Diageo Is The Best Alcohol Stock To Buy Now Using Key Value And Income Metrics

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Includes: ABEV, BF.B, BUD, CCU, DEO
by: Dave Hickling
Summary

Alcohol stocks are one of the best industry sectors for investing.

Screening metrics focusing on enterprise value, operating income, and debt are emphasized.

After screening 12 alcohol stocks, Diageo is my only new investment at this time.

Alcohol is a great business due to strong consumer demand. About 50% of the world's population drinks alcohol. When you consider that 35% of the world's population belong to religions that do not permit drinking alcohol and 26% of the world's population is under the age of 15, it seems that everyone who can drink alcohol does ("nudge, nudge, wink, wink" on the numbers)! Alcohol consumption is so well entrenched as a self-medication in our global cultures that people continue to drink no matter what the situation. Conventional wisdom says that the alcohol industry is "recession-proof". In fact, it is more accurate to say that is "recession-resistant". Overall, there is less spending on alcohol during recessions, especially with higher unemployment rates. But the difference is usually small (<1%), and the level of binge drinking among some demographic groups increases with unemployment.

Alcohol is a strong business to invest in. The alcohol industry has one of the highest profitability levels of any industry. A comprehensive, and very informative, analysis was made by Philip Campbell in 2018 which compares profitability metrics across industry sectors. The range is huge and shows the importance of comparing profitability between companies within rather than across sectors. Tobacco (another sin stock) is first with an operating margin of 43%. Tobacco is followed by some financial and internet software stocks from positions 2 to 6, and the alcohol sector is in 7th place with an operating margin of 21% (the best alcohol stocks have operating margins over 30%). A good operating margin is important in measuring company management performance as well as a company's ability to withstand economic headwinds.

This is my third Seeking Alpha article on alcohol stocks, and I have owned shares in Ambev (ABEV) and Brown-Forman (NYSE:BF.B) for a long time. The reason that I am writing this third article is to incorporate some of my current thoughts on the best metrics for screening stocks to look for additional investment opportunities in the sector. Current timing is also a potential opportunity. The recent downturn in the stock markets has hit some alcohol stocks hard - losing 1/3 of their value, while some other alcohol stocks have continued to increase in price. I am looking for undervalued alcohol stocks. In this article, I will discuss my screening methods and why Diageo (DEO) is the only stock to make the cut at this time.

Methods and Database

I have chosen 12 alcohol companies traded on US stock exchanges with a market capitalization of $300 million or higher (small cap and larger). The 12 are mainly spirits and beer companies and include the big guys like AB InBev (BUD) and Diageo.

I am looking at slightly different metrics than I have in the past. My "Better than Average Stock Selection system" that I discussed in earlier articles focuses on four main areas:

1. Value. I used PEG in the past

2. Management Efficiency. I used ROE in the past

3. Dividends. I used dividend yield in the past

4. Debt (leverage). I used D/E in the past

I have changed some of the metrics. As a measure of value, I now like EV/EBITDA instead of PEG. I am now using operating margin instead of ROE as a measure of management efficiency. I still use dividend yield, and I now use Debt/Operating Income (DOI) instead of Debt/Equity.

The reasons for these changes are:

EV/EBITDA vs PEG: PEG is basically market cap divided by net earnings adjusted for growth. There is nothing wrong with it, but I think that Enterprise Value gives a better measure of the total value of the company than market cap mainly because it includes debt. EBITDA is almost the same as net income, and the reason that I use EV/EBITDA rather than EV/Net Income is that the former is a widely reported metric. EV/EBITDA is commonly used by the venture capital industry to determine whether a company is undervalued and, therefore, a potential acquisition target. There are differences between industry sectors as to what is a good EV/EBITDA. For alcohol companies which have an average EV/EBITDA of about 18 then 15 or lower usually indicates that it is undervalued.

Operating Margin vs ROE: I am a big fan of Operating Margin. It really sorts the wheat from the chaff if you are looking at stocks in the same sector. It is straightforward and less subject to manipulation. It's a measure of how efficient a company is in generating profit strictly through controlling production costs, marketing costs, and overhead. To me, adding in interest, taxes, amortization and depreciation takes you further away from a pure analysis of how strong and well managed a business is. Usually, when you see big differences in Operating Margin between companies in the same sector you usually find that management inability to control costs is the main reason.

