When alcohol giant Diageo [DGE] reported estimates-beating half-year results on 31 January, analysts’ top lines were glowing: “Organic sales growth of 7.5% is excellent,” wrote Morningstar’s Philip Gorham, while financial adviser Hargreaves Lansdown called the effect on profits “sparkling”.
Commentators were impressed with the Johnnie Walker, Guinness and Smirnoff parent’s ability to grow cashflows – and hike dividends – at a time when peers such as Irn-Bru owner A.G. Barr [BAG] and Budweiser maker AB InBev [ABI] were struggling to stay ahead of consumers. Diageo reported an 8.2% increase in earnings before interest, tax, depreciation and amortization (EBITDA), to £4.7bn, and operating cashflow of £1.6bn, up 28% year-on-year.
|PE ratio (TTM)||25.91|
|Operating margin (TTM)||32.52%|
Diageo stock vitals, Yahoo finance, 17 April 2019
As a drinks company, Diageo is undoubtedly doing well. Having a portfolio that spans from dry stout and lager to scotch and gin means that, “it can simply switch on other parts of the collection when spirit trends change,” wrote Hargreaves Lansdown.
As a FTSE 100 constituent, however, the plc is embroiled in a series of disputes across various tax jurisdictions that could ultimately impact its cashflow – particularly at a time when billions in equity is being returned to shareholders. So, how easy can shareholders rest?
As in the case of other multinationals operating in the US, Diageo’s 2017-18 earnings per share (EPS) were supercharged by the Trump administration’s corporate tax cuts. That boost has now elapsed, resulting in a final EPS figure of 80.9p for the six months to December, down 1.6% year-on-year. But since Trump’s giveaway was accounted for as an exceptional item, Diageo was still able to report growth of 13.6% to 77p for adjusted EPS, well above the company-provided consensus.
This year, however, worldwide tax regulation is set to be one of the company’s most pernicious adversaries.
Diageo's final EPS figure for the six months to December 2018
Buried deep on page 41 of the interim results, a paragraph reads that Diageo could end up paying as much as £278m to HM Revenues and Customs, if a European Commission investigation finds that a tax break scheme for multinationals enacted in 2013 by the then-UK government broke EU rules on state aid.
As of January, the investigation was still ongoing and Diageo did not yet feel necessary to include a related provision in its interim statement. Earlier this month, however, the commission ruled against the scheme and ordered British tax authorities to recoup lost revenues, making a hit to Diageo’s full-year cashflows more likely.
That case comes on top of ongoing tax disputes with authorities in France, Brazil and India, which, by the company’s own estimate, leave it exposed for as much as £604m. In those cases, too, the company refrained from making provisions, citing how the “complex tax and legislative regimes” across markets “are open to subjective interpretation”.
Diageo's cumulative tax litigation exposure
Enough cash to pay it all?
When it comes to shareholders, Diageo is certainly ready to splurge. Its board approved both to hike the interim dividend 5% to 26.1 and – thanks to a disposal of sixteen brands last December – to boost the ongoing share buyback programme by £660m, bringing it to a total of £3bn, of which £1.2bn has been completed.
On the surface, Diageo’s plans to return shareholders’ equity look well-covered: analysts expect free cash flows to total £2.5bn for the year to June, according to the company-provided consensus. And the company has just issued two bonds of £500m and €600m (£519m) respectively, with proceeds to be used for “general corporate purposes”.Diageo 1-year share price performance, CMC Markets, 17 April 2019
But lurking behind a share price that has been recovering far faster than the rest of the FTSE 100, and is up 11% since the start of the year, is more than £800m in exposure to tax litigations, which management has so far been confident enough not to convert into provisions.
“The group believes that the likelihood that the tax authorities will ultimately prevail is lower than probable but higher than remote,” the board wrote, of the Brazil and India disputes. Shareholders can only hope for better luck than with Brussels.