Diageo shares tipped to rebound

Hopes that the worst is over for Diageo (LSE:DGE) and its loyal band of shareholders including Nick Train, were fuelled today when a leading City firm upgraded the drinks firm to a Buy rating.

The support of Bank of America comes after two challenging years in which earnings per share forecasts have been downgraded by about 30% and the shares have fallen 40%.

The bank expects the company’s performance to show improvement in the current financial year, adding that international spirits is still an attractive category even if growth may not quite return to pre-pandemic levels in some markets.

It added: “With a reasonable valuation, improving momentum in the business and a relative scarcity of compelling investment alternatives in staples, there is enough for the stock to outperform, we believe.”

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Bank of America lifted its target price to 2,800p, which compares with this afternoon’s 2,500p after a strong session added 66p in a performance near the top of the FTSE 100 index.

Diageo’s reputation as a quality stock for the long term has been shaken by a sell-off that started with the disclosure of lower consumption and downtrading by consumers in Latin America and the Caribbean.

Portfolio manager and long-term supporter Nick Train told holders of Finsbury Growth & Income Ord (LSE:FGT) Trust in July that Lindsell Train has taken the opportunity to add to its exposure where possible. At the time, Diageo was the sixth-largest holding at 9.8% of the total.

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Train called it a disappointing phase of Diageo’s history but said there were some bright spots after the company ended the financial year with 75% of brands gaining or holding market share.

Two of its big long-term growth drivers – Guinness and Tequila outside the United States – grew revenues at a double-digit pace while the company generated $2.6 billion of free cash flow, up $400 million on the previous year.

He noted in July that Diageo was valued at just under 20 times prospective earnings.

Train said: “We have long held the view that a company with brands of Diageo’s calibre and, crucially, half of its earnings generated in the world’s biggest, and most dynamic economy, the United States, could be valued on up to 33x earnings per share, for an earnings yield of 3%.

“Or put differently, we would not even consider selling out of an asset as advantaged as Diageo at anything less than a 30x or more multiple. That gives a possible target price of £40, which will be higher when Diageo’s earnings grow again.”

Today’s note by Bank of America forecasts current year sales and earnings growth of 2.9% and 2.3% respectively, driven by a Latin American recovery and gradual improvement in the US on easier industry comparatives. Cost savings should limit margin erosion this year.

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The bank believes the company is well positioned through its category exposure, brand portfolio and best in class capabilities to grow sales 4.5-5% and earnings by about 6% mid-term.

Writing in the annual report, Diageo chair Javier Ferrán said the industry remains an exciting sector having delivered a 4.4% annual compound annual growth rate over the past decade.

The former Bacardi boss backed the long-term trend of sector premiumisation, supported by demographic trends, rising incomes in developing markets and spirits continuing to take share from beer and wine.

Diageo has an ambition to increase its industry share to 6% by 2030, up from 4.5% currently.

The company will hold its AGM in London on 26 September and is due to pay a final dividend of 62.98 cents (48.07p) a share on 17 October.

The past financial year saw a 24% decline in total shareholder return, with the record across three years placing Diageo 14th in a 16-strong peer group that includes Anheuser-Busch InBev SA/NV (EURONEXT:ABI), Procter & Gamble Co (NYSE:PG) and Carlsberg.