Bottoms Up for Diageo

08/26/2008 12:00 am EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Ann Gilpin like the world’s largest producer of premium spirits.

With eight of the world’s top 20 brands and unrivaled global distribution, Diageo (NYSE: DEO) is the world’s leading producer of branded premium spirits, and the strength of its portfolio is unmatched. It also produces and markets beer and wine.

Brands include Guinness stout, Smirnoff vodka, Tanqueray, and Gordon’s gins, Captain Morgan rum, Baileys Irish Cream, and Johnnie Walker scotch. It also owns 34% of champagne and cognac maker Moet Hennessy. The company continues to flex its marketing muscle to gain share in each of its 180 markets.

One key strength of Diageo’s business is its distribution advantage. No other company has come close to matching its exclusive distribution scale in the US. Diageo’s operating margins in North America are in excess of 33%, higher than most of its other competitors’. The trend of American consumers trading up to premium-and-above spirits brands, where the majority of Diageo’s products are positioned, bodes well for sales growth [there].

Europe is the firm’s biggest sore spot. Declines in on-site (bar) consumption have led to flat to negative volume growth, and margins have compressed as a result of more competitive pricing.

International markets outside the US and Europe are Diageo’s biggest opportunity for growth, and volume in these regions is increasing at a double-digit clip. Operating margins there are somewhat lower than in the rest of Diageo’s business because of heavy marketing spending, but we view this as an investment, given the brand equity that must be built up in these newer markets.

Diageo will probably continue to invest heavily in marketing and advertising in markets such as Asia-Pacific while we expect operating profit growth to outpace sales growth in North America. Overall, we forecast operating profits to increase about 7.5% to 8.0% annually for the next five years.

On an internal, “currency-neutral” basis, we expect Diageo’s annual sales growth to average about 5.5% to 6.0% over the next five years as strong growth in emerging markets offsets low-single-digit growth in Europe.

Paul Walsh, a veteran who started at Grand Metropolitan in 1982 and spent a decade running Pillsbury, stepped into the CEO role in 2000. Walsh has been the driving force behind Diageo’s strategy to shed noncore businesses in order to focus on spirits.

We applaud the separation of the chairman and chief executive officer roles and the fact that Diageo’s board is composed of nine independent members. About 75% of compensation is variable, based on both annual and longer-term performance. Management and shareholder interests appear well-aligned.

Our fair value estimate for Diageo is $112 per ADR. (It closed below $74 Monday—Editor.) Our valuation is based on an exchange rate of GBP 0.5012 per dollar. If the pound were to appreciate by 10%, our fair value estimate would increase by about $13 per ADR, all else equal.

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