As the general market indices keep on rising, pushing valuations higher, we are looking to buy companies that offer tangible returns, while trading at decent valuations, with resilient business models.

One such company is U.K.-based Diageo (DEO), which boasts 33 years of consecutive dividend increases. The company is one of the world’s largest alcoholic beverages seller, owning some of the most iconic brands in the sector.

Source: Diageo

We believe that the company makes for a great buy during the current times of uncertainty, with a business model that is generally recession-proof, as alcoholic drinks tend to deliver solid sales regardless of the underlying economic environment.

For that reason, the company’s shares have historically traded with low volatility, even during adverse times, such as the Great Financial Crisis. We view Diageo’s price to be a great entry point for dividend growth investors, currently near 2-year lows.

Source: Google Finance

In this article, we will:

  • Go over some of Diageo’s financials and prospects
  • Assess the stock’s total return potential
  • Conclude why shares offer a decent opportunity at their current price levels

Financials

During H1-2020, the company delivered robust results, despite the overall market challenges. Its diversified portfolio of brands saw resilient sales, while all its flagship brands saw noted organic sales growth, except for Johnnie Walker.

Source: Investor presentation

As a result, Diageo was able to deliver strong profitability. Despite some FX headwinds and lower earnings due to brand disposals, EPS saw a 4.2% YoY growth powered both organically and through share buybacks.

Source: Investor presentation

The company’s profitability benefits from substantial gross margins, which have hovered in stable levels over the past decade, within a 500bps range.

We believe that margins will remain strong in the future since Diageo holds incredibly resilient pricing power. Like every consumer product, alcohol demand is relatively inelastic. In other words, if Diageo chooses to increase its alcoholic drink prices, the fall in consumption should be proportionately smaller than the increase in prices. This is the case with many addictive products, such as tobacco. In our recent British American Tobacco (NYSE:BTI) article, we highlighted how the company retains stable profitably through price increases, despite the decreasing cigarette volume sales.

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Further, while Diageo is operating in mature markets in the western part of the world, the company is seeing promising growth avenues in Asia, particularly in China. Its businesses across Greater China are continuing to perform very strongly, with combined net sales up 24%, 21% of which is organic.

The company is seeing exceptional growth both in products targeted specifically for the Chinese market and in its flagship, already successful brands. For example, Shui Jing Fang grew net sales by 26% YoY, gaining market share, particularly in the rapidly growing super-premium market. At the same time, Scotch keeps on growing at a double-digit rate, up 19% in H1, with a specially strong performance from scotch malts and Johnnie Walker’s super elegant variants.

Source: Investor presentation

With sales volumes growing organically by around 1.5%-2.5% annually, coupled with price increases due to the company’s robust pricing power, its overall sales have not only been increasing but also accelerating, as the graph illustrates below.

However, as we mentioned earlier, shares have not recouped their value post the COVID-19 selloff and are currently trading near their 2-year lows. As a result, Diageo’s stock movement has been disanalogous to its underlying growth. Thus, we believe that shares are currently presenting an investable opportunity, as we are about to illustrate.

Investor returns

Diageo has been consistently returning cash to shareholders over the past decade primarily through dividends, currently boasting a record of 33 years of consecutive dividend increases.

Management has not been shy with its dividend raises as well, with distributions been increasing annually by at least 5% over the past 14 years. Shares are currently yielding around 2.7%.

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Source: Dividend Max

Further, in efforts to return any excess cash to shareholders, the company has been executing meaningful buybacks over the past few years. More specifically, management bought back £1.1bn worth of shares just in H1 alone, which is an impressive 1.8% of the total shares outstanding.

Considering that management aims to return up to £4.5bn to shareholders over FY2020-FY2022, it has so far been delivering to its promises. Further, to maximize shareholder value, management mentioned that it might issue a special dividend if they feel shares are overvalued, which we believe makes for a thoughtful policy.

Regarding the stock’s valuation, Diageo shares have been undergoing a long-term valuation expansion over the past decade. We believe that this is attributable to the company’s continuously proven resilience, which has entitled the stock a safe-haven status, combined with an overall multiple expansion in asset valuations.

Overall, the company’s forward P/E of around 24 is still decent considering its recession-proof characteristics, stable cash flows, and commitment to shareholder returns.

We are going to project EPS and DPS growth of 7% and 5.5% in the medium term, respectively. We believe these are prudent estimates based on the following reasons:

  • Based on management’s flexible buyback policy, Diageo should prioritize suspending repurchases before decelerating its dividend growth.
  • The payout ratio remains incredibly safe at around 52%; further management has guided to a mid-single digits DPS growth in the medium term.
  • Our profitability growth expectations are lower than the company’s historical average, lower than consensus estimates, while its aggressive buybacks should further accelerate EPS growth.

Applying these growth rates, we get the following medium-term projections:

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Source: Author

Plugging in the company’s current price and different potential valuation multiples, we get the following annualized return scenarios:

As you can see, assuming the stock retains its current valuation (P/E of 20 assuming FY2020 EPS of 130p), investors should record high single-digit annualized returns, while enjoying a growing dividend.

Source: Author

While these returns may not excite many investors, we believe that they are well worth it since:

  • The company operates in a recession-proof sector. Combined with its credible dividend aristocrat status, the stock offers a low volatility investment.
  • The company’s long-term dividend growth commitment provides predictable returns, while investors are enjoying an above-inflationary income growth.
  • The high single-digit return projections indicate market-beating returns compared to those of FTSE’s 100 historical average.

As a result, shares are priced to deliver notable returns with a significant margin of safety, deserving the slight valuation premium, which limits an otherwise double-digit return potential.

Conclusion

Diageo has been a long-term compounder of shareholder returns, featuring an impressive dividend growth record of 33 consecutive annual increases. The company operates a resilient business model, in a non-cyclical sector, with significant pricing power. Its sales are growing organically, while Asia offers a great long-term growth avenue.

We believe that while investors should not expect explosive future returns, the company’s stable cash flows and commitment to returning capital to shareholders, offer a low volatility investment, that should generate annualized returns in the high single digits. We will be actively adding to our position below a 20X earnings valuation to tap into a slightly higher yield.

Disclosure: I am/we are long DEO. 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.



Via SeekingAlpha.com