Drinks giant Diageo is a top-notch franchise. However, this is one defensive stock to avoid – even after the recent stockmarket sell-off, it’s shares remain far from cheap. Let me explain why.
Diageo (LSE:DGE), rated as a BUY by Nomura Securities
Diageo is the world’s largest premium drinks group. Its market capitalisation is around £22bn and it has an estimated 28% share of the spirits industry, ahead of rivals Pernod Ricard (16%) and Bacardi (11%). It owns tier 1 brands including Smirnoff, Johnnie Walker, Guinness, Baileys and Captain Morgan – which, like the other ‘vice-related’ areas of tobacco and gambling, provide it with a measure of resilience at times of turbulence. But investors who buy now are in danger of overpaying for perceived safety.
So how much is this spirits giant worth? Well, at 940p the shares trade on 2008 and 2009 p/e ratios of 16.1 and 14.1 respectively. But to get a better grasp of this full-bodied rating, one needs to strip out the distortive effects of its £6.4bn net debt pile and the £1.3bn pension deficit.
On this basis the stock trades on a far more stretching EV/EBITDA multiple of 11.2. For this type of premium valuation I would expect top-line growth of more than 10% a year. However, even with the tailwind of a softer pound, like-for-like sales growth is running at only 7%, with 4% of this generated from price increases rather than volume growth. In fact, given the brutal discounting seen in the supermarkets, the parlous state of the pub sector and the fact that consumers are trading down to cheaper own-label brands, then I see this frothy multiple compressing next year.
There are also other dark clouds on the horizon that need to be considered. For instance, there are concerns over the impact of more stringent regulation on binge drinking, the sustainability of emerging-market growth, and the ongoing shift towards less-profitable home consumption. Diageo’s shares could easily fall back down to an EV/EBITDA multiple of eight, which would trigger a 30% or so fall in the share price from today’s levels.
In summary, although Diageo’s brands are resilient in a recession, they are not immune. And priced at $150 to $500 a bottle, then I’m sure there will be far fewer cases of Johnnie Walker Blue Label sold this Christmas.
Rather than buying the overpriced shares, income seekers may instead prefer to look at Diageo’s corporate bonds. The firm’s latest €1bn fixed-rate loan-note pays a generous coupon of 6.625% for the next six years.
The next trading update is expected in early January.
Recommendation: SELL at 940.5p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.