LONDON -- Guinness-to-Baileys drinks giant Diageo (LSE: DGE.L) (NYSE: DEO) is a business with very definite attractions. A 45 billion pound FTSE 100 constituent, the company is expected this year to deliver revenues of 11 billion pounds, and pre-tax profits of 2.6 billion pounds.
And with margins like that, no wonder this defensively-positioned business is popular with many investors -- even though it's not the cheapest share around. Indeed, with its shares changing hands today at 1,800 pence, the company is rated on a prospective P/E of 18 and offers a relatively modest forecast dividend yield of 2.7%.
But how safe is that share price? And -- critically-important for income investors -- how safe is that dividend? In short, how could an investment in Diageo adversely impact investors' wealth?
In this series, I set out to answer just these questions. My starting point: Diageo's latest annual report, where the company's directors are obliged to address the issue of risk.
Risk management
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of Diageo's size and caliber, the company has in place a risk management policy. The bad news? Compared to other companies that I've looked at, Diageo's treatment of risk mitigation is sparse, and there's no indication of trend -- which risks are increasing and which are decreasing.
But what, precisely, are those risks that the company faces?
Read the small print, and Diageo identifies no fewer than 17 risks as having a significant prospective impact on the company's financial performance. They range from the state of the economy to anti-alcohol legislation, and from counterfeiting to exchange rates.
So let's take a look at three of the biggest.
Consumer tastes
Diageo is nothing if not upfront. Demand for its products, it notes, is not only discretionary and highly consumer-centric, but also subject to changing consumer tastes. As the company says:
Demand for Diageo's products may be adversely affected by many factors, including changes in consumer preferences and tastes, and adverse impacts of a declining economy.
That said, it points out, its collection of brands includes some of the world's leading alcohol brands, as well as brands of local prominence. Brand extensions, and new products, aim to keep pace with consumer tastes as they change, keeping Diageo in a position of market prominence. In addition, it points out, "We have relevant brands at almost every price tier of every category... and given the range of our price points, we are able to capture consumption shifts across the price spectrum."
Anti-alcohol legislation
It's not just changing consumer tastes that the business needs to worry about: Governments, too, are concerned about the effects of alcohol. What's more, tobacco-style class-action litigation is a possibility, as are changes in taxation rates that may affect demand. As the company puts it:
Diageo is subject to litigation directed at the beverage alcohol industry and other litigation... Regulatory decisions and changes in the legal and regulatory environment could increase Diageo's costs and liabilities or limit its business activities.
How does the company address this risk? Naturally, the company is coy about conversations with governments concerning regulatory matters. That said, it reports that it is "routinely subject to litigation in the ordinary course of its operations." But its strong global presence in more than 180 markets around the world limits its exposure to legislation in any one country.
Product quality
Fairly obviously, the success of Diageo's brands depends upon the positive image that consumers have of those brands. And product contamination -- whether arising accidentally, or through deliberate third-party action -- could adversely affect their sales. Counterfeiting and quality failures are also risks. As the company puts it:
Contamination, counterfeiting or other events could harm the integrity of customer support for Diageo's brands and adversely affect the sales of those brands.
How are such risks dealt with? Clearly, as the company notes, product recalls are an option, but carry brand-damaging risks in their own right. Likewise, liability claims in the event of consumer harm also carry the potential to be brand-damaging. That said, strong quality systems are in place, and the company's vertical integration adds resilience: It owns manufacturing production facilities across the globe, including maltings, distilleries, breweries, packaging plants, maturation warehouses, cooperages, vineyards, wineries and distribution warehouses.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend-reinvested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Woodford's largest and most successful current picks.
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