Diageo - a value stock or value trap?

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I have been building a position in Diageo progressively. The share price has dropped by almost half, from more than GBP40 per share in 2021 to around GBP21-22. The P/E multiple dropped from 30x to 17x. I like hunting for value stocks, and every time I see an opportunity, I identify the risks involved and assess whether these are acceptable.

Part I of the article identifies the risks by focusing on a few questions. It may be boring, as it replicates viewpoints from sell-side research analysts. Please bear with me as I want to provide a proper backdrop to Part II of the article.

1. Why is the stock trading at a low valuation?

2. Can the valuation go lower?

3. What may drive a re-rating and how long does it take?

Part II of the article assesses whether the risks identified are tolerable. This is the most challenging task as it involves a lot of judgement, and I am likely to be wrong in many areas. If I fail to identify certain critical risk factors in part I, I could make a poor investment decision even if I get Part II right.

1. Are the risks structural or cyclical?

2. What have the management accomplished, considering the hand they were dealt when they took over compared to what is happening in the industry? (note: Warren Buffett mentioned this during Berkshire Hathaway’s 1994 annual shareholder meeting)

I will make a game plan to build my position in the stock only if I figure out the abovementioned questions. Feel free to let me know your comments and thoughts. Here we go.

Part I - The Key Questions

1. Why is the stock trading at a low valuation?

   • High capex intensity and net working capital investment lead to low free cash flow conversion compared to consumer staples peers (bear in mind that tobacco, beverage, and household products companies typically have 90-100% FCF conversion). The last time Diageo reached such low FCF conversion was 2012-14, when it was troubled by the ongoing sovereign debt crisis in Europe and had to invest aggressively in growth outside of Europe and premiumisation initiatives.

     

     

     

   • The unwinding of the post-COVID spirits consumption boom leads to a declining depletion volume (particularly on-trade channels being sensitive to change in social interactions, whilst off-trade channels to a lesser extent due to increased household penetration of spirits). Oversupply of spirits and excess channel inventory in the U.S., the most profitable spirits market globally, exacerbate the negative impact on shipment from producers (i.e. retailers need to ensure depletion volume is higher than shipment volume from producer to reduce channel inventory). Over 2019-2024, organic volume CAGR was 0.8%, similar to the average growth of 0.8% per annum over 2008-2021. The last time Diageo recorded a low single-digit volume decline was in 2009 and 2014-2015, which were affected by the global financial crisis and emerging market weakness (partly due to anti-extravagance campaign in China) respectively.

     

   • Weak consumer sentiment leads to downtrading, and Diageo’s product portfolio is skewed toward the premium and ultra-premium segments, which limits the room for an increase in pricing.

     

     Source: Diageo CAGNY 2025 presentation

   • Weak performance in Latin American markets due to excess channel inventory and challenging consumer environment.

   • In the U.S., the Surgeon General recently warned of the explicit link between alcohol consumption and cancer, sparking fears about increased regulatory scrutiny.

   • The high gearing ratio of 3x net debt to EBITDA is still increasing due to declining profit and capex / net working capital commitment.

     

   • Potential U.S. tariff on imports from Canada and Mexico. ~40% of Diageo’s revenue in the U.S. relies on import from Canada (Canadian whisky) and Mexico (tequila). This could amount to a USD200mn hit on its annual operating profit.

   • Increased availability and adoption of GLP-1 treatment, which could reduce consumption due to reduced appetite for alcohol.

2. Can the valuation go lower?

   • Diageo still trades at a premium to some of its consumer staple peers despite lackluster growth. There’s a risk to close the valuation gap. In this case, Diageo could trade at mid-teens or low-teens P/E multiple.

   • A non-zero risk of trading at a high single-digit P/E multiple (similar to tobacco stocks) implies another 50% downside.

3. What may drive a re-rating and how long does it take?

   • The resumption of U.S. market growth. It is still too early to tell, as recent Nielsen data showed mixed results. However, Diageo has been gaining market share consecutively for a few quarters, despite some weakness recently lapping a tough comparator in early 2024.

     

   • Normalisation of capex intensity. Based on management guidance, this will remain elevated until 2027. Greenfield projects take years to plan and implement. Unless a massive shift in market dynamics exists, previously committed expansion projects will unlikely stop. However, Diageo is becoming more selective in pursuing expansion projects. For instance, Diageo halted the construction of a new CAD245mn distillery in Canada in Nov 2024, which was destined to produce spirit for the popular Crown Royal whisky. In contrast, it recently announced a new USD415mn manufacturing and warehousing facility in Alabama to enhance its North American supply chain operations and support future growth for its export business. Diageo explained its capex guidance during the Q2 2025 earnings conference call, which you may find below.

