybacks are continuing. With shares at 3,269.5p and assuming a return to a 25.0x P/E, our forecasts indicate a total return of 62% (19.1% annualized) by June 2026. Buy.

(For a recap of our Diageo investment case, see the Substack article we published on the company in July.)

Diageo FY23 Results Headlines

FY23 results were better than we expected, with organic growth of 6.3% in sales and 6.7% in Adjusted EBIT:

Diageo Group P&L (FY23 vs. Prior Years)

Source: Diageo company filings.

Gross Margin fell 97 bps organically year-on-year, but Gross Profit rose 8.5% as reported. FY23 saw significant inflation in costs, primarily in energy but also in glass, paper, metal and transportation. Inflation is now “moderating” in FY24. Management stated that price increases “more than offset Costs of Goods Sold inflation in absolute terms”, but the larger denominator (in COGS) contributed to a decline in reported Gross Margin.

Adjusted EBIT Margin rose 15 bps organically in FY23, despite the fall in Gross Margin as well as a 14 bps increase in Marketing costs margin, thanks to Other Operating Expenses improving by 98 bps in margin (and growing by just 0.8%).

Adjusted Net Income grew 5.1% (£181m), less than the growth in Adjusted EBIT (6.7%, or £457m), largely due to an (£172m) increase in Net Finance Charges after interest rate hikes, with Diageo’s effective interest rate rising 1.2 ppt to 3.9%. (This is expected to rise to “just over 4%” in FY24.) An increase in the effective tax rate (by 0.5 ppt to 23%), largely due to a shift in product mix, was another headwind. (This is expected to rise to “in the region of 24%” in FY24.)

Adjusted EPS grew 7.6% year-on-year, helped by a 2.3% reduction in the average share count after buybacks.

Compared to pre-COVID FY19, Diageo’s Net Sales has grown 33.0% (37.0% organically), its Adjusted EBIT has grown by 27.6% (35.4% organically) and its Adjusted Net Income has grown 17.0%. Adjusted EPS has grown 25.1% in 4 years, helped by buybacks. Currency and disposals explain the difference between organic and actual growth.

No Material Over-Earning in FY23

We believe Diageo did not materially over-earned in FY23.

FY23 group Net Sales implies a CAGR of 8% across the entire period, only slightly ahead of the 5-7% medium-term target, and the outperformance is likely permanent given the pandemic has accelerated the continuing move in consumer habits towards spirits in general and premium spirits in particular:

Diageo Net Sales Growth By Region (FY19 to FY23)

Source: Diageo results presentation (FY23).

The 8% Net Sales CAGR consists of a 2% volume CAGR and a 6% price/mix CAGR, also a good balance, and is broad-based across different regions (slightly lower in Asia Pacific, due to a sales decline in China during FY23 after COVID-related disruption) which, given the pandemic was a negative for some countries (especially in Emerging Markets), also reduces the likelihood that the U.S. market is materially over-earning.

U.S.: Normalized Inventories, Healthy Demand

FY23 Net Sales in North America were flat organically as reported, but shipments (on which reported sales are based) lagged depletions by 2 ppt, a normalization after a prior year when shipments were ahead of depletions by 3 ppt (largely due to distributors keeping more stock as a reaction to supply chain disruptions).

Diageo believes U.S. distributor inventories, including those at the largest distributors on which it has “daily” visibility, are now back to a normal level, as CFO Lavanya Chandrashekar stated on the call:

“Distributor inventory levels started fiscal 23 broadly in line with historic levels and ended fiscal 23 at a very comfortable place, very much in line with historic pre covid levels of inventory.”

U.S. consumer demand remains healthy, as CEO Debra Crew explained on the call, albeit with growth moderating at the luxury end and pressure on the mainstream and below, which should not affect most of Diageo’s portfolio:

“Look on the US market … the underlying consumer, we're actually seeing a lot of resilience. If you step back and you look at the industry, from an industry perspective, we are seeing it return to kind of mid-single digits … The spirits industry is still gaining from ... We're still premiumising as an industry …

We do see at the luxury end some moderation of growth there, but that's a very small part of our portfolio. We also see, if you look at mainstream and below, that's really where you're seeing a lot of the pressure.”

There will be a U.S. recession at some point and this can have a temporary impact on Diageo, but we do not believe that current sales are atypically high or that a downturn is imminent.

In the event of a U.S. downturn, good cost control and growth in other markets could still enable Diageo earnings growth to continue. These dynamics were on display during the Global Financial Crisis (“GFC”):

Diageo Organic Sales & EBIT Growth (FY09-11)

Source: Diageo company filings.

During the GFC, Diageo sales stagnated in North America and fell in Europe in FY09-10, but group Adjusted EBIT growth was nonetheless at positive low-single-digits each year. Sales and EBIT both rebounded in FY11 (though not in Europe, due to continuing financial crises in Spain and Greece). The next downturn will likely have a similar but smaller impact, thanks to a shift towards premium brands and further diversification, delaying the investment case but not changing it fundamentally.

China: Less Than 5% of Diageo Sales

Diageo Net Sales in Greater China fell 4% organically in FY23, and many investors are concerned about the Chinese economy, including problems in its property sector and falling imports.

However, any downturn in China should have only a limited impact on Diageo, as Greater China currently represents less than 5% of group sales. (The Asia Pacific region was 19% of group sales in FY23, and Greater China was less than a quarter of Asia Pacific sales.)

