After a 21% fall year-to-date, at the current levels, we believe Diageo stock (NYSE: DEO) can see higher levels. DEO stock fell from $220 in early January to under $175 now. The YTD -21% move for DEO marks an in-line performance with -22% returns for the broader S&P500 index.
Looking at the longer term, DEO stock is up 23% from levels seen in late 2018. This marks an outperformance compared to some of its peers, with Anheuser-Busch InBev stock falling 21%, Molson Coors Beverage stock down 7%, but an underperformance compared to the broader markets, with the S&P 500 index rising 51% over the same period.
This rise over the last three years was driven by the company’s P/E ratio, which grew 36% to 28x currently from 21x in 2018. This is offset by its earnings, which fell 9% to $6.15 in 2021, compared to $6.76 in 2018, on a per-share basis. Earnings contraction was due to a 16% decline in net income margin, more than offsetting a low single-digit revenue growth over this period.
Diageo’s revenue rose 2% to $17.2 billion in 2021, compared to $16.9 billion in 2018. The revenue plunged to $14.8 billion in 2020 due to the impact of the pandemic. However, the demand over the last few quarters has recovered, with pubs and bars reopening after the easing of Covid-19 restrictions. An increase in the population of drinkers with higher disposable income, and rising penetration rates, especially in the emerging markets, are driving the company’s sales growth. However, more recently, rising interest rates, supply chain disruptions, and a high inflationary environment are expected to weigh on revenue growth for the company.
Diageo’s net income margin of 20.9% in 2021 reflects a 400 bps fall from 24.8% in 2018 due to higher costs. We expect the net income margin to improve to 22.2% in 2022, led by better pricing and cost efficiencies. Diageo has spent $7.4 billion in share repurchases between 2018 and 2021, resulting in the share count falling to 586 million in 2021 from 624 million, and this trend is expected to continue over the coming years.
We estimate Diageo’s valuation to be $225 per share, reflecting a 30% upside from its current market price of $173, implying that investors may be better off using the recent dip to enter DEO stock for gains in the long run. Our valuation represents a forward P/E ratio of 32x based on our earnings forecast of $7.10 on a per share and adjusted basis for full-fiscal 2022. This compares with an average of 34x seen over the last three years. That said, investors should take into account the near-term risks. DEO stock faces headwinds from the current weakness in broader markets. The S&P500 has now entered bear market territory with rising concerns of slowing economic growth given the high inflation, Fed action, and supply chain disruptions.
Furthermore, the Covid-19 crisis has created many pricing discontinuities which can offer attractive trading opportunities. For example, you’ll be surprised how counter-intuitive the stock valuation is for PepsiCo vs. Williams-Sonoma.
|S&P 500 Return||0%||-22%||84%|
|Trefis Multi-Strategy Portfolio||-9%||-26%||189%|
 Month-to-date and year-to-date as of 6/22/2022
 Cumulative total returns since the end of 2016