     Consistent with ensuring our business is well placed for the long-term, the team has clearly invested quite heavily in recent years, which Diageo previously guided would normalise from 2027. We will be reviewing all CapEx commitments and future CapEx plans to assess any needs to reprioritise and/or rephase using clear and consistent IRR and payback metrics for all future CapEx. But also drive greater asset utilisation and efficiencies from our existing asset base, i.e., really trying to sweat our assets a lot more.

   • Reduction of net working capital investment. Diageo's net working capital is manageable if it reduces its maturing stock investment (i.e., strategically stops production at existing manufacturing sites). For instance, Diageo recently paused production at its carbon-neutral whiskey distillery in Lebanon, Kentucky, to “support its efficiency and productivity goals” (i.e. there’s oversupply of whiskey in the market and it is unwise to pile up inventories in the current environment). Concurrently, its competitors Pernod Ricard and Brown-Forman also announced similar plans to halt whiskey production. However, I am not convinced that moves like this will impact Diageo’s working capital management significantly. Diageo explained its working capital guidance during the Q2 2025 earnings conference call, which you may find below.

     I’m also fully aware of the importance of laying down liquid and the significance of maturing stock for future business needs. This offers us a huge competitive advantage. Debra and I have initiated a deeper review with scenario planning around recovery timelines for the categories and future growth potential in the short and long term, particularly in whiskey and agave liquids to ensure that the spend here is balanced and leverages the significant step-up in investment over the past number of years. We had some of the best aged liquid inventory to the team’s credit, and we will need to leverage this differentiated profile as we think about our pricing looking forward. And also, while the team has unlocked a lot of value from working capital improvements, as I said earlier, we will continue to look to deliver further sustainable improvement in working capital.

   • U.S. to reach an agreement with Mexico and Canada on tariffs. This depends on many factors and even President Donald Trump alone won’t have the answer.

   • Asset disposal to accelerate deleveraging. There were speculations that Diageo may sell its beer brand Guinness and stakes in Moet Hennessy to reduce debt. However, Diageo has already released a statement ruling out such a possibility. But still, there could be other non-core assets which Diageo may divest in the near term.

     We note the recent media speculation around the Guinness brand and our stake in Moët Hennessy and we can confirm that we have no intention to sell either.

Part II - Are the Risks Tolerable?

1. Are the risks structural or cyclical?

   • While there are forever concerns that the next generation will consume less alcohol due to health concerns, there’s also a scenario where people will drink less but drink better. Taking the U.S. as an example, a report from the National Institute of Alcohol Abuse and Alcoholism (NIAAA) found that per capita alcohol consumption plateaued in 2022 following almost 3 decades of increase. The decline could be cyclical if one attributes such decrease to reversal of post-COVID boom in social interactions and consumption expenditures. This could be structural if one attributes such a decrease to increasing health awareness.

   

   • While I don’t know the answer to the previous question, let’s look at the following data set from the same report. American alcohol consumers have increasingly opted for spirits over beer over the past three decades. It is worth noting that there’s a spike in spirits consumption post-COVID in particular, which may be due to increased social interactions after COVID lockdown, such as graduation/wedding ceremonies and corporate events postponed from 2020-2021 to 2021-2022. Lapping a period of elevated spirits consumption, the category growth may normalise to be in line with historical trend, thus resulting in volume decline since late 2023.

   

   Source: NIAAA Apparent per Capita Alcohol Consumption: National, State, and Regional Trends, 1977–2022

   • As both spirits producers and distributors have overestimated the demand for spirits, the supply chain bottleneck quickly turned to excess channel inventory in 2023-24. Depletion is currently outpacing the shipment growth of producers to reduce excess channel inventories, resulting in a significant volume decline reported by key producers such as Diageo, Pernod Ricard, and Brown-Forman. This situation could be cyclical if the abovementioned trends don’t reverse.

   • Diageo also provided its assessment of the industry dynamics, which you may find below for reference.

     

2. What have the management accomplished, considering the hand they were dealt when they took over compared to what is happening in the industry?

   Considering everything mentioned above, a critical issue remains why Diageo maintains an elevated capex and working capital investment despite weak consumer sentiment and a high gearing ratio. Answering this question involves a thorough assessment of management’s capital allocation priorities. Is the capex and working capital investment committed to profitable and ROIC accretive growth opportunities? Sorry to disappoint you, but I don’t have a good answer. I have in mind the worst-case scenario and the best-case scenario.

