The coronavirus situation is causing serious problems to many industries, not least the alcoholic beverages industry. To prevent the spread of infection, bars and restaurants have been closed in many areas across the world, while sports tournaments have been axed or delayed.
However, once the world gets through this difficult period, it seems highly probable that the effects of these lockdowns will be temporary. Yes, there are significant short-term hits to sales, profits and cash flows, but stocks are valued on the present value of all future cash flows, not just the next quarter or two. Alcohol is not going away and the long-term future of drinks giant Diageo plc (DEO), with its leading portfolio of brands, strong financial track record and defensive characteristics, is in a good position to ride out the storm of COVID-19 in 2020.
Diageo updated the market on COVID-19 on February 26. Back then the company focused mainly on the impact of the outbreak in China and other countries in Asia-Pacific, guiding investors that it thought the virus would cause organic net sales to drop by £225m-325m, and operating profits to fall by £140m-200m. Clearly, since then, other countries across the world have had to introduce far more stringent social-distancing measures, which means that Diageo’s overall hit to performance would be greater. But while the West is being hit, Asia – and particularly and importantly China – is starting to normalise.
Diageo’s diversified product range starts to pay off now, acting as a natural hedge. The group has a dominant market share in each of the categories in which it operates. The group sells into more than 180 countries, so it is not too reliant on any one individual market; however, America does make up more than a third of revenues. Diageo boasts two of the world’s five biggest spirits brands by value: Smirnoff and Johnnie Walker as well as 23 of the world’s top 100. The group also owns Guinness, the number four premium beer brand by value. Successful brands are very difficult to create, so The Global Investor thinks that Diageo has built a nice moat for its business.
Longer-term trends look set to benefit the group as it should continue to benefit from the sustained ‘premiumisation’ of the drinks market. Another important trend is the growing preference for spirits and the world’s population growth. On the population point, 550m new alcoholic beverage consumers are expected to join the market by 2030. Over this same time, 750m more consumers are expected to join the global middle class and become able to afford international spirit brands.
Going into the current coronavirus disruption, Diageo had reported positive and improving numbers, which is a trend that The Global Investor expects to continue after the coronavirus shock. For the three years to June 2019, Diageo’s net sales produced a compound annual growth rate of 7%, reaching £12.9 billion. Over the same period, operating profits produced a compound annual growth rate of 12%, reaching £4 billion.
In the six months to December, net revenue grew by 4.2% to £2.4 billion. Organic operating profits grew by 4.6%, this was driven by cost savings and a smart price-to-mix ratio. In the same period, Diageo increased its half-year dividend by 5% to 27.41 pence.
Management has stated its intention for earnings per share to cover dividend payments by 1.8 to 2.2 times. Dividend cover for the Full Year 2019 was 1.9 times. Before the corona crisis, Diageo was planning to make mid-single-digit increases until the cover ratio was closer to the mid-point of targeted range. Now, however, it’s possible that the group could cut its dividends to preserve cash during the crisis.
Diageo’s stock price has fallen by about 20% over the past three months. The stock trades at 19x trailing earnings and 20x forecast earnings. Over the last five years, the stock has tended to trade around 23x trailing earnings.
Since the February COVID-19 update, earnings consensus has come down 17% for 2020 and 13% for 2021. The Global Investor believes now is an opportune time to buy this stock, whose underlying fundamentals include massive brand power and global revenues. Return on Equity at 35% is higher than UK listed beverage peers’ average at 31%, which shows the company is well-run financially.
Investors should think about two risks going into this stock. First, it is impossible to know for sure how much longer the coronavirus crisis will last and the true impact of it on the business during 2020. Second, even if the business performs well, short-term sentiment could change as investors switch from consumer discretionary stocks to consumer staples. However, The Global Investor believes in Diageo’s long-term growth story; moat-like quality product offerings and reasonable valuation outweigh the short-term risks inherent in the stock price. Cheers!
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DEO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.