Brian Gaudet's  Instablog

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 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: