Diageo shares a buy after their 45% price decline?

$Diageo PLC(DEO)$ Diageo, the world's leading producer of premium alcoholic beverages, boasts a portfolio of iconic brands such as Guinness, Johnnie Walker, Smirnoff, Tanqueray, and Baileys.

Throughout the 21st century, the company has demonstrated remarkable consistency, increasing its dividend annually regardless of economic conditions, including financial crises and pandemics. However, 2024 has been challenging, with declining sales in Latin America and sluggish growth in other regions.

These underwhelming results have led to a 45% drop in Diageo's share price, making its valuation considerably more appealing. But is this lower price enough to justify buying the shares?

Reasonable overall growth, but shareholder equity is declining

Dividend growth doesn’t happen in isolation. Dividends are funded by earnings, which come from revenues after expenses are deducted. These revenues are generated by productive assets such as factories, machinery, and inventory, which are financed through equity or debt. For dividend growth to be sustainable, growth must occur across all these areas.

The good news is that Diageo's dividend growth has been supported by consistent earnings and revenue growth. Over the past decade, both have grown at an annual rate of 3-4%, roughly matching the rate of dividend growth. This alignment suggests that Diageo's dividend growth has been on solid footing.

However, despite increases in revenue, earnings, and dividends, the company’s shareholder equity has declined over the past ten years. This decline is evident both in absolute terms and on a per-share basis (measured in U.S. dollars, which I’ll use for all of Diageo’s historical results moving forward).

Diageo’s declining equity is unusual, as a growing company typically sees its equity increase—this being the core financial foundation that supports the rest of the business. In Diageo’s case, however, equity has fallen over the past decade. So, what’s happening?

The explanation lies in the company paying out more to shareholders through dividends and share buybacks than it has earned in profits. A helpful analogy is a savings account: if you start with £100 earning 10% interest, the account generates £10 in interest. If you withdraw £15, you deplete not just the interest but also £5 of the principal, leaving only £95. This mirrors Diageo’s actions in recent years.

Since initiating share buybacks in 2018, Diageo has returned $25 billion to shareholders via dividends and buybacks, while earning just $22 billion in profits during the same period. This $3 billion shortfall has contributed to the decline in shareholder equity. Consequently, the company’s recent annual buybacks of about $2 billion are unsustainable at current levels.

This decline in equity also affects Diageo's Growth Rate metric, which measures ten-year growth across dividends, revenue, and equity. The reduced equity drags the Growth Rate down from 3.5% to 2.0%. Given that I avoid companies with a Growth Rate below 3%—which I classify as “poor”—this poses a significant red flag. However, it doesn’t necessarily disqualify Diageo as an investment. Ideally, the company would halt its buyback program and redirect surplus cash to reduce debt and rebuild equity (a topic I’ll explore further shortly).

While I seek above-inflation growth, I also prioritize consistency, and Diageo performs well here. Over the past decade, revenues, earnings, and dividends have increased steadily in most years. However, the company’s declining equity, which shrank more often than it grew, tempers its overall performance. This results in a Growth Quality score of 69%, which falls into the “okay” range (66-75%) rather than the “good” range (75%+).

Consistently good profitability is a sign of enduring competitive advantages

Diageo’s underwhelming growth track record—aside from its impressive dividend growth—the company’s profitability tells a more positive story. Over the past decade, its net return on capital has averaged 13%, and if not for the pandemic, it would exceed 14%. I consider this a strong performance (10%+ qualifies as “good”), making Diageo nearly twice as profitable

Diageo’s consistent and robust profitability suggests the presence of at least one enduring competitive advantage—a topic I’ll revisit shortly.

As for profit margins, while they don’t necessarily indicate a competitive edge (being more influenced by the nature of the industry), high margins offer a valuable cushion against challenges like declining revenues or rising expenses. For dividend-focused investors, this makes them a desirable feature. Fortunately, Diageo excels in this area, with an impressive average profit margin of 21%—well above my “good” threshold of 10%.

Debts have grown to where they're almost excessive

In recent years, Diageo has returned more cash to shareholders through dividends and buybacks than it earned in profits. This approach has inevitably reduced its equity, yet the company has still managed to grow its revenues and earnings during this time. How is this possible? By increasing its debt.

Between 2014 and 2019, Diageo maintained debt levels ranging from $12 billion to $16 billion. Given its average annual earnings of $3.6 billion over the last decade, this translated to a Debt Ratio (debt to 10-year average earnings) of approximately 3x to 5x.

When the pandemic hit, Diageo took on additional debt to support its operations, pushing its Debt Ratio to 6x in 2020. Although the pandemic has since passed, management prioritized share buybacks over reducing debt, leaving the Debt Ratio elevated at 5.9 today.

This is a borderline red flag, as I typically avoid companies with a Debt Ratio above 6x, where the risks of further borrowing often outweigh the benefits.

