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Diageo Plc ADR(DEO-N)

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Warren Buffett's Buying This Passive-Income Stock. Should You?

Motley Fool - Wed Oct 25, 2023

Berkshire Hathaway(NYSE: BRK.A)(NYSE: BRK.B) discloses the stocks it holds each quarter. That means we can follow Berkshire's recent buys and sells, and one new purchase in 2023 is Diageo(LSE: DGE)(NYSE: DEO), a U.K.-based alcohol beverage company with brands that include Guinness, Captain Morgan, and Smirnoff, among others.

According to its most recent filing, Berkshire owns 227,750 shares of Diageo, equating to a roughly 0.04% ownership stake. That's tiny in the context of Berkshire buys, and Diageo stock has fallen an estimated 11% since Berkshire initiated the position in the first quarter of 2023, so let's look at why Berkshire might have purchased Diageo and whether the stock is worth adding to your portfolio.

Diageo is taking market share

Over the past five years, publicly traded alcohol companies have struggled as a whole. During that time, Diageo stock generated a total return (stock appreciation plus dividends) of only 21%, trailing the benchmark S&P 500's total return of 66%. Still, Diageo's smaller competitors by market capitalization, Brown-Forman (NYSE: BF.A)(NYSE: BF.B) and Constellation Brands (NYSE: STZ), have also lagged the market, with a five-year total return of 25% and 11%, respectively.

Nonetheless, two years ago, Diago management announced its goal to grow its total beverage alcohol (TBA) market share of retail sales from 4% to 6% by 2030. Since then, Diageo claims to have 4.7% of the global TBA market. To put that in context, IWSR, the leading source of data and analysis on the global beverage alcohol market, estimated 2022's total retail sales of global alcohol $1.17 trillion. While Diageo splits those gross sales with retailers, its annual net sales growth is starting to show in its income statement. Diageo's net sales grew from roughly $18.6 billion to $20.7 billion, or 11%, from the company's fiscal year 2022 to its fiscal 2023. Comparatively, Brown-Forman and Constellation Brands grew their annual net sales over its past fiscal year by 8% and 7%, respectively.

Diageo is focused on returning capital to shareholders

While Buffett hasn't publicly commented on Berkshire's Diageo investment, he has frequently opined about two of his favorite qualities in a stock: growing dividends and share repurchases. Diageo management favors both of these shareholder-friendly strategies. Specifically, Diageo has paid and raised its semiannual dividend since 1998. Totaling $5.02 per share in 2023, the stock's annual dividend yield is roughly 2.6%.

For any dividend-paying stock, investors should key on its payout ratio to determine whether a company's earnings can safely cover its dividends. A payout ratio exceeding 75% suggests vulnerable or declining earnings, presenting risks, especially in the face of unexpected difficulties. Considering Diageo's fiscal 2023 net income of $4.5 billion and $2.1 billion paid in dividends, equating to a payout ratio of 47%, it's reasonable for investors to assume management will likely continue to raise its dividend annually just as it has done each of the last 25 years.

Second, the company recently announced a new $1 billion share repurchase program to be completed before the end of its fiscal 2024. This announcement comes on the heels of the company's previous buybacks, which lowered 7% of shares outstanding over the past five years. Warren Buffett explained in his most recent annual shareholder letter why he believes share repurchases are important: "The math isn't complicated: When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices."

Warren Buffett listening to a question.

Image source: The Motley Fool.

What could go wrong for Diageo?

Before buying any stock, an investor should examine its bear case or what could cause the business to falter. As an acquisitive company, Diageo frequently purchases smaller, fast-growing alcohol brands with attractive margins to fuel its growth. Most recently, in early 2023, Diageo bought Don Papa Rum, a Philippines-based company that makes a "super-premium, dark rum," for $275 million, plus a potential $188 million, subject to its performance.

Diageo also acquired Mr. Black, an Australian-based coffee liqueur, and Balcones Distilling, a Texas-based single malt whiskey producer, in 2022 for undisclosed prices. While growth-by-acquisition is a common strategy for an established business, it can also lead to a growing debt that becomes expensive to pay back in a high-interest rate environment. To illustrate, Diageo's net debt (total debt minus cash and cash equivalents) stands at $18.8 billion, a 42% increase over the past five years. The interest expense on Diageo's debt totaled $733 million in its fiscal 2023, nearly 200% higher than it paid five years ago. That debt will only become more expensive to service as interest rates remain high, so Diageo will probably need to pay it down, which could lead to fewer acquisitions and slower dividend growth.

Is Diageo stock a buy?

While Diageo stock has underperformed the market, it does look cheap on a valuation basis. Using the common valuation metric for mature companies, the price-to-earnings (P/E) ratio, Diageo recently traded at a P/E ratio of 19, meaning the company's stock price is 19.4 times its annual earnings per share of $7.95. Notably, the stock is well below its five-year average P/E ratio of 31 and lower than its competitors Brown-Forman and Constellation Brands, which trade at a P/E ratio of 35 and 28, respectively.

DEO PE Ratio Chart

DEO PE Ratio data by YCharts

To sum up, Diageo is a top player in the alcohol sector but has delivered below-average returns in recent years. Berkshire's tiny position in the company gives some credence to the legitimacy of the stock's potential, especially with management's laser focus on returning capital to shareholders. Keep an eye on the company's debt, but if the management can pay it down, the stock should reward patient dividend-seeking investors.

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Collin Brantmeyer has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway and Constellation Brands. The Motley Fool recommends Diageo. The Motley Fool has a disclosure policy.

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