Can Diageo Keep The Party Going?

By Stephen D. Simpson, CFA | February 13, 2012 AAA

Right now is a pretty good time to have a global business with valued brands and pricing power. Recent years have proven that demand for spirits is not as inelastic as once conjectured, but Diageo (NYSE:DEO) has nevertheless been a popular stock in a nervous market. Curiously, even as the investors in 2012 have shown more interest in risky names, Diageo has maintained its momentum. The question for investors is how much room is left in this run.

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A Strong Fiscal First Half
So far, so good when it comes to Diageo's relatively ambitious targets for 2012. Organic revenue grew 7% for the first half and while the quarter-by-quarter performance was a little unbalanced (almost twice as much growth in the first quarter), underlying growth was consistent in both. As was the case for Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP), 3% volume growth seems like the magic number this quarter.

Diageo also made solid progress on profits. Gross margin ticked up almost a point, while organic operating profit rose 9% and margin expanded by about half a point. Interestingly, Diageo achieved this in spite of a 10% increase in marketing expenditures. (For related reading, see Analyzing Operating Margins.)

Will Emerging Market Growth Prove Sustainable?
Diageo has long been known for its strong brands; holding nearly 30% of the top 100 brands in the alcoholic beverage sector. That hasn't always translated into great sales outside of North America and Western Europe, though, as affordability has supposedly been a problem. Curiously, Pernod Ricard has been much, much stronger in markets like China and India despite a little less brand power, and it's not as though Pernod's products are cheap by comparison.

With all of that said, developing and emerging economies were quite strong for this reporting period. Sales in North America were up 3% and sales in Europe were down 3%, but Africa, Latin America and Asia-Pacific all saw high single-digit to low-teens growth.

Plenty of Options Left on the Table
Diageo is certainly doing well right now ... but that's no reason not to contemplate what else management may have in mind for further improvements.

Diageo lacks scale in its brewing business, so it may be worth considering the sale of Guinness to a larger brewer like Anheuser-Busch Inbev (NYSE:BUD). With or without such a sale, Diageo could contemplate bids for a host of companies like Moet-Hennessy, Cuervo, Beam (Nasdaq:BEAM) or Remy-Cointreau. Any of these would likely be highly additive deals as it would largely mean pushing more high-value product through existing distribution lines with minimal incremental investment required.

The Bottom Line
Arguably the worst thing going today for Diageo is that the stock has already been so strong. I'm comfortable with the idea that Diageo can grow its free cash flow at very nearly a double-digit compound rate over the next decade through solid mid-single digit revenue growth and ongoing improvements in free cash flow conversion. With that assumption, though, the stock is less than 10% undervalued and that's just not enough potential to entice me to buy today. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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