Diageo Lives Up To Its Billing

By Stephen D. Simpson, CFA | August 24, 2012 AAA

I may not love the premiums that alcoholic beverage companies carry today, but I can't fault the underlying premise that these companies pay for their multiples with solid and relatively consistent performance. To that end, while British alcohol giant Diageo (NYSE:DEO) saw some modest erosion in second half growth, the company's performance continues to offer both a port in a storm and leverage to emerging market growth. Once again, though, the question is whether investors ought to pay up for it.

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A Respectable End to the Year
Although Diageo didn't blow away analyst numbers for the second half of its fiscal year, the company delivered respectable results all the same. Revenue rose 6% on an organic basis, about 1% less than in the prior half. Volume added 2% of that growth, with so-called strategic brands and emerging markets showing better volume growth than the company average. North America was surprisingly strong (up more than 7%), while Europe saw a small single-digit decline.

Profits also grew reasonably well. Overall, EBIT grew more than 8%. North American profit growth was slightly disappointing at 7%, as the company spent more on promotion and advertising. However, Europe saw 3% profit growth during a difficult period.

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No Stopping the Land-Grab
Whether it's Anheuser-Busch InBev (NYSE:BUD), Heineken or Diageo, there seems to be little inclination for the big players to stop buying. Distribution is increasingly key, as is sufficient leverage to fast-growing emerging markets, but there are only just so many properties out there worth owning. To that end, it's not altogether surprising to hear that Diageo is interested in acquiring all of Jose Cuervo - a deal that would probably cost more than $3 billion. If there's anything unusual about this deal, it's that it's for a relatively internationally popular spirit - Diageo's recent deals have been targeted at regional tastes like raki, baiju and cachaca. If there's a substantial risk, it would be in buying a brand that seems to be losing some share in the category, but the share loss doesn't look irreversible.

On some level, though, I have to ask whether this expansion binge is really necessary. I'll admit that properties like Jose Cuervo don't come around every day, but it seems like there are always new labels/brands taking off. SKYY and Grey Goose (both owned by Bacardi) have been around less than 20 years, and I see no reason to believe that companies will stop launching new concepts, even in supposedly mature spirit categories (consider the growing micro-distillery trend in the U.S., for instance).

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So I don't necessarily see such high scarcity value that companies like Diageo need to stress their balance sheet for acquisitions. At the same time, I'm a little surprised that Diageo hasn't been more aggressive with its beer business. The company owns a few well-known properties like Guinness and Tusker, as well as some lesser-known brands that are popular in emerging markets. Still, I wonder if the company ought to consider the benefits of scaling up this business.

Still a Strong Emerging Growth Angle
The second half of this fiscal year was a good news/bad news situation for Diageo's international growth. The mid-teens growth in Latin America was good news, as was the 9% growth in Africa. Asia-Pacific grew just 5%, though, as currency and economic issues are taking a toll. It's hard to argue against the long-term demand potential, though, as increased disposable income almost always correlates with certain lifestyle changes, including more protein and high-end alcohol consumption.

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The Bottom Line
So long as Diageo enjoys high equity premiums and low rates, I suppose there's no reason to turn away from accretive acquisitions. Likewise, while ongoing economic malaise could lead consumers to trade down in their alcohol consumption, there aren't many markets that seem as solid on a long-term basis as alcoholic beverages. What's more, like Coca-Cola (NYSE:KO) or PepsiCo (NYSE:PEP), I can appreciate how strong brands, global reach and solid returns on capital support above-average multiples.

As it did a half-year ago, Diageo seems about 10 to 20% undervalued. I won't be too surprised if flight-to-quality and risk-off investing drives the multiples even higher here and once again moots that fair value. Overall, valuation keeps me at bay on Diageo, but I have no qualms about the company's quality and if investors can make their peace with the valuation, I can see the case for owning the shares.

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

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