Description

Disclaimer: This note reflects my view as of today and may change. We may have a position in the security referred to in this note.

N.B. earnings estimates and multiples above reflect consensus but we believe consensus estimates are probably too high.

Overview

Near-term fear gives us the chance to buy shares in one of the best businesses in the world at a price that offers unusual asymmetry. At decade low multiples on normalised earnings power, Diageo offers a downside case that is likely to keep up with 5.5% treasury-bills for the next five years and a conservative base case of +90% over five years, with the chance of a front-loaded IRR as fear fades. There’s also a reasonable bull case that sees the shares rise 2.3x or more in that time. Finally, Diageo is a business where you can happily keep buying if the shares drift down with continued controversy, or even if the business trips up—it’s difficult to come up with a risk that drives a significantly lower intrinsic value. (Of course there's always real downside risk from a structural breakdown of the business including for reasons we cannot see.) 

While the upside case may seem unexciting, we've learned that high probability “modest” returns in excellent businesses, with little chance of losing money, shouldn’t be sneered at. Some of our best investments had that profile at the outset, only to deliver long-term returns well above our expectations. The same for some of our mistakes of omission when we didn’t invest in high-quality businesses during brief moments of fear. Re-ratings often surprise (in size and speed), as do exit multiples, as cash flow predictability gets rewarded with a lower cost of equity (something we don’t assume here).

High-quality businesses have seen big re-ratings in the last decade. Starting multiples at 30x NTM EPS or more with moderate growth are common, with ten years or more of growth priced in. And where a de-rating to even ~20x leaves you with dead money. Even ex-growth businesses like Walmart with some capital intensity, trade on mid-20x P/E multiples and more than 30x FCFE. Instead, Diageo, with healthy long-term growth, trades at 18.6x FCFE and at lower multiples than the S&P 500 (it typically trades at ~30% premiums). And lest we get sucked into the dangers of relative multiples, Diageo looks cheap on absolute multiples also. While it’s known to be a fine business, we believe the width of its moat is still underappreciated, which makes the valuation gap more glaring for us.

Business

Diageo is the number one spirits producer globally and is listed in the UK. It’s diversified across geography, spirit category, and brand. Its largest region is the US (~34% of sales), and its largest category is scotch (23% of revenues). Most of its categories are around 6%–7% of revenues. Its largest single brand is Johnnie Walker at 10% of revenues. The higher margin US, UK, and Australia regions make up about two-thirds of EBIT.

As well as Johnnie Walker, its portfolio includes Capital Morgan, Crown Royal, Don Julio, Smirnoff, Casmigos, and Bailey’s. About 15% of its revenues come from beer, more than half of which is Guinness. Most of its brands are over 100 years old, and some over 200 years old, although it has a couple of younger brands such as Ketel One (1983) and Cîroc (2003).

“Premium” brands make up just under two-thirds of revenues, and around half of that are “reserve” or super premium brands.

Diageo sells into the “on-trade” (on-premise consumption such as at bars and restaurants) and into the “off-trade” (off-premise consumption such as from supermarkets and off-licenses). The mix by value differs per region with developed markets tending to be more tilted to on-trade and emerging markets to off-trade.

Estimated Revenue Mix by Category

Unusually Wide Moat

Diageo’s competitive advantages support 30%+ EBITA margins and high returns on tangible capital. High returns mean it can grow while making 100% of net profit available in cash to shareholders: ~85% of net profit is converted to free cash flow, and another 15% comes from keeping the leverage multiple steady as earnings grow. (Diageo keeps a steady leverage ratio targeted at 2.5x-3.0x net debt/ EBITDA and is at 2.6x today.) Its moat comes from the interplay of the following:

1) Local economies of scale in a) distribution, and in b) advertising and promotion: Unusually, Diageo is blessed with leading local scale across (i) total spirits sales, (ii) each spirit category, and (iii) individual brands. Most consumer product companies have a “tail” of less good positions that often reaches 30% of sales, and that tends to be “leaky”. We believe the tail at Diageo is very small and that:

