Shares in premium drinks maker Diageo (DGE) are down 8% year-to-date amid worries over a global recession and soaring raw material costs. Also weighing on the price have been fears that drinkers might trade down to cheaper beverages as inflation squeezes consumer budgets, at least in the short term.

Yet over the long term, Diageo is ideally placed to prosper from growth in premium drinks. With Diageo scheduled to have published its full-year results on the day this article is published (28 July), now is a great time to distil the many competitive strengths of a quality business that generates a high return on equity.

WHAT MAKES DIAGEO SPECIAL?

It is home to some of the world’s most iconic alcoholic beverage names including Johnnie Walker, Smirnoff and Guinness. The £83.6 billion company boasts over 200 brands operating across 180 countries and has a worldwide distribution footprint and massive marketing clout.

This unrivalled portfolio of brands confers pricing power on the business, crucial during inflationary periods, and underpin Diageo’s consistent profitability.

A cash generative business model has enabled the FTSE 100 group to establish an enviable dividend growth record, uninterrupted even by the pandemic, while investing in the organic growth opportunities and acquisitions and returning additional capital to shareholders through earnings-enhancing share buybacks.

Another key competitive strength is Diageo’s global reach and dense distribution network which has cost advantages that allow the company to spend more on advertising and promotion, creating a virtuous circle. These strengths and its brand-building expertise also mean Diageo is an attractive home for upcoming brands looking for global reach and maximum promotion.

Guided by CEO Ivan Menezes, Diageo has strong relationships with on-trade customers (pubs, bars, restaurants and hotels) and is also building its e-commerce and direct-to-consumer capabilities in order to further expand its sales reach to thirsty consumers.

Diageo's drinks portfolio

Diageo owns Johnnie Walker, the world’s best-selling Scotch whisky established back in 1820 and Smirnoff Vodka, as well as iconic stout Guinness, Baileys cream liqueur, Captain Morgan rum and Tanqueray premium gin.

It also owns ‘Local stars’ such as Crown Royal, Buchanan’s and Chinese white spirit Shui Jing Fang and a ‘Reserve’ portfolio of global luxury market-focused labels including Ketel One and Cîroc vodka and acquired tequila brands Don Julio and Casamigos, the latter purchased from actor George Clooney.

Diageo has also made some strategic disposals over the years, including the sale of its main US wine businesses in 2016 and 19 US brands in 2018.

BEVERAGES BRAND BUILDER

Diageo is a top 10 holding in Sanford DeLand’s CFP SDL UK Buffettology Fund (BF0LDZ3). Sanford DeLand analyst Chloe Smith says the drinks giant ‘exhibits the attributes we look for in quality businesses, including high returns on equity, an enduring franchise with pricing power and consumer brand loyalty. The strategy to leverage its global brands whilst also nurturing local stars in individual markets has proven Diageo’s track record in brand building.’

The stock is also held in Troy Asset Management-steered portfolios including the Trojan Income Fund (B01BP17) and investment trusts Personal Assets (PNL) and Troy Income & Growth (TIGT).

Troy fund manager Blake Hutchins says Diageo owns ‘some of the world’s most desired spirits brands’ and stressed ‘they are just so rare, and when they are cultivated in the right way by good brand owners over many years, they are incredibly valuable. And the nice thing about spirits is it comes with quite a high price point.’

Since spirits aren’t that expensive to make, they generate high gross margins, explains Hutchins. The fact some of Diageo’s spirits are aged, notably the premium scotch range, creates a huge barrier to entry. Diageo has the distilleries and the maturing whisky stocks that smaller rivals have neither the capital nor the time to compete with.

Johnnie Walker is a great example. Scotch can only be made in Scotland and has been distilled by people there for more than 500 years. After distillation, the spirit must be matured in oak casks (in Scotland) for a minimum of three years before it can be called Scotch whisky.

