The past weekend, investors turned away from a volatile stock market and turned their attention to the celebration of St. Patrick's Day.

The festivities of which, as always, saw more than

a couple of mugs of Guinness lifted into the air.

A Stock with Good Spirits
One of the main beneficiaries of those happy events is Diageo PLC (NYSE: DEO).

Born out of the merger of Grand Metropolitan and Guinness in 1997, DEO is the leading producer, marketer, distributor of premium branded spirits, beer and wine.

Among the more notable brands include Bailey's Irish Cream, Captain Morgan rum, Tangueray gin, Smirnoff vodka and, of course, Guinness stout.

DEO has nine of the world's top 20 brands, with spirits comprising 75% of the company's revenue, beer 20% and the balance from wine. DEO also owns 34% of upscale champagne and cognac maker Moet Hennessey.

Size and Clout
One of the major advantages DEO, as a worldwide presence, has is its marketing muscle. Although the advantages of its scale have been lessened in recent years due to industry consolidation, DEO is still the premier provider as evidenced by DEO's ownership of 17 of the top 100 premium brands.

The marketing muscle invested behind 8 priority brands accounted for 59% of the company's volumes in its fiscal 2006. The marketing expertise allows DEO to maintain top brands and innovative new products without a budget-busting R&D program -- R&D expenditures for 2006 amounted to only 0.2% of net sales.

Risky Business
Despite its strong performance, DEO faces the same issues that many top providers do. Consolidation in the spirits industry has created competitors that now approach the scale of DEO. Management however, did not aggressively try to acquire rivals but efficiently picked-up complimentary brands that fit into DEO premium brand profile. DEO selectively acquired the rights to Bushmill's Irish Whiskey, for example.

DEO is also in an industry that draws quite a bit of attention from regulators and government officials. DEO, an alcohol producer, is labeled a sin stock and regulators spend a great deal of time overlooking DEO's marketing message so that it does not target underage consumers or promote over-indulgence.

Alcohol producers are also a favorite target of legislators for revenue enhancement via increased taxes. DEO is also dealing with a poor capacity utilization rate, as the production rate for full-year 2006 only hit 63.9%. This certainly adds to the operating costs but also provides DEO with the opportunity to grow.

By the Numbers
For the first half of 2006, volumes increased 4% and net sales rose 6% as pricing and the sales mix improved. Volume in North America grew 3% as net sales rose 7%, while internal operating profit increased 11%.

Europe continues to be a disappointment for the company, as volume declined 5% and net sales fell 2%. In an effort to hold profitability flat, management has reduced marketing costs which allowed for a 60 basis point improvement in margins.

The biggest contributor to DEO's success is its international operations. Volumes increased 14%, sales rose 16% which resulted in a 17% increase in operating profits. Management believes this success will be a long-term trend for its international operations. With the success of its first half of 2006, the company raised its forecast for annual operating profit growth to 8% (excluding impact of acquisitions and foreign exchange). Management has typically been conservative in its forecasts.

The operating results of DEO have been stellar. Current estimates for its current full-year ending June 2007 are $4.32 and $4.77 for 2008. The balance sheet is a bit levered as a result of some acquisitions and sits at a ratio of around 49.7% long-term debt to total capital. This is much higher than the industry average, which stands about 28%.

DEO does have strong cash flows and investors can expect management to repay debt and steadily increase the already attractive dividend. The current dividend yield of DEO is 3.13% substantially above its peer group.

Selling on the Cheap
On a valuation basis, DEO is selling at around 16.5 times earnings -- about a 22% discount to its peer group. Only Constellation Brands (NYSE: STZ) at 14.8 times sells at a larger discount. Its return on assets (ROA) of 14% is well above average the industry average of 9.2% and its ROE is a whopping 52.8% more than double the industry average of 20.4%.

The long term growth rate is expected to near 10.5%. Its margin over that time is expected to be around 29%, above its nearest competitor, Brown-Forman (NYSE: BF.B).

As the markets remain volatile, investors will begin to look for attractive defensive stocks to invest. DEO is a stable, global stock that is now attractively priced after its recent sell off.

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Tickers in this Article: DEO, STZ, BF.B

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