(Barron's) Diageo Is on the Road to Recovery

Diageo Is on the Road to Recovery

The glass looks more than half-full for the seller of Johnnie Walker Scotch whisky and Captain Morgan rum. Some analysts see the stock rising 25%.

Diageo ’s outlook is improving after several years of subpar growth. In a statement last week, the world’s leading producer of branded premium spirits said that its fiscal year, ending next June, is off to a good start, with volume growing in the mid-single digits.

That could translate into a modest improvement in earnings, notwithstanding muted price increases, unfavorable foreign-exchange rates, and tougher comparisons later in the fiscal year. If current positive trends persist, the company’s London-traded shares (ticker: DGE.UK) could return about 25% in the next 12 months.

For at least a year, the glass has been half-empty at Diageo, whose brands include Smirnoff vodka, Johnnie Walker Scotch whisky, Captain Morgan rum, Baileys liqueur, and Guinness stout. The shares, which peaked in August 2013 at 21.37 pounds, finished Friday at £17.50 ($26.55), down about 22% from an all-time high. The stock is off about 5% since the start of this year, compared with a rise of 6% in the Stoxx Europe 600 food-and-beverage sector over the same period.

Diageo also has American depositary receipts that trade in New York under the symbol DEO. Each ADR is equivalent to four ordinary shares. The ADRs fetched $106.31 on Friday, not far above their 12-month low of $100.59.

The London shares trade for about 18 times estimated earnings for the fiscal year ending in June 2017. Diageo has traded for as much as 21 times future earnings in the past five years.

A consensus of analysts’ price targets of £19.45 points to potential upside of 11% in the next 12 months, but some of Diageo’s more ardent fans see the stock climbing as much as 26%, to £22, driven by a more efficient operating platform, improving sales, and better cash conversion.

DIAGEO IS EXPECTED to report net income of £2.43 billion, or 97 pence a share, in the fiscal year ending in June 2017, up 8% from this year’s forecast of £2.25 billion, or 90 pence per share. Sales in the current fiscal year are likely to be flat with last year’s £10.81 billion.

Diageo has been hurt by weakness in emerging markets, which account for 43% of revenue but less than 30% of operating profits. Management is trying to alter its EM strategy to grow more profitable in developing markets. The company raised its stake to 55% in India’s United Spirits (532432.India) in 2014, and subsequently attempted to force out the chairman over questionable financial dealings. It is also crafting a beer strategy for Africa.

Diageo’s biggest market is North America, which accounts for 45% of operating profit and 32% of sales. Revenue could grow 3% in the current fiscal year, matching last year’s performance. It would be a creditable achievement after the company revamped, putting its focus on sales to retailers rather than shipments to wholesalers.

Diageo is under investigation by the Securities and Exchange Commission for alleged “channel stuffing,” or shipping excess inventory to wholesalers in a bid to boost sales. A personnel shakeout at its North American division took place over the summer.

Despite those problems, last week’s corporate update is cause for optimism. It suggests that Chief Executive Ivan Menezes’ strategy to “de-layer” the organization and deliver operating efficiencies through a focus on core and high-end brands, innovation, distribution, and cost savings, is showing more promise.

Last year, Diageo’s free cash flow increased by £700 million, to £2 billion, largely due to improvements in working capital. That figure could top £2.5 billion this year. The company’s balance sheet is healthy.

DIAGEO “IS A SELF-HELP STORY,” says Chris Dyer, London-based director of global equity at Eaton Vance Investment Managers, which owns the stock.

The British company, formed in 1997 from the merger of Grand Metropolitan and Guinness, appears capable of meeting its target of a one-percentage-point improvement in operating profit margin in two years, rather than the three that it is aiming for.

However, currency markets continue to be nettlesome. Diageo estimates that the stronger dollar and British pound will trim earnings by £150 million this year.

Foreign-exchange woes could add to the pressure on management to sell assets to boost returns. Its reserve-brands portfolio or beer brands could be candidates for divestment.

“Without solid execution over the next six to 12 months…Diageo could become increasingly subject to scrutiny from activist investors, who could seek to sell assets deemed as noncore,” Morningstar senior analyst Philip Gorham wrote last week in a research note. “Either way, we believe there is value in Diageo’s shares at current levels.