• More than 80% of Diageo’s net profit is earned in geographies where its total share of the spirits market puts it at number one, and 92% if we include number two positions, with dominant share in several countries (e.g., UK, Australia, Turkey, Ireland, India).
• More than 90% of Diageo’s net profit is earned in spirit categories where it has strong local positions (either a clear number one or strong second place/ in a duopoly). For example, Diageo enjoys ~30% share in scotch in the US and nearly 50% share in gin in the UK (clear number one positions). An example of a duopoly position is Canadian Whiskey in the US where its ~37% share compares to Fireball’s ~41%.
• More than 90% of Diageo’s net profit is earned in brands with strong local market shares (again, either a clear number one or strong second place/ in a duopoly). For example, Johnnie Walker is the clear number one in Scotch in the US, Australia, Mexico, and Brazil, and Captain Morgan leads in rum in the UK while sharing a duopoly with Bacardi in the US.

This privileged position, built over decades, gives Diageo muscle in negotiations with distributors and end-market customers (both on-trade and off-trade), giving it best prices, and importantly, allowing it the best shelf-space and bar positioning. Where it self-distributes, it achieves logistics density, which is most important in the on-trade where frequent deliveries are needed. Diageo spends a significant ~18% of revenues on advertising and promotion, scaling its local brand shares. 18% puts it at the high end of consumer brand companies—especially those with gross margins in the 50%–65% range (Diageo’s are at 60%). This has been rising as a percentage of sales given Diageo’s cultural focus on the customer value proposition and on reinvesting SG&A scale back into brand equity. Finally, its large category share allows it to drive through innovations by obligating both on-trade and off-trade to carry brand extensions and trial products. Even if Diageo is late to an innovation (e.g., “ready-to-drink” spirits), it can catch up quickly.

2) Cumulative economies of scale following decades of brand build: Its 100y+ of brand investment has built large mind and emotional share.

3) Brand captivity/ switching costs/ search costs: Unlike beer, several spirit categories enjoy brand loyalty and stickiness such that distribution and brand share is a bonus. We believe that more than two-thirds of Diageo’s net profits come from such spirits (e.g., scotch, liqueurs, bourbon). Those spirits are fabulous businesses where a company also enjoys dominance in distribution and high brand share—very high sustainable margins and returns are possible (e.g., 35%+ EBITA margins). Even its main beer brand, Guinness, has a sticky, loyal customer base, making it an outlier for beer. (The balance of the portfolio is more dependent on distribution and brand share—e.g., tequila, gin, and vodka.)

Demand and Growth

A highly diversified portfolio protects from capital cycles and “taste trends”: Every few years a spirit category can end up in vogue, driving booms and capital cycles. For example, the vodka boom of the 1950s and 1960s, the scotch whiskey boom of the 1980s, the tequila boom of the 1990s, the gin boom of the 2010s, and the recent boom in premium tequila. At the same time, as tastes change, categories may see gradual waning in interest over decades (or indeed growth in interest). So, there’s always a chance that intrinsic value estimates fall under the weight of long-term taste trends or post-boom hangovers.

Long-term Demand: Branded spirits in the mid-market and above have been taking structural share from beer for the last two decades as brand equity continues to be built and premiumisation occurs. As seen in other brand driven consumer products such as luxury goods and branded athletic wear. So, market demand tends to be “nominal GDP plus”. Within that Diageo has been a structural share taker and aims to continue being so. Today Diageo has ~5% share of the total alcoholic beverage market in the geographies it operates in. Pre-COVID, and in a low-inflation environment, Diageo’s organic revenue growth was +6%, or +5% in dollar terms after absorbing emerging market currency deflation. Of course, as with all consumer products, wallet share will hit a ceiling at some point, so we prefer to buy at points of controversy like now when little is priced in.

