Description

Diageo PLC (DEO-- $51.23 for the ADR, DGE LN is London Ticker).

Diageo PLC, trough a series of restructuring transactions, has evolved into a virtually pure-play spirits company. Its recent journey began with the almost completed sale of General Mills holdings (more later), purchase of Seagrams Brands, and the recent sale of Burger King. Diageo is the leading world-wide spirits player. Its brands include Smirnoff (#1 in Vodka), Johnnie Walker (#1 Scotch Whisky), Gordons (#1 Gin), J&B (#2 Scotch Whisky), Jose Cuervo (#1 Tequila), Baileys, Guiness, Crown Royal and Captain Morgan. While the stock has moved quite a bit over the last six months, given the quality of the business and its valuation, we believe it to be a great long-term holding.

We believe the spirits business to still be one of the great “franchise” types of businesses across the board. There is still unit growth as well as pricing power overall across its business. In the US, spirits are gaining share from beer. It is an addictive product, and people care very much about choice of brand. Additionally, in contrast to beer, it has much less exposure to more price competitive channels like supermarkets and convenience stores. In Asia, gift-giving of the company’s high-end brands has become somewhat customary among diplomats and corporate leaders. DEO’s world-wide exposure may help to insulate it from major currency movements over time as well as developments in any single market.

The company’s EBIT margins are roughly 20%, and ROE exceeds 30%. The US represents about 38% and the UK and Ireland represent about 15% of operating income. Overall, in terms of top line, sales are broken down 74% spirits, 14% beer, 4% wine, and 8% ready to drink.

The main fundamental concern has to do with potential growth in unit volume. Growth has been modest—although positive-- (the category essentially mature) without new product introduction although the top brands do not have as large a market share as other categories (beer and soda). DEO has been a pioneer in the Ready to Drink category with products like Smirnoff Ice. After a very rapid start, sales have slowed from what was expected. So this remains a concern. We would note that Brown-Forman did a dutch-auction buy-back earlier this year. They have done of few of these over the years, and they have been very opportune in their timing, both in terms of the stock price as well as business fundamentals.

The company has a net 3.4% dividend yield and it has been a buyer of stock. We expect the company to buy close to $1bn of stock this year. Once General Mills clears its SEC investigation, the company will be able to begin to liquidate its remaining stake. This should facilitate further buy-backs over the next 6 months. The company is levered less than three times with about $US9bn of debt, so it is in an extremely strong financial position. If one backs out the value of the Moet joint venture (see below), it is levered closer to 2x. The company’s equity market capitalization is close to $40bn.

Valuation is in line with UK comparables (like Allied Domecq), and this is a concern that valuation will continue to be set in the UK. However, we believe DEO to merit a higher multiple given its larger market shares. Additionally, it is at a sizeable discount to US companies like Budweiser and Brown-Forman, a gap which we expect to narrow as the company sells its GIS stake and becomes better known in the US. For a USD $40bn market cap company, it receives very little attention here.

In terms of valuation, DEO is at 15.5x this year’s FCF estimate of $3.30/share as opposed to about 20x for Brown-Forman and Budweiser. We prefer an EV to operating income metric. On this metric, Brown-Forman and Bud have mid-teen multiples. DEO works out to roughly 13.5x EV/EBIT. The company has roughly 3.3bn dollars of EBITDA-Capx, excluding income from its joint venture with Moet-Hennessey which distributes champagne and cognac and its earnings from its General Mills stake. The EV is $39.7bn for equity+8.7 of debt+ roughly 2bn for pension liabilities-3.7bn for GIS stake-2bn of book value for its 40% stake of the Moet venture (clearly too low)—for a net EV of roughly $44.7bn.

For a company of this quality financial strength with near term events and a demonstrated desire to buy back stock, we think DEO both an attractive short-term and long-term investment candidate.

Catalyst

sale of General Mills Stake, share buy-backs, greater recognition in the US