(Barron's) It’s Too Early in the Crisis to Bet on VW Shares

It’s Too Early in the Crisis to Bet on VW Shares

An emissions-falsification scandal that clobbered the stock could pave the way for the auto company to overhaul management and implement reforms.

Cheaters never prosper, as the adage goes. Just ask Volkswagen, the German auto maker, and its suddenly poorer shareholders, who could become even poorer in the short term if the scope of the company’s diesel scandal widens. And that’s precisely what seemed to be happening at week’s end.

On Friday, German Transport Minister Alexander Dobrindt said that VW, currently the world’s largest car manufacturer, had rigged emission tests on about 2.8 million diesel vehicles in Germany—nearly six times the approximately 500,000 it has admitted to rigging in the U.S. He added that, in addition to the 2.0-liter and 1.6-liter four-cylinder diesel engines already implicated, 1.2-liter engines might be affected, too.

VW has admitted that engine-control software that could rig emissions tests exists in 11 million of its cars worldwide. In the U.S., the affected vehicles are VWs and Audis; in all, Volkswagen has 12 brands, including Porsche. The software is designed to automatically turn on during tests, curbing emissions, but turn off on the road, letting vehicles spew much higher amounts of pollutants, but apparently boosting acceleration and fuel economy.

By Friday, officials in virtually every nation in which diesel VWs have been sold had pledged to begin stringent real-world tests aimed at determining whether the vehicles’ pollution-control systems were performing properly.

On the week, VW’s shares (ticker: VOW.Germany) tanked 28%, closing at 115.55 euros ($129.50), erasing €23 billion ($26 billion) from Volkswagen’s market value.

While the selling may be overdone, venturing into the shares before the potential toll of the scandal becomes clear is dangerous. VW could be fined about $18 billion in the U.S. alone (although that’s unlikely), and it could face billions of dollars in fines in Germany and other countries that find that tests have been rigged. In addition, the cost of bringing the cars into compliance and dealing with lawsuits linked to the mess could easily surpass the €6.5 billion that the company is setting aside “to cover the necessary service measures and other efforts to win back the trust of our customers.”

If the problem can be addressed with a software fix, that might be relatively inexpensive. But it’s probable that the reason VW put the test-cheating program into its cars in the first place is because no software could make them meet the emission standards without subtracting fuel efficiency, acceleration, and maybe driveability.

If a mechanical fix is necessary, it could cost hundreds of dollars a car, which would add up to a hefty sum for the 3.3 million affected vehicles in the U.S. and Germany alone.

VW had a net liquidity position of €21 billion at the end of June, according to Société Générale. But the potential costs of the diesel problem present a massive challenge to VW’s new CEO, Matthias Müller, Porsche’s chief, who is replacing Martin Winterkorn, who resigned on Wednesday.

The crisis isn’t the only challenge Müller faces. By many measures, VW is inefficiently managed. Almost all of its cost ratios are high, compared with rivals’, says Arndt Ellinghorst, head of global automotive research at Evercore ISI in London. “These shortcomings can be turned into opportunities if there’s a management team in place that focuses on lifting value,” says Ellinghorst.

Telling numbers: VW sold 10.14 million cars last year and has about 600,000 employees around the globe, many in high-wage Germany. Toyota (TM), which sold 10.23 million vehicles, has about 344,000 employees. (So far this year, VW is No. 1 in global sales.)

Volkswagen’s shares trade for 5.1 times estimated 2016 earnings, and 0.6 times book value, though analysts’ earnings forecasts are falling to account for potential charges. The price/earnings ratio and a recent intraday low of €102 are reminiscent of the situation four years ago, when Barron’s Vito J. Racanelli wrote a positive cover story about Volkswagen (“World Beater,” Sept. 26, 2011), calling the stock a bargain. It was a good call; VW hit a high of €254.50 six months ago, up almost 174%.

Is the current situation similar?

“If you have the luxury of patient capital and aren’t marking to market, it is an opportunity to buy,” says Bernd Ondruch, founder of Astellon Capital Partners in London.

But we’d suggest keeping your foot on the brake until the scandal’s ultimate potential toll becomes clearer.