The Diageo (LSE:DGE) share price surged 10% after the firm announced a dividend cut on Thursday (6 August). The FTSE 100 firm announced a bold turnaround plan alongside its full-year results.

Investors have been waiting to see what Sir Dave Lewis has in mind for the company. And it starts – unsurprisingly – with a dividend cut. 

Where it went wrong

Diageo’s slump has three familiar culprits:

• A K-shaped US economy. While wealthier individuals are doing well, everyone else is struggling and this has been hitting Diageo’s mid-range brands.
• China issues. Government policy has squeezed the white spirits market and this has weighed on the firm’s sales in the region.
• GLP-1s and shifting consumer preferences. Weight-loss drugs and younger consumers drinking less have been recent challenges to sales volumes.

Some of these are likely to be more durable than others, but all of them are related to the demand side of the equation. And my view for some time has been that this is important. 

Diageo’s key strength – its distribution network – remains intact and unmatched. So I think it’s a matter of finding the right products for an evolving market. 

The Lewis effect

Diageo’s full-year dividend has been cut by more than 50%. That’s one of the things I predicted pretty much as soon as Sir Dave took charge. 

The CEO outlined around $1bn in cost savings to fund the turnaround. As a shareholder, I see this as a good thing, but cost-cutting by itself isn’t a long-term growth strategy.

The most important thing, in my view, is the focus on “activating the wider portfolio”. That means using $13bn brands – not just Johnnie Walker and Smirnoff to reach consumers.

Lewis says this can happen while maintaining operating profits. With US sales set to remain under pressure in the next 12 months, that would be impressive.

Start of a comeback?

The latest figures don’t obviously signal the start of a comeback. Reported sales fell 3% to $19.64bn, but the market is (quite literally) buying the guidance. 

Diageo shares initially responded with their best one-day move in years. But there are other numbers that investors need to pay attention to.

In terms of the US, the Census Bureau’s wholesale inventory-to-sales ratio for beer, wine and spirits is one that I keep an eye on. This peaked at 1.68 in October before easing to 1.61 in May. 

Off the highs, but still elevated, that means distributors aren’t fully destocked yet and that’s likely to weigh on demand going forward.

My verdict

The headline figure in Diageo’s forecasting is $8bn of cumulative free cash flow targeted for 2027-29. At today’s prices, that’s roughly 5% of the current market value each year. 

That should be enough to keep rebuilding the balance sheet and – eventually – the dividend. So investors have a line of sight to a recovery, though it’s going to take time.

I’m already well-invested here, so I’m going to watch and wait for balancing purposes. But for anyone thinking of getting started, the situation now looks better than it did and may be worth considering.

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Stephen Wright owns shares in Diageo.