Though this is a bit funny but it is always said that the liquor business is sort of an evergreen business and generally it is immune to recession and expands during joyous phases. Ironically, Diageo’s (DEO, Financial) last quarter results (announced on July 31) doesn’t satisfy this paradigm as the company missed earnings across almost all business segments. However, analysts are showing interest in the stock because of its attractive valuation and improvement in global economic scenario.
In the fourth quarter, net sales were up by 0.8% and positive consumer trends were observed in the higher priced categories. The EPS before considering extraordinary items was down approximately 7.6% to 95.5 pence per share. Also, the free cash flow was ÂŁ1,235 million for the quarter. Diageo has segmented its overall operations in terms of geographies and therefore, the challenges faced by the company in various geographies are different and as such, their impact on the numbers also varies. In its earnings call, the company pointed out that the business in North American region was strong and the company was able to achieve expected topline growth. However, in Europe, the company was not able to perform phenomenally and as for the emerging geographies, it exhibited a weak performance.
Diageo’s prospects are weak in Europe.
As I mentioned above, the operations of Diageo are segmented by geography and therefore the company has to encounter market-specific challenges. In this article, my intent is to give you an understanding of Diageo’s future prospects and to which, the economic scenario across different geographies, holds the key. I would begin with Europe first because the company has been present in the region for a considerable time but the recent shifts (negative, of course) in Europe’s economy has hurt Diageo’s sales.
A recent article on RT clearly pointed out the sorry state of the European economy as the region is trapped in its own budgetary policy and it seems that it is having a difficult time to come out of the crisis. On Tuesday, the European commission slashed its economic outlook for the Eurozone, putting immense pressure on the European central bank to come out with extraordinary measures to arrest the slow growth and push off the lurking fear of deflation. The revisions made for Germany and France, two of the largest Eurozone countries, were the sharpest. The 2015 GDP forecast for Germany was cut from 2 percent in May to just 1.1 percent. Similarly, France’s forecast was cut from 1.5 percent to 0.7 percent.
Since the GDP is falling in the region, it implies that the disposable income per person is also going to be hit. This will have a direct impact on Diageo’s Euro brands and especially, the high-end brands will see a decrease in sales. Moreover, since the top brands contribute better to the margins, it is not going to be a healthy news for the company. Eastern Europe isn’t providing much hope for growth either. Recently, the region saw a decline in sales due to weak consumer confidence and uncertainty over events in Ukraine
Not so good emerging markets
Besides the Euro economy, the other markets that have troubled chief Ivan Menezes is the emerging markets as a result of which, Diageo’s overall earnings have suffered. The company was hit by ongoing volatility in markets like Nigeria, Brazil and China and that showed in its results. Diageo's first quarter results were also affected by ongoing currency weakness, in particular the devaluation of the Venezuelan bolivar.
A big worry is China where the Government’s anti-extravagance policies have hit a number of consumer and luxury companies including Diageo, to an extent. Diageo previously relied on China's government dinners and gifts for good profits, a practice now seen as corruption and its premium brands including Johnny Walker and Smirnoff are seeing a cut in sales. After President Xi Jinping put anti-corruption laws in place, premium alcohol sales dropped 30%, thus lowering China's GDP by 1.2%. In 2012, the Chinese average spirit consumption reached a whopping 4.7 liters. However, now that the government crackdown has slowed sales, Diageo would have to look for new and innovative ways to fuel sales or see a continuing decline in the region.
Final words
At the onset of this article, I hinted at the attractive valuation that is pulling analysts to the stock in spite of the earnings miss and bleak prospects in instrumental markets. Agreeably, its trailing P/E of 19.75 is highly favorable in comparison with peers, but the PEG of 2.90 is dangerously high and this means that the stock could tumble in light of any negative event. Additionally, the EPS growth for the next five years is projected at a minimal 7.6 percent and considering the risk of deflation and staggering economic situation highlighted in above paragraphs, it is not prudent to call Diageo a bargain.
In my opinion, Diageo has been a strong performer but in the light of recent crisis and circumstances that are not entirely within the control of the company, I would not advise investors to put money in the stock. Though the company is trying desperately to revive high and sustainable growth by shuffling its product portfolio, varying its price mix and also investing in credible brands, it may not suffice in the near term. Therefore, it is wise to quit the position in Diageo and book profits.
