Once again, Diageo (DGE) is paying a full price for an acquisition target. The company's purchase of the tequila brand Casamigos for $700 million with the potential for an additional $300 million in long-term performance-based consideration, is neutral to Morningstar analysts’ valuation of Diageo at the low end of that range, and modestly dilutive at the high end. We are maintaining our £22.50 fair value estimate because the deal is relatively small for Diageo, less than 3% of North American sales.
The stars must line up perfectly for this deal to create value
We still believe Diageo has a wide economic moat, based on its dominance in several large categories and its broad product portfolio, but bolt-on deals like this highlight an emerging risk for investors in many large-cap consumer product manufacturers--the loss of market share to craft and artisan products.
The stars must line up perfectly for this deal to create value, in our opinion. Diageo disclosed that Casamigos sold 120,000 cases last year and should sell 170,000 this year. At these volumes, we estimate sales to be in the region of $85 million this year and $120 million next year, assuming the 40% volume growth rate can be sustained.
If that level of growth is maintained, it is reasonable to assume that the undisclosed performance targets will be met and the full $1 billion will be due, valuing the company at an eye-popping 11.5 times 2017 sales and eight times 2018 sales.
What is in it for Diageo?
Diageo is chasing growth with this deal. Diageo has struggled in recent years with organic growth rates in the low-single digits, due to both stagnant volume growth and soft pricing. The tequila category, however, has been one of its bright spots, with 9% volume growth in the first half of the fiscal year and double-digit pricing.
The emergence of Casamigos underscores the growing threat from craft products. Consumers, particularly affluent and aspirational younger consumers, are increasingly turning their backs on the big brands in favour of small, independent brands, often with health and wellness credentials or regional heritage. A trend that began in the U.S. is now spreading to spirits (the U.K. gin industry is becoming highly fragmented with independent distillers, for example), food and personal care. The challenge the big distillers face is how to meet this demand with niche type products but with sufficient scale to maintain margins.
Diageo has been somewhat successful in this regard with Haig Club single grain scotch, with the help of a celebrity endorsement from David Beckham, and Bulleit bourbon. Casamigos plays into this craft trend, and is something of a unique asset in that it was founded by, not simply endorsed by, celebrities.
The cofounders include the actor George Clooney and Cindy Crawford's husband Rande Gerber, who claim to have initially produced the brand for personal consumption and "tequila filled nights." We assume Clooney will continue his association with the Casamigos brand after the transaction closes, but we believe this is an expensive way of acquiring a celebrity association.
Threat from Trump
We are also concerned that Diageo is doubling down on the U.S. tequila market at a time when the Trump Administration is considering imposing trade barriers with Mexico. We believe Casamigos retails for $50, on average, for a 750 ml bottle, putting it in the premium segment which targets the relatively price-elastic aspirational consumer.
The retail price could soar if a border tax is imposed, risking a severe slowdown in volume growth. Even allowing for the optionality inherent in the deal structure, we think such a sequence of events would make the deal value destructive. With limited visibility into the trade policy between Mexico and the U.S., it strikes us that this is a risky time to be paying a full price for tequila pure play.