Dividend Yield: For a dividend investor like myself, it is a very important metric. Dividend history and Payout Ratio are also important dividend metrics but for an initial screen I look at DY.

Debt / Operating Income vs D/E. D/E is a very common metric, but equity by itself does not provide much information. Some investors use Debt/EBITDA, and in reality, the differences are small between that and Debt/Operating Income. As indicated above, I think that Operating income is a much cleaner and easier to understand metric than EBITDA which is why I use it. Financial institutions often use Debt Service Coverage Ratio/Income, rather than total debt as a way of looking at how well a company can cover its debt. There is nothing wrong with DSCR other than it is a snapshot analysis. I think that if you look at total debt relative to the income that supports it, you get a better picture of the overall ability of a company to handle adverse scenarios, especially when comparing companies within an industry sector. Also, I am a little suspicious that DSCR can be subject to financial manipulation. My mantra is: "keep it simple when it comes to income!" Since I am not an investment professional and do not have formal financial training, I invite readers that do have experience with DSCR to argue the opposite view.

By having Debt included in two of the metrics (EV/EBITDA) and Debt to OM, and Earnings included in two different ways (EBITDA and Operating Income), this allows for cross-referencing and double-checking the numbers. The debt measures should agree with each other, and the Income measures should agree with each other, and if they don't, then something is wrong.

First of all, here is the list of the 12 alcohol companies with some general financial information.

Table 1 Alcohol companies (small cap and larger) traded on US stock exchanges. Values as per Dec 7, 2018. $ Values USD Millions. Numbers are mostly from Yahoo Finance website and company financial statements when clarification needed.

Stock

Name

Price

Market cap, $M

Debt, $M

Div Yield %

Revenue, $M

Operating Income, $M

ABEV

Ambev

$4.08

$65,190

$1,320

4.76

$12,453

$4,255

BF.B

Brown Forman

$45.93

$22,240

$2,490

3.48*

$3,248

$1,051

BREW

Craft Brew Alliance

$15.80

$306

$11

0

$207

$6

BUD

Anheuser Busch InBev

$70.77

$136,550

$117,830

2.35

$56,444

$17,564

CCU

Compania Cervecerias Unidas

$25.03

$4,460

$457

2.34

$2,548

337

DEO

Diageo

$141.29

$85,630

$13,390

2.91

$16,176

$5,065

FARM

Farmer Bros

$23.98

$405

$102

0

$607

$5

FMX

Fomento Economico Mexico

$82.50

$31,040

$6,870

1.70

$22,562

$675

MGPI

MGP Ingredients

$61.56

$1,040

$45

0.45

$347

$43

SAM

Boston Beer

$265.90

$3,020

$0

0

$863

$118

STZ

Constellation Brands

$188.61

$35,870

$9,920

1.50

$7,585

$2,479

TAP

Molson Coors

$63.37

$13,680

$10,570

2.53

$10,930

$1,600

* includes special dividend

So, here are the key financial characteristics of the data set.

Table 2. Key value, management efficiency, dividend performance and leverage metrics of the 12 alcohol stocks traded on US stock exchanges - 2018.

Stock

EV/EBITDA

Operating Margin

Dividend Yield

Debt / Operating Income

ABEV

12.25

34.17%

4.76%

0.31

BF.B

22.09

32.36%

3.48%

2.37

BREW

16.68

2.90%

0

1.83

BUD

12.41

31.12%

2.35%

6.71

CCU

8.94

13.23%

2.34%

1.36

DEO

18.96

31.31%

2.91%

2.65

FARM

14.49

0.82%

0

20.40

FMX

16.20

2.99%

1.70%

10.18

MGPI

22.73

12.39%

0.45%

1.05

SAM

22.13

13.67%

0

0.00

STZ

16.29

32.68%

1.50%

4.00

TAP

9.87

14.64%

2.53%

6.61

Average

16.09

18.52%

1.84%

4.79

First a few comments about the averages.

EV/EBITDA: The average EV/EBITDA is 16.09. This is close to the 15 threshold that investment companies often use to determine if a company is overvalued. Therefore, it is not a bad metric for the alcohol industry, and I am looking for a number less than 15.

