Diageo plc

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Diageo is a global leader in the alcoholic beverages industry, boasting a vast portfolio of iconic brands and a wide geographic reach.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Diageo operates in a notoriously challenging and competitive landscape. This demands a deep dive into its sources of competitive advantage.

Moat Analysis

Diageo’s moat is complex and isn’t based on a single factor, so it will receive a “3 / 5” rating. The company benefits from some strong characteristics such as:

  • Brand Strength (Intangible Assets): Diageo boasts an impressive portfolio of globally recognized and iconic brands, such as Johnnie Walker, Smirnoff, Guinness, Baileys, Tanqueray, and Captain Morgan. These brands, built over decades, command a degree of pricing power due to their recognition, emotional connections with consumers, and perceived quality. However, while brands are the foundation of Diageo’s pricing power, it is still susceptible to consumers switching to premium local alcohol. Hence, a brand alone doesn’t warrant a “wide” moat, because there are plenty of local companies that also have strong brands.

  • Niche Domination (Economies of Scale & Cost Advantage): Diageo benefits from scale in distribution and production capabilities. However, many smaller spirits and beer companies are able to compete on the margins for higher prices on localized brands and are actually competing on cost in some ways. The supply chain efficiency of Diageo, while impressive, may not be too difficult for many competitors to replicate, and cost advantage is difficult to gauge in alcohol because price elasticity (meaning alcohol sales aren’t usually affected by a small rise in price) means there is no race to the bottom. A company’s scale is most important if it has lots of fixed costs that can be divided among sales. It is unclear how much fixed capital investment is involved in making alcohol, or it may be low, considering most alcohol production involves fermenting large volumes. So, a cost advantage is usually quite difficult to assess among alcohol producers.

  • Customer Switching Costs: There are low switching costs associated with Diageo’s brands. A customer can easily chose to switch to a competitor, and there is low loyalty. Thus, having a well known brand and a superior sales force is one of the only ways to keep customers from leaving. But these aren’t a moat in themselves.

Risks to the Moat and Business Resilience

Despite its strengths, several risks could undermine Diageo’s moat and business resilience:

  • Changing Consumer Preferences: Consumer tastes evolve rapidly and could shift away from Diageo’s core products. The alcohol sector is highly susceptible to change.
  • Competition: The alcoholic beverage industry is fiercely competitive, with rivals investing heavily in brand building, R&D, distribution, and marketing. Local competitors in different regions pose a constant challenge. Increased M&A within the industry can also pose risks to Diageo’s moat and pricing power. Also, it may take very little time or money to imitate a specific alcohol.
  • Regulatory and Political Risks: Changes in alcohol-related regulations and tax policies could adversely affect Diageo’s profits, or its ability to enter certain markets. The recent restrictions on advertisement for alcohol in India can be cited as an example. Further, geopolitical instability could affect supply chains or consumer markets in emerging economies.
  • Economic Downturn: Macroeconomic slowdowns and recessions can hurt consumer spending on discretionary items, including premium alcoholic beverages, which can result in a decline in revenues and profits.

Despite all of these risks, the company still has a robust portfolio of brands and is a global player in alcohol. The company has demonstrated a strong track record of adaptation. While the company is certainly not invulnerable, it does have good defenses.

Business Explanation

Diageo operates with a wide reach throughout the world and a diverse range of categories.

  • Revenues by Region: In the last annual report from 2023, the revenue distribution by region was as follows: North America (37%), Europe (27%), Asia Pacific (20%), Latin America & Caribbean (12%), and Africa (5%). These revenues numbers are all affected by exchange rate fluctuations between the various currencies.
  • Revenues by Category: Diageo reports revenues based on categories. The largest in 2023 was Scotch, followed by Beer, then North American Whiskeys, then Tequila. After that came Vodka and then Gin, Indian Made Foreign Liquour (IMFL), and lastly Liqueurs & Other.
  • Industry Trends:
  • Premiumization: Consumers are increasingly opting for premium and super-premium alcoholic beverages, contributing to higher profit margins for companies that control those categories. However, the company is susceptible to losing market share to cheaper local premium alcohols.
  • Growth in Emerging Markets: The expanding middle class in emerging markets presents opportunities for growth for the alcoholic beverage industry, however, economic and political uncertainties remain. Also, rising tensions between the countries are having adverse effects.
  • Shift towards Health and Moderation: Growing concerns around health and wellness are pushing consumers towards lower-alcohol and non-alcoholic beverages. The trend toward moderation is also a concern, because the company profits by selling more alcohol per person.
  • Digital Transformation: The rise of e-commerce and digital marketing is transforming how companies distribute and promote their products. Diageo must increase their digital presence to remain competitive. Also, many younger companies with a better understanding of internet marketing have entered this space to compete with the incumbent companies.
  • Margins: Diageo has good profit margins and it is one of the reasons the stock is attractive for value investors, as well as a high return on invested capital. In the annual report ending June 2023, the operating margin before exceptional items was 31.5%, higher than 30.6% in the previous year. The adjusted gross profit margin for 2023 was 59.2% (higher than 57.9% in 2022) and the adjusted operating profit margin (before exceptional items and share-based payments) was 29.2%, higher than 28.8% in 2022.
  • Competitive Landscape: The alcoholic beverages industry is highly competitive, with major players including Anheuser-Busch InBev, Pernod Ricard, Brown-Forman, and Molson Coors, as well as many local and craft players. These companies compete on brand recognition, product quality, distribution, and price. However, despite the fierce competition, many large players have still seen very high returns on capital.

