Description

With names that are cheap on an absolute basis in short supply, my focus has turned to high quality names that offer good relative value and have not participated in the overall gains put in by the general indices this year. With nearly every high quality name up this year – even some that have been hit quite hard by the pandemic and are likely to put in 2 years of full year losses – I am attracted to high quality companies that took a significant hit to profitability, yet aren’t bleeding money and have also not yet recovered all their price drops… basically relative value with a bit of a recovery trade yet to come. 

One stock that meets this criteria is alcoholic beverage maker Diageo, which remains off 5% on the year despite neither turning unprofitable and racking up debt nor suffering any permanent impairment to its long-term business prospects. Essentially, on a relative basis, Diageo has multiple contracted quite a bit.   

While the company doesn’t screen cheap on an absolute basis at 25x forward earnings estimates – on a relative basis it trades near ten-year lows (ignoring the extreme dislocation of this past spring and summer). Currently, Diageo on a forward P/E basis, trades at around an 11% premium to the S&P 500 vs. its ten-year average of a 20% premium. When the relative P/E of DEO has been at or below 1.1x that of the S&P 500 (192 trading days in the last ten years), one-year forward returns have averaged 12.8%.

Diageo’s weak 2020 performance is related to its exposure to the on-trade business (i.e., restaurants and bars), which led to a 23% decline in organic sales in the first six months of this calendar year. (The Diageo fiscal year runs July to June.) On-trade accounts for 50% of Diageo’s revenue in Europe, 20% to 30% of its revenue in the U.S., and 75% of its beer sales in Africa. Increased at-home consumption purchased at retail stores partially offset the dramatic decline in the on-premises business, but not enough to prevent the23% decline in organic sales from January through June. 

At-home consumption will likely moderate in a post-COVID world but the increase in folks returning to drinking (and eating) out will more than offset this decline allowing a post-COVID Diageo to quickly return to its pre-COVID sales and earnings – if not more given the positive comps already coming out of Mainland China and the much speculated upon possibility that countries hard hit by COVID-19 could experience a sort of “Roaring 20s” effect when we get past the pandemic. 

Beyond a likely post-COVID snapback to normalized – or even temporarily heightened - profits, the bigger reason to own Diageo is that it should be a fairly steady 10% per year compounder via a combination of mid-single digit topline growth, 40 bps to 50 bps of annual margin expansion, a 2.25% dividend yield, and 1.5% to 3% worth of annual buybacks. 

The topline growth will be driven by two key trends: premiumization and geographic diversity. In recent years, Diageo’s results have proven out the theory that that the working affluent’s strong interest in attainable luxury experiences combined with an increasing interest in health – and consuming less “bad stuff” (like cheap beer or liquor) - leads to consumers reaching for a better bottle of vodka or scotch for both health and taste reasons (and in some cases, for status as well). In developed markets, premiumization has driven growth.

At the other end of the spectrum of products, 42% of the company’s revenues comes from developing markets, which sets the company up well to capture increased alcohol spend by the incremental 750 million people that are expected to enter the middle class by 2030. 

Diageo’s portfolio of high-quality brands, diversified by spirit, geography, price tiers, and distribution channels mean it is always there to meet the consumer’s ever-changing taste – making it one of a handful of companies today for which I have high confidence that it will be around in fifty or even one hundred years. That is quality… and I think it can offer an average return of 10% per year, a valuable attribute, even if not one that is particularly highly valued in a year that has seen some tech stocks soar 300% or more.  

Business History and Description

Diageo was formed out of the 1997 merger between Guinness Brewery and Grand Metropolitan. 

Subsequently, the company used M&A to create a spirits portfolio that includes iconic brands like Johnnie Walker scotch and Captain Morgan’s rum. M&A is often very successful in the beverage space, as the difficulty in scaling a liquor business is threefold. First, the quality and consistency of batches across multiple distilleries, often in different countries, must remain consistent. Second, there must be enough capital to both acquire or develop said distilleries. And lastly, the liquor company must have enough of a marketing budget to compete with global brands. Given large liquor companies have manufacturing and marketing expertise and ample access to low cost capital, liquor conglomerates can pay above market prices for smaller brands and still achieve high IRRs, because a large spirits company can grow the smaller brands faster and more profitably in-house than the liquor brand can usually grow as a standalone business.

