Wednesday, August 4, 2010

Diageo's Global Brands

Diageo has 8 of the top 20 global spirits brands. It's spirits portfolio includes Smirnoff, Baileys, Johnnie Walker, Jose Cuervo, Tanqueray, and Captain Morgan (among others) while the beer portfolio includes Guinness and Harp.

Here's an article presenting the bullish case for Diageo (ADR: DEO). I have liked the combination of Diageo's brand and distribution strength for a long time but at the current stock price have concerns with valuation.

Some excerpts from the article:
Diageo's big brands do more than create future growth. They also drive Diageo's massive 40% return on equity – a measure of profitability per unit of equity dollar given to the company. That's one reason its shares have outperformed the S&P 500 by a dividend-adjusted 188% over the past decade.

A full 17% of its sales convert to free cash flow -- the purest measure of both company profitability and ability to pay dividends, better than Anheuser-Busch
(NYSE: BUD) at 11%, Constellation Brands (NYSE: STZ) at 6%, and Brown-Forman (NYSE: BF-B) at 16%. They're all good alcohol companies in their own right; I just think Diageo is a little better.

The article also mentions that Diageo has a fair amount of debt. While this is true, the company's predictable earnings stream puts it in a position to easily service that debt.

Back to valuation which is of bigger concern. I continue to like Diageo but these days it is no longer cheap. The above article is being written with Diageo hitting ~$ 70/share. I first highlighted the company as selling well below intrinsic value in this post back in April 2009 when it closed at $ 45.54/share and was selling below 10x earnings. In that post, I said the intrinsic value of Diageo should be between $ 70-80/share in 3 years and that there was a good chance the stock price would close the gap and begin to more closely reflect that intrinsic value. At the current ~$ 70/share, the stock is already selling at the low end of that intrinsic value range and the gap between price to intrinsic value has been largely closed. Since the time of that post the stock (not the intrinsic value) has increased 62% and as a result - while I think it's a great franchise that should increase intrinsic value steadily going forward - it's no longer a bargain.

I also mentioned Diageo in Stocks to Watch on July 21st of last year and it remains on the most recent watch list selling well above the max price I'm willing to pay.

Diageo's stock is not extremely expensive selling at ~15-16x earnings but has just become difficult to buy with a sufficient margin of safety. Hopefully, the price will get below $ 60 again.

Adam

Long position in DEO

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