INFLATION BEATER

Charismatic ‘buy and hold’ stock picker Nick Train owns Diageo in the Finsbury Growth & Income Trust (FGT) and doesn’t view Diageo and other portfolio holdings such as Unilever (ULVR) and RELX (REL) as just defensive investments if ‘defensive’ means that the only time to own them is if you fear that stock markets are likely to fall, or economies go into slowdown.

Instead, Train believes such businesses offer the prospect of protection against monetary inflation and the likelihood of real earnings growth over time. ‘These are characteristics that make for fine long-term investments,’ he says.

IS THERE GROWTH TO GO FOR?

Despite decades of consistent growth, Diageo still only commands around 4% share of the global alcohol market. By 2030, management wants that share to rise by 50% to around 6% share, aided by the increased sales of spirits in emerging markets where penetration remains low.

Greater China has the largest and fastest-growing super premium spirits segment in the world and Diageo is well placed to prosper in the Middle Kingdom via popular brands including Johnnie Walker, Talisker and The Singleton.

In the second half of 2021, Diageo shrugged off global supply chain constraints and rising cost inflation to serve up operating margin expansion and organic net sales growth of 20%. This was thanks to continued recovery in the global on-trade and resilient consumer demand in the off-trade (sales through supermarkets and other shops).

Growth was broad-based across most categories, with Diageo enjoying particularly strong performance in scotch, tequila and beer.

WHICH BRANDS ARE SPEARHEADING GROWTH?

Sanford DeLand’s Chloe Smith says Diageo’s portfolio spans the price range, but growth opportunities are really being embraced in premium spirits, where the market continues to outpace the total spirits category.

Consumers are increasingly looking for quality over quantity and ‘drinking better, not more’, she says. ‘This is driven by a range of factors from more health-conscious younger generations and a burgeoning middle-class population in regions such as China, which continues to be one of the world’s largest premium-and-above markets for spirits.’

Smith explains that Diageo has taken advantage of this trend by taking heritage brands like Johnnie Walker and introducing premium labels, such as its Blue Label and through younger brands such as Don Julio and Casamigos in the fast-growing tequila category. Diageo is also tapping into the low or no alcohol market, with investments in the likes of the alcohol-free spirit brand Seedlip and offering a 0% alcohol version of Guinness.

IS GUINNESS STILL RELEVANT TO DIAGEO?

Investors often ask Diageo’s management about the rationale for continuing to own Guinness, yet the brand continues to demonstrate its relevance and importance to the group.

While Guinness suffered from pandemic-induced on-trade restrictions, there are signs of this growth coming back. ‘Confidence in the Guinness story can be seen with Diageo’s recent investment in a new micro-brewery in London’s Covent Garden, expected to open in 2023, after the success of its Guinness Storehouse in Dublin, which remains one of the Irish capital’s most visited tourist attractions,’ says Smith.

‘Overall, Diageo has a very diversified beverage portfolio, with its ultimate earnings driver being its continued investment in brands and ability to forge a healthy volume and price mix, with a good portion of this, I expect, coming from the continued growth in its premium labels.’

TASTY TIPPLE

The consensus analyst forecast for the financial year to June 2023 points to robust organic net sales growth of 6.3% and organic operating profit growth of 7.1%, giving earnings per share of 162.8p. That places Diageo on a prospective price to earnings multiple of 22.7, demanding for a lesser company perhaps, but a palatable rating as this is a discount to a 2021 peak of 37.3 times, according to Stockopedia.

Nick Train recently said he finds Diageo’s share price weakness to be ‘perplexing’. He commented: ‘There can be few companies in the world that offer greater certainty of inflation protection and access to secular real growth.

‘We know that some analysts believe Diageo is expensive. We disagree. Instead, we concur with US stock market scholar Jeremy Siegel – author of the classic Stocks for the Long Run – who concludes “stocks with steady growth records are worth 30, 40 and more times earnings”. On this basis Diageo is given away.’

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