While one could argue that defensive companies like Diageo can safely carry higher debt levels, I would feel more comfortable if management scaled back its buybacks and allocated surplus cash to reducing debt instead.

Despite these concerns, Diageo’s debt doesn’t appear high enough to undermine its investment case entirely. Given the scale of its current buybacks, the company could quickly address its debt by redirecting the $2 billion per year it spends on buybacks toward debt reduction. Even so, Diageo’s elevated debt levels remain a negative factor that must be considered in its valuation.

Decent cash generation and mostly organic growth

As a dividend investor, I prioritize companies that efficiently convert profits into cash since dividends are paid in cash, not accounting figures. This is why I tend to avoid businesses with high capital expenditures (capex), as significant capex can reduce cash flows relative to profits.

Cash flow issues often arise when capex consistently exceeds profits, but that’s not a concern with Diageo. Being a relatively capital-light business, its capex has averaged just 26% of earnings over the past decade. This low capex burden supports the sustainability of Diageo’s dividends, especially as the company typically maintains a robust dividend cover of around two times.

I also favor organic compounders—companies that focus on organic growth rather than relying on acquisitions. Organic growth avoids the operational and cultural challenges often associated with large or frequent acquisitions.

Diageo fits this profile well, with a low Acquisition Ratio (the 10-year ratio of acquisition spending to earnings) of just 16%. This indicates that the majority of Diageo’s recent growth has been organic rather than driven by acquisitions.

Highly stable core business

Diageo is the world’s leading premium drinks company, specializing in the production, marketing, and sale of branded alcoholic beverages, many of which dominate their respective markets. Its flagship brands include Baileys, Guinness, Johnnie Walker, Smirnoff, and Tanqueray, all of which are global leaders in their categories.

Short-term headwinds and attractive long-term prospects

Diageo’s share price has dropped by over 45% in the past two years, signaling significant investor concerns—primarily about the company’s ability to meet its ambitious medium-term growth targets.

The challenges began in early 2024 when sales in Latin America and the Caribbean (LAC) fell by 20% due to weak demand and excess inventory. By mid-year, underperformance in LAC and other regions contributed to a 1% decline in overall sales, prompting management to revise its growth targets.

While the medium-term target for organic net sales growth remained at 5-7% annually, the operating profit growth target was lowered from 6-9% to 5-7% annually. However, with sales currently declining, skepticism about the achievability of these targets is understandable.

The critical question is whether the weak demand and inventory issues in LAC during 2024 will significantly impact Diageo’s long-term prospects. I believe they won’t. These seem like typical business challenges that investors are unlikely to dwell on a decade from now.

This perspective is encouraging, as it suggests the 35% decline in Diageo’s share price may be an overreaction.

Looking beyond these short-term hurdles, Diageo remains well-positioned in a large and expanding market. The total beverage alcohol market is projected to grow at approximately 4% annually through the rest of the decade, with the spirits segment growing even faster at around 5% annually, driven by an increasingly affluent global population.

Additionally, despite its market-leading scale, Diageo’s market share is still below 5%, leaving ample room for growth.

While the world continues to evolve rapidly, there’s no clear indication that the longstanding tradition of consuming alcohol for enjoyment is under threat. This resilience, combined with Diageo’s growth potential, suggests a brighter long-term outlook than recent challenges might imply.

Trading at a discount to fair value?

Starting with the dividend yield, Diageo’s share price of $118.80 gives it a yield of 3.4%. This slightly exceeds my minimum acceptable yield of 3%, but I wouldn’t classify Diageo as a high-yield stock.

Regarding the discount (or premium) to fair value, as a dividend investor, I base my fair value estimates on expected future dividends. In other words, an investment is worth only what you can take out of it in cash, so fair value is the present value of all future dividends, discounted by a "fair" annualized rate of return.

Diageo’s management aims to grow earnings (and, presumably, dividends) by 5-7% annually in the medium term and 6-9% over the long term. However, I believe it would be overly optimistic to use these growth targets for estimating future dividends, given that Diageo’s historical long-term growth rate has been closer to 3-5%.

Rather than relying on management’s targets, here are the conservative and realistic assumptions I’ve used to estimate Diageo’s future dividends and fair value:

• Diageo’s net return on capital is maintained at its historical average of 14%.

• Cash that was previously returned through buybacks is now redirected to dividends, but at a more conservative level than before. As a result, the dividend increases from $1.01 in 2023 to $1.38 in 2024, and dividend cover falls to 1.4, where it remains indefinitely.

• This approach allows Diageo to retain enough earnings to grow by 4% annually without taking on additional debt.

• Diageo sustains a 4% long-term growth rate, driven by the increase in global wealth.

Based on these assumptions, and applying a discount rate of 7% per year (the target fair rate of return), the following model is generated:

It’s important to note that this is not a prediction or forecast. Rather, it’s a straightforward, yet hopefully realistic and conservative model of what could happen based on the assumptions outlined above. The focus is on the long-term outlook, rather than attempting to precisely predict outcomes in the next year or two.