Operating Margin: The average OM is 18.52%. This is a little below the numbers reported by Philip Campbell at 21%. Five of the 12 companies had operating margins greater than 30% with ABEV the highest. This is bimodal. The big names in the business (ABEV, BF.B, BUD, DEO and STZ) all had Operating Margins greater than 30%. None of the other 7 companies in the group could even reach an Operating Margin of 15%. It makes you wonder what some companies are doing right and what other companies are doing wrong!

Dividend Yield: The average DY was 1.84%. This includes the 3 alcohol companies that don't pay dividends. Generally, I look for companies with dividend yields of at least 4%, but I will consider companies with lower DY but higher growth prospects.

Debt/Operating Income: The average is 4.79. What this number means to me is that companies could pay off their debt (excluding interest) in 4.79 years if they applied all their net income to debt. In a sense, this is very similar to ROI. Generally, if a company makes a capital investment that can be paid off in 5 years, then that is generally considered to be a good investment.

Companies that beat the averages:

ABEV is the only company that beat the averages in all four metrics.

BF.B, BUD, CCU and DEO beat the averages in 3 of 4 metrics. These are worth a closer look.

STZ and TAP beat the averages in 2 of 4 metrics. Missing 2 of 4 metrics means that I am not interested. Even though STZ didn't miss by much, another strike against them is their investment in the cannabis industry which is too speculative for me.

Ambev (ABEV)

I wrote an SA article about ABEV in March 2018, and most of the things I said then still stand. They are an extremely well managed company, and I have owned shares for quite a while. I am not inclined to buy more shares now but will continue to hold. The one update from March is to discuss the reasons for the drop in ABEV price from approximately $7 to $4 since then. The main reason for the drop is currency deterioration in their two largest beer markets Brazil and Argentina. The Argentinean economy is especially worrisome. From the end of April 2018 to September 2018, the Argentina peso has depreciated 100% to the USD (see figure1 below). Argentina is now officially defined as a hyper-inflated state and new currency accounting rules are mandated for businesses. The huge June IMF loan to Argentina ($USD 57 billion over 3 years) has conditions attached that Argentina must eliminate the deficit, impose export taxes and institute currency controls. The currency has stabilized somewhat since the IMF loan, but there is still uncertainty. Economic conditions are deteriorating and there is increased social unrest. China is also helping Argentina with loans and business investment. Argentina makes up approximately 20% of Ambev beer sales volume and approximately 25% of its total profit. For economic instability reasons in Argentina, I will not recommend purchasing ABEV at this time.

Figure 1. Exchange rate between USD and ARS (Argentina peso).

usdars chart dec 2018.png

Chart courtesy of TradingView.com

Brown Forman (BF.B)

Brown Forman misses on EV/EBITDA. The company is certainly overvalued, and they have been for quite some time even with the recent drop in stock price. As a US based company, they are currently facing tariffs on a number of their export products, but they reported solid first half results on December 1, 2018, and the impact of tariffs appears to be minimal so far. Since I already own shares, I am content to hold and have no plans to sell. In my opinion, ABEV and BF.B are the two best run alcohol companies of all. I wrote about Brown Forman for SA in March 2017.

Anheuser-Busch InBev (BUD)

BUD misses on debt. I wrote about BUD for SA in March 2018 (same article as ABEV, which is a BUD subsidiary). I complained about their excessive debt in March. Now I can also complain about their 50% dividend cut in November (even though the extra $4 billion savings will be put towards reducing the debt which is a good thing). I am staying away from BUD for those reasons.

Compania Cervecerias Unidas (CCU)

CCU misses on operating margin. They are close to the average but nowhere near the operating margins of the top companies (>30%). Nevertheless, I will take a closer look. Since I haven't written about CCU before, I will provide a bit more detail that I did for ABEV, BF.B and BUD.

Overview

The company is headquartered in Chile but also has alcohol and non-alcohol beverage business throughout Latin America (Argentina, Bolivia, Colombia, Paraguay, Peru and Uruguay). They own a number of Chilean wineries which are marketed globally. Beer is the primary alcohol driver of the business with liquor and wine, a much smaller segment. As well as their in-house alcohol brands, they also market brands for Heineken, Coors and Pernod Ricard in the region. They had a licensing agreement with Anheuser-Busch InBev to market Budweiser in Argentina, but this agreement was terminated early in Q2 2018. As compensation, CCU received cash and rights to several other beer brands. The termination was not surprising given that CCU and ABEV compete in the Argentine market, and ABEV is a partially owned subsidiary of BUD.