Financials In-Depth

Diageo’s financials are mostly healthy, but they require a closer look at its debt and cash generation ability.

  • Revenues and Profitability: In fiscal year 2023 (ending in June), Diageo saw a strong organic growth of net sales at 9.0% (driven mostly by pricing, rather than volume, with a 1.3% increase in organic volume) with operating profits increasing 9.5%. The biggest revenue gains were in the North America segment and Asia Pacific. However, organic volume increases are lower than in previous periods, which could be a concern. The company’s revenue in 2023 reached £20.49 billion, while its operating profit reached £6.01 billion. The reported numbers increased by a significant margin (10.7% and 11.9% respectively), but this was due to a positive change in exchange rates.
  • Cash Flow: Despite strong reported profits, the company had £4.93 billion of net cash from operations and £2.07 billion of free cash flow. The difference is due to capital expenditures, acquisitions, and other financing activities. The adjusted earnings from operations were £6.39 billion, making net income £3.9 billion after a large tax payment of £1.34 billion. Given these strong numbers, the company will likely continue to provide dividends to shareholders.
  • Debt: One of the things that could bring the company down is a potential decline in the market, as the company has a net debt (total debt minus cash) of £14.4 billion. The company has many different kinds of debt at various interest rates and maturities. So a downturn in the market or higher interest rates will make it more difficult for the company to repay its debts. Also, a significant downturn may hinder its cash generation.

Based on its performance, Diageo has a strong global presence and cash generating capability. Although it has a substantial debt burden, it is mostly able to service that debt.

Understandability Rating: 2 / 5

While the products of Diageo are very common, its overall operations are very large and complex, making the company not easy to understand. Also, understanding accounting differences across countries and the complex reporting for this multinational company makes it less understandable.

  • Business Complexity: Operating in diverse geographic regions and across multiple segments adds complexity, as it is tough to comprehend all the different products the company produces, and the various markets where they are selling them.
  • Accounting Nuances: Understanding Diageo’s financials requires familiarity with international accounting standards (IFRS) and their interpretations. This is necessary to make comparisons to other similar companies. As mentioned previously, a deeper understanding of their complex financial statements is needed to arrive at a true estimate of their earnings and cash flows. Also, certain items are reported in a pro-forma manner, which make analysis difficult.
  • Industry Dynamics: It can be difficult for an outsider to fully understand the alcohol industry, with its complicated regulatory rules, different consumer tastes, and competitive market pressures.

Balance Sheet Health Rating: 4 / 5

Diageo’s balance sheet is generally healthy, but it does not achieve a top rating due to its sizable debt and its reliance on intangible assets:

  • Cash Flow Generation: Diageo consistently generates strong cash flows from operations and also has a high percentage of free cash flow. This gives it the power to pay down debt if needed.
  • Debt Level: Diageo’s net debt to EBITDA ratio is quite high. While the company generates enough cash to service its debt, the high debt level makes the company more susceptible to the pressures of a bad economy or an increase in interest rates.
  • Intangible Assets: More than half of Diageo’s assets are intangible, mainly brands and goodwill. Such assets are subject to potential write-downs. If those brands suffer from a loss in popularity or are otherwise threatened by outside factors, it can cause major losses on the balance sheet.
  • Working Capital: The company’s overall liquidity ratio looks healthy, as they have a current assets-to-current liabilities ratio of 1.17 in the annual report for the year ending June 2023.
  • Non-Operating Assets: While there are some holdings that are not directly part of the business, they make up an insignificant portion of the balance sheet.

Recent Issues and Management Views

In its latest earnings calls and shareholder reports, Diageo has emphasized its focus on organic growth, premiumization, and improving operational efficiencies.

  • Inflationary Pressures: The company has expressed caution on the effects of inflation, specifically stating that it will need to take some time before inflation reaches their products on the shelves. It has also been using various cost-cutting strategies to increase profits without increasing prices for customers.
  • Supply Chain: Management has stated that they have been adjusting to the supply chain disruptions, which were created during COVID, and have since made strides in improving it.
  • Currency Fluctuations: Like most multinational corporations, Diageo’s financial results are affected by exchange-rate fluctuations. In the last report, the company saw substantial positive effects due to changes in currency, which pushed up sales and profits in USD terms.

Overall, management is cautiously optimistic regarding long-term prospects, but acknowledges the various economic and geopolitical challenges that it is currently facing.

In conclusion, while Diageo has a strong brand portfolio and a long track record of success, potential shifts in consumer preferences, increased competition, and a large debt burden do present some risk to long-term investment returns. However, it remains a highly profitable and relatively stable company with good cash generating capabilities.