Diageo: Buy, Sell, or Hold?

LONDON -- I'm always searching for shares that can help ordinary investors like you make money from the stock market.

Right now, I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index.

I hope to pinpoint the very best buying opportunities in today's uncertain market as well as highlight those shares I feel you should hold... and those I feel you should sell.

I'm assessing every share on five different measures. Here's what I'm looking for in each company:

  1. Financial strength: low levels of debt and other liabilities
  2. Profitability: consistent earnings and high profit margins
  3. Management: competent executives creating shareholder value
  4. Long-term prospects: a solid competitive position and respectable growth prospects
  5. Valuation: an underrated share price.

A look at Diageo
Today, I'm evaluating Diageo  (LSE: DGE  ) (NYSE: DEO  ) , a company engaged in producing, distributing, and selling premium drinks beers, wines, and spirits, which currently trades at 1,974 pence. Here are my thoughts:

1. Financial strength: Diageo is in solid financial position with net debt less than three times its three-year average operating profit and interest payments covered a comfortable eight times. The company also has generated positive free cash flow each year for the last 10 years and converts an average of 14% of its revenues into cash.

2. Profitability: Revenues per share and earnings-per-share growth have been very good, increasing by 8% annually, while dividend growth has been strong, compounding by 6% per year over the past decade. Operating margins have been consistently around 21% while the 10-year average return on equity (ROE) has been excellent at 42%.

3. Management: Paul Walsh has been one of the FTSE's 100 longest-serving CEOs, having been with Diageo for 12 years. He is responsible for streamlining Diageo's operations -- shedding such non-core business units as Burger King and Pillsbury -- and steering the company to become the leader in premium drinks.

4. Long-term prospects: Diageo is the world leader in premium drinks, with products sold in 180 markets around the world and owning a broad portfolio of leading brand names such as Johnnie Walker, J&B, Smirnoff, Baileys, Guinness, and Jose Cuervo. These brands are responsible for two-thirds of net sales.

North America continues to be the company's leading market, generating one-third of the group's total revenues in 2012 and earning operating margins of 35%. Meanwhile, revenues from emerging markets -- Russia, Eastern Europe, Turkey, Latin America, Africa, and Asia-Pacific -- have enjoyed tremendous growth, increasing by 33% since 2010. They now account for the 40% of the company's total revenues. However, performance from the Southern European region continues to be a problem. Due to austerity measures and ongoing economic uncertainty, sales and volume decreased by 9% and 6%, respectively, in 2012.

To take advantage of emerging market growth, the company plans to rapidly expand in these faster-growing economies, making key acquisitions such as the Mey Icki business, Turkey's leading spirits company, which brought in 291 million pounds in revenues in 2012.

Also, due to the strong performance of Scotch sales in 2012, growing by 12%, the company believes there is a lot more opportunity for growth in this area and has invested an additional 1 billion pounds in whiskey production.

5. Valuation: Consensus earnings forecast for 2013 is 103 pence per share giving it a forward price-to-earnings (P/E) ratio of 19, a premium to its 10-year P/E average of 15. It also returns a dividend yield of 2.15%, twice covered.

My verdict on Diageo
Diageo is a very good business. It has a good management team and a broad portfolio of market-leading brands that it leverages to earn high margins and excellent returns on capital. It has performed well over the last 10 years and it looks like it can continue producing similar results right into the next decade with an increasing presence in emerging markets and an ability to grow through acquisitions and strengthen its already impressive portfolio of premium brands. However, factoring in the continued uncertainty and weakness in the European region, a P/E ratio at the higher end of its historical range, and a dividend yield below the FTSE average, I think it's already too expensive.

So, overall, I believe Diageo at 1,974 pence looks like a hold.

More FTSE opportunities
Although I feel Diageo is a hold right now, I am more positive on the FTSE shares highlighted in "8 Dividend Plays Held By Britain's Super Investor." This exclusive report reveals the favorite income stocks owned by Neil Woodfordthe City legend whose portfolios have thrashed the FTSE All-Share by 200% during the 15 years to Oct. 2012.

The report, which explains the full investing logic behind Woodford's dividend strategy and his preferred blue chips, is free to all private investors. Just click here for your copy. But do hurry, as the report is available for a limited time only.

In the meantime, please stay tuned for my next verdict on a FTSE 100 share.

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