Using this strategy, Diageo has assembled a portfolio of the #1 or #2 brands in rye whiskey, scotch whiskey, vodka, rum, gin, and tequila – with a particular focus on whiskey. 

Whiskey: Chugging along

Whiskey accounts for roughly 40% of revenues and 45% of EBIT. The company’s largest brands are scotch whiskey Johnnie Walker (#1 selling scotch whiskey), Canadian whiskey Crown Royal, American rye, and bourbon whiskey Bulleit, as well as a number of high-end scotches like Tallisker and Dalwhinnie. 

Within whiskey, scotch is the company’s largest exposure, as it accounts for 24% of company-wide revenues and nearly a third of EBIT. Diageo’s premiumization strategy is on full-display with its most well-known scotch brand, Johnnie Walker, as it offers the scotch at a variety of price points from value ($20 for a 750ml bottle of Johnnie Walker Red Label) to super premium ($200 for 750ml of Johnnie Walker Blue Label). By getting consumers to move up its pricing ladder into more expensive and better-quality scotches, it has led to sales growth above volume growth for the better part of a decade. 

While the scotch market growth was somewhat limited in the middle part of the decade due to macro issues in both Latin America and China, scotch has seen a resurgence since 2016. The rebound in macro conditions certainly helped, but part of the rebound has been attributable to growth in developed markets, thanks to innovative marketing and limited editions, such as the “White Walker” scotch – a whiskey inspired by the popular HBO show, Game of Thrones. 50% of buyers of the White Walker scotch were women even though roughly 2/3rds of scotch drinkers are men. In Spain, 52% of White Walker scotch customers were new to the Johnnie Walker Brand. 

Diageo has also had success in the North American whiskey space over the last few years through innovation, an example of which is Crown Royal Green Apple whiskey, which led to growth 4.5 ppts above the Canadian whiskey market in 2018. The North American whiskey business is also benefitting from increased overall consumption of whiskey - the American whiskey market grew 11% in 2019 due to shifts in consumer tastes. 

Vodka and Rum: Pressured

The company’s second biggest exposure is to the vodka market (11% of sales) with its Smirnoff (#1 vodka brand), Ketel One, and CÎROC brands. Growth here has been more limited – low single digits – driven by a combination of smaller distilleries in North America taking share (Tito’s) and shifting consumer tastes towards gin and tequila. It seems likely that this segment will remain somewhat pressured unless there is a shift in consumer tastebuds, or a clever marketing scheme or innovation reignites the category. 

Diageo’s third largest liquor, rum, (7% of sales) is similarly challenged. The company’s main brand, Captain Morgan’s, has seen growth fluctuate around 0%. Rum weakness is largely due to the health & wellness trend that led consumers to shift away from high-calorie and sugary rum-based drinks. 

Gin and Tequila: Hot

The company has a roughly 5% exposure each to tequila and gin. Evolving consumer tastebuds for cocktails involving gin – particularly, a Fever Tree and gin popularized by Spaniards – and tequila has led to outsized growth in each liquor. Premium, super-premium, and ultra-premium gins are projected to grow at 10%+ CAGR from 2018 to 2023, while market research firm IWSR predicts similar growth trends for tequila – high single digit to low double digit growth for more premium tequilas. In both liquors, lower quality tequila and gin will remain pressured, as consumer preference is shifting towards higher-end cocktails as a result of both premiumization and health & wellness. 

The surge in both gin and tequila consumption led Diageo to acquire actor Ryan Reynolds’ Aviation gin for $610mn and actor George Clooney’s super-premium and ultra-premium tequila brand, Casamigos, for $1bn. Emerging brand Aviation joined existing Diageo gin brands Gordon’s (#1 in the market) and Tanqueray (#3). The fast-growing Casamigos joined Don Julio and DeLeon in Diageo’s tequila portfolio. 

Liqueurs, Regional, Ready-to-Drink: Mixed Bag

Diageo also has a 5% exposure to liqueurs via Bailey’s, which I expect to remain somewhat pressured given the health & wellness trend, as well as a 6% exposure to an assortment of regional liquors like Baijiu in China via its 70% ownership of Sichuan Shuijingfang Company Limited (SJF).

The company also has a 7% exposure to ready-to-drink beverages like Smirnoff ice. 

