Description

Diageo (DGE.LN, DEO) – Long Idea
Fiscal Year End: June
All figures in millions of GBP unless otherwise noted

Shares Out: 3.1m
Price: 734p
Mkt Cap: 22,566
Net Debt: 4,724
GIS Shares: 667
EV: 26,173

2004 2005E 2006P
Net Revenue 6,862 6,786 7,159
EBIT 1,911 1,920 2,035
EPS 48.2p 43.6p 46.3p
Free Cash Flow 1,449 1,199 1,253

Description: Diageo PLC is the largest premium spirits company in the world. The company owns or distributes 9 of the top 20 premium spirits brands in the world including Smirnoff, Johnnie Walker, Crown Royal, Tanqueray, Jose Cuervo, Bailey’s, J&B, Captain Morgan and Guinness Stout. Many of these brands are leaders in their segments. The company also owns a 34% stake in Moet Hennessey, which owns the Hennessey cognac brand and several Champagne brands. Diageo’s 4 largest markets by sales are North America (35%), Great Britain (12%), Ireland (9%) and Spain (5%).

Spirits is an attractive business with EBIT margins close to 28% for Diageo (excluding excise taxes) and post-tax returns on tangible capital close to 35%. The customer base is highly fragmented and price-insensitive as the majority of sales occur on-premise (bars, restaurants) in most markets, and there is low substitutability across brands. Most brands have existed for decades, and little is required in the way of R&D or capital investment, although significant marketing support is required. Moreover, in several large markets such as the US and the UK, spirits is taking share from beer as a younger generation of consumers that prefers mixed drinks enters the market. Finally, the competitive dynamics are attractive with 5 major players - Diageo, Brown Foreman, Allied Domecq, Pernod Ricard and Bacardi – controlling most of the market share. Diageo is well over 2x the size of its next largest competitor.

Diageo generates well over 1b GBP of cash flow per annum and returns almost 100% of cash to shareholders via dividends and buybacks. Management is highly focused on ROIC and has a long track record of creating value for shareholders. Over time they have shed non-core businesses (Pillsbury, Burger King) and made smart acquisitions, like the Seagram’s brands.

At this price, Diageo is trading at a 5.7% free cash yield (treating as cash the General Mills shares, which will likely be sold next year, as cash). The capital structure is conservative with 2x debt / EBITDA. Management believes 6% long term growth is achievable, driven 50% by organic volume and 50% by price/mix improvements. Thus, the shares offer a stable, low-risk 12-13% return from here.

Catalyst

None. You are buying a very good business at a very good risk-adjusted return.