Diageo Looks Good Enough to Drink

In the world of consumer goods, we have all seen some products become immensely popular almost overnight, and then fade into obscurity almost as quickly. Alcohol is most definitely not one of those products.

According to a recent Gallup poll, 64% of those surveyed said that they drink alcoholic beverages. That percentage has held steady for decades; a similar survey conducted in 1939 showed an almost identical reading of 63%.

However, while the overall percentage of drinkers has remained level, those that do imbibe are doing so more frequently these days. Of those polled who drink, nearly 75% said they had consumed a drink within the past week -- a sharp increase from the 54% who had done so in the 1996 survey. Furthermore, ten years ago the average drinker consumed just 2.8 alcoholic beverages per week. That figure has since risen to around 4.5 per week.

Beer remains on top as the nation's drink of choice. However, the wine and spirits groups have closed the gap markedly in recent years, and they now sit close behind. Around the country, many drinkers, particularly the trend-conscious younger crowd, have been increasingly ordering a glass of wine or a splashy cocktail over a bottle of beer.

While per-capita beer consumption has been flat over the past several years, wineries and liquor distillers have seen an uptick in their business.

Major Players in the Alcoholic Beverage Industry

Thanks to several waves of global consolidation, the total number of breweries and distillers has declined sharply over the past several decades. As a result, the pool of potential investment candidates has narrowed somewhat.

However, each of the four companies listed above is worthy of additional consideration. Of these, we believe industry leader Diageo (DEO) has the most to offer investors.

A Closer Look at Industry Leader Diageo
Diageo is the world's largest distributor of beer, wine, and spirits. The company produces, packages, and distributes a wide range of premium products in more than 180 markets around the world.

Many of the world's most popular brands fall under the Diageo umbrella, including: Crown Royal, Guinness Stout, Johnny Walker, Smirnoff, Captain Morgan, Jose Cuervo, and Tanqueray. Better still, industry insiders have noted that many consumers are migrating to high-end premium brands -- playing right into Diageo's strength.

Along with a bright revenue picture, Diageo also enjoys powerful economies of scale, intoxicating net profit margins of around 22%, and very low capital requirements. Last year, the company's capital expenditures ($549 million) only amounted to about 3% of total sales ($16.8 billion). As a result, DEO is able to generate barrels of annual free cash flow -- much of which it uses to fund a $2.29 (ttm) annual dividend payment, which equates to a yield of about 3%.

Clearly, DEO is the "800-pound gorilla" of the alcoholic beverage space, with revenues and profits that exceed those of the other three firms on the above list combined. Last year, the company reported staggering sales volume of 91 million cases -- around 15 million more than its closest competitor.

Not surprisingly, Diageo enjoys considerable scale advantages over many of its peers. At the same time, the firm's earnings outlook is among the brightest of the bunch. Yet despite these positives, of the four stocks above, DEO is still trading at the steepest discount to fair value.

Last Call
The alcoholic beverage business is a mature industry. As such, there are limited opportunities for strong top-line growth, particularly in developed markets. Nevertheless, stepped-up marketing efforts industry-wide continue to pay off, siphoning market share away from leading brewers like Anheuser-Busch.

All things considered, the major producers of wine and spirits have many reasons to smile. Chances are virtually nil that consumers around the world will suddenly lose their thirst for alcoholic beverages, so demand for their high-margin products is all but guaranteed. With this in mind, conservative investors who are drawn to steady, predictable revenues and cash flows might want to sample something from the alcoholic-beverage group.

Disclosure: Author is long DEO