Diageo's Discount Too Deep to Disregard

We think

The punches keep coming for Diageo. In the heady days before the financial crisis, Diageo enjoyed some of the strongest pricing power in consumer staples as drinkers paid a premium to trade up to distilled spirits. When the crisis hit, however, and with the multiyear premiumization trend in reverse, Diageo had few levers to pull, having raised prices too high too quickly in the boom years. The hangover cure of lower pricing and slower organic growth has taken three years to take effect, and although Diageo is still struggling to reignite volume, last year was the first year it achieved real pricing in several years. At the same time that it wrestled with the excesses of the past, Diageo entered into some badly timed and poorly executed acquisitions. The firm acquired a stake in baijiu producer Shui Jing Fang for almost 4 times sales in 2011, just before the Chinese government cracked down on conspicuous consumption. Earlier this year, Diageo increased its investment in India's United Spirits to 55%, only to discover almost GBP 150 million in loans made by the firm to its previous owner for capital needed elsewhere in his business empire. Finally, it was revealed last month that the Securities and Exchange Commission was looking into channel stuffing by Diageo in the United States.

All of this has created headwinds on multiple fronts, and Diageo's stock has failed to consistently outperform the alcoholic beverages space for the past four years on a total return basis. With the stock now trading 13% below our fair value estimate and around 2 turns of earnings below its consumer staples peer group, we think the time could be right for investors to look at Diageo. In an environment of sluggish volume growth and weak real income growth, we prefer companies with self-help options for kick-starting revenue growth, and we think Diageo has several of those options.

We think clearing pipeline inventory should be priority number one. If the firm can achieve that by the midpoint of the fiscal year, we would expect to see positive volume growth in the second half. Second, we would prefer to see management refrain from chasing near-term trends in order to manage its very strong brand portfolio for the long term. Third, we would like to see a more coherent strategy on beer in Africa. Divesting the beer portfolio would probably unlock near-term value. Diageo does not disclose EBITDA by category, but we estimate that at 2.5 times sales, the beer business could be worth GBP 6.5 billion, capital that could be used to fill gaps in the firm's product portfolio (Irish whiskey, in particular) and geographies. Nevertheless, our strong preference is that management focuses on the long term and takes steps to integrate the beer and spirits business in Africa. Without solid execution over the next 6-12 months, we think Diageo could become increasingly subject to scrutiny from activist investors that could seek to sell assets deemed as noncore. Either way, we believe there is value in Diageo's shares at current levels.

In addition to the self-help opportunities available to it, Diageo should ride the coattails of any improvement in the global economy. We have identified a long-term trend of trading up through categories in developed markets, in which distilled spirits are taking share from beer and wine. This trend is sensitive to disposable incomes, however, and can be temporarily reversed in times of economic downturns. Despite the noise around channel inventory rightsizing, the primary cause of the weak volume growth of the past three years in North America, in our opinion, has been that the slow economic rebound has restrained that trade-up among American consumers. Growth appears to be concentrated in the reserve brands, suggesting that only the high-income consumer is trading up. Aspirational middle-income consumers have not returned to the category in any meaningful way, but when economic growth accelerates, we expect Diageo's volume growth to return as consumers resume the trade-up to spirits.

M&A Part of Diageo's DNA Diageo was created in 1997 following the merger of Grand Metropolitan and Guinness. Mergers and acquisitions remain part of the firm's DNA, and subsequent transactions, some transformative, others bolt-on, have established Diageo as the global industry leader. Although the industry is fairly concentrated (we estimate a four-firm concentration ratio of 0.6, above many other fast-moving consumer goods categories including the global brewing industry at 0.5), we believe there is more consolidation to come. Outside the top five firms, the industry is highly fragmented, with local players often dominating in niche product categories or local markets. These firms present a new wave of merger opportunities for the industry consolidators--including Diageo--to strengthen their presence in emerging markets.

