Bloomberg reported on Tuesday afternoon that Diageo (DGE) is in talks to acquire Jose Cuervo, the world's largest tequila brand, to which Diageo already holds international distribution rights. We think the deal would make perfect strategic sense, although at the rumoured valuation of £2 billion, it would have no material impact on our fair value estimate. Ownership of this important brand, if the report is true, would give Diageo control over the brand's marketing message and positioning within the portfolio. If the rumoured price is accurate, however, we estimate that it would represent around 3 times sales, a slightly rich valuation, but not outrageous given that Diageo would be able to cut cost from Jose Cuervo's back-office functions. More significantly, however, is what this deal implies for any potential deal for Fortune Brands FO in the coming months. Fortune is breaking up into its component parts (beverages and home and security, with the golf business already sold), and we think Diageo will be interested in acquiring the beverages segment. Jim Beam is a strong bourbon brand and would plug a gap in Diageo's portfolio. However, Fortune also owns Sauza, the world's second-largest tequila brand, and we suspect that Diageo would be forced to sell the brand on antitrust grounds, if it acquires Jose Cuervo. Nevertheless, we do not think this will be a deal-breaker for Diageo, and we expect the firm to take a close look at Fortune Brands after its breakup.
The Irish Times also reported yesterday that Diageo is restructuring its operations in Europe. The move will likely involve cost cuts and the loss of some jobs in the region. We have been saying for some time that the volume declines in Europe may be not only cyclical but also, at least in part, structural. In markets such as Spain, where much of Diageo's pre-2009 volume was captured in on-premise locations between the hours of 10 p.m. and 4 a.m., a sharp decline in late party activities during the last two years has driven steep double-digit declines in volumes. If yesterday's story is true, it could lend support to our view that volumes may not rebound to prerecession levels for many years to come in some Western European markets. Despite its troubles in Spain and Greece, however, Diageo is still one of our favourite consumer-staples companies. Its phenomenal scale and brand strength give it solid competitive advantages across many markets throughout the world, and its presence in emerging markets should ensure that the company grows its top line for many years to come. We regard Diageo as a safe haven from inflation due to the multiyear maturing process of around one third of its volume, but with the stock trading at around 16 times fiscal year 2011 earnings and 14 times cash flow from operations, we recommend waiting for a more attractive level before creating or adding to a position.
