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The City: Sharing the wealth

Published:  18 January, 2007

Why buy shares? Essentially for dividend payments and capital growth (share-price rises) that, combined, will outstrip the return of putting your money in the bank and pay a premium to reward for the risk of potential losses. So, on both counts, shareholders in Diageo have done well. In the past five years they have seen the value of their shares rise by about 50% to around 820p at the same time as receiving a strong dividend stream.

But the stock market is fickle. Investors want go-go growth, but they don't want the accompanying risk. So, as a company matures it can take on a worthy but uninspiring image. Hence the slick jokes last week about Diageo's forthcoming Formula 1 sponsorship of MacLaren looking much racier than its own growth profile.

In truth, however, Diageo's annual figures for the year to 30 June did not deserve the cheap shots. Stripping out the one-off costs, pre-tax profits fell from 2.07 billion to 2 billion, dragged down by continued weakness in Europe, a factor besetting all drinks companies. But both organic volumes and net sales were up and margins grew. Even more interesting, Diageo is throwing up 1.4 billion a year in free cash flow.

Chief executive Paul Walsh has acknowledged that there are too many regulatory hurdles to Diageo buying another spirits group (though it could take niche brands, as it did with Irish whiskey Bushmills), and he has effectively ruled out purchases in beer to bolster Guinness's position in the world market. So that leaves wine.

The market expects Diageo to exercise its option to take most of Montana from Pernod Ricard as its reward for not interfering with the dismemberment of Allied Domecq, but the purchase price will be more than easily covered by the 600-million-plus proceeds from Diageo's stake in General Mills, likely to be unloaded later this year. After that, the number of wine groups that earn both the return on capital that Walsh demands and also have the volumes to fit into Diageo's portfolio diminish rapidly.

Shareholder returns are top of Walsh's agenda. That's why he is planning to use the surplus cash for further share buybacks. Last year Diageo bought back shares worth 700 million, and in the next 12 months it will repurchase a further 1.4 billion. Each remaining share will be worth more and will also attract a higher proportion of the growing dividend stream.

Although that may not set the imagination on fire for most investors, it is the best bet in the drinks industry. Diageo remains the global leader by a country mile; it has no obvious weaknesses; and in the US, its biggest market, demographics are starting to work in its favour. Add in new product launches and Diageo looks as inviting as a tot of Johnnie Walker Gold on a winter's evening.

Ron Elmer