Investors looking for companies with strong brands, as well as steady cash flow and dividends, should consider alcohol stocks. The alcoholic beverages industry enjoys multiple qualities that make it appealing for investment. First, alcohol stocks enjoy brand loyalty and see steady sales even during recessions. They also benefit from pricing power and global scale.
These qualities allow alcohol stocks to generate consistent growth and pay dividends to shareholders each year, regardless of the economic environment. Diageo (NYSE:DEO) (LON:DGE) is one of the top alcohol stocks based on its premier brands and excellent growth potential. The stock also pays a solid dividend above 2.5%. However, shares appear overvalued right now, a consequence of Diageo’s bounce off of its 52-week low. Despite this, investors should be willing to buy Diageo shares on any meaningful pullback.
Business Overview and Recent Events
Diageo is a large alcoholic beverage company. The company dates all the way back to the 17thcentury and the Haig family, the oldest family of Scotch whiskey distillers. Today, Diageo manufacturers popular spirits and beer brands, such as Johnnie Walker, Smirnoff, Captain Morgan, Baileys, Tanqueray, Guinness, Crown Royal, Ketel One, and many more. Diageo has 20 of the world’s top 100 spirits brands.
Diageo recently concluded its fiscal year and released full-year financial results on August 4th. Net sales declined 8.7% to $13.9 billion. Much of this decline was attributed to the impact of COVID-19, and the ensuing closures of restaurants and bars. Organic sales fell 8.4% as 2% growth in North America was more than offset by weakness inall other regions.
Organic volumes decreased more than 11% company-wide. Organic sales for beer decreased 15% while Scotch was lower by 17%. The majority of global brands were weaker during the second half. Johnnie Walker, down 22%, and Guinness, down 16%, led to the downside.
The upcoming year will certainly be challenging for Diageo. Qualitatively researching stocks in the alcohol industry like Diageo shows that they tend to have advantages in a recession. Specifically, they continue to see demand hold up fairly well, whereas other market sectors can see massive declines during a steep recession. Alcohol is a recession-resistant product, which means Diageo should continue to generate profitability and pay dividends to shareholders, regardless of whether the global economy remains in a deep recession for an extended period. Even though this is a challenging time for Diageo, investors can be reasonably confident the company will be among the first to recover and return to growth once the coronavirus ends.
Long-Term Growth Catalysts
Diageo’s primary catalyst for earnings growth is the emerging markets. Emerging markets such as Latin America, China, and India have huge growth potential for Diageo, as these regions have large populations and rapidly-expanding middle classes. While these regions are being negatively impacted by the coronavirus, they should return to long-term economic growth once the pandemic ends. Diageo’s huge market share in the emerging markets is a long-term competitive advantage due to their higher growth potential.
These markets were among Diageo’s best performers in recent years including 2019 before the coronavirus crisis. For example, in fiscal 2019 Diageo reported organic sales growth of 9% in Asia-Pacific and the Latin America & Caribbean operating segments, and 7% organic sales growth in Africa. This compared to 5% organic sales growth in North America and 4% growth in Europe & Turkey.
Lastly, share repurchases are a catalyst for earnings-per-share growth. Profitable companies that generate positive free cash flow have the ability to return some of their cash flow to shareholders by buying back stock. This has the effect of reducing the number of shares outstanding, which in turn results in higher earnings-per-share. Diageo retired $1.4 billion worth of stock during the first half of the year. The company paused plans to buyback additional shares during the second half of the fiscal year, but it is likely this will only be a temporary issue. The company had projected share repurchases of $5.6 billion through fiscal 2022.
Wait For A Pullback
Diageo has a positive long-term outlook and a safe dividend, but the stock appears overvalued right now. Diageo trades for a price-to-earnings ratio of approximately 23, based on expected EPS of $5.95. We feel this is somewhat too high, as our fair value estimate for this stock is 18-19 which is in-line with the 10-year average valuation multiple of the stock.
Overvaluation matters when it comes to the future returns a stock will generate for shareholders. Even a high-quality business can be a poor investment if too high a price is paid for the shares. Diageo is certainly a high-quality business, but investors should exercise patience and resist the urge to buy just yet. If the stock valuation multiple fell to 18.3 times earnings (our fair value estimate), it would reduce annual returns by 4.5% annually over the next five years. Therefore, even with positive earnings-per-share growth and dividends, shareholders would only earn mediocre returns.
We expect a 8% annual EPS growth, while the stock has a 2.6% dividend yield. The combined expected rate of return, therefore, works out to 6.1% in this scenario. As a result, investors could earn satisfactory returns by buying at the current share price, although we recommend investors wait for a better price before buying Diageo stock. That said, if Diageo were to return to a fair value of 18x earnings, or a share price of around $109, the stock would once again become a buy.