Diageo Price Talk Will Tighten, Best Ideas’ SABMiller Bonds Comparatively Cheaper

Diageo is the world’s largest spirits maker, and the strength of its portfolio is unmatched. With eight of the world’s top 25 brands and unrivaled global distribution scale, the firm generates robust free cash flows and has a wide economic moat, in our view. With its strong brand portfolio and unmatched distribution scale, the firm is able to leverage its strength to gain shelf space and successfully negotiate with retailers on pricing. 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, covering 80% of its total U.S. volume. No other firm has come close to replicating this breadth in the U.S. While sales in Europe struggle due to the eurozone’s recession, the firm’s top line continues to grow and margins are stable as emerging markets more than offset European weakness. Diageo’s premium positioning leaves the company’s portfolio more vulnerable to down-trading in a weak economy; however, its brands are some of the strongest and most well-known in the world and outperform during economic recoveries. We forecast Diageo will generate returns on invested capital in the midteens, well above the firm’s weighted average cost of capital, supporting our assertion that the firm has a wide economic moat.

Diageo’s balance sheet is moderately leveraged, as debt to EBITDA was 2.6 times at the end of fiscal 2012, and the firm has significant near-term debt maturities representing a significant portion of its debt. In April 2013, Diageo issued $3.25 billion of new notes, which should be enough proceeds to refinance maturing debt through the end of fiscal 2014. We forecast that the firm will balance its free cash flow usage between dividends and share buybacks and that debt leverage will decline to an average 2.1 times over our five-year forecast period.

Issuer profile
The product of a merger between Grand Metropolitan and Guinness in 1997, Diageo 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 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 LVMH.

Financial Health

Diageo is financially healthy. At the end of fiscal 2012, net debt was GBP 8.1 billion and net debt/EBITDA was a respectable 2.3 times. Diageo is capable of turning roughly 20% of its revenues into free cash flow; some of that cash flow can be used for either reducing its outstanding debt or closing the funding gap in its pension plans, which were GBP 1 billion underfunded at the end of June 2012. Our credit rating for the firm is A-, and in the unlikely event of a liquidity crisis, Diageo could suspend share repurchases and cut its dividend.

Capital Structure

Although Diageo ended fiscal 2012 with a very manageable amount of debt, we note that the company could meaningfully increase its leverage were it to acquire another large spirits company (such as Beam). Although net debt/EBITDA was 2.3 times in fiscal 2012, we expect that (excluding any acquisitions) ratio could drop to 1.5 times by 2017. We forecast EBITDA to cover interest an average of 10 times during our 10-year forecast period. Diageo’s debt maturities are nicely spaced out over the next five years, and we expect the company to comfortably manage to refinance or pay off its debt maturities.

Enterprise Risk

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.


As a result of its immense distribution system that spans 180 countries coupled with its cornucopia of top-shelf brands, Diageo has established a wide economic moat. Although we like the firm’s focus on premium brands and investments in international growth, we worry that cyclical weakness in some key European markets could induce a temporary headwind to earnings and might entice management to overpay for an acquisition.

Diageo is the world’s largest maker of spirits, and the scale and scope of its portfolio is unmatched. Brands such as Johnnie Walker, Smirnoff, Bailey’s Irish Cream, and Jose Cuervo are number one in the world in their respective categories. Additionally, Diageo’s portfolio includes other top brands such as Guinness, Tanqueray, and Captain Morgan.

The company’s position in North America (a highly profitable market) is particularly strong, where it has developed a sustainable competitive advantage in its distribution network. Diageo, where allowed, has consolidated its distribution base to just one exclusive agent per state. Currently, these distributor relationships, which cover 80% of Diageo’s U.S. volume, have more than 2,800 dedicated sales people that are focused on Diageo’s brands. This army of exclusive sales people is highly profitable, resulting in operating margins in North America in excess of 35%, well above the firm’s consolidated margin in the high-20s, and higher than most of its competitors.

Although individual brands do not necessarily form an enduring economic moat (as consumers’ tastes and preferences can change over time), possessing a broad portfolio of strong beverage brands can create a competitive advantage if the brands are leveraged to gain shelf space and successfully negotiate with retailers on pricing. We believe that Diageo is effectively able to leverage its strong brands such as Johnnie Walker and Smirnoff vodka to drive retail traffic, which makes it an invaluable partner to retailers across the globe and ensures that its competitive edge remains intact.

While rising input costs can temporarily compress any company’s operating margins, they don’t affect Diageo to the same extent. About one-third of Diageo’s volume (primarily scotch, but also tequila and rum) is derived from maturing products, which can sit in inventory and age for up to 30 years. Under International Financial Reporting Standards, Diageo expenses these input costs on an actual usage basis, meaning that it could be 10 to 30 years before today’s cost inflation affects the income statement. Therefore, we suggest investors look closely at cash flow in addition to earnings when valuing Diageo.

