Diageo's Whiskey Acquisitions Make for a Top Shelf Investment

By Daniel Ferry - June 11, 2012 | Tickers: BEAM, BF-B, KO, STZ, DEO | 0 Comments

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In a time of economic uncertainty, one thing is guaranteed: people are going to drink. Lost your job? Drown your sorrows in a beer. Got a new one? Pop the champagne. Truly, any event whatsoever appears to be a legitimate reason to imbibe. And no company is better positioned to profit from the place alcohol holds in our hearts (and livers) than Diageo (NYSE: DEO), a global company with strong brands in every major adult beverage market. 

Diageo has been in the news recently for investing over $1.5 billion in Scotch whisky production, and for the acquisition of family-run distiller Cabin Fever Maple, continuing their expansion into craft whiskey.* I view this as a sign of management's focus on extremely long-term success -- since their Scotch can take decades to mature -- as well as their shrewd understanding of the trends in the marketplace.

Even as the sales of Diageo's flagship brands remain strong, consumers in the critical North American market and elsewhere are increasingly gravitating toward craft distilleries, echoing a similar movement in favor of craft beers. Diageo's Catalyst Division has been created to exploit this trend, focusing on acquiring small regional distillers, building brand equity, and plugging their product into Diageo's powerful marketing and distribution network. This is the key to Diageo's success: much like Coca-Cola (NYSE: KO), Diageo has built up a network of consolidated importers, distributors, and a veritable legion of salespeople and marketers that give it an impressive reach and cost advantage. This allows Diageo to add significant value to new acquisitions, and I believe this approach is the driver behind the company's future growth.

Diageo enjoys considerable scale over its rivals, to the extent that some of its smaller competitors, particularly Beam Inc. (NYSE: BEAM) with its attractive portfolio of bourbons, are more credible as takeover candidates for Diageo than true peers:

Also important in the marketplace is privately held Bacardi, whose brands include Grey Goose vodka, Dewar's Scotch whisky, Bombay Sapphire gin, and Martini vermouth in addition to its namesake rum.

Despite these large corporate presences, however, the spirit market remains highly fragmented. The top ten producers collectively have a global market share under 15%, with even lower shares in emerging markets. There are two avenues to capture greater share, and Diageo is well-positioned to pursue both. One is the strategy of leveraging existing premium brands and promoting them as aspirational beverages for newly wealthy consumers. Diageo's portfolio of top shelf brands is unparalleled, particularly in the high-visibility Scotch whisky and ultra-premium vodka markets. The second approach is to acquire small producers with excellent regional reputations, and build out these brands. Diageo has a strong record of making prudent acquisitions that prove accretive to earnings in short order.

Diageo's 2008 acquisition of Dutch vodka distillery Ketel One is an excellent example of the firm's ability to leverage its distribution as well as its discipline in expanding their brand portfolio. At the time, the Swedish government was divesting itself of its national booze distributor, which owned the popular Absolut ultra-premium vodka. Diageo expressed interest, but found itself in a bidding war with Pernod Ricard and Bacardi. Rather than swallow a price tag over $8 billion, Diageo abandoned Absolut and opted to become the exclusive distributor of Ketel One for just $900 million. Ketel One has consistently outperformed Diageo's expectations, as the company's legendary distribution system continues to build Ketel One into one of the world's most valuable ultra-premium vodkas. Meanwhile, the smaller debt load required to buy Ketel One has allowed Diageo to expand aggressively into Asia, South America, and Africa. Pernod Ricard ultimately acquired Absolut, but the debt it took on has crippled its ability to compete with Diageo in emerging markets.

Diageo is expensive today, trading for nearly 24 times earnings. Even at this valuation, however, I expect it to outperform its peers as it pursues its two-pronged strategy of acquisitions and brand expansion. Diageo is on track to meet its goal of generating half of its revenue from emerging markets by 2015. If Diageo can continue to execute well, it will create an insurmountable brand presence in the wide open markets of the new global middle class. While this might take awhile, just as in whiskey production, good things take time. And for Diageo, just as for good whiskey, I'm willing to pay a premium for quality.

*Reader's note: American and Irish distilleries call their product whiskey, while Canadians and Scots prefer the spelling whisky. Apocryphally, this standard was adopted in the 19^th century, when Irish distillers wanted to differentiate their high-quality product from what they regarded as the slop coming out of Canada and Scotland in order to stand out in the American export market. Ironically, since today Scotch whisky is one of the world's most admired liquors, the Scots actually try to protect the “whisky” spelling as a mark of quality; and certain American distillers (including Cabin Fever) have begun giving up the “e” to copy the Scots. Enthusiasts of the product can be very pedantic on this point, especially after sampling a bit.

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