Raise Your Glass To Profits

By Chad Henage - June 11, 2012 | Tickers: STZ, DEO | 0 Comments

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When you have volatility in the stock market like the last few years, there are two companies that “drink” up more profits. I'm sure these companies feel in the celebrating “spirit” when the market drops. Okay enough of the bad puns, both Constellation Brands (NYSE: STZ) and Diageo (NYSE: DEO) would seem to benefit directly when adults want to unwind with their favorite beverage. With brands like Captain Morgan, Johnnie Walker, Jose Cuervo, Robert Mondavi, Corona, and others, to say that these two companies sell some of the worlds most popular brands isn't an understatement. While both companies have attractive name brands, and very specific market niches, which one is the better investment?

On strictly a PEG basis, it looks like Constellation Brands should get the edge. Both companies have similar growth rates, but Constellation sells for a 40%+ discount based on the P/E ratio. (Constellation – 2, Diageo – 1)

A significant contributor to total returns are dividend payments. In this category, there is a clear winner in Diageo and to be blunt I'm not sure why Constellation isn't even in the race. Diageo pays a current yield of 2.14% versus Constellation pays no dividend at all. Diageo's payout isn't consistent, but any dividend clearly beats nothing. The company paid out about 58% of its free cash flow last year, so the current payout seems sustainable. Though Diageo wins this category, let's pretend for a moment that Constellation decided to pay a similar dividend to Diageo. Constellation generated about $700 million in free cash flow last year. With a 50% payout ratio this would mean $350 million in dividends. With 188.8 million outstanding shares, this would equate to an annual dividend of about $1.85 per share. With a $1.85 hypothetical dividend, Constellation would yield nearly 10%! As you can see, while Diageo wins this category for now, if Constellation initiated any decent dividend this could change very quickly. (Constellation – 1, Diageo – 2)

Since I've already touched on free cash flow, let's compare the two companies on this measure. I like to use a ratio of free cash flow versus total assets. This ratio shows how efficient each company is at using its asset base to generate free cash flow. In theory, a company that generates more free cash flow from less assets is the more efficient operator. Constellation Brands generates $0.10 of free cash flow per $1 of assets, versus $0.08 of free cash flow at Diageo. This gives Constellation Brands the edge as they generate 25% more free cash flow with each dollar of assets. (Constellation – 2, Diageo – 1)

Last, let's look at each company's balance sheet. I use the debt-to-equity ratio as a way to compare companies in the same industry. Constellation Brands shows a debt-to-equity ratio of 0.90 versus Diageo's ratio is 1.32. This is sort of a double negative for Diageo because the company also generates relatively less free cash flow. With less debt on the balance sheet, Constellation should be able to make positive acquisitions, and this also gives the company more flexibility than Diageo. (Constellation – 2, Diageo – 1)

Looking at the total scores, it's Constellation – 7 versus Diageo – 5. While Diageo's dividend is attractive, the stock appears to more than fully value this payout with a much higher forward P/E ratio. The fact that Constellation has beaten estimates by an average of 23% in the last four quarters is a positive as well. As mentioned before, if Constellation decided to pay a dividend, even a 50% free cash flow payout ratio would be a game changing event. Constellation seems to offer a better “mix” of features, and the potential for an outsized dividend should have investors “drunk” with anticipation.

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