Bottoms-Up for This Spirits Maker

03/25/2010 12:00 pm EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Ann Gilpin say that giant alcoholic-drinks maker Diageo is a formidable cash and dividend machine.

Diageo (NYSE: DEO) is the world’s largest spirits maker, and the strength of its portfolio is unmatched. With eight of the world’s top 20 brands and unrivaled global distribution, the firm generates robust free cash flows and has a wide economic moat.

Brands such as Smirnoff, Baileys, Johnnie Walker, and Jose Cuervo are number one in the world in their respective cate­gories, and the firm’s portfolio includes other heavy hitters such as Guinness, Tangueray, and Captain Morgan.

Because of its strong portfolio, Diageo has built a distribution fortress. For example, in America (the most profitable spirits market in the world), Diageo has consolidated its distribution base, where allowed, to one exclusive agent per state, or 80% of its total US volume. No other firm has come close to replicating this, and this exclusivity leads to industry-pacing profit margins.

Although Diageo’s portfolio and scale are best in class, the global recession has placed the firm at a difficult crossroads. For years, Diageo benefited from consumers trading up to its premium brands, but the slump in the global economy and the subsequent pullback in spending have caused consumers to trade down.

Over the long term, we believe consumers will return to premium products, especially in emerging markets, where Diageo’s brands are perceived to be aspirational. However, Diageo’s slow earnings growth in the near term could prompt management to make an acquisition to drive growth.

While chief executive officer Paul Walsh has said that the firm would walk away from an overpriced acquisition and instead opt to increase the dividend, an acquisition is not entirely out of the question, in our minds. We are cautious of the firm’s stake in the spirits business of LVMH, as we think Diageo has a strong desire to own 100% of the assets. Under Walsh’s leadership, Diageo has also paid steep prices for certain acquisi­tions, like Ketel One.

Aside from the possibility of a large acquisition, we think Diageo’s dividend is well funded. Debt is large relative to capital (73%), but ratios of operating income/interest (4.7x in fiscal 2009) and net debt/earnings before interest, taxes, depreciation, and amortization (EBITDA) [of] 2.8x are more than adequate for a firm of Diageo’s stability. A 53% payout ratio also provides a cushion for currency fluctuations.

Denominated in pounds sterling, Diageo’s annual dividend payments have grown at a steady 5% clip since 2005. We find Diageo capable of at least 7% annual growth in its dividend and would like to see management deliver on this potential.

With a yield of 3.9% indicated by our Dividend Buy price of $61 and the potential for annual total returns averaging 11%, we think Diageo has the making of a stalwart performer—that is, if management can be content with the dominant franchise it already has. (The stock closed at around $66 Wednesday, with a yield of 2.7%—Editor.)

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