Brexit makes Diageo a takeover target

Perhaps the biggest effect of Brexit thus far has been its impact on the pound. It has weakened by 18% versus the dollar since the EU referendum as confidence in the UK economy has deteriorated. More of the same could lie ahead and it would be unsurprising for the pound to weaken yet further, particularly since US interest rate rises are likely to lead to a stronger dollar. One effect of this is to make companies that report in sterling cheaper to buy for foreign investors. That’s a key reason why I think Diageo (LON:DGE) is now an obvious takeover target.

Sterling weakness

Undoubtedly, the future direction of sterling is difficult to predict and depends to a large extent on news flow. However, it seems likely that a further weakening of the pound will take place since uncertainty surrounding Brexit is building. Unemployment is forecast to rise, GDP growth is unlikely to be significantly positive in 2017 and UK interest rates are more likely to move down rather than up as the Bank of England has stated that inflation may be a necessary cost of supporting UK economic growth.

Further, the political risks to the UK remain high. The government has not yet invoked Article 50 of the Lisbon Treaty to begin negotiations with the EU on the terms of the UK’s exit. Once this starts, there is likely to be a ramp-up in uncertainty since there could be periods of time where a deal to access the single market seems unlikely. With the clock ticking towards the UK leaving the EU in 2019, investor confidence in the pound could decline.


At the same time, the US dollar is likely to strengthen over the medium term. An interest rate rise before the end of the year seems likely, with over 70% of economists in a recent poll predicting a rate rise in December. Between now and 2020, a further six rate rises are forecast as the US interest rate is expected to increase to 2.25%. At the same time, UK interest rates are forecast to remain at 0.25% for the next year before rising to 1% by 2020. This should mean that (other things being equal) the dollar strengthens versus the pound over the next four years.

International business

As a result of a weakening pound, Diageo will have greater appeal to foreign investors since it reports in sterling. Not only will its share price be more appealing, the company’s performance in non-UK markets will be given a significant boost by a positive translation effect when income is converted into sterling.

Although it reports in sterling, Diageo is very much an international business. This provides it with significant diversity since weakness in one region of the world can be offset by improved performance elsewhere. For example, in the 2016 financial year Diageo posted an 11% fall in operating profit in Africa which was offset by a 13% rise in operating profit in Asia Pacific. This should help to smooth out earnings volatility, which may be appealing to a potential bidder.

Diageo’s focus on emerging markets such as Africa and Asia Pacific is likely to positively catalyse its long term earnings growth. For example, discretionary consumer goods sales are forecast to rise by over 7% per annum in China between now and 2020. Similarly, wages in India are forecast to rise by 31% over the next four years, while GDP per capita in Nigeria is due to be 10% higher in 2020 than it is today. Diageo is well positioned in those three markets and across the emerging world to benefit from rising wealth. This will act as a positive catalyst on its financial performance in my view.

Product appeal

Diageo’s range of products is likely to appeal to other beverages companies. That’s because it has a number of products which are placed at either number 1 or 2 within their respective product categories. Its six largest brands such as Johnnie Walker and Guinness account for 40% of its revenue and they grew their sales by 3% in the 2016 financial year. They provide stability via a high degree of customer loyalty. This gives Diageo considerable pricing power over the medium term.

Diageo also owns a number of popular regional brands such as Windsor and Bundaberg which have the potential to become global brands. It is also moving into super-premium brands such as Ciroc which offer the prospect of high margins and high growth.

Outlook

In terms of its valuation, Diageo has more appeal following the pound’s recent weakness. Its P/E ratio of 24.6 may be higher than for consumer goods peers such as Unilever (LON:ULVR) and PZ Cussons (LON:PZC), which have P/E ratios of 22.1 and 19.8 respectively. However, Diageo is forecast to increase its EPS by 16% in the current year, which is ahead of both Unilever and PZ Cussons. Unilever is due to increase its EPS by 5% in the current year, while PZ Cussons is expected to report a fall of 1% this year.

In my opinion, Diageo is a high quality business which has bid potential due to the strength of its brands. They provide a mix of stability and growth potential. Diageo also has exposure to the fastest growing regions of the world, while also having diverse geographical exposure to lower its risk profile. Further, its near term growth outlook and valuation versus consumer goods peers indicate that it offers good value for money.

However, it is the weakening pound which makes now a credible time for a bid approach. For companies which have modest UK exposure and that do not report in sterling, Diageo has become cheaper as the pound’s value has fallen. Due to an expected US interest rate rise, a dovish Bank of England and an uncertain outlook for the UK economy, further weakness could lie ahead for the pound. Therefore, Diageo’s takeover appeal could become irresistible in the coming months.