Diageo: The Coca-Cola of the Alcoholic Beverage Industry?

Although – with the possible exception of a rum and Coke – Diageo (DEO) and The Coca-Cola Company (KO) do not seem to have much in common, I believe both are excellent companies with many of the same sources of competitive advantage.

Like Coca-Cola, Diageo has a large-scale global distribution network that provides a formidable barrier to entry. In particular, Diageo’s large scale production and global distribution channels give it economies of scale, and the strong brands give the company guaranteed shelf space in stores and bars (at the expense of potential market followers). And retailers have an incentive to reserve shelf space for premium spirits as the retailing margins are higher for these products. Diageo also gains economies of scale in advertising. The following table nicely illustrates Diageo’s scale in advertising during 2008:

Although Diageo’s products are more expensive than soft drinks and juices, purchases of the company’s products are a small enough fraction of consumer’s budgets that there is relatively low volume sensitivity to price. Diageo’s pricing power was recently demonstrated with the fall of emerging market currencies with respect to the dollar, euro, and pound. Rather than keep the price of their products constant in local currency, they increased price to minimize transaction loss, with a minimal loss of volume.

Another similarity with Coca-Cola is how Diageo leverages its global distribution network to add value by marketing and acting as a distributor for other company’s brands, sometimes by purchasing the brand outright, and other times through joint ventures. Some examples are the joint ventures with Moet-Hennessey, Jose Cuervo Tequila, and Kettle One Vodka.

Operating History:

Over the last nine years, demand for Diageo’s products has been steady, although, as would be expected, 2009 broke the company’s long track record of increasing organic volume growth. But considering that this is the worst global recession since the 1930’s, Diageo’s 2009 performance is remarkably stable. The fact that Diageo competes in multiple price categories: value, popular, premium, super premium, and ultra premium was a factor in the company’s strong performance during the last two recessions. Multiple price categories allow customers to trade down during tough economic times, and also helps fill retail distribution channels, blocking potential competitors. The data in the following table is from Diageo’s alcoholic beverage business.



Future Prospects:

I believe Diageo’s long-term prospects are very favorable. Although volume is growing slowly in United States and Western Europe, it is growing faster in Eastern Europe, Russia, Africa, Middle East, Asia, and South America due to higher penetration resulting from higher per-capita GDP growth rates allowing consumers to purchase global brands. This developing market growth provides a large upside to the company’s future prospects. For example, 2007 sales in North America were $3,000M, whereas the combined revenue for the rest of the world excluding Europe (with a population over ten times that of North America) was $3,455M. The potential for developing economies is evident in Eastern Europe and Russia, which provided 2/3 of European sales growth in 2007, with volume growth of 25% in Russia and 13% in Eastern Europe. Similarly, Africa had 2007 beer revenue growth of 19% and spirits revenue growth of 21%.

Management:

Since the spin-off of Burger King (BKC) and Pillsbury, management appears focused on Diageo’s core business of the distillation and distribution of alcoholic beverages. Management is striking a good balance between re-investing in the business and returning cash to shareholders in the form of dividends and share buybacks, as indicated by the steady track record of organic revenue growth, and a high return on retained earnings.

Valuation:

My estimate of Diageo’s intrinsic value is $64 per share. Since the market price is currently $61.71, Diageo is fairly valued.

Disclosure: I own shares in both Diageo (DEO) and the Coca-Cola Company (KO).

Comments

[No Moss:]

Good comments on Diageo. You capture the essence of Diageo, that is, unmatched stable of brands and unmatched scale of marketing and distribution. The marketing leverage comes from the fact that their marketing and distribution infrastructure is scalable, that is, it doesn't add a lot of expense to take on another brand. You can see the benefit to Diageo and the mannufacturing company in their recent agreement with Grand Marnier.

You can see a direct relationship between Diageo and the British Pound. Intuitively, the stock should benefit from the fall of the British pound in the last year (and vice versa for its recent rise). However, the stock is widely held internationally, so in fact it seems to fall on the Pound's weakness and rise on its strength.

Try comparing a chart of the British Pound to the price of the stock over the last year.

You don't mention how you arrived at the value of $64. I'd be surprised if the stock remained in the sixties once the growth in volume resumes, and I expect that to be the case this year (fiscal year ending June 30th, 2010). You have to remember that fiscal year 2009 coincided with the worst recession in modern memory.

You might want to check the spelling of Ketel One.

Sep 28 10:56 PM

[Brian Gaudet:]

No Moss,
I had included a couple of links to the derivation of intrinsic value, but the editors removed them. The basic approach is in this article: seekingalpha.com/artic...


On Sep 28 10:56 PM No Moss wrote:

> Good comments on Diageo. You capture the essence of Diageo, that
> is, unmatched stable of brands and unmatched scale of marketing and
> distribution. The marketing leverage comes from the fact that their
> marketing and distribution infrastructure is scalable, that is, it
> doesn't add a lot of expense to take on another brand. You can see
> the benefit to Diageo and the mannufacturing company in their recent
> agreement with Grand Marnier.
>
> You can see a direct relationship between Diageo and the British
> Pound. Intuitively, the stock should benefit from the fall of the
> British pound in the last year (and vice versa for its recent rise).
> However, the stock is widely held internationally, so in fact it
> seems to fall on the Pound's weakness and rise on its strength.<br/>
>
> Try comparing a chart of the British Pound to the price of the stock
> over the last year.
>
> You don't mention how you arrived at the value of $64. I'd be surprised
> if the stock remained in the sixties once the growth in volume resumes,
> and I expect that to be the case this year (fiscal year ending June
> 30th, 2010). You have to remember that fiscal year 2009 coincided
> with the worst recession in modern memory.
>
> You might want to check the spelling of Ketel One.

Sep 29 10:53 AM

[benitocamela:]

Moss good article, although my take on them is that their management is not up to par, compared to KO. They have let, for example, Spain the cash cow of the Grand Met days run down, due to silly "strategic" reasons. They have lost their advantage of covering the entire trade, like KO does, by relying more on wholesalers. They should expect more of themselves.

Oct 14 09:35 AM