Diageo (DEO) Dividend Stock Analysis

Summary

-Diageo is a leading producer of spirits, wines, and beers in the world.
-Sales growth over the last five-year period: 7%
-Earnings growth over the last five-year period: 5%
-Dividend growth over the last five-year period: 5%
-The current dividend yield is over 3.4%
-The balance sheet is a weakness; Diageo has a lot of debt.
-Overall, I think the company would make a decent investment, I but would like to see it at a lower price.

Overview

Formed in 1997 as the result of a merger between Guinness and Grand Metropolitan, Diageo (LGE: DGE, NYSE: DEO) is the world’s largest producer of spirits. Headquartered in London, the company is traded on the London Stock Exchange and has an ADR on the NYSE. The ADR represents 4 shares of the company.

In 2010, the company reported £12.958 billion in total sales, and excise duties of (£3.178 billion), which resulted in a net sales total of £9.780 billion.

Geographic Segments

North America
For 2010, the North American segment reported £3.306 billion in sales, which accounts for approximately 34% of company net sales. Volume and sales were down 2% and 3%, respectively, compared to 2009, while marketing expenditure increased 6% and operating profit stayed flat.

Europe
For 2010, the European segment reported £2.759 billion in sales, which accounts for approximately 28% of company net sales. Volume and sales were up 1% and down 2%, respectively, compared to 2009, while marketing expenditure decreased 6% and operating profit decreased by 1%.

Asia Pacific
For 2010, the Asia Pacific segment reported £1.018 billion in sales, which accounts for approximately 10% of company net sales. Volume and sales were up 2% and 1%, respectively, compared to 2009, while marketing expenditure increased 3% and operating profit increased 6%.

International
For 2010, the International segment reported £2.627 billion in sales, which accounts for approximately 27% of company net sales. Volume and sales were up 8% and 13%, respectively, compared to 2009, while marketing expenditure increased 13% and operating profit increased 25%.

Category Sales

Diageo sells a diverse collection of alcohol types. This is a listing of what percentage of net sales were from each product type.

Scotch: 27%
Beer: 22%
Vodka: 11%
Ready to Drink: 8%
Whiskey: 6%
Rum: 6%
Wine: 6%
Liqueur: 5%
Gin: 3%
Tequila: 3%
Other: 3%

Revenue, Earnings, Cash Flow, and Margin

Revenue, Earnings, and Cash flow have seen fairly consistent growth.

Revenue Growth

Year	Total Sales
2010	£12.958 billion
2009	£12.283 billion
2008	£10.643 billion
2007	£9.917 billion
2006	£9.704 billion
2005	£8.968 billion

Revenue has grown by over 7% annually, on average, over this five-year period.

Earnings Growth

Year	Earnings
2010	£1.743 billion
2009	£1.706 billion
2008	£1.586 billion
2007	£1.556 billion
2006	£1.965 billion
2005	£1.399 billion

Company net earnings have grown by nearly 5% annually over this time period.

Operating Cash Flow Growth

Year	Cash Flow
2010	£3.184 billion
2009	£2.654 billion
2008	£2.325 billion
2007	£2.272 billion
2006	£2.199 billion

Cash flow growth was 9% annually over this four-year time period.

Metrics

Return on Equity is 43%, but this is largely exaggerated due to the debt levels of the company. Return on Investments is 17%.

The company’s net profit margin is 18%.

Dividends

Diageo pays an interim and a final dividend each year, with the final dividend being the larger of the two. The current dividend yield is over 3.4%, and the payout ratio is approximately 60%.

Dividend Growth

Year	Dividend	Yield
2010	38.10p	3.50%
2009	36.10p	4.00%
2008	34.35p	3.80%
2007	32.70p	3.20%
2006	31.10p	3.20%
2005	29.55p	3.50%

Over this time period, the company has grown its annual dividend by over 5% annually, on average. The dividend in US currency has decreased during some of these years, but that’s a result of currency conversion rather than the company actively paying out less money per share.

I have observed that some finance sites seem to have a problem calculating the dividend yield of this stock. Both Google Finance and CNN Money report a dividend yield of 4.2% on the ADR. This seems to be a result of doubling the most recent dividend payout (the larger, final dividend) and then dividing by the share price. If one recalls that the interim dividend is smaller, one realizes that this calculation won’t be correct. If one adds the 2010 interim and final dividend together and then divides by the current price of the stock, one will get a dividend yield of around 3.4%. The exact number depends on the currency and what share price is used.

Balance Sheet

The balance sheet is a weak point for Diageo. The company has over £8 billion in long-term debt. The Total Debt/Equity ratio is over 2.

With an interest coverage ratio of 3.7, Diageo’s debt certainly does not put it in any immediate danger, but this amount of debt can be detrimental for long-term profitability and can reduce business flexibility. If two companies are in the same business, have the same growth, and have the same stock valuation, then the one with the lower debt levels is usually the better value.

Investment Thesis

Diageo’s market share and brand strength are unparalleled.

-Smirnoff Vodka is the best selling premium spirit in the world by volume according to Diageo.
-Johnnie Walker is number one in Scotch, worldwide.
-Guinness is number one in stout.
-Captain Morgan is number two in rum.
-Baileys is number one in liqueur.

The company has a host of other global and regional brands, and has distribution rights for Jose Cuervo, number one in Tequila.

32% of total sales are from developing countries, and the company’s “International” segment is by-far their fastest growing segment.

This is a good type of company for dividend growth investors to invest in because the company doesn’t have to change much to grow. It’s not a company that has to spend huge amounts on research and development, or has extremely complex products, or operates in a fast-changing industry. They just make alcoholic beverages in a variety of price ranges, in a variety of categories, with a variety of top brands, and use marketing to try to keep their top position and expand their business. Their size gives them increased distribution efficiency over their competitors, which provides them with a respectable economic advantage.

Risks

Every company has risk. Diageo has regulatory risk, currency risk, competition risk, commodity cost risk, and more. The company’s large collection of top brands operates in a fairly recession-resistant industry in a globally diverse market, which offers it some safety.

For investors looking for dividend income from the ADR, a risk is that even if the company raises its dividend in a given year, the dividend in US currency might be lower than the previous year.

Conclusion and Valuation

In conclusion, I find this to be a very respectable company at a price that is not too attractive to me at the moment. Although I do think this would make a respectable investment, with 3+% yield and 5+% dividend growth, I am not too keen on paying a P/E of nearly 17 for a company with such high debt levels and fairly mediocre growth prospects. Either the debt would have to be lower, the growth more impressive, or the price reduced for me to be a buyer of this stock.

I do like the company’s vast international exposure in an industry that’s not going away, and their array of market-leading brands. The dividend yield is solid, the dividend growth is respectable, revenue is climbing, and I can’t particularly envision a large chance of an investment in this company turning sour over the long-term.

Full Disclosure: I do not have any position in DEO at the time of this writing.
You can see my full list of individual holdings here.

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