A Closer Look at Diageo's Dividend Potential

LONDON -- Dividend income accounts for around two-thirds of total returns, the actual rate of return taking into account both capital and income appreciation. Given that share prices are often volatile and unpredictable, the potential for plump dividends can give shareholders much-needed peace of mind for decent returns.

I am currently looking at the dividend prospects of Diageo  (LSE: DGE  ) (NYSE: DEO  ) and assessing whether the company is an appetizing pick for income investors.

How does Diageo's dividend history stack up?

  2009 2010 2011 2012
FY Dividend Per Share 36.1 pence 38.1 pence 40.4 pence 43.5 pence
DPS Growth 5.10% 5.50% 6.00% 7.70%
Dividend Cover 1.8x 1.9x 2.1x 2.2x

Source: Diageo company accounts.

Diageo has steadily grown the dividend in recent years alongside an improvement in earnings, even if expansion in the shareholder payout has lagged the double-digit increases in earnings per share during the period. Still, annual dividend expansion is now staked out in the higher echelons of single-digit growth.

As well, bubbly earnings growth has seen dividend cover stage a year-on-year improvement during the period, and the drinks giant now boasts coverage comfortably above the generally regarded safety watermark of 2 times forward earnings. The company's role within the defensive alcohol sphere also helps allay fears of wider macroeconomic woes striking earnings and thus potential dividends.

What are Diageo's dividends expected to do?

  2013 2014
FY Dividend Per Share 47 pence 52 pence
DPS Growth 8.00% 10.60%
Dividend Cover 2.2x 2.2x
Dividend Yield 2.40% 2.60%

Source: Digital Look.

City analysts anticipate earnings per share to rise 9% and 12% in 2013 and 2014 correspondingly, to 103 pence and 115 pence. This is expected to keep annual dividend per share growth moving skywards in the medium term, even breaking above the 10% marker next year. And stable dividend cover around 2.2 times earnings provides investors with peace of mind over payout safety.

Diageo announced last month that organic sales advanced 5% in the June-March period, although 4% growth in the final three months raised concerns of potential revenues slowdown. As well, volumes fell 1% in December-March versus 1% growth in the entire nine months, although the firm's considerable pricing power achieved through brands such as Smirnoff, Guinness, and Johnnie Walker still kept turnover ticking over. Also, quarter three is traditionally a 'slow' period for the company.

Promisingly, Diageo is making strong headway in developing markets -- even though technical issues including shipment phasing in Columbia and Venezuela pressured third-quarter revenues -- and is stepping up M&A activity here to boost underlying growth. Specifically, the company announced substantial growth in the African spirits market and share gains in the Asia-Pacific region. Galloping activity here is likely to represent the key to future growth, in my opinion, particularly as Western revenues stagnate.

How does Diageo's dividend prospects rate against the competition?

  Prospective Dividend Yield Prospective P/E Ratio
Beverages 2.30% 19.8
FTSE 100 3.20% 15.5

Source: Digital Look.

Diageo was recently dealing on a forward P/E reading of 19.4 for 2013, which makes it a slightly better pick versus its competitors in both terms of value and prospective dividends. However, the drinks maker lags behind the average for the U.K.'s 100 largest-listed entities on both counts.

I like Diageo on the basis of the strength of its brands and thus pricing power, pan-global presence that protects against weakness in single markets, and strong operations in developing regions, all of which are likely to fuel long-term earnings expansion. However, even though annual dividend growth is expected to keep accelerating and payments are well protected, I think that better dividend payers can -- at least for the time being -- be found elsewhere.

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