Diageo Net Sales Growth By Region (FY23)

Source: Diageo annual report (FY23).

Latest Chinese official figures also show a 7.2% year-on-year increase in Tobacco & Liquor retail sales in July.

Greater China may represent a key growth market in the future, but it generates less sales for Diageo than Great Britain (the U.K. minus Northern Ireland) at present. Sell-side analysts mostly recognise these, and this is reflected by how the word “China” did not appear anywhere in the Q&A section of the earnings call.

Slight Loss in U.S. Market Share

The main negative in FY23 is a slight loss in U.S. market share, with Diageo’s share of U.S. Total Beverage Alcohol (“TBA”) down 1 bps, after gaining 24 bps and 26 bps respectively in FY22 and FY21:

Diageo U.S. TBA Share Change (FY21-23)

Source: Diageo results presentation (FY23).

Management attributed Diageo’s U.S. market share decline to two factors:

One is the growth of low-value Ready-to-Drink (“RTD”) spirits, which was a “meaningful” part of U.S. TBA growth and “more than a third” of U.S. spirits industry growth. Diageo described the growth in RTDs as driven by “new, mostly undifferentiated entrants flooding the market and promoting heavily”, and stated it did not participate in this growth because of its focus on the premium end. (Diageo’s RTD sales in North America fell 16% organically in FY23.) This does not materially impact our investment case at present, because premiumization trends are continuing and Diageo’s market share loss is marginal and relative to a growing market.

Two is a loss in market share by Crown Royal, a key Diageo Canadian Whisky brand. Diageo attributed this to “severe liquid constraints” which limited Crown Royal’s ability to innovate and its in-store presence. (Crown Royal sales fell 10% organically in FY23.) The liquid constraints “have subsided”, and Diageo is taking steps to catchup on both innovation and advertising & promotion, so we expect the issues to be only temporary. Diageo also continues to be benefit from a comprehensive portfolio where at least some of its products will benefit from local market trends at any one time. (In FY23, this manifested as both Don Julio and Casamigos tequilas growing sales by 13% organically in North America, and Guiness beer growing by 9%.)  So this also does not materially impact our investment case.

Medium-Term Guidance Reiterated

Management reiterated its medium-term guidance of:

• Organic net sales growth of 5-7%

• Organic EBIT growth of 6-9%

We believe Diageo has a good chance of these targets, given it did not materially over-earn in FY23, the trends of increasing spirits consumption and premiumization remain powerful, and Diageo’s franchises continue to be strong.

For FY24, management expects Net Sales to show sequential “improvement” (from H2 FY23) in H1, then acceleration in H2 (helped by a softer prior-year comparator), and Adjusted EBIT to similarly “improve” from H2 FY23 and then “accelerate gradually through the year”.

Diageo Valuation: 20x P/E

At 3,269.5p, relative to FY23 financials, Diageo shares have a 20.1x P/E:

Diageo Earnings, Cashflows & Valuation (FY19 & FY21-23)

NB. FY21 £290m dividends received included £161m for CY19 and £128m for CY20. Source: Diageo company filings.

Free Cash Flow (“FCF”), based on the management definition, was nearly £1bn lower year-on-year in FY23, due largely to a larger outflow for working capital, which in turn was largely the result of a decrease in accounts payable. Management attributed this to lower sales growth and thus lower purchases in FY23. We add the amount involved back, and deduct dividends to minorities, to arrive at a FCF figure of £2.30bn, which implies a FCF Yield of 3.1%.

Even if we regard all of the growth in FY20-23 as transient, and base our valuation instead on FY19 financials, Diageo shares have a P/E of 23.5x and a FCF Yield of 3.4% (helped by much lower CapEx in FY19).

Capital Expenditure was 8% higher year-on-year in FY23, but management expects it to remain unchanged at $1.3-1.5bn in FY24 (around £1.0-1.2bn). (Diageo is switching its reporting currency to USD in FY24.) CapEx is currently higher due to investments in production capacity, supply chains, sustainability, et., and is expected to remain at “these levels” for the next few years, before falling back to historic level (as a percentage of sales) starting in FY27.

The total dividend for FY23 was 80.0p, up 5% year-on-year, and implies a Dividend Yield of 2.4%.

Buybacks in FY23 totalled £1.4bn, equivalent to 1.9% of the current market capitalization. A new buyback program of “up to $1bn U.S. dollars” (around £790m) was announced as part of FY23 results.

Net Debt / EBITDA was 2.6x at the end of FY23, at the low end of the 2.5-3.0x target range. Net Debt increased £1.40bn during FY23, roughly equal to the amount spent on share repurchases (£1.38bn).

Illustrative Diageo Stock Forecasts

FY23 EPS was 0.5% higher than our most recent forecast; we update this and keep the rest of our forecasts unchanged.

Our assumptions now include:

• FY24 Net Income growth to be 3.0%

• Thereafter, Net Income grows at 8.0 % annually

• Dividends to be based on a 50% Payout Ratio

• Share count to fall by 1.0% annually

• FY26 year-end P/E of 25.0x

Our new FY26 EPS of 201.8p is virtually the same as before (200.8p):

Illustrative Diageo Return Forecasts

Source: Librarian Capital estimates.

With shares at 3,269.5p, we expect an exit price of 5,045p and a total return of 62% (19.1% annualized) by June 2026.

We reiterate our Buy rating on Diageo.

Ends

Stocks mentioned: DEO 0.00%↑ . We are long.

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.