Value in Premium Spirits Bonds

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with bond strategist Dave Sekera to look at Diageo and see if its bonds are attractively priced.

Dave, thanks for joining me.

David Sekera: Thanks Jeremy. Good seeing you again.

Glaser: I know that there are a lot of people may be familiar with Diageo. Can you talk to us little bit about what this company does and how we view its competitive advantages?

Sekera: Of course. So, Diageo is the world's largest spirits maker and in fact in their brand portfolio they own eight of the top 20 largest brands globally. And if you take a look at these brands, they are all premium brands, they have Guinness. Smirnoff, Tanqueray, Johnnie Walker, Gordon's, Captain Morgan, the list goes on and on. And because of that brand portfolio and these premium brands, in addition to the extensive distribution platform they have globally--I believe they distribute to over 180 countries--these guys have really built a wide economic moat, and we believe that economic moat is stable. And as evidence of that, if you look at the returns on invested capital of the company, they are in the mid to high teens. Well in excess of the company's 9% cost of capital.

Glaser: If we look at the bonds then, do you think they are attractively priced today or are they fully valued given that the company looks so attractive?

Sekera: I think that in the consumer defensive space, spreads generally are tighter for the individual rating than you see across a lot of other sectors, and that's just because of the nature of the defensiveness of the consumer product space.

However, in looking at the space, I do believe their bonds are attractive. Now, we rate Diageo as A- on a issuer credit rating basis. So, when you look at where other bonds are trading compared with Diageo, you do have some additional yield pickup.

So, right now Diageo's, the 2020s, are trading probably a little bit wide of 100 over Treasuries. Now, if I look at similarly rated companies such as Kellogg, which we also rate with an issuer rating A-, you can pick up an extra 20 basis points of yield. And if you look at some other companies, which we rate, one notch higher, for example, General Mills and SAB, which we rate A for both of those companies, you also pick up an additional 10 basis points on those two companies.

Now, to the downside, Coca-Cola Enterprises, which we rate below Diageo at BBB, actually trades tighter than Diageo by 7 basis points. So, to the downside I think the spread widening that we would see is also limited. So, I think you have some good additional yield pickup to the upside and limited downside.

Glaser: Let's take a closer look at the company's balance sheet. Can you talk to us a little bit about what the cash flow generation looks like, how they are going to be able to support these bond payments?

Sekera: Sure. Now, the company itself does report in British pounds. We expect them to report in 2011 about GBP 10 billion and about GBP 3.3 billion in EBITDA, with EBITDA being a proxy for the firm's cash flow, to be able to payoff debt. Now, in dollar terms that's about $16 billion and about $5.3 billion. So, it's a very large company.

It has very solid credit metrics, interest coverage over 5 times. Leverage maybe a little bit on the higher side, over 3 times, but we fully believe that because of the defensive nature and the value of the brands portfolio, just the solid recurring free cash flow that they can easily support 3 times debt coverage.

Now, the financial performance of the firm has been hindered as you would expect in the recession. However, there are just some long-term trend that we have been seeing of premiumization in the spirits business, as people trade up, as disposable incomes trade up, and urbanization increases, and we expect to continue to see that as the economy continues to recover.

Glaser: Is there anything on the horizon that you think could have an impact on the company's bonds, or could affect where the bonds are trading?

Sekera: Sure. Now, over the long term, we do expect the company to grow 4% to 5% on the top line. We do expect to see an increase in the firm's operating margin as they get additional fixed-cost leverage as the top line grows. And really we are looking at the emerging markets as really being probably the best opportunities for the company to continue to grow. As the emerging markets get larger, as you have population increase, and as you have more disposable income, you have people moving into urban areas, and you tend to see an increase in trade-up and an increase in consumption levels.

Now, in the near term there have been rumors that the company may make a bid for Jose Cuervo tequila, which they currently have the distribution license on that brand until 2013. So, the thought is they may just go ahead and try and buy that. If they do, it is possible that could be something that they are going to finance mostly with debt. You could see a backup in credit spreads as they bring new debt to the market in order to finance it. I would actually just look at that as being a buying opportunity at that point in time.

Glaser: Dave, thanks for you thoughts today.

Sekera: Thank you very much.

Glaser: For Morningstar, I am Jeremy Glaser.