Diageo

Moat: 4/5

Understandability: 2/5

Balance Sheet Health: 4/5

Diageo is a multinational alcoholic beverages company, owning a vast portfolio of iconic brands across spirits and beer, with a significant presence in both developed and emerging markets.

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.

Business Explanation

Diageo operates within the dynamic global alcoholic beverage industry. They generate revenue from the sale of their diverse portfolio of spirits (such as Johnnie Walker, Smirnoff, and Tanqueray) and beer brands (like Guinness), catering to varying consumer preferences and price points. Let’s break it down further:

  • Revenue Distribution: Diageo’s geographical footprint is incredibly diverse, with revenue derived from a wide array of regions and products. The largest share of revenues come from North America and Europe, but there are considerable and rising revenues from Asia Pacific, Latin America, and Africa. Within those markets revenue is split across multiple categories, they do not rely on one product and there is a portfolio diversification, with spirits being a greater chunk of the business. There is also a substantial reliance on developed markets rather than developing, at this point, but they are investing more in the latter.
  • Trends in the Industry:
    • Premiumization is an important trend, consumers trade up for higher quality and more unique experiences.
    • There is a growing demand for more low- and no-alcohol options.
    • E-commerce is becoming a vital channel for alcoholic beverage sales.
    • Sustainability is very important, companies are working to reduce their carbon footprint.
    • Consumer preferences are rapidly shifting, therefore companies have to be in tune with consumer needs and tastes.
  • Margins: Diageo benefits from strong brand equity, allowing them to maintain above-average margins and price premiums over less established brands. Their operating margins usually hover around 30%, which is a strong point of the business.
  • Competitive Landscape: While it is a fragmented industry, the top producers are very large companies. Diageo is in the top three along with AB InBev and Heineken. There is competition from newer spirits and craft brands, but they have not yet achieved the scale and distribution capabilities of established players. They also face a significant number of national and local brands that compete at a local level, and are popular within specific regions.
  • What Makes Diageo Different?
    • Premiumization Focus: Diageo strategically positions its portfolio toward premium brands which have better margins than low-cost products.
    • Global Reach and Diversification: They are not dependent on a specific region or product.
    • Brand Management: They are exceptional in growing their portfolio of brands by marketing and differentiating them effectively.
    • Supply Chain and Distribution: They leverage a wide network to distribute their products globally.
    • Data and Technology: They use technology to better forecast trends and make better managerial decisions.

Financial Analysis

Diageo’s financial performance has been generally solid and stable, driven by its strong portfolio of brands.

  • Recent Results:
  • In Fiscal 2023, organic revenue grew 10.7%, driven by premiumization and price increases, but volume growth was fairly flat. * They generated £5.7B in operating profit and increased profits by 15.7%. * Their margins remained consistent at 30.4% * Net sales were 11% over the prior year, although there was a 3% increase in price and 0.6% from acquisitions.

  • They increased their dividend by 5% and have a plan to repurchase $1 billion of shares in Fiscal 24.

  • Profitability: They maintain strong profitability with high margins because their business benefits from several moats (as discussed later). Their net income and margins are highly correlated with the state of the economy, but they tend to be resilient even in difficult periods because of the defensive nature of their products and their strong pricing power.
  • Capital Expenditure: CapEx tends to be stable, and is done mainly to improve existing production and processes.
  • Balance Sheet: They have a relatively stable debt structure, with around £15B in net debt at the end of Fiscal 23. While this debt level does not come without risks, the ability of the company to manage the debt, the consistent cash flows they generate, and low interest rates mean it is relatively healthy. The maturity of that debt is spread out, limiting the risks associated with any immediate repayment of large borrowings.

Moat Assessment: 4 / 5

Diageo has a wide economic moat based on:

  • Brand Intangible Assets: Diageo owns a collection of well-established, iconic brands with strong brand recognition and loyalty, giving it the power to charge premium prices, which is the foundation of its moat. These brands have stood the test of time and are loved globally by the consumer. They benefit from consumer loyalty and repeat sales. This also gives Diageo some pricing power in periods of inflation. Brands like Johnnie Walker, Smirnoff, Guinness, Tanqueray, Baileys, etc. have a significant recognition with the general public.
  • Distribution Advantages: Diageo’s extensive global distribution network is costly and difficult for new competitors to replicate. This allows them to reach customers even in difficult to reach markets, while making it very difficult for competitors to do the same. Also, it means it’s harder for new players to get their brands in front of customers.
  • Economies of Scale: The large scale of Diageo’s operations leads to cost advantages in production and distribution, as well as lower research and development costs per product.
  • Switching Costs The company often forms strong, long-term relationships with suppliers and distributors who become reliant on each other. There is switching costs associated with finding another supplier, but since the relationships are usually long term, it means the likelihood of switching is also low.

Risks to the Moat and Business Resilience

  • Shifting Consumer Preferences: Changes in consumer tastes towards low or no alcohol options or to new categories of beverages represent a risk. It’s also a risk that there are changes in consumer preferences towards other categories of alcohol which might hurt sales of existing products.
  • Government Regulation: Increased alcohol regulation, taxes, and health mandates can limit demand, increase costs, and hurt profitability. There may be new or stricter regulations introduced by governing bodies.
  • Economic Downturn: The business is largely tied to discretionary spending, which might drop in periods of economic crisis or recession.
  • Strong Competition: Smaller brands are trying to disrupt the market, and it’s important for the company to maintain and defend its leadership.
  • Acquisition Risks: Future acquisitions, which make an integral part of the company’s growth, carry integration risks and potential capital destruction should they not live up to expectations.
  • Currency Fluctuations: Given its worldwide presence, results are prone to fluctuations in foreign exchange rates.

Despite these risks, Diageo’s diversified portfolio, strong brand recognition, pricing power, and robust financial structure provide a high degree of business resilience and protection of its moat. Management has proven itself to be capable at navigating difficult economic situations as well as making good acquisitions.

Understandability: 2 / 5

The business is relatively easy to understand and the product offerings are very simple. However, the complexity comes from the global operations, multiple business units, and reliance on complex and often difficult-to-predict supply and demand factors. The way that the company operates and manages its supply chain and its acquisitions means the company has a lot of complexity, but this does not necessarily reflect its moat or ability to continue to deliver in the long run.

Balance Sheet Health: 4 / 5

Diageo’s balance sheet is in good shape. While the company has a significant amount of debt, it is not excessive for such a large, established company with consistent cash flows. The maturities of that debt also mean it is not likely to run into problems in the near term. The company benefits from a diversified portfolio, which means that cash flows are not reliant on a particular product or market.

Recent Concerns / Controversies

The most recent controversy that has been faced by the company is the ongoing investigation by the Kenyan tax authorities regarding alleged tax evasion by its subsidiaries. Management has stated that it is fully cooperating with these investigations, and that they are being taken seriously. So far no charges have been filed, so the final impact on the business is not clear. But it does add an element of uncertainty. Overall, the news of this has not negatively impacted the stock too much and is seen as being an isolated, non-systematic risk.

The company has also faced some criticism that its acquisitions have been too expensive, including the most recent one of Don Julio. But management remains confident that these acquisitions will provide long-term value to the company. The company is also being pressured by new players and the changing consumer preferences that have been mentioned earlier.