Luxury goods tend to fare well over the long term but when times get tough, they’re often the first to feel the brunt of economic tightening. Diageo (LSE: DGE) is one such company, managing the production, marketing and sale of premium brand drinks like Johnnie Walker and Dom Perignon. Over the past two decades, the Diageo share price has enjoyed relatively consistent gains, achieving a three-fold increase since the 2008 market crash.
However, Diageo’s shares suffered lately when preliminary results revealed a performance slump in crucial Latin American and Caribbean markets. Most notably, the projected growth of operating income slid a few percentage points from a median of 7.5% down to 6%, leaving some investors skittish. With the share price down 23% this year alone, I’m now wondering if Diageo represents an undervalued stock that has the power to bounce back in the new year.
A weakened economy
Diageo’s recently appointed CEO Debra Crew blames a weakened global economy on the downturn, one that has driven customers towards more economical beverage choices. Some cite fears of a recession in 2024 as another reason that consumers may be tightening their belts.
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However, I’m already seeing evidence of a recovery in many sectors, and with Christmas on the horizon, luxury goods should enjoy a boost in the coming weeks. A recent survey by the Association of Investment Companies (AIC) found that 70% of managers believe global stock markets will rise in 2024, while 22% are optimistic about opportunities to invest in cheap companies.
An undervalued share
Despite the recent dip, I think Diageo exhibits some relatively strong financials. Over the past few years, its earnings have increased at an average rate of 4.9% while the rest of the beverage industry has been declining by 0.04% per year. Regarding debt, its assets exceed liabilities in the short term, with an interest coverage ratio (which determines how well a business can pay the interest on its outstanding debts) of 8.7.
That said, its debt-to-equity ratio has increased considerably over the past five years and isn’t well covered by cash flow. I would imagine that if the current period of losses drew out for too long, its high debt could spell trouble for the company.
So what makes me think it’s a good buy?
The recent drop in share price means Diageo is now considered undervalued, with some analysts estimating it to be 43% below fair value. That gives it a lot of room to grow, and with earnings forecast to increase by 4.2% a year, I think it could recover and fill that gap.
We’ve endured a long market slump through 2023 but interest rates appear to have peaked. While there’s always some risk when investing during a downturn, I think 2024 could be the year for me to capitalise on today’s undervalued shares. I believe Diageo is just the kind of company that will enjoy renewed interest once consumers begin spending again.
