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Why Diageo PLC Has Preformed So Well And Why It Will Continue To Do So

|Includes: Diageo plc (DEO)

Diageo DEO ,one of the world's largest alcoholic drink manufacturers, has preformed well and will continue to do so because of its geographical diversification, product diversification, relative valuation and the industry it's in. We will also take some time to look at the market forces that are exerted onto the industry to get a better understanding why this industry has preformed so well for so long.

"Diageo plc engages in producing, distilling, brewing, bottling, packaging, and distributing spirits, beer, wine, and ready to drink beverages in North America, Europe, Africa, Latin America, and the Asia Pacific"Yahoo. Among some of their most popular brands include Smirnoff vodka, Johnnie Walker whisky, Baileys Original Irish Cream, Captain Morgan rum, J&B scotch whisky and Guinness stout. Diageo also produces other spirits brands, including Crown Royal Canadian whisky, and Seagram's whisky. Diageo also produces many popular wine brands and beer brands.

The stock performance of Diageo since 2000 has done quite well. It has Grown 11% YOY since early 2000 as can be witnessed below. This growth in stock price is on top of the 1.8% dividend yield the company provides.

When we take a closer look at how Diageo has done compared to its peers and the market in general its even more impressive. The Google graph below indicates that it has more then doubled both the S&P and Dow Jones Indexes while easily beating out its competitors in the same industry since April 2003.

With its geographical reach, Diageo PLC will be able to withstand changing tastes from one continent to another. The tastes may change from place to place, but overall demand I don't feel will decline. I don't think its going to decline because people have been preaching healthy lifestyles for so long ,and yet many have not heeded the call. We are all affected by the stress of our daily lives and we are all going to look for ways to relieve that stress. One way many people cope with daily life is to have a few drinks either with the co-workers after work or with people on the weekend. The general population has been over worked, over stressed for sometime; this trend has been happening for decades and does not look like its going to subside any time soon. A positive sentiment for the industry over the next year is shared from the analyst of S&P in their latest research report on Diageo published April 6th.

"Our fundamental outlook for the distillers and vintners sub-industry for the next 12 months is positive, reflecting our view of favourable demographics and strong consumption trends as drinkers favor wine and spirits over beer. We look for consumers to continue to trade up to luxury items over the long term."

Relatively speaking, Diageo PLC is undervalued. The average systematic measure of market risk, or beta, for the companies is 1.05, while the individual beta for DEO is 0.79. Furthermore, the P/E ratio on average is higher for the other companies then Diageo. Basically Diageo is cheaper and safer then the average competition, while getting the best ROE and the second best profit margin.

Source data

While we have taken a direct look at Diageo, let's take a moment to look at the underpinnings of the malt beverage industry. The look may help us explain why the industry has preformed so well and why it's going to keep producing above average returns.

Source

Some industries on the figure have preformed well year-over-year, while other industries are right at the bottom like air lines. There are certain forces that effect profitability year over year for each industry, now we are going to look at those elements with the help of Professor Porter's 5-forces framework.

Threat of Entry: Low-Medium

  • Brand power is quite strong with all the advertising money sent.
  • If someone wanted to compete with large established companies, they would come up against the Net Work effect. Basically people want to drink what is popular and what everyone else is consuming.
  • Advertising budgets in the industry will make any potential entrant think twice, in 2012 Diageo spent 1.69 Billion British pounds on advertising.

Power of Supplier: Low

  • Suppliers have almost no power. The basic inputs to alcoholic beverages are farm outputs, and there are many farms competing to sell their grains.

Power of Buyers: High

  • There is no cost to switch from one product to another. If someone wants to try something else, that simple idea is all that it takes for Diageo to lose the sale.

Threat of Substitutes: Medium

  • If someone wants to try something else, there is no way for any industry participant to stop them. But with so many different products offered, that substitute drink, which the customer picks up might just be owned by Diageo.

The fifth force with be quantified with the Herfindahl-Hirschman Index - HHI' "A commonly accepted measure of market concentration. It is calculated by squaring the market share of each firm competing in a market, and then summing the resulting numbers. The HHI number can range from close to zero to 10,000. The HHI is expressed as:

HHI = s1^2 + s2^2 + s3^2 + ... + sn^2 (where sn is the market share of the ith firm).

The closer a market is to being a monopoly, the higher the market's concentration (and the lower its competition)" Investopedia

Any score below 1,000 indicates a competitive market place, 1,000 to 1,800 is moderately concentrated and anything above 1,800 is highly concentrated-uncompetitive.

he HHI of 2800 speaks for its self; even thou there are hundreds of different brands to chose from at your local liquor store, there is only a highly concentrated hand-full of companies that compete. This lack of competition in conjunction with the other 4 forces, has contributed to elevated returns in the past, and should keep those returns elevated into the future.