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If you’ve ordered a pint of Guinness in London lately, you’ll have noticed that it wasn’t cheap. But while the black stuff costs a pretty penny, the stout’s brewer, Diageo (LSE: DGE), looks a lot like a value share.
It has a proven business model yet has lost a quarter of its price in the past 12 months alone.
This week saw Diageo’s new boss talk about fixing challenges including that of getting hold of a Guinness in London. He was focussed on product availability. But he’s also got price in mind too, with plans to make the company’s offering more competitive.
As a lover of the black stuff, that sounds good to me. As a Diageo shareholder, though, I am deeply concerned about what it means.
Built up over decades, but now in danger
Why? In a nutshell: pricing power.
Look at Diageo’s portfolio and what stands out is not just how iconic many of it brands are, but also how costly some of them can be.
Sure, there are some cheaper names like Johnnie Walker Red Label and Smirnoff Ice. But there are a lot of costly tipples too, such as Johnnie Walker Blue Label.
With demand for high-end white spirits struggling over the past couple of years, Diageo’s business has suffered.
But the combination of a falling share price and unique, high-quality brand portfolio has made it look like a value share. I’ve stocked up (on Diageo shares, not Blue Label).
However, making the company more competitive on price could mean it ends up being a value trap, if it damages Diageo’s pricing power.
That pricing power has been nurtured over decades, but is fragile. Once you slash selling costs, even if sales volumes grow, profit margins can suffer – and the pricing power that took decades to build can be permanently destroyed.
Is this the right medicine?
Frankly, that risk concerns me a lot. And, combined with a dividend cut, I seriously weighed selling my Diageo shares following this week’s news. They remain well below what I paid for them, though, and on reflection I decided to hang on for now.
After all, Diageo’s asset base really is fantastic: not just the brands, but unique production facilities too.
Plus, the dividend cut and aim to become more price competitive could actually turn out to be the right move. Diageo has had a challenging couple of years and its new boss has been brought in by the board with the aim of turning it around.
He is in the hotseat; I am not. He may understand the market and Diageo’s challenges far better than I do.
A lot will hang on the next year or two
If so, the currently lacklustre Diageo share price could end up offering significant value.
Still, I remain sceptical. Time will tell whether a sharper focus on costs pays for itself in terms of higher sales volumes. That looks like a tricky feat to achieve in a market where alcohol demand generally is in structural decline.
A massive dividend cut – Diageo plans to halve its payout – is rarely good news in my experience, as it suggests a business with deep problems.
The next couple of years will show whether the firm’s woes are fixable – and whether today’s share price ultimately turns out to be a long-term bargain.
