Diageo and its cash flow

 Diageo is the world's leading premium drinks business, I have a holding in my income portfolio (epic code: DGE)

Diageo has an outstanding collection of alcohol brands and earnings and valuation to match, but if one had to be critical of Diageo, it would be on the deterioration of their cash generation over the past few years.  If you take the view that the value of a business is the discounted value of all future free cash flows (FCF) - then it matters, or even if you are sceptical of any management’s EPS numbers – then it matters.

One year of operating cash flow (OCF) or FCF on its own is less informative, but an accumulation over the years or a trend is informative.

DGE’s last four years of earnings, accumulation of those earnings (ACC) and the last twelve months (LTM) show a positive trend:

2010 - £1,629m

2011 - £1,900m

2012 - £1,942m

2013 - £2,485m

ACC - £7,956m

LTM - £2,546

Although FCF shows a different trend and accumulation:

2010 - £2,023m

2011 - £1,763m

2012 - £1,609m

2013 - £1,405m

ACC - £6,800m

LTM - £939m

Part of the FCF decline has been due to increase in capital expenditure, up from £374m in 2010 to £643m in 2013, but OCF has also declined from £2,396m in 2010 to £2,048m in 2013.  Part of the reason has been the requirement for DGE to hold higher levels of working capital.  For example Inventory has increased from £3,281m in 2010 to £4,222m in 2013 representing an increase from 26.1% of sales to 27.3% and, over the same period, receivables have increased from £2,008m to £2,484m representing an increase from 15.5% of sales to 16.0%.

 Over the last four years DGE has returned 62% of its FCF to shareholders by the way of dividends, this looks to be a very comfortable ratio, but the trend is more concerning as the distribution has deteriorated each year from 47% in 2010 to 85% in 2013 and 131% for the LTM.  Here I have used the declared dividend in each year.

On a FCF valuation basis DGE’s SP is 51x its LTM FCF, the median for the FTSE All Share is 20x, but then companies such as DGE will be highly valued at times, due to the expected future FCF from its brands.  So the market must be assuming that the trend of the last four and a half years will be reversed, or it has become obsessed with the EPS trend and is ignoring the cash that is being generated.