Reason for the Opportunity

We believe there are two main reasons:

1) Recent spirit demand has been above trend, so earnings are likely to be pressured in the near term: COVID lead to a boom in premium spirits, especially in the off-trade. Of course, management and market estimates didn’t assume a return to normal trendline demand levels, and since the beginning of the year, the ongoing normalisation has led to ~10% downgrades for this year and next. There’s probably more to come. But it’s not as bad as in other fast-moving consumer good categories, given that a large portion of their revenues go to the on-trade which was depressed during COVID. We estimate that organic revenues were some 7% above trendline with the biggest offender being US off-trade. Some of this has washed out with recent reported weakness in their US organic revenues, so we see management expectations of revenues for the next year as being just 3% above trendline and profits perhaps 5%-6%. But revenues may well shoot below trendline, as a valley of demand in the off-trade follows the boom, with spirits enjoying long shelf lives—so near-term numbers could be much worse.

2) UK listing and corporate governance: The poor economic performance and outlook in the UK has driven large fund flows from UK holdings even for businesses like Diageo that make a minority of profits in the UK (10% for Diageo). Diageo comes with the usual UK corporate governance problems (an “agency” non-executive board with short-tenure and no skin in the game). But the board has deep consumer experience (Danone, Unilever, Bain, LVMH, and Rémy Cointreau). And they’ve been able to pay up for their executive team: CEO, Debra Crew, can earn $19mn a year with 70% in equity, which competes well with US-listed companies. Debra has just taken over and needs to hold 5x of her salary in equity. Meanwhile, historical capital allocation has been sensible, and with the shares undervalued, the ongoing share buy-back is pleasing.

Valuation and Potential Upside

We believe that at trendline revenues and margins, Diageo trades at 18.6x NTM FCFE. At some point, Diageo will go ex-growth, with organic growth dropping to sub-nominal GDP growth. This seems some way off. At such point, given the high ROIC, an exit multiple of 18x seems fair to us (5.5% FCFE plus 3% long-term growth, vs. a cost of equity of ~8.5%). Other ex-growth consumer product companies sport higher multiples, with cost of equity compressed by reliable earnings and the ability to keep up with inflation. Today Diageo is pricing in nearly no growth.

Once the controversy fades, and earnings weakness slows, Diageo should trade closer to its historical NTM P/E multiple of ~23x which reasonably prices in a few more years of above GDP growth. Over five years, the compounding effect of +5%–6% organic growth (post FX drags), a little operating margin leverage, +5% annual FCFE returned in buybacks and dividends, and a re-rating to 20.5x gives ~90% upside. As with all quality businesses, this could come with a compressed IRR, or a higher exit multiple as the cost of equity squeezes. (Low-growth peers such as Brown Forman, Campari, and Constellation Brands regularly trade at 25x–35x P/Es, which is punchy to us, but highlights the cloud hanging over Diageo.) Further increases in operating margins (as management expects) or a higher multiple, would see this rise to 2.3x and beyond.

Downside protection is healthy. Even if trend-line revenues were some 5% lower than our estimates (implying well below nominal GDP growth through COVID), multi-year organic growth immediately collapses to ~3% (sub-nominal GDP growth), and margins settle at 29% vs. the pre-COVID 32%, and putting it on an ex-growth 6% FCFE yield P/E (assuming well below inflation growth), over five years total shareholder returns should still be 25%: annual FCFE and a small amount of organic growth offsets the de-rating. This would be a lower multiple than other high-quality ex-growth consumer product companies. As a sanity check, today’s share price is 6% below where it was over three and a half years ago before COVID hit, and its market capitalisation some 13% lower because of share count shrinkage, with leverage multiples at similar levels. (N.B. currency has had a neutral effect with headwinds from emerging market currency weakness offset by tailwinds from GBP softening.) This in markets that have seen some ~21% nominal GDP growth, ~26% trendline spirits market growth, and where Diageo has taken share. And compared to then, the business has a stronger portfolio.

Risks

We see three main risks:

1) The new generation of GLP-1 medications that lower appetite for sugary food may lead to lower long-term end demand. While the main use of GLP-1 will likely be to control appetite, a side-effect is that it may dampen the drive for other dopamine-linked behaviours including gambling, smoking, gaming, drinking alcohol, and even sexual desire. We keep an open mind here, but for now, it looks like the quantitative effect on alcohol sales is likely to be negligible:

