Keep the Drinks Coming, but Hold Diageo

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I’ve recently been evaluating the companies in my portfolio, deciding whether I want to buy more, sell some or all of my position, or just keep holding. Today I’m looking at Diageo (NYSE: DEO), one of the largest manufacturers of liquor worldwide. My opinion: I plan on holding, but if the stock (actually, the ADR) creeps up to $140, I may sell part of my position.

Great Brands

I was initially attracted to Diageo because of its great brand recognition. While many people wouldn’t know the name Diageo, they have heard of Johnnie Walker, Crown Royal, Smirnoff, Ketel One, Ciroc, Captain Morgan, Bailey’s, Jose Cuervo, Tanqueray, and Guiness. These are just SOME of Diageo’s strategic brands that they market worldwide. While they only distribute Jose Cuervo and the contract is set to run out next year, Diageo owns 17 of the top 100 premium spirits brands and 8 of the top 20 premium spirits brands worldwide.

They also own many local brands that are very strong in their home markets, including two they picked up this year: Mey Icki, a distiller of Raki and other spirits in Turkey, and Ypioca, a Cachaca distiller in Brazil. Both of those companies’ distribution networks will be consolidated with Diageo’s, and Diageo’s distribution network will allow for these brands to be sold worldwide. Mey Icki and Ypioca are the leading brands of their spirits in their home countries, adding to the great brands that Diageo already owns.

Diageo is also in the process of ‘premiumising’ their brands: that is, they are coming out with variations on the liquor they already make that has some added cachet so it can be sold for higher margins. A great example of this is Captain Morgan Black Spiced Rum. It’s a tribute to Captain Henry Morgan with an inner label that reveals the story behind the Captains death as the liquid leaves the bottle. Diageo launched Captain Morgan Black in North America at a 35% price premium to the Captain Morgan Rum. Also, they often do special runs with other premium product manufacturers, such as cross selling Johnnie Walker Platinum with Porsche. Incidentally, their biggest competitor, Pernod Ricard, has the same strategy of premiumising.

Diageo has done pretty well with their premiumising strategy, as can be seen in the chart below. Most of their revenue growth has come from their premium and premium plus brands, which has allowed their operating margin to increase from 28.1% in 2010 to 29% in 2011 to 29.7% in 2012.

 

Recession Resistant

Diageo is as global a company as they come, selling alcohol in 180 countries across the world. Diageo splits the world into five geographic regions, none of which account for more than 33% of revenue. A recession in any part of the world isn’t going to affect Diageo in a huge way thanks to its global diversification. Over the last year only one region, Europe, had negative growth, and that was by just 1%. Now, a global recession would be a slightly different story, but here we need to remember that alcohol is generally considered recession resistant. Remember also that Diageo sells a product that generally doesn’t go bad very quickly, and will not be made obsolete by technological innovation.


While South and Latin America, Africa, and Asia only account for 39% of sales, they accounted for the majority of the growth. The growth of the middle class worldwide will be a great tailwind for Diageo, as the middle class continues to trade up to premium spirits and beers. You can see that effect in the chart above, as both South and Latin America and Africa had growth rates in double digits, and Asia was just behind. In fact, 85% of Diageo’s growth this past year came from these three regions.

Diageo is the largest producer of Scotch in the world, and it had a banner year. About 30% of Diageo’s sales come from the different brands of scotch it produces, chief among them Johnnie Walker. Diageo’s sales of scotch increased by more than 12% in every region but Europe, but even there it grew 2%.

Is the price worth the growth?

Diageo's shares are currently around $115 and have been on a tear over the past year, having returned about 33%. It’s trailing PE tells the same story, as it's sitting around 23. But analysts are expecting Diageo to show great growth in the next year, as it’s expected forward PE is about 16. I generally prefer to purchase companies that have PE’s in the lower teens at most, so this a little expensive to me. But Diageo has great brands, and is growing pretty well. Analysts expect the company to post earnings of $7.10 next year, compared to $5.03 this year, mostly due to the addition of the acquisitions I mentioned earlier.

Diageo also has a solid, small dividend, and is currently yielding about 2.4%. Note that it is an English company, and pays dividends on a semiannual basis. One payment is generally in April, the second in October, and the payments are generally split about 40:60. Diageo is similar to many other European companies in that its dividend is variable from year to year, although it is generally growing. Diageo reduced their dividend 14% between 2007 and 2009, but since then has had a string of increases, and during 2012 paid out 21% more than 2009.

Diageo is sitting on a PEG of more than 2.3, and has about $14 billion in debt. In fact, to fund the acquisitions mentioned earlier, Diageo has been adding to its debt. I see it as well worth it in the long run, and Diageo still has a current ratio of 1.5. Below, I’ve compared DEO to a few well known competitors.

Company (Ticker)

Market Cap (USD)

Trailing P/E

Forward P/E

PEG

EPS growth past 5 years

Jim Beam          (NYSE: BEAM)

9.7B

26.5

23

2.36

-30.75%

Brown-Forman (NYSE: BF-B)

13.4B

24.31

21.27

2.05

7.94%

Diageo

73B

23.22

16.45

2.35

9.31%

Constellation Brands (NYSE: STZ)

6.4B

18.73

12.58

1.77

6.72%

Pernod Ricard

30.8B

20.1

17.4

2.1

3.35%

I want to highlight three things about the table. The first is that BEAM’s EPS growth is negative only because it recently split from Fortune Brands Home & Security, so that number should be taken with a grain of salt. I also want to highlight that Diageo is many times bigger than any of the other companies listed: its biggest competitor is the aforementioned Pernod Ricard, which has half the market capitalization. The third thing I want you to notice is that Diageo has a middle of the pack PE, despite having the best EPS growth and being the largest company by far.

Conclusion

I really like Diageo’s brand recognition, but I think that right now, it’s a little overvalued compared to the general market. Compared to its peers, though, it doesn’t seem to be overvalued. Being one of the largest companies in its space, and as geographically diversified as it is, maybe its earnings deserve to be valued at a premium to the other companies mentioned. And just so you know, even though I own Diageo, my favorite drink is Jameson, neat, which is sold by Pernod Ricard.


thenoffya has a position in Diageo. The Motley Fool recommends Beam and Diageo plc (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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