Stock in Focus: Diageo

Top-shelf spirits manufacturer Diageo will have received a boost in sales this festive season. What does the next 12 months hold for the specialist retailer?

Thomas Mullarkey, CFA 27 December, 2013 | 2:56PM
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The product of a merger between Grand Metropolitan and Guinness in 1997, Diageo (DGE) is the world's leading producer of branded premium spirits. It also produces and markets beer and wine. Brands include Johnnie Walker scotch, Crown Royal Canadian whiskey, Smirnoff vodka, Captain Morgan rum, Bailey's Irish Cream, and Guinness stout. Diageo also owns 34% of premium champagne and cognac maker Moet Hennessy, a subsidiary of French luxury-goods maker LVMH Moet Hennessy-Louis Vuitton SA.

Spirits companies are subject to heavy regulation and taxation. Governments around the world may enact policies that place restrictions on Diageo's business activities or increase liquor taxes, resulting in a demand headwind. Additionally, as a result of operating in 180 countries, foreign exchange rate fluctuations can cause large swings in Diageo's financial results. Furthermore, the company's acquisition strategy is inherently risky, and should the firm overpay for acquisitions, shareholder value could be destroyed. Finally, 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.

We continue to believe that over the next decade Diageo will grow revenue by almost 6% per year and earnings per share by roughly 8% to 9% per year. Overall, we haven’t wavered from our stance on the company’s economic moat, which remains wide, bolstered by its premium brands and unmatched geographic scale.

Diageo’s business in the United States continues to premiumize, with strong performance from the Ciroc, Crown Royal, and Ketel One brands. We continue to forecast that spirits will continue to gain share of throat in the coming year at the expense of beer. CEO Ivan Menezes is still forecasting a low-single-digit decline in Diageo’s Western European business, which strikes us as reasonable in light of the challenging macro environment.

Recently, the Chinese government has been cracking down on corruption, bribery, and gift-giving to public officials. As such, demand for high-end spirits has fallen, and this has negatively affected several publicly traded Chinese spirit companies (such as Kweichow Moutai and Wuliangye Yibin) as well as Diageo’s Chinese white spirits subsidiary (Shui Jing Fang). However, despite weakness in baijiu and white spirits, management confirmed qualitatively that Diageo’s super- and ultra-premium scotch brands continue to perform well in China.

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Thomas Mullarkey, CFA  is an equity analyst at Morningstar.