• Around a third of those prescribed GLP-1 are alcohol abstainers already, due to health reasons (that ratio may drop of course as GLP-1 becomes more widely prescribed).
• The effect on desire for alcohol consumption is much lower than for on sugary food—a Jefferies survey suggested that ~37% of those that weren’t abstaining lowered their alcohol intake, while 15% increased intake. (Note that lowering alcohol intake doesn’t mean stopping drinking alcohol entirely.)
• The total population on GLP-1 medication in the US is likely to still be in single digit percentages in ten years with industry estimates at ~6%-7% of the population (and lower in other geographies). This may be peak levels.
• Unlike, for example, gambling, the majority of alcohol consumption is by non-addicts (non-alcoholics). So, there isn’t a fat tail of consumption that’s likely to collapse.
• So, you end up with small percentages multiplied by small percentages. Rough estimates suggest a cumulative drag of less than 1% on volumes over ten years.

Even if the above estimates are some way off, the effect is likely small and covered in our margin of safety. But there may be some dynamic effect that we’re underestimating. For example, a relevant input may be the cumulative percentage of the population who have ever been on GLP-1, if it leads to significant permanent changes in behaviour. So, we will continue to keep an eye here.

2) The normalisation to trend line growth destabilises the business or leaves post-boom excess supply. The reason for the opportunity is of course also a main risk. While we believe that the risk of above trendline revenues is more than priced in, our estimate of intrinsic value could be dented if the adjustment is painful. Stranded costs, excess industry advertising, and a short-term margin hit may take out some cash flows, and high channel inventories may lower brand equity. Post-boom adjustments are always hard to estimate in depth and length. We’re reassured that excess demand is not material, that wholesale inventories are now back to historical levels, while average days of inventory and average days of sales are both back to 2019 levels even on a forward-looking basis. And the US has helpfully already reported a sub-nominal GDP organic revenue growth at 0%. That said, retail inventories still seem high. Management expectations are still probably too benign for the next two years and could throw them off.

3) Any hidden “brand abuse” which leads to a period of market share losses. Diageo last struggled in 2013–2015. In a bid to hit earnings targets going into 2013, the previous CEO had allowed the value proposition to drift in the US, by pushing pricing and wholesale inventories without enough support in advertising and promotion. Diageo ended up losing significant share and US organic growth went negative. The reinvestment into the value proposition saw EBITA margins temporarily dropping from ~30% to ~28% and earnings per share shrinking 14% from peak to trough. And the stock saw mild multiple compression. Spotting a worsening in customer value proposition from the outside is challenging given the number of brands and regions, and the difficulty of price comparisons. One sign is how much growth is coming from price and mix, as opposed to volume. Diageo has been a value share-taker in the last few years, but in 2020–2022, like all spirits company, they experienced big price mix and benefits in the US, so it’s possible that the value proposition worsened. They did take volume share within most categories which is encouraging. Outside the US, volume growth has been good.

The previous CEO, the late Ivan Menzies who sadly passed away earlier this year, took over during the 2013–2015 challenges and fixed the value proposition. He had high respect for its importance, so it’s unlikely that under his stewardship it’s been allowed to drift. Even so, given the structural advantages Diageo enjoys, such a situation is fixable, and the playbook of reinvesting into the value proposition is well understood within consumer product group companies. For what it’s worth, during the 2014 “crisis”, the stock was flat over two years (the de-rating and earnings drop were offset by FCFE in dividends and buybacks), and then more than doubled in three years once Ivan’s actions took hold.

Noting, however, that Debra only joined Diageo in 2020, running the US Division, and came from tobacco (RJ Reynolds) where brand dynamics are different.

Catalyst

It’s always hard to know what the catalyst is for a cheap stock where near-term management expectations and consensus earnings estimates are likely too high. Sometimes the final estimate downgrade and line of sight of industry stabilisation is enough to cause the stock to begin re-rating. Indeed, during Diageo’s last challenging period, the stock and multiple troughed well before the earnings. We wouldn’t want to wait for the downgrades. First, because they may not happen (there’s a chance our estimates are too conservative), and second, who knows where the stock will be at that time.

Another catalyst may be a relisting in the US following the trend of other UK companies doing so. This may lead to a higher multiple. It’s notable that in the current fiscal year, Diageo is moving its functional currency for its reported accounts to the US dollar.