Fair Value Estimate: 1250p | Uncertainty Rating: Medium | Economic Moat: Wide
Thesis (Last Updated 11/02/11)
With eight of the world's top 20 brands and an unrivalled global distribution platform that spans 180 countries, Diageo (DGE) has a wide economic moat, in our opinion. We like the firm's focus on premium brands, but we expect growth to be harder to achieve over the next few years than it has been in the past, and we worry that the weak economy could provoke management to make a pricey acquisition.
Diageo is the world's largest spirits maker, and the strength of its portfolio is unmatched. Brands such as Smirnoff, Baileys, Johnnie Walker, and Jose Cuervo are number one in the world in their respective categories, and the firm's portfolio includes other heavy hitters such as Guinness, Tanqueray, and Captain Morgan. Diageo is particularly dominant in North America, where, driven by consumer demand for its leading brands, it has built a sustainable competitive advantage in its distribution network. In the United States--the most profitable spirits market in the world--Diageo has consolidated its distribution base, where allowed, to one exclusive agent per state, or 80% of its total US volume. This exclusivity is highly profitable and has resulted in operating margins in North America in excess of 35%, well above the firm's average in the high 20s and higher than most of its competitors'.
Despite its best-in-class product portfolio, Diageo's performance has been dented in recent quarters by elevated unemployment and economic contraction in some key markets. As a result, demand has fallen and consumption has switched to the less profitable at-home channel as consumers have frequented bars and restaurants less often. In addition, the long-term trend of premiumisation came to an abrupt halt during the recession as adult drinkers switched to cheaper brands. Despite these headwinds, we think Diageo did a reasonable job of managing through the recession. It cut prices in order to keep customers loyal to spirit categories and loyal to Diageo's brands, and we think this strategy will hold the firm in good stead when consumer spending rebounds. However, in an environment of high unemployment and a lingering threat of a double-dip recession in some markets, that rebound may be a long time coming, and we expect consumers to be more cautious on their discretionary spending in the medium term.
We applaud the firm's strategy over the past 10 years of spinning off noncore operating businesses and concentrating on its core competencies in the spirits industry. Having said that, Diageo's beer portfolio is important to future growth because beer is a gateway to other alcoholic beverages such as spirits. We think the Guinness brand will play an important long-term role in driving migration to spirits in emerging markets such as Africa.
Valuation
Our fair value estimate is 1,250p per share, which implies fiscal 2011 price/earnings of 16 times, enterprise value/EBITDA of 12 times, and a free cash flow yield of 6.0%. We have boosted our 2011 revenue growth assumption to 3% from roughly flat, following some strong macroeconomic data that suggests on-premise traffic might grow more than we had originally anticipated in the next six months. However, continued high unemployment is likely to limit volume growth and demand premiumisation. In the long term, we expect Diageo to generate average annual revenue growth of between 4% and 5%. We expect a resumption of premiumisation and growing disposable income in emerging markets to drive greater economies of scale during the next decade, and we forecast 160 basis points of operating margin improvement during our 10-year forecast period from the 26.3% achieved in fiscal 2010. Diageo has taken advantage of low advertising rates in fiscal 2010 to lower operating costs, but as rates rebound, we expect marketing expense to represent almost 15% of revenue in the long term, more in line with historical levels and above the 14% spent in fiscal 2009. We do not forecast any acquisitions, which could change our fair value estimate depending on the timing, size, and price paid for such deals.
Risk
Foreign currency fluctuations can cause large swings in Diageo's financial performance and, therefore, our fair value estimate. Diageo's acquisition strategy is inherently risky and could destroy shareholder value in the event that the firm overpays for an acquisition. Finally, spirits companies are subject to heavy regulation and taxation, both of which can change rapidly, even in developed markets.
Management & Stewardship
Paul Walsh, a veteran who started at Grand Metropolitan in 1982 and spent a decade running Pillsbury, stepped into the CEO role in 2000. Walsh has been the driving force behind Diageo's strategy to shed noncore businesses in order to focus on spirits. Franz Humer, a director since 2005, was appointed board chairman in July 2008 following the retirement of James Blyth, who presided as chairman for eight years. We applaud the separation of the chairman and CEO roles and the fact that Diageo's 11-member board has 9 independent members. We don't see any red flags in corporate governance. Compensation levels seem consistent with those at comparable companies, and the CEO's and CFO's salaries were flat in 2009 to reflect the performance of the company. About 70% of compensation is variable, based on both annual and longer-term performance. Management and shareholder interests appear well aligned. The only gripe we have is that directors do not stand for elections annually; we think the company could strengthen its governance policy by removing staggered board elections.
Overview
Financial Health: Diageo is in comfortable financial health, but it is quite highly leveraged and its employees' pension fund is underfunded. Debt/capital was 0.7 at the end of fiscal 2010, although EBITDA covered interest expense by a relatively healthy 5.5 times. Diageo generates free cash flow to the tune of around 20% of revenue, and it should be able to direct some of that toward paying down debt. We expect free cash flow to also be used to close the funding gap in the company's defined-benefit pension scheme, which was £ 1 billion underfunded at the end of June. Although asset prices have rebounded since that time and the hole in the funding will have closed somewhat, we expect the pension funding to provide a drag on cash flow for several years. Our credit rating for Diageo is A-. The firm could suspend share repurchases and cut its dividend, which is currently yielding 3%, in the event of a liquidity crisis.
Profile: The product of a merger between Grand Metropolitan and Guinness in 1997, Diageo is the world's leading producer of branded premium spirits. It also produces and markets beer and wine. Brands include Guinness stout, Smirnoff vodka, Tanqueray and Gordon's gins, Captain Morgan rum, Baileys Irish Cream, and Johnnie Walker scotch. Diageo also owns 34% of premium champagne and cognac maker Moet Hennessy, a subsidiary of French luxury goods maker Moet Hennessy-Louis Vuitton.
Bulls Say
-- Diageo is the largest spirits maker in the world, with 8 of the world's top 20 brands and a distribution platform that spans 180 countries.
-- In the longer term, consumers in emerging markets are likely to trade up to premium spirits brands, where Diageo's portfolio is positioned.
-- Diageo controls exclusive distribution rights where allowed in the US, where no single competitor has achieved a similar feat. This has contributed to above-average profitability in the region.
-- Emerging markets are growing at a much faster clip than the rest of Diageo's operations, and the firm has been quick to establish a foothold in distribution and marketing.
Bears Say
-- Diageo's premium positioning could make near-term top-line growth more difficult if consumer spending continues to be sluggish in the medium term.
-- Diageo manufactures products that contain a potentially addictive drug, leading some people to label the equities of alcohol purveyors as vice stocks; certain classes of investors will not own vice stocks regardless of price.
-- One of the company's largest brands, Jose Cuervo tequila, is not owned by Diageo outright, but is an agency brand manufactured and distributed under license. This license extends through 2013, and it is uncertain whether Diageo will retain the brand after that.
-- Consolidation in the spirits industry has created competitors that, once dwarfed by Diageo, are now approaching the company's scale. Pernod Ricard has bulked up considerably after buying V&S (maker of Absolut) and carving up Allied Domecq.
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