   • Worst-case scenario:

     • During the industry's recovery from COVID-19, a supply chain bottleneck prompted Diageo to reassess its product's long-term demand and become overly confident in the premiumisation trend or growth potential of specific product categories. This led to its decision to increase capex aggressively until FY2027 and increase maturing stock investment. These two issues are related, as increased production capacity amid soft consumer demand leaves Diageo with several options:

       • Utilise existing facilities to produce finished products for sale at regular price. This may not increase sales volume due to weak consumer sentiment and excess channel inventory. Unsold finished products will become inventories on Diageo’s balance sheet and negatively affect operating cash conversion, one of Diageo’s Annual Incentive Plan performance targets. (note: increase in unsold finished products as inventories will reduce operating cash conversion, while increase in maturing stock is excluded from operating cash conversion calculation based on Diageo’s Annual Incentive Plan)

       • Utilise existing facilities to produce finished products for sale at a discount. However, this will jeopardise Diageo’s premiumisation objective and may not increase revenue, profit, or cashflow.

       • Utilise existing facilities to produce maturing stock. This may then be bottled to become finished products for sale several years later, or as soon as consumer sentiment improves.

       • Pause production at certain facilities to stop producing finished products and maturing stock altogether. However, low utilisation rate of existing facilities may make it more challenging for the senior management to justify elevated capex investment.

     • Cancelling capex commitments incurs costs, and senior management spearheading these expansion projects will be let go. Nobody likes to lose their job or admit to overestimating market demand, so they will do whatever they can to convince the board to support Diageo’s expansion initiatives and justify their career in Diageo.

     • Meanwhile, for working capital investment, the worst case is that maturing stock investment is an excuse for under-utilised facilities (i.e., market demand can’t match production output). A characteristic of the spirits industry is that its product could become more valuable through aging. Instead of bottling the liquid, which they know will become slow-moving inventory, they can keep it for aging to sell it years later at a higher price. Although such investment won’t hit the P&L, increased maturing stock will consume capital, dilute ROIC and increase leverage.

     • Diageo’s Annual Incentive Plan (AIP) doesn’t incentivise the management team to improve its cash flow and capital efficiency. As you may find below, it is mainly linked to top-line and bottom-line growth in the P&L statement, with no weighting allocated to FCF conversion or ROIC. Even for operating cash conversion, it excluded maturing stock investment, which you may find below for more details. Nobody gets penalised for excessive investment in capex and working capital investment until depreciation and overhead expenses eventually hit the bottom line.

       

       For AIP purposes, operating cash conversion (OCC) is calculated by dividing cash generated from operations excluding cash inflows/outflows in respect of exceptional items, dividends, maturing inventories and post-employment payments in excess of the amount charged to operating profit by operating profit before depreciation, amortisation, impairment and exceptional items. The measure incorporates the organic treatment of hyperinflationary economies. The ratio is stated at the budgeted exchange rate for the year.

       — Diageo Directors’ Remuneration Report 2024

   • Best-case scenario:

     • Diageo management’s assessment is likely the best-case scenario: elevated capex and maturing stock investment are critical long-term growth enablers and won’t reduce them because of near-term headwinds. Below are Q&A extracted from Diageo’s recent earnings conference call.

       Celine Pannuti (JP Morgan):

       Then my second question is really on the midterm outreach where you have not yet seen when the demand will be turned, I mean, CapEx investment is quite elevated now for several years. You have more than doubled your CapEx investment and you continue to invest in maturing inventory. I want to understand what kind of volume growth underpins these investments and whether your consumer insights programme that we're rolling out, how has it informed you in terms of behaviour versus structural in terms of the weakening demand in volume? Thank you.

       Lavanya Chandrashekar:

       So Celine, when we think about CapEx and maturing stock, let me just start with maturing stock maybe and then come to CapEx. Maturing stock, the way we think about the investments we make in maturing stock is really looking at long-term projected volume growth rates. And this is based off of both looking at historic volume growth rates but also modelling forward based on what we see happening with the consumer. And so, these are not based on the next three years or the next five years volume growth rate, but much longer-term projections of volume growth rate. And the way to think about it perhaps from a modelling perspective would be to — the easiest way would be sort of looking at historic volume growth base, which typically would have been a combination of population growth as well as the growth from consumers moving out of beer and wine into spirits. And then the third is volume growth that you get in emerging markets as GDP and earnings levels increase in these emerging markets. So, the combination of the three is what really drives the maturing stock investments. On CapEx, a significant portion of our CapEx investment this year was projects that we had announced. So, we started the construction of a second distillery, or a second brewery for Guinness in Ireland. And if you look at the growth rates that we've had on Guinness this year, you can understand why we need to put in that investment. And Guinness is an extremely asset light model. Unlike regular beer businesses, most of our global Guinness volume comes out of one factory in Ireland, which we are now trying to build the second one also to keep pace with the growth of Guinness 0.0. So that's been a part of it. The other project that I will mention is we are building out a new distillery for single malt whiskey in China, in Yunnan. Now that's going to come — we just started to make liquid to put into barrels now, we're not going to see the benefit of that come through for many, many years. But it'll be delicious liquid, I'm sure, when it comes out. But again, the reason I mentioned these is because a lot of our capital investments are of this nature, they are much more long-term in nature, and that's what's driving the CapEx growth. What we have guided to is that we do expect this level of CapEx investment to stay on fiscal 25 and 26 and then come back down as a percentage of NSV, back to historic levels after that.

