Happy Hour on Horizon 

10/07/2009 9:32 am EST

Focus: GLOBAL

Carla Pasternak

Editor, The Income Investor

Diageo's steady income stream from spirits will swell as the global economy revs up, writes Carla Pasternak in High-Yield International.

London-based Diageo (NYSE: DEO, LSE: DGE) is one of the world's largest alcoholic beverage producers. The company sells eight of the world's top 20 brands including Guinness, Smirnoff, Captain Morgan, and Johnnie Walker.

At current exchange rates, DEO [offers an annual dividend] yield of nearly 4%. The dividend has been raised by about 6% to 8% per year for the past five years, and the company carries a payout ratio of roughly 50%, based on operating cash flow of £1.7 billion against dividend payments of £870 million over the last year.

Diageo is facing pressure from the ongoing recession, but is taking strong steps to more than offset any slowdown. The company reported full-year 2009 results in August. Earnings per share increased 10% year over year, from 59.3 pence to 65.2 pence. However, overall sales volumes slipped 4% due to the weak economy.

With most of Diageo's sales coming from outside the UK, the company benefited from a weaker pound. Net profits rose 6.6% and sales revenues increased 15%, primarily because of favorable currency fluctuations.

Volume sales were weaker in Europe. For example, sales in Spain were down 21% as that market was hit particularly hard by the economic downturn.

However, cost-cutting measures resulted in only a 1% decline in operating profit for the region. The international region, which includes growth markets in Africa and Latin America, provided a 10% increase in operating profit for the year.

Without the effects of currencies and acquisitions, the company still managed an organic operating profit increase of 4%, largely aided by aggressive cost cuts.

The company implemented two restructuring initiatives this past year. The first program, announced in February, will generate £120 million in cost savings by fiscal year end 2010. A second initiative, announced in July, will save £40 million by year end 2012.

Diageo has also reduced marketing spending on brands and markets that offer less growth and is channeling more of its marketing expenditures toward its profitable spirits brands. As consumers have cut back on bar and restaurant jaunts during the recession, they have trended toward at-home drinking, where they currently opt for beer and wine.

Diageo has embarked on a strategy to get consumers to drink the more profitable spirits at home. As part of the effort, Diageo recently announced that they will purchase all the remaining share of Stirrings, the seller of premium mixers for home consumption.

The company was cautious in guiding projected 2010 profit growth to the low single digits due to uncertainty over the economy. That said, premium brand usage should increase as the economy recovers and emerging market sales should also spur long-term growth.

DEO offers a secure yield, a defensive business with consistent growth in a weak economy, and the potential for stronger growth and appreciation as the economy recovers.

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