Diageo: investors see glass half-full as profits slump

Investors have found Diageo (LSE:DGE)’s recent performance difficult to swallow, and these results underline the scale of the challenges ahead. That being said, there are emerging glimmers of hope given the reach and power of the group’s brand portfolio.

It remains to be seen whether the concerns overhanging the sector as a whole are cyclical or societal. There is some evidence of customers trading down to cheaper alternatives, which provides an immediate headwind to Diageo’s premiumisation aspirations.

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Meanwhile, there is some debate as to whether the younger consumer market is a growth area at all given changing attitudes, although the growing proliferation of the “moderation”, low to no-alcohol drinks could provide an opportunity. In addition, the pandemic “drink at home” boom has long since subsided, on top of which some are questioning whether the exponential growth in weight-loss drugs is a contributing factor to falling sales.

A generally torrid trading environment has clearly damaged the numbers for this period. Operating profit fell by 27.8% to $4.34 billion (£3.2 billion), although on an adjusted basis a decline of 0.7% is less painful. Operating profit margin plunged by 8.19% to 21.4%, the sum total of which led to a 39.1% decrease in net profit to $2.54 billion. Impairment and restructuring costs took their toll on the number, as did unfavourable foreign exchange movements and the margin decline.

There was some slightly better news in terms of net sales, where a fall of just 0,1% was reported to $20.25 billion, in line with expectations. Organic net sales growth of 1.7% comprised a gain of 0.9% for volumes and 0.8% by price, demonstrating that the group retains the ability to raise prices as a potential lever. Free cash flow was also something of a positive, rising by $139 million to $2.75 billion, which should provide the group with some financial flexibility as it continues to invest. With net debt of $21.5 billion now within the group’s target range, and in a cautionary move, the dividend was left unchanged, although the current yield of 4.3% is clearly an attraction.

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More broadly, the current effects of the tariffs are likely to cause an annualised hit of some $200 million (upgraded from a previous $150 million) on profits although the group estimates that its mitigating actions, such as increasing prices, cost control and supply chain management will limit the damage.

To this end, Diageo previously announced the beginning of its “Accelerate” programme which, inter alia, seeks to create a stronger operating model by delivering around $3 billion of free cash flow next year, alongside some $625 million (increased from $500 million) of cost savings.

By geography, there was a mixed to positive performance. Its largest market in North America appears to have stabilised, while Latin America and the Caribbean, a particular thorn in the side over recent times, saw a jump in sales, although the figure was flattered by soft comparatives from the year before.

In terms of performance, the jewel in the crown remains the Guinness brand. Apparently exempt from the concerns seen elsewhere by geography, habits or price, the stout produced sales growth of 12%, with double-digit hikes now being established for the fifth consecutive year. Guinness also gained share in its three largest markets, while the availability of a no-alcohol version has opened up an entirely new potential area of growth. It is therefore of little surprise that the group was quick to quash any rumours earlier in the year that the brand was being prepared for a spin-off. Sales of this famous brand are estimated to be responsible for around two-thirds of beer sales for the group and for 12% of total revenue, and one which Diageo is keen to protect.

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The progress which has been achieved has been warmly received in opening exchanges. The group remains a behemoth, with 13 billion-dollar brands stretching across 180 geographies even though developments over the last year have taken the sheen from a stock traditionally regarded as a core portfolio constituent.

Prior to this update, the shares had declined by 24% over the last year, in sharp contrast to a gain of 14% for the wider FTSE 100, and by 53% over the last three years. While the valuation is currently at an historic low compared to the recent past, the search for a new CEO adds an unwelcome distraction. On balance, however, the market consensus of the shares has improved of late to a cautious buy, as investors take more of a glass half-full approach even if this has yet to be fully reflected in overall profitability.