       Debra Crew:

       Oh, and then I think you had a final question of consumer insights, and just what we were doing around consumer insights. And so, yeah, look, we are strengthening our — and I mentioned this consumer choice framework, this is our proprietary network — our network data. This is our proprietary data that we use to look at occasions and how those are growing around the world. Some of that we featured at our Capital Markets Day, but we are taking it to all of our major markets and that will be in place really by the end of the calendar year. We will literally have it everywhere that we want it to be. And that's enabling us to really identify these pockets of growth and actively move resources. And in this volatile environment, it has been very important for us to get underneath and to be able to shift as appropriate. And we have done that in several places just to make sure that we are getting the right A&P deployed in the right place, the right liquid allocations put in the right place, and where we've decided to invest in route to market. And of course, this even goes down into our US route to market changes as well.

       — Diageo FY24 Prelim Results Conference Call

       Gen Cross (BNP Paribas):

       A couple from me. Just reading some of the presentation slides, it seems that you are pointing to more of a focus on cash generation, returns, and operating leverage, things like more rigorous review of CAPEX plans and investments in maturing liquids. When I compare that to the messaging before, would it be fair to say this reflects a lower midterm sales growth opportunity in some of your categories?

       Debra Crew:

       Look, on maturing liquids, remember that there is a couple of things that has happened within that that we have had to invest incremental money, if you remember. First is, coming out of the COVID super cycle, we had depleted a lot of, call it, the reserves within that. So, I think particularly on the Scotch side, there was a bit of a catch up. There was also we had shut down some distilleries at the early part of COVID as well. There was a bit of a recovery of that scotch maturing liquid that is, call it, a bit of a one timer in the sense that it is making up for that supercycle. At that same moment, there has also been the acceleration of tequila, and particularly the acceleration of aged liquids. So, guys, I mean, within tequila, things like Reposado is now 30% of the category. Of course, these things are not aged as long, but certainly it goes into our maturing stock numbers. That build up, particularly as we were bringing in-house a lot of these, distilling and building up our capabilities down in Jalisco, that also had a massive impact on that maturing liquid growth. Then, of course, also even things like rum, we’re aging rum as well. It is not just Scotch. Then also bringing in and up the distilleries for Bourbon for Bulleit. So, there was quite a bit going on in the maturing inventory space. What Nik is talking about is he has really brought a nice scenario planning around some of this, because not all of this liquid is 10-year plus scotch. Some of this is, of course, and in fact, a lot of these other categories, none of them are really as long. So, there is a bit more flexibility around that. And also, with the softness in volume over the last probably 18 months or so, it does present opportunities. That is the type of thing we are looking at. It does not necessarily point to lower growth. What it points to though is just optimising that for the right time. What hopefully this assures you on is that we continue to look at that and make sure that we have got the optimal investment in that area.

       — Diageo FY25 interim results conference call

   • Base-case scenario:

     The eventual outcome would settle somewhere between the best-case and worst-case scenarios. Diageo may be executing its expansion plan against profitable opportunities. Still, it may lack the incentive to correct course unless its strategy fails badly, that its Board and shareholders can no longer tolerate.

Conclusion

Is Diageo a value stock or a value trap at the moment? It could go either way depending on management’s integrity and the market environment. That’s why I have been progressively building a position in the stock instead of going all-in from day one. I will continue to monitor its operating performance and adjust my position based on prevailing valuation.

This article mainly covers my assessment of Diageo’s downside risk without mentioning particular upside potentials. I also decided to invest because of some encouraging developments, such as the success of its Canadian whiskey and tequila portfolio in the U.S. and Guinness in Europe. I will now take a break and do some homework before sharing more about the latter subjects.

I have learnt a lot by writing and publishing this article, as it forced me to do a lot of research and fact check, which I may not do when investing my money. Hope you enjoy reading this article :)