Diageo – profits rise with growth across the board

Net sales in first half of £8.0bn reflected organic growth of 20.0%, driven by double digit growth across all regions. Operating profits grew 24.7% organically, to £2.7bn, with more efficient supply chains and price increases offsetting the impact of rising costs.

The group announced an interim dividend of 29.36 pence per share, a 5% increase.

Diageo expects organic net sales growth to continue into the second half, with organic operating profit growing at a faster rate.

The shares were broadly flat in early trading

Diageo had a rough time thanks to the pandemic, but ultimately brands like Johnnie Walker, Guinness, and Gordon’s, have been strong enough to see it through.

Supermarket spending has been resilient throughout the pandemic and allowed the group to recoup some of the losses from bars and restaurants (aka “on-trade”). And as restrictions continue to ease, we’re starting to see a recovery in on-trade too. That’s good news for Diageo and we’re already seeing the benefit over the first half as sales and profits begin to recover.

As we move out of the shadow of lockdowns and store closures, it’s important to remind ourselves of the groups long-term investment case.

Whisky is an especially attractive market because it takes a lot of up-front investment and time for a newcomer to compete. Good whisky needs to be aged, so a new competitor would need to be comfortable waiting for their investment to pay off. Alternatively, they could buy existing distilleries and spend heavily on marketing, but scaling up would be difficult and expensive. Strong brands and barriers to entry have meant attractive margins in normal times.

A growing middle class in emerging markets is playing into the group’s hands too. It has attractive positions in the key Chinese and Indian markets, and as consumers move up the value chain, Diageo is waiting for them with Black, Blue and Double Black labels.

That said, performance in developed markets hasn’t been entirely plain sailing in recent years. Offloading a selection of smaller brands shifts the dial towards sales of more lucrative products, but the remedial work isn’t over. Management is forging ahead with investments in e-commerce, capacity, sustainability and marketing. Covid may slow some of this down, but it’s encouraging to see the group staying on the front foot.

Diageo is also carrying more debt than we’d like. The ratio of net debt to cash profits will come down as the group recovers, but further effort will need to go into reducing the debt. Management is feeling confident though, and is restarting the share buyback programme. As the shares are currently trading on a PE ratio well above the long run average and debt is still higher than is ideal, we think there’s a strong case for keeping buybacks on ice for the time being.

Recent dividend decisions continue an enviable record of growth that stretches back to the 1990s but it should be remembered all dividends are variable and not guaranteed.

With a world class stable of brands and exposure to emerging markets, the group has some enviable advantages. It’s well positioned to benefit from a smooth recovery and the long-term attractions are firmly intact. Keep in mind the valuation means there could be some ups and downs

Half Year Results (figures are organic)

In North America (37% of revenue) net sales grew 13% to £3.0bn. That was largely driven by US spirit sales where the sales to bars and restaurants recovered well while supermarket sales remained ‘resilient’. Tequila sales were the primary driver of growth while rum, US whisky and Baileys all posted declines. Marketing spend and cost inflation pushed operating margins lower, but an increase in super-premium plus products and price increases meant reported operating profits rose 6% to £1.3bn.

Europe (22% of revenue) saw net sales of £1.8bn, up 27% on last year as all markets saw double digit growth. Bar and pub sales recovered in Great Britain, Southern Europe and Ireland which contributed to a 44% increase in beer sales. Supermarket sales were strong as the group continued to gain market share. Inflation was more than offset by cost savings and an uptick in higher-margin sales, which helped operating profits grow 43% to £613m.

Net sales grew 13% in the Asia Pacific (19% of revenue) region, to £1.5bn. That was driven by strong growth in Chinese spirits and super-premium plus scotch in Greater China and a recovery in pub and bar sales in India. Premium brands performed well, somewhat offsetting higher marketing spend and inflation headwinds, helping reported operating profits grow 17% to £451m.

Africa (11% of revenue) saw growth across all markets with net sales up 23% to £868m. Reported operating profits grew 85% to £176m, as price increases and cost saving more than offset inflationary pressure.

Latin America and Caribbean (11% of revenue) had net sales of £819m, up 45% with double digit growth across all markets. A higher proportion of premium brand sales and price increases mostly offset marketing investment and cost inflation which meant reported operating profits grew 69% to £333m.

As at the end of 31 December 2021, free cash flow was £1.6bn. That was down from £1.8bn the previous year as capital expenditure increased. Net debt stands at $12.1bn, or 2.5 times underlying cash profits. That’s down from £12.5bn a year ago.