Diageo: A Premiumization Play At A Premium Price

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About: Diageo plc (DEO)
by: Steven Chen
Summary

Diageo is well-positioned to capture the premiumization trend in the beverage alcohol sector.

The business is high-ROIC and growing organically.

However, the valuation is not that favorable, so I would recommend waiting for pullbacks.

Source: Annual Report 2018.

Overview

Formed in 1997 following the merger of GrandMet and Guinness, Diageo is a global leader in beverage alcohol with iconic brands across spirits and beer that are sold in more than 180 countries. The company employs approximately 30,000 people worldwide in around 80 countries and its manufacturing facilities are located across the globe including the UK, US, Canada, Italy, Africa, Australia, and Latin America.

Diageo encourages everyone to celebrate life every day, everywhere, as reflected by the company name (DIA is the Latin for "day" and GEO is the Greek for "world").

The shares of the company are listed on both the London Stock Exchange (DGE) and the New York Stock Exchange (DEO).

Financial Performance

The company reported its 2019 first-half interim results earlier this year (please note its fiscal year ends in June). On a YoY basis, volume increased by 3.5%, net sales 7.5% and operating margin expanded 152 bps, all of which are organic. EPS excluding one-offs was up 14% and the dividend was increased by 5%.

As you can see below, most of the growth here is organic, driven by volume, price/mix, as well as improvement in operational efficiency.

Source: 2019 Interim Results Presentation.

Source: 2019 Interim Results Presentation.

The continuous investment in brands, marketing efforts, and macro trend of premiumization in the alcohol space together have constituted the reliable compounder of Diageo's organic growth at mid-single digits for the past couple of years (see below).

Source: 2019 Interim Results Presentation.

Economic Moat

Diageo’s performance ambition is to become one of the best-performing, most trusted and respected consumer goods companies in the world. In my opinion, brand power, scale, and market-based approach build the economic moat of the high-ROIC and organically growing businesses at Diageo.

The company owns two of the world’s largest premium spirits brands, Johnnie Walker and Smirnoff, and 22 of the world’s top 100 premium spirits brands, including Guinness.

Source: 2019 Interim Results.

Diageo has a broad reach to customers, especially in the United States and Europe, and with leading positions in many of the markets, the business should generate most of the medium-term industry growth with certainty.

The global supply capabilities enable Diageo to manufacture and distribute their brands efficiently and effectively.

Source: 2018 Annual Report.

Diageo's broad portfolio consists of international and local brands, reaching across categories and price points. As a result, the company is able to participate where the management sees that the consumer opportunity is greatest and support consistent growth and to diversify away risks specific to geographic regions and market segments.

Source: 2018 Annual Report.

The organization at Diageo is structured in a market-based model, which means the teams, by using local market insights, select the most relevant brands and strategies to meet the consumer opportunity in their individual countries with quick reactions to market trends and development.

As indicated below, free cash flow has been growing at double digits for the last two decades, and meanwhile, returns on tangible assets have improved significantly, demonstrating sustainable competitive edges.

Source: GuruFocus; data as of 7/8/2019.

Source: GuruFocus; data as of 7/8/2019.

Long-term Prospect

Per SimplyWallSt below, analysts expect Diageo to grow its EPS by 5.8% annually, which I think is a bit conservative in light of the global consumer trend of premiumization.

Source: SimplyWallSt; data as of 7/8/2019.

The global premium beverage alcohol sector has shown resilient, long-term growth. This is being driven by population and income growth, and the increasing penetration of premium brands around the world. Spirits continue to take share from wine, premium beer continues to outperform mainstream beer.

Diageo's strategy is to support premiumization, as consumers want to drink better, not more. In developed markets, the company supports premiumization through premium core and reserve brands. These enable consumers to trade up into luxury categories. In emerging markets, the management aims to grow participation in international premium spirits. To support this, the company participates in mainstream spirits so consumers can access their brands at affordable price points.

It is expected that 730 million new consumers will be able to afford international premium spirits over the next 10 years. They will be increasingly interested in trying new brands and categories and be prepared to pay more for products of superior quality, craftsmanship, and provenance.

For the long run, I think that a high-single-digit CAGR in earnings is doable for Diageo as the business has plenty of opportunities to reinvest its retained cash income at attractive rates of return.

Management

The board currently consists of 9 members, including CEO, CFO, and 6 Non-Executive Directors, Non-Executive Chairman, with the average tenure of 4.8 years. Javier Ferrán was appointed Chairman of Diageo in 2017, having been a Non-Executive Director since July 2016. His current external appointments include Non-Executive Director at Associated British Foods and Non-Executive Director at Coca-Cola European. Mr. Ferrán was President and CEO at Bacardi Limited and Non-Executive Director at SAB Miller.

Ivan Menezes has been CEO of Diageo since 2013 and has been an Executive Director since 2012. His current external appointments include Member of the Council at Scotch Whisky Association, Non-Executive Director at Tapestry Inc., Chair at International Alliance for Responsible Drinking. Before the current role, Mr. Menezes was Chief Operating Officer, President of North America, Chairman of Diageo Asia, Chairman of Diageo Latin America and the Caribbean at the company.

The management appears shareholder-friendly as free cash flow and ROIC are the two of their important KPIs to focus on.

For the past 12 months, the insider activities appear favorable, with a few buy transactions.

Source: SimplyWallSt; data as of 7/8/2019.

Valuation

Diageo appears to be a good business that consistently earns high returns on capital and has organic growth opportunities. However, the valuation of the stock is not attractive at all, with EV/EBIT near the all-time high (see below).

Source: GuruFocus; data as of 7/8/2019.

Even given a 10% growth rate going forward, the free cash flow yield of 3.3% should set a low expectation in terms of total returns for investors establishing a position at this point.

Source: GuruFocus; data as of 7/8/2019.

Summary

I expect the organic growth at Diageo to continue thanks to the consumer trend of premiumization around the world. The economic moat and the superior returns on tangible capital would make any growth just more meaningful and valuable to the business owners.

However, as discussed above, the share is not priced attractively by Mr. Market. Therefore, I would recommend investors keep the stock on their watch list and wait patiently for pullbacks.

Disclosure: I am/we are long 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.

Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.