Up 60%, Diageo Stock Still Has Potential To Rise

Diageo stock (NYSE: DEO) has registered a formidable recovery of more than 60% from its March 2020 low. At the current price of $167, DEO stock still looks undervalued and is a decent bet for investors. DEO stock has rallied 62% from $103 (on 23rd March 2020) to $167 off its recent bottom, compared to the S&P 500 which has increased 75% from its recent lows. The recent rally was driven by the US government’s announcement of a string of measures to keep businesses afloat and expectations of a rise in consumer demand and reduction in supply bottlenecks as the global lockdowns are gradually lifted. Despite a healthy rise, the stock is still slightly below its June-2019 level. The recent spike in Covid-positive cases in Europe and some other economies has limited the stock rise over the last three months. However, now with the lockdowns being lifted and vaccine rollout leading to expectations of faster economic recovery, volume sold is expected to rise. Also, the reopening of restaurants and retail chains is likely to boost revenue and margins in FY 2021 and FY 2022. This provides a further modest growth potential of close to 10% for DEO’s stock. Our dashboard What Factors Drove 16% Change In Diageo Stock Between 2018 And Now? provides the key numbers behind our thinking.

Some of the stock price decline between June 2018 and June 2020 was justified by the 12.4% decrease in Diageo revenues from $16.9 billion in FY’18 to $14.8 billion in FY’20. This effect was further amplified by a sharp deterioration in profitability as net income margin halved from 25.8% in FY’18 to 12.4% in FY’20. On a per share basis, earnings declined 55% from $6.76 to $3.03 during this period. Lower revenue and margins were driven by the impact of the pandemic in the second half of FY2020, as the shutdown of pubs and restaurants took a toll on volume sold, while cost per unit increased, thus affecting margins.

Though EPS declined sharply, the fall in the stock price was not as severe, thus leading to a rise in the P/E multiple from 21x in 2018 to 44x in 2020. The stock price, in fact, recovered quickly after March 2020, leading to a faster rise in the P/E multiple by June 2020. As lockdowns continued to be lifted gradually, the multiple increased further post FY2020 and currently stands at 55x. We believe the multiple will drop to more realistic levels of close to 25x in the near term as the EPS recovers sharply with the stock price remaining elevated, as the market has accounted for a large part of the sharp recovery in top and bottom line expected in 2021 and 2022.

Outlook

The global spread of coronavirus led to lockdown in various cities across the globe, which affected industrial and economic activity. This took a toll on consumption and consumer spending, which was reflected in DEO’s H2 2020 results where its revenue declined by 25% y-o-y. The widespread closing of restaurants and bars, plus the cancellation of sporting events, concerts, and nearly every other form of public entertainment across key markets, led to a plunge in alcohol sales, thus affecting the stock price adversely.

However, there have been signs of lifting of the global lockdowns over recent months. As the global economy opens up and lockdowns are lifted in phases, consumer demand is slowly picking up. Any further recovery and its timing hinge on the broader containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. With the lifting of lockdowns, reduction of supply bottlenecks is expected to help a company like Diageo, which has a global supply network, to increase its volume. This was partially reflected in the company’s H1 2021 results, where DEO’s revenues saw only a sequential rise (compared to H2 2020) of 57%, with absolute revenues going back close to the year-ago period.

With investors’ focus having shifted to 2021, the stock has seen healthy growth over recent months in anticipation of strong revenue and margin expansion. However, the recent surge in Covid positive cases in Europe and new virus strains coming into the picture could prove to be an impediment in this growth path. But in the absence of another full-fledged lockdown (which looks unlikely at the moment), the stock is likely to remain elevated. Also, the roll-out of the vaccines have enthused the markets, while reopening of restaurant and pubs along with restarting of live events is expected to lead to significant improvement in volume, revenue, and margins in 2021 and 2022. Projections of improving fundamentals provides a further upside of about 10% to the company’s stock.

While Diageo stock may have moved a fair amount, 2020 has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how the stock valuation for Coca-Cola vs Merck shows a disconnect with their relative operational growth. You can find many such discontinuous pairs here.

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