Diageo Standing Out In A Dispirited Market

By Stephen D. Simpson, CFA | August 26, 2011 AAA

Normally, booze is a great business. When times are good, people drink to celebrate. When times are bad, people drink to commiserate or forget. Better still, alcohol is expensive, easy to make and requires precious little research and development (though plenty of brand-building and marketing support). And yet, that idyllic reputation isn't working out so well right now. As consumers find their budgets increasingly stressed, they seem to be drinking less and turning to cheaper brands.

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That makes Diageo (NYSE:DEO) unusual. While several major alcohol companies have recently disappointed the Street and worried investors with disappointing results and guidance, Diageo seems to be doing relatively well. With good growth in emerging markets, it looks like Diageo can wait out the turbulence in North America and Europe and perhaps add a few more good brands to its world-leading stable. Think of it like Coca-Cola (NYSE:KO) or PepsiCo (NYSE:PEP) for the adult crowd.

A Solid Close to a Decent Year
Diageo reported full-year organic sales growth of 5%, supported by 3% volume growth. Growth was strong in Asia (up 9%) and in the company's "international" segment (up 13%), while North America was up a middling 3% and European sales fell 3%. Growth was especially strong in the company's premium vodka and scotch brands, and the beer business was surprisingly solid as well.

Diageo didn't disappoint with earnings either. Gross margin ticked up 70 basis points, but the company gave that back largely through higher marketing expenses. All in all, then, operating income grew 5% for the full year.

Relatively Cheerful Guidance
Investors have had to deal with some bad news in the sector lately. Large European brewers Carlsberg and Heineken (Nasdaq:HINKY) are struggling, hurt in part by their greater reliance on European sales. Even still, major global players like Anheuser-Busch InBev (NYSE:BUD) are not exactly rolling out the barrels and estimates have been heading lower.

It's not just beer that's troubled. Constellation Brands (NYSE:STZ) is going through a difficult reset as the U.S. wine boom peters out. Likewise, spirit makers have had a rough go of it lately. Central European Distribution (Nasdaq:CEDC) is struggling; partly due to regulatory changes, but also difficult market conditions and management missteps. Among Diageo's larger peers, Remy Cointreau still gets some Street love, but Pernod Ricard has struggled.

So amidst that glum backdrop, it was definitely encouraging to hear optimism and upbeat guidance from Diageo management. In fact, Diageo is looking for even better revenue growth next year and ongoing margin improvements (enough to fuel double-digit EPS growth over the next three years). Some of this is certainly due to growth in emerging markets, but investors should not underestimate the power of Diageo's distribution and brand value - those really are the name of the game in the liquor business and Diageo does it better than anyone else.

The Bottom Line
Diageo is a great company with a collection of leading brands and a return on capital well in excess of the cost of that capital. What's more, Diageo may be in place to take even more advantage of these difficult times - this company is always willing to do a deal and while the number of meaningful brands worth owning is shrinking, there is no reason to think that the company wouldn't be interested in a good brand with good distribution in emerging markets like Russia, Brazil or China.

It would be nice if Diageo were cheaper, but there would be no particular reason to expect a high-caliber player in an attractive industry (even if it's not quite as attractive as hoped) to be cheap. Still, Diageo is priced a little lower than its peers and near the lower end of its historical range. There's certainly a risk here of the global economy tanking further and taking Diageo sales with it, but the stock seems to discount a lot of that already - perhaps too much. (For additional reading, also take a look at Beeronomics: Factors Affecting Your Pint.)

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