Down 40% in three years, I have to admit the Diageo (LSE: DGE) share price is starting to look tempting to me.
Brands such as Johnnie Walker, Guinness and Gordon’s have been around for over 200 years. They seem like safe long-term performers to me. After all, unlike tobacco, alcohol consumption has been the norm in much of the world for 1,000 years, or more.
However, the fact that Diageo shares are trading at levels first seen eight years ago is a painful reminder that this situation isn’t quite so simple.
One too many (problems)?
Recent headlines have focused on the possible impact of US tariffs on Diageo’s sales. The company imports much of its US product from Mexico and Canada. Hard-pressed American consumers might not welcome price rises.
Market conditions are already a little slow. Sales fell 0.6% during the six months to 31 December, while volumes were 0.2% lower. In the US market, which generates about 40% of sales, volumes fell 3% during the half year.
The company has now abandoned its previous guidance for medium-term sales growth of 5-7% a year. This target no longer had any serious credibility with the market, so it’s a sensible decision, in my view. But it’s also a reminder of an uncertain outlook.
Will we stop drinking?
There are fears among some investors that Diageo’s post-pandemic slowdown’s only the start of a broader reduction in alcohol consumption. Younger generations are said to be drinking less than older cohorts.
For existing drinkers, new weight-loss drugs are said to be proving helpful as a way of reducing problem drinking. Veteran fund manager Terry Smith cited this factor as one reason for his decision to sell his fund’s Diageo shares last year, having held them since 2010.
It’s perhaps a sobering statistic to realise that in the US, research suggests that half the alcohol sold each year is consumed by just 10% of drinkers. If they cut back, it could have a noticeable impact on demand.
Diageo: a contrarian opportunity?
Fundamentally, I reckon Diageo remains a high-quality business. Although debt levels are higher than I’d like to see, I still think the shares are starting to look interesting at current levels.
One valuation measure I use is to compare a company’s earnings before interest and tax with its enterprise value (market-cap plus net debt).
On this measure, Diageo shares trade on a profit multiple of 14. That’s a level I consider to be reasonable value for a growing business. And that’s the big question.
Ultimately, I think Diageo’s attraction as an investment today depends on whether alcoholic drinks are going to become a legacy business that’s in decline, like cigarettes.
If alcohol follows tobacco then I would say Diageo share are still too expensive. But if the drinks market returns to growth in line with pre-pandemic norms, I think the shares could offer value at current levels.
Are Diageo shares at a turning point today? I think we’re close, but I’m not quite convinced. This business will stay on my watchlist for now.
This post was originally published on Motley Fool
