Diageo Undervalued Despite 35% Recovery?

Following a 35% rise since the March 23 lows of this year, at the current price of around $139 per share, we believe Diageo’s stock (NYSE: DEO) has more upside left. DEO stock has increased from $103 to $139 off the recent bottom, compared to the S&P which increased by around 42%. The rise in stock price was mainly driven by the expectations of a pick-up in consumer demand with the US government announcing a string of measures along with stimulus packages announced in other economies to keep businesses afloat.

Despite a healthy recovery over recent weeks, the stock currently is about 5% below the levels at which it was at the end of 2017. We believe that the company’s stock still has a modest upside from the current level, driven by an outlook for healthy revenue growth and rising margins post the current crisis. Our dashboard What Factors Drove -5% Change In Diageo Stock Between 2017 And Now? has the underlying numbers.

Some of the stock price rise between 2017 and 2019 was justified by the 8.5% growth in revenue. Diageo’s revenues increased from $15.3 billion in 2017 to $16.6 billion in 2019, mainly due to an increase in the share of premium scotch. This was further accentuated by 12.7% rise in profitability, with net income margins increasing from 23% in 2017 to 25.9% in 2019 due to significant income from associates and JVs, cost efficiencies, and reduction in effective tax rate due to tax benefits received. On a per share basis, earnings increased from $5.49 in 2017 to $6.72 in 2019.

With the increase in stock price during this period, the P/E multiple still saw a marginal decline from 27x to 25x, as the rise in EPS was more than the stock price growth. The P/E multiple saw a sharp decline in 2020 due to the impact of the coronavirus crisis and currently stands at 21x. However, we believe that the company’s P/E ratio has the potential to rise from here as the impact of the crisis gradually abates, which could drive the stock price higher.

What’s The Likely Trigger & Timing For Further Upside?

The global spread of coronavirus in early 2020 affected industrial and economic activity. This is likely to adversely affect consumption and consumer spending. Additionally, the lockdowns in major global cities over recent months are expected to adversely affect global companies with global supply chains like Diageo. The impact of the crisis is likely to be reflected in the company’s H2 and FY 2020 results (fiscal year ends on June 30).

However, over the coming weeks, we expect continued improvement in demand and subdued growth in the number of new Covid-19 cases in the U.S. compared to the rate seen in April-May to boost market expectations. Additionally, the gradual lifting of lock downs is also giving investors confidence that developed markets have put the worst of the pandemic behind them. Following the Fed stimulus — which helped set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view, with investors now mainly focusing their attention on 2021 results.

As the global economy opens up and lock downs are lifted in phases, consumer demand is expected to pick up, and in addition, reduction of supply bottlenecks will also lead to higher sales. This could be reflected from H1 2021 onward, followed by healthy revenue growth for full year 2021. Further, the company’s continued cost efficiency measures and rising share of premium drinks is expected to lead to margin growth in 2021. Though the stock has recovered at a healthy rate in the last 3 months, with investors’ focus now primarily shifting to 2021 numbers, we believe expectations of healthy revenue and margin growth is likely to drive the stock higher from its current level of $139. As per Diageo’s Valuation, Trefis has a price estimate of $147 for DEO’s stock, higher than the current price.

While Diageo’s stock is likely to rise further at a modest rate in the near term, which S&P 500 component stocks have the best chance of outperforming the benchmark index? Our 5 In the S&P 500 That’ll Beat The Index: TWTR, ISRG, NFLX, NOW, V look promising

Additionally, here’s how the current crisis has hit Diageo’s peer and global alcoholic beverage giant Anheuser-Busch InBev.

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