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The Science of Hitting
The Science of Hitting
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Diageo (DEO) - Conference Notes

September 11, 2011 | About:

Diageo (NYSE:DEO), the world’s leading premium alcoholic beverage company (brands include Johnnie Walker, Guinness, Jose Cuervo, and Capital Morgan, among many others), presented at the Barclay’s Back to School Consumer Conference on Thursday. I started following Diageo more closely after I heard David Herro (portfolio manager of the Oakmark International Fund and Morningstar’s International Stock Fund Manager of the Decade) talk about the company during an interview with Consuelo Mack:

“There is one nice, stable, well-managed company that at this stage does not appear very expensive, and it’s a stock you can hold for a long, long time unless it spikes way up… that stock is Diageo. It is the world’s largest drinks company… in the emerging world, this is growing; in the developed world, as people age, they go from beer to spirits. So aging population kind of helps it, emerging situation helps it. Overall, no matter how you slice it, whether you like it or not, people like to consume alcohol… The profit dynamics of this business are great, it’s extremely well managed… today, you can buy it at a relatively low valuation (somewhere around ten time’s gross cash flow)… unless you believe we’re going to have global prohibition, this is going to be a very good stock to own”.

Here are some of the notes from the conference:

The company is the #1 spirits company in the United States, the #1 international spirits company in Asia (a continent that they believe will account for 40% of luxury demand by 2014), the leading beer company in Africa, and the largest premium drinks company in Europe.

An example of their reach: vodka. Their most well known brand in this category, Smirnoff, is the number one vodka brand in the world; however, that isn’t the end of their vodka business. They also have offerings at the value end of the market (such as Popov), and on the other tail in the super premium market (with brands like Ciroc). This same idea spreads across multiple categories (like rum, scotch, etc) and geographic regions (as shown by their recent acquisitions, such as Mey Icki in Turkey); in the words of Mr. Mahlan, “No other premium drinks company..... has our range of brands across categories. Nor can they match our presence in as many markets around the world. This strength has meant that we continued to grow our business during the global down turn. And the results from the financial year just past speak volumes... our brands delivered volume growth... positive price/mix... gross margin expansion... and strong cash flow, with organic net sales growth across all spirits categories, beer and wine.”

Operating targets for the future include 6% top line growth and strong margin improvement (beginning with a 200 basis point increase in operating profit margin by 2014), which collectively should drive “double digit EPS growth to underpin a progressive dividend policy”, said Deirdre Mahlan, CFO.

When it comes to making the business stronger and growing, management is focused on the opportunity in emerging market consumption: “The global economic balance continues to move toward Latin America, Africa, and Asia… Russia, Turkey and Eastern Europe. There’s huge growth in the number of middle class consumers in those rapidly growing markets. Here we’ve seen rapid expansion in access to information; a move from traditional behaviors.... and the rise of new consumer groups, who are adopting new products and services. As a global, branded company... this opens up exciting opportunities for Diageo.” This has come from a mix of increased M&A (control of Shui Jing Fang in China and Mey Icki acquisition in Turkey) and also increased marketing investment (which was up 22% in the first half of the year).

In regards to North America (the company’s largest geographic region by sales), Mr. Mahlan expanded on some of the points Mr. Herro made in his interview; for example, that Diageo holds a leading 28% share of the market, and owns 10 of the top 25 brands (by sales). Management believes that “the US spirits market presents a significant opportunity for us; not only is this a highly profitable market, it is also a growth market. Long term demographic trends are driving multicultural diversity and an increase of 1 million legal purchasing age adults each year. Together with social change these demographics are leading to an increase in the number of young adults who choose spirits over beer and wine”.

At the time of Mr. Herro’s comments (mid-May), the ADR traded for roughly $84 per share; today, it is nearly 10% lower at $76 per share (with a dividend yield of 3.5%), and accounts for roughly 2.3% of his equity holdings.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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