Beer: Struggling

Diageo has a 15% exposure to beer – primarily via Guinness. Large, legacy beer brands have been pressured for a number of years due to both a shift towards spirits as a substitute as well as the rise of craft beers. Diageo’s beer sales have been roughly flat from 2013 to 2018 in the Asia-Pacific region, North America, and Europe, while it has continued to grow 3.5% per year in Africa and 1.2% per year in Latin America. COVID has hit Diageo’s beer business even harder than its spirits business, as much of its beer exposure is in Africa and Europe, where on-trade (bar and restaurants) makes up a majority of its business.

While COVID is a temporary headwind, the shift away from beer is not. I do feel as though Guinness is one of the most differentiated and authentic large beer brands in the world with a dedicated following among those who enjoy dark beers. Within a beer universe where the “artisanal” is increasingly cherished, Guinness is one of the only large beer brands unlikely to get you mocked for consuming it by beer snobs. On top of that, beer is only 10% of Diageo overall profits, which means the company’s overall exposure - should beer trends markedly worsen - would be limited. 

Growth Prospects for Diageo

Diageo owns the #1 or #2 brands in nearly every liquor type. So, as consumer preferences inevitably shift, Diageo is always there to meet the customer. If the tide turns back to vodka and rum, Diageo is well-positioned. And if gin and tequila remain hot, it has good exposure there as well. Alcohol isn’t going anywhere – people have drunk booze for centuries and they will continue to in the future. No matter where fashions and tastes go, Diageo is poised to meet demand. 

Diageo’s brands, marketing and market position also play well with the major consumer trends driving the alcoholic beverage market globally: premiumization, health & wellness, and the growth of the middle class. 

Premiumization is the industry term for how consumers move up the pricing ladder of alcohol as they grow wealthier. Cheap liquor (or beer) usually costs just cents per drink - this is the value segment. But moving up the pricing tier to something much better tasting generally only costs a $1 or $2 per drink. Thus, when consumers grow wealthier, better alcohol is one of the first things they will choose to spend their money on. It is a luxury to pay $2 for a beverage, but a rather affordable luxury. Paying up for a super-premium bottle of booze at $35 or $40 is a lot cheaper than paying up for a luxury home, car, or vacation. Ordering better spirits is a way to treat oneself, but still is a relatively small expenditure within a middleclass budget. The consumer orientation towards premiumization has led to liquor companies to successfully take pricing year-after-year in ever-wealthier countries. 

Trading up in liquor is also much cheaper than trading up in wine. A 750 ml (“fifth”) bottle contains 17 shots (enough for 17 mixed drinks). Going from a $15 bottle to a $50 bottle will offer a big taste (and prestige) upgrade, but only cost about an incremental $2 per serving. Taking a similar upgrade on a bottle of wine – going from $15 to $50 per bottle – will cost $7 per serving (as there are 5 glasses of wine in a bottle). 

In the developed markets, this trend has played out with consumers moving from premium brands to super-premium and ultra-premium brands. Premiumization is a secondary growth driver in developing markets, as the aspirational middle class is growing quickly in these markets…. although in developing markets, the upgrade may be from a local or mainstream brand to a global standard brand versus a premium one.  

This premiumization trend should drive low single digit pricing growth in both the emerging and developed markets.

A second theme in the industry is the health & wellness trend. Currently, there is a trend amongst Gen Zers and Millennials to focus more on holistic health. The rationale is twofold: 1) because it is actually better for you to do so and 2) because there is a desire / need to be camera-ready all the time – thanks to ever-present social media. This trend is showing up in drinking habits, as younger generations (Millennials and Gen Z). In fact, people in their early 20s are drinking 20% less these days compared to previous generations at the same age. 

Despite the reduction of alcohol volumes consumer in key younger cohorts, alcohol’s wallet share has remained unchanged. Younger generations are just choosing to have fancier drinks like a Fever Tree and Tanqueray at a bar for $15 rather than three beers for the same price. While this has somewhat hurt overall volumes for spirits, this has been more than offset by share gains (from beer). The spirits industry has benefitted further, as consumers are also drinking more expensive spirits – less drinks means more money available to be spent on each drink. It’s truly quality over quantity for many people these days. The health & wellness trend has primarily been a driver of growth through premiumization in the developed markets, but it’s likely this wellness trend will eventually spread globally over time as regional household wealth grows in developing countries and social media continues to export trends from the developed markets into developing ones. 

