What do Johnnie Walker scotch, Smirnoff Vodka, Bailey’s Irish Cream and Crown Royal Canadian Whiskey have in common? They’re all No. 1 brands in their respective categories, and they all belong to Diageo Plc ADR (NYSE:DEO). As the world’s leading producer of branded premium spirits, wine and beer (Guinness Stout), this company has built an $80 billion market capital empire leading the alcoholic beverage industry. In addition to the aforementioned brands, this firm also owns 34% of the premium champagne and cognac maker Moet Hennessy. Since investment gurus Ruane Cunniff (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) bought this company’s shares last quarter, I decided to take a look at its profitable business model.
A Well-Rounded Business Model
When Diageo’s CEO Ivan Menezes declared last quarter that the company would not be buying Beam Inc. (NYSE:BEAM) in order to boost its bourbon and tequila portfolio, it became clear that the firm was well off as it is. And I applaud management’s decision to hold back, because this firm’s unmatched spirit portfolio combined with its vast distribution network make it a solid global market leader. Although the company operates in 180 countries, its particularly strong position in the U.S. market is highly beneficial, as this is the most profitable spirits market worldwide. The distribution, handled by 2,800 exclusive salespeople that only attend the company’s namesake brands, is highly profitable, resulting in domestic operating margins of almost 40%. Also, these distributor relationships cover 80% of the company’s U.S. volume, making for a business model that would be very difficult for new market entrants to duplicate.
Furthermore, after the row of acquisitions executed this past decade, including Seagram, Allied Domecq and Mey Icki, Diageo is now focusing on its expansion strategy in the emerging markets of India, China and Africa. Spinning off most of its noncore operating business, except its beer portfolio, which acts as a gateway to spirits and is therefore crucial for growth in the African region, was also an accurate move. Long-term expansion will benefit investors as the company gains additional distribution scale and attract more consumers towards its premium (and higher margin) brands, adding on to its wide economic moat. The growing scale will allow for returns on invested capital in the high teens over the next 10 years, strongly exceeding the firm’s 8% cost of capital.
Valuation and Risks
While Diageo reported 4.9% revenue growth throughout 2013, the five-year forecast expects organic growth to average an annual 5%, while earnings per share grow at a 6% rate, below 2013’s 14.70%. Moreover, the impressive 21.7% net margin and 9.9% returns on assets should be encouraging to investors, as well as the solid 8.8% EBITDA growth rate (currently $5.8 billion). However, some risks remain concerning the heavy taxation and regulation applied to spirit companies. The Chinese government, for example, just recently passed a regulation regarding extravagant gifts, leading to strong drops in prices and demand of the Diageo’s high-end baiju segment. But, nonetheless, I believe this company’s healthy balance sheet should be able to leverage these headwinds, without majorly affecting shareholders' position.
In fact, the 2.6% dividend yield is well above the industry’s average of 2.03%, and the same goes for the 30% operating margins, which is double the industry median. I also must point out that the stock's trading price of 18.6x trailing earnings is currently at a discount to the industry average of 19.2x, making this an appropriate time for investors to buy the company’s shares. Therefore, I feel very bullish about Diageo’s long-term future and believe its wide moat rating will continue to prevail and increase as the firm expands into new markets.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.