Spirits are not as high as they were among Diageo’s investors. The lockdown sales boom in its core North American market has cooled more rapidly than expected.
A miss stateside dented the drinks group’s top level, where it announced organic sales growth of 9.4 per cent for the final six months of last year, ahead of the 7.9 per cent pencilled in by analysts. In the United States and Canada, which account for more than a third of group revenue, sales growth was about half the rate the market had been hoping for at only 3 per cent ahead of the same period in 2021.
Greater caution is reflected in Diageo’s market valuation. Its shares trade at 20 times forward sales, down from a peak of almost 29 at the end of 2021. That puts them a touch below their ten-year average.
• High spirits at Diageo as it shrugs off cost of living
Some long-term perspective is helpful here. A decline in volume growth now that lockdown boredom has been alleviated should hardly be a surprise. US consumers have also spent their Covid cheques, money that, over the three years to the end of last June, helped sales volumes to grow at a compound annual rate of just over 8 per cent, more than double the annual level recorded in the years before global lockdowns.
True, volume growth rates clocked up by the business on the other side of the Atlantic were at least in positive territory compared with the same months before the pandemic, but then progress in other territories was worse. The result? Over the first half of this year, volume growth of 1.8 per cent at the group level was in line, or better than, the rates achieved in comparable periods in four out of the five years before the pandemic.
There is one problem. Diageo has set out ambitious targets to increase both organic sales and operating profits up to 2025. It is punching for underlying sales growth of 5 per cent to 7 per cent, up from the 4 per cent to 6 per cent aimed for previously, and operating profit up by 6 per cent to 9 per cent, all at a time when incomes will be under pressure.
The pricing power of many of Diageo’s brands could lend a hand. Price rises delivered 7.6 per cent organic sales growth over the first half of the year. Moreover, rather than being foresaken by cash-strapped customers trading down, growth in “super-premium” booze (retailing at more than $50 a bottle) and premium products is outpacing Diageo’s cheaper line-up. Sales of the former rose 12 per cent, while the latter was up 9 per cent. Value brands sold more in emerging markets, such as Gilbey’s gin, grew by only 3 per cent over the same period.
Diageo is pivoting towards the structurally growing spirits market. Sales of beer and wine in America declined by 2 per cent last year, according to researchers at IWSR, compared with growth of the same proportion in spirits.
Cost inflation is running in low-double-digits in some parts of the business, according to Lavanya Chandrashekar, the finance chief. That is not getting worse, but it is also not easing. Price increases, productivity savings and the inherent benefits of greater volumes have offset those margin pressures and pushed up organic operating profit by 9.7 per cent.
Some of its brands date back centuries, a staying power it is difficult to argue with. The best indicator of Diageo’s durability? The shares have delivered a total return of 143 per cent over the past decade, outpacing the 84 per cent return generated by the FTSE All-Share.
Industry giants do not often pump out spectacular growth, which would make it all the more impressive if Diageo can hit its loftier three-year targets. Trading might be tougher in the near term, but the best returns will compound over time.
ADVICE Buy
WHY The shares have the potential to produce consistent returns ahead of the market over the long term
Tullow Oil
Tullow Oil is keen to steer the focus away from the state of its balance sheet and towards the production it can generate from its oilfields in Ghana, Gabon and Kenya. Trumpeting leverage reduction and the chance of lower interest costs as the chief benefits of a since-terminated bid for Capricorn Energy, its cash-rich rival, hasn’t helped.
Yet there is also the fact that the need to bring down debt, while at the same time funding production growth, has prevented Tullow from capitalising as much as rivals on booming commodities prices and returning cash to shareholders. Indeed, Tullow pays no dividend and is not forecast to declare one before 2025 at the earliest.
Cash generation is in a better position. Even after funding $426 million of investment and decommissioning expenditure, free cashflow stood at $267 million. This year, free cashflow is expected to be slightly lower at $200 million, after an increase in spending.
As part of its 2021 refinancing, the group was forced to hedge production at less favourable oil prices, although around two thirds of those are due to roll off in May. That might partially explain why debt reduction has been “painfully slow”, as analysts at Panmure Gordon put it. Net debt was $1.9 billion, compared with $2.1 billion at the end of 2021. Tullow’s leverage had reduced to a ratio of 1.3 at the end of December, although it would have been at a multiple of one had the Capricorn deal gone through.
Tullow’s cost of capital remains high, with two outstanding bonds maturing in 2025 and 2026 with coupons of 7 per cent and 10.5 per cent, respectively. There are no plans to refinance the debt any time soon.
True, an enterprise value of only 2.8 times forecast earnings before interest, taxes and other charges is cheap, but a lowly valuation does not make Tullow special. Energy majors such as Shell and BP, as well as Harbour Energy, Britain’s biggest independent producer, also trade at undemanding valuations and offer investors generous cash returns. Without a dividend on offer, there doesn’t seem to be much to merit getting behind this stock.
ADVICE Avoid
WHY Shares appear less attractive than rivals offering generous dividends