Another of Diageo's incentives to continue consolidation is to broaden its product portfolio. Volume in the spirits industry is fairly stable (albeit more cyclical than beer), but trends are transient. For example, the current shift away from white spirits (mainly vodka) to brown spirits is a reversal of the trend in the 1990s. The breadth of Diageo's portfolio across categories with both global strategic and local niche brands mitigates some of the risk to volume from such shifting consumer tastes and preferences. Nevertheless, bourbon and Irish whiskey are examples of gaps in Diageo's category footprint.

We think premiumization will be a significant long-term tailwind for the global distillers. Today in mature markets, spirits are taking share from beer and wine as consumers trade up. In both the U.S. and the United Kingdom, for example, the distilled spirits category has added an average of around 20 basis points of share of throat from other categories every year for the past decade, and a continuation of that trend could support Diageo's volume in developed markets, despite an underlying headwind of falling alcohol consumption. In emerging markets, however, trading up is occurring within, rather than among, categories, and given the higher price points of spirits, we believe the medium-term volume growth opportunity from premiumization lies with the brewers.

Leading Brands Fill Broad Portfolio Strong intangible assets and a cost advantage are at the heart of Diageo's wide economic moat. While we believe the firm's total alcohol product portfolio is far from complete, it contains 14 of the top 100 global premium distilled spirits brands and 7 of the top 20. Its presence with number-one or number-two brands in most of the major spirits categories would be difficult to replicate by a new entrant. Diageo's positioning in the leading categories means that its brands have high churn in on-premise channels and significant shelf space in the off-premise channels. This makes Diageo an important partner for bars, restaurants, and retailers, and the firm works closely with its customers to optimize product displays, promotions, and pricing at retail. We believe this is a competitive edge over less valued distillers, even ones as large as Pernod Ricard, whose positioning as the leader in second-tier categories generates lower inventory churn in the on trade and less shelf space in the off trade.

With 27% global volume market share according to Impact Databank, Diageo has greater scale than its competitors. It sold 165 million equivalent units of beverages in fiscal 2013-14, including its beer and wine portfolios, which dwarfed the 98 million equivalent units of its closest competitor, Pernod Ricard, and the gap is likely to grow in 2015 following the United Spirits acquisition. With only a limited number of raw materials used in the spirits production process across categories and with some synergies with beer and wine, this scale gives Diageo greater pricing power in its raw material procurement than its competitors, as well as efficiency in its distribution and capacity utilization.

Diageo has generated at least high-teens returns on invested capital, after adding back goodwill and removing excess cash, every year for more than a decade. We expect this to continue through our five-year forecast period. These returns are well in excess of the firm's weighted average cost of capital, which we estimate to be 8%, and the consistency of the excess returns, even through the financial crisis, supports our belief that Diageo possesses a wide economic moat.

Regulation, Cyclicality, and Acquisitions Are Risks Spirits companies are subject to heavy regulation and taxation. Governments may enact policies that place restrictions on Diageo's business activities or increase liquor taxes, resulting in a demand headwind. Recently, the Chinese government's crackdown on gifts to government officials has led to drastic drops in demand and price in scotch and the ultrapremium baijiu segment.

Distilled spirits is more cyclical than some other consumer staples industries, including brewing, and more closely tied to economic growth. For example, we estimate the correlation between GDP per capita growth and the spirits industry retail value to be 0.8, but only 0.3 between GDP per capita and retail beer sales. As a result of operating in 180 countries, foreign exchange rate fluctuations can cause large swings in Diageo's financial results. This is likely to increase over time as the firm looks to expand its emerging-market footprint.

The company's acquisition strategy is inherently risky, as demonstrated by the GBP 264 million write-down at Shui Jing Fang and the post-acquisition problems at United Spirits. Also, most of Diageo's maturing inventory is stored in Scotland. If this maturing inventory suffers a catastrophic loss due to contamination, fire, or other natural disaster, Diageo may not be able to satisfy consumer demand, and insurance may not fully cover the replacement value of the lost inventory.

Diageo has generated historical annual total returns in the low double digits over three- and five-year time frames, and it has outperformed the market by almost every measure of risk-adjusted returns over the long haul. Shareholders have been well served by management's capital-allocation strategies, in our opinion, but we will reserve judgement on the new leadership until we see evidence that the financial discipline of the past is being continued under the new regime.