For non-alcoholic beverages, they are licensed for Pepsi, Seven-up, Schweppes, and Nestle. When they report financial results, they split the business into three areas: Chile, International Business, and Wine. Chile contributes 63% of the revenue and 73% of the profits. International Business contributes 26% of the revenue and 21% of the profits. Wine contributes 11% of the revenue and 6% of the profits. This makes Chile the most important driver of the business.

Investment Thesis and Target

As per their most recent financial report, their business is growing, even correcting for the loss of Budweiser in Argentina. Net income is on track to increase 26% from 2017 to 2018 even after removing the CLP 154 Billion ($USD 230 million) increase in net income from the Budweiser termination. In YTD 2018, volumes have increased.

The DY is 2.34%, and the dividend payout ratio is only 22% of net income, so it appears to be safe. Analysts are skeptical about CCU next year with no significant increase in stock price and an expected earnings per share decrease from $1.76 in 2018 to $1.24 in 2019 mostly due to currency issues. Despite the many positive things about this company, their less than adequate operating margin, together with concerns about the Argentina economy, means that I will not buy CCU at this time. If the situation in Argentina stabilizes and especially if their Operating Margin improves, then I will likely buy CCU.

Here is the stock price chart for CCU

Figure 2. CCU price on NYSE from 2016 to 1018.

stockchart ccu dec 7 2018.png

Chart courtesy of StockCharts.com

Diageo (DEO)

Overview

I have written about DEO in the past. In my March 2017 article on distillers, I rejected Diageo as having underwhelming operating margins (about 28%), slow growth and poor employee efficiency (revenue per employee) compared to their peers. Things have improved somewhat in the last 18 months. They have focused their strategy to grow the premium segment and have sold off some of their under-performing brands, with more offloads from the recently announced sale of Seagram's VO and other brands to Sazerac. Their revenues, operating margin and employee efficiency have all improved as per the following table. I have used GBP as the currency in the table rather than USD to make the comparison more relevant (the GBP/USD ratio has declined from about 1.5 to about 1.3 in the last three years).

Table 3. Diageo revenue, operating income and employee efficiency from 2016 to 2018. All values in GBP (£) as per June Diageo annual reports.

Stock

2016

2017

2018

Revenue, £ M

£10,485

£12,050

£12,163

Operating Income, £ M

£3,003

£3,576

£3,808

Operating Margin, %

28.6

29.7

31.3

Employees

33,000

30,433

29,362

Revenue per employee, £

£318,000

£396.000

£414,000

Since 2016, revenue, operating income, operating margin and employee efficiency have all improved. I expect the employee efficiency will improve further once the sale of Seagram's brands to Sazerac (announced in November 2018) takes effect. I do have some concerns that they paid a premium price ($1 billion) for Casamigos yet received only about half that ($550 million) for a whole bunch of brands with a total much higher volume. They are obviously putting their eggs in the high margin basket, and they will need to be good, and perhaps a bit lucky, to succeed.

Investment Thesis and Target

Diageo has turned its act around. They have a healthy dividend of $4.20 which has increased every year in the last 6 years. The payout ratio is 65%, which is sustainable. Their focus on premium brands should continue to help profitability. Analysts expect about a 10% increase in stock price (to $160) next year, and earnings per share are expected to increase from $6.49 to $7.01.

Here is the three-year chart for DEO.

Figure 3. DEO price on NYSE from 2016 to 2018.

stockchart deo dec 7 2018.png

Chart courtesy of StockCharts.com

There are some other concerns. As a UK headquartered company, it is possible that a hard Brexit could impact their sales into the EU. Add that to potential US tariffs and general currency exchange issues, it makes investing in DEO somewhat risky. I like their improvements in operating margin and employee efficiency as well as their focus on premium and high margin markets. For those reasons, DEO is a buy. I concur with the analysts' price target of $160.

Summary

There are a number of very good companies in the alcohol sector which are good long-term investments. By applying strict screening metrics on value, debt and profitability I am being picky though, and at the moment, I am only buying Diageo in which I have made a small investment. I currently also have shares of ABEV and BF.B and will continue to hold them.

Disclosure: I am/we are long "ABEV" "BF.B" "DEO". I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.