Also in the developing markets, the rise of the middle class should drive mid-single digit growth in volumes for years to come, as the developing market population both ages (gets to drinking age) and grows wealthier. Diageo expects that there will be 750 million new customers for them to tap into by 2030, with the vast majority coming from developing markets. 

In particular, Diageo’s 10% sales exposure to India via its USL (acquired) subsidiary should do well, as the Indian market is both young (45% of population < 25 years old), is growing wealthier (see below), and drinks far less than its peers (see below). India alone is projected to add 300 million middle income households and add 60+ million affluent households by 2030. 

Source: DEO Capital Markets Day 2019

Source: DEO Capital Markets Day 2019

Putting it all together, Diageo should experience low to mid-single digit topline growth in developed markets – 58% of revenues – and experience mid to high single digit ex-FX topline growth in emerging markets – 42% of revenues. 

Outside of the topline growth, Diageo has found scale cost efficiencies leading to an average of 40bps to 50bps of margin expansion annually. This kind of continued incremental margin improvement is common among CPG companies with global scale and strong market positions within their category. Moving forward, Diageo should be able to continue to expand upon its healthy 30%+ pre-COVID operating margins at a similar rate via smarter marketing (using more data to make better ROI-based decisions with regards to traditional and digital advertising, experiential, on-trade activations, in-store display, and sampling), intelligent automation (for variable costs within COGS, digital tech can improve commodities sourcing, use AI to predict maintenance activity and use data analytics to improve truck fill rates), and using more tech within the office (like Zoom to replace some travel in a post-COVID world). 

Risks to the Business

A big knock against the alcohol industry is evolving consumer preferences. Consumers tastes can be fickle and shift quickly and violently – as we have seen in the move from rum and vodka to gin and tequila. Taste preferences will undoubtedly continue to evolve and shift over time… but with a brand portfolio that is diversified by spirit and price level, Diageo is well-positioned to meet nearly every possible consumer preference that might trend. Owning the #1 or #2 brands in nearly every liquor category offers a natural hedge for investors. And when it has found a hole in its portfolio, it has historically successfully filled it with M&A (and has the persistent cash flow to do so). 

The health & wellness trend of drinking less but better quality is likely to persist long-term, which should keep the wind in the sails of the profitable premiumization trend, although it will pressure volumes.

The other main knock against the business and industry is its correlation with rates – meaning rising rates would be a big negative given its 4% earnings yield and premium multiple to the S&P. That being said, I’m more worried about the multitude of tech companies trading at 100 P/E or more when it comes to rates, or companies battered by the pandemic that have swaths of new floating rate debt on their books. 

While increasing rates would be negative for Diageo’s stock, I think DEO shares offer good relative value and current business conditions are arguably as bad as it gets for this normally stable business, so better times are ahead… and likely to hit before materially increased rates do.

Valuation

Relative to alcohol peers, DEO is the cheapest on a forward P/E basis with margins the second highest in the group. 

Operationally, the company should be able to grow in the MSD range (3% to 5% or so) and gain 40bps of margin improvement a year. This leads to 5% to 7% bottom line growth. 

On top of that, the company pays a 2%+ dividend that is more than covered by free cash flow ($2bn in dividends paid in 2019 vs. $$3.3bn in FCF). The remaining cash flow is used to either bring down debt to their target leverage of 2.5x to 3.0x, M&A, or return cash to shareholders via buybacks. Pre-COVID, the company repurchased $2bn to $3bn of stock annually. 

Currently, the company is slightly over-leveraged vs. their internal targets but this is mostly due to COVID. Assuming EBITDA returns to pre-COVID levels – which I believe is very likely post-pandemic – leverage is a touch over 3x, indicating some cash could be directed at debt paydown in the more immediate term. In the longer term, I see no reason why the company cannot return to repurchasing 1% to 3% of shares annually thanks to excess cash flows. 

Putting it all together, I believe that DEO should compound at a ~10% rate on average for years to come. I think it could do much better than that in the next year given the company is currently trading at a multiple of COVID-impacted earnings (10% to 15% hit from on-trade being closed) and its current relative multiple is depressed versus historical levels. A normalization of its relative multiple should accompany its return to its pre-COVID earnings power, offering the potential for a 15-25% return over the next year, with much less risk than the average stock in the market. 

Catalyst

1) Vaccines/reopening of the economy (bars and restaurants specifically) leads to earnings recovery

2) Likely boom in socializing and going out post-COVID

3) Resumption of buybacks