Despite the company’s best-in-class product portfolio, Diageo’s financial results have been hampered by elevated unemployment and economic uncertainty in some regional markets. For example, in fiscal 2011, Diageo’s net sales in Greece plunged by 38% as a result of a significant increase in excise duties on spirits combined with Greece’s economic turmoil, which greatly weakened consumer demand within the Hellenic Republic. Additionally, in the larger and more stable markets of North America and Western Europe, the long-term trend toward premium brands came to an abrupt halt during the past recession, as drinkers switched to cheaper brands. Despite these headwinds, we think that Diageo has done a good job of managing through recessionary circumstances. It cut prices in order to keep customers loyal to spirit categories and to Diageo’s brands, and we think this strategy will buoy the firm when consumer spending rebounds. However, in an environment of high economic uncertainty and concerns of European contagion, the rebound could be several years off, and we expect consumers to continue their cautious ways over the medium term.

Although Diageo spent a decade spinning off noncore operating business in order to focus on the spirits industry, we note that Diageo’s beer portfolio (which includes Guinness) is also important for the company’s future growth, as its beer brands can serve as a gateway to other alcoholic beverages, such as spirits. From our perspective, this is particularly notable in driving the company’s growth aspirations in Africa.

Economic Moat

Diageo has built a wide economic moat thanks to its unmatched distribution scale, bevy of strong brands, and impressive distribution network in the U.S.–the most profitable spirits market in the world. These competitive advantages would be outrageously difficult for a new entrant to duplicate. Despite the goodwill assumed during a throng of acquisitions, such as Seagram in 2002, the spirits brands of Allied Domecq in 2005, and Mey Icki in 2011, we forecast Diageo to generate returns on invested capital in the mid- to high teens for the next decade–well in excess of our 8% estimate for the firm’s cost of capital–supporting our take that Diageo maintains an economic moat.

Moat Trend

We believe that Diageo’s moat trend is stable. Although the European debt crisis has cooled sales growth in countries such as Greece and Spain, the company’s market share remains stable, and the firm continues to generate strong cash flows. Diageo is able to maintain its wide economic moat because of its entrenched distribution system in the U.S. and its strong collection of brands.

Diageo Price Talk Will Tighten, Best Ideas’ SABMiller Bonds Comparatively Cheaper

Diageo DEO (rating: A-, wide moat) is reportedly issuing 5-year, 10-year, and 30-year bonds in benchmark size this morning. Diageo has built an enviable business empire with an unmatched portfolio of spirits, which when combined with its vast distribution network, would be very difficult and expensive for any competitor to duplicate and results in a wide economic moat. Longer term, the company is making investments to grow its business in the emerging markets which we expect will benefit investors as Diageo gains additional distribution scale in these fast-growing regions. In addition, the company will benefit as it continues to shift additional global consumers into more premium (and higher-margin) brands. In our opinion, these competitive advantages combined with the firm’s moderately leveraged balance sheet justify our A- issuer credit rating. Diageo has numerous debt issues that mature over the next few years, representing a significant proportion of the company’s debt. In our credit perspective, we noted that we expected Diageo to access the capital markets to refinance maturing debt into longer-term notes and that the firm will balance its free cash flow usage among debt repayment, dividends and share buybacks. Last week, the firm released its interim results for the nine months ended March 31, 2013 which were in line with our expectations.

The whisper talk we heard on the new deal is +65, +105, and +115 for the 5-year, 10-year and 30-year, respectively. We think those levels are too cheap compared to where the firm’s existing bonds trade and will tighten five to ten basis points before the official price guidance is released. Prior to the announcement, the mid-point of where the firm’s 1.50% Senior Notes due 2017 were indicated was +50 over the curve (+35 to the benchmark), the 2.875% Senior Notes due 2022 were +95 (+81 to the benchmark), and the 4.25% Senior Notes due 2042 were +101 (+98 to the benchmark). At these levels, we think the notes are fully valued.

Comparatively, we think SABMiller SAB (rating: A, wide moat) notes are cheap. For example, midpoint pricing on SAB’s 2.45% Senior Notes due 2017 are +64 to the curve (+35 to the benchmark), the 3.75% Senior Notes due 2022 are +103 (+83 to the benchmark), and the 4.95% Senior Notes due 2042 are +114 (+112 to the benchmark). For investors that are able to find SABMiller’s 5.875% Senior Notes due 2035, which is on our Best Ideas list, can pick up additional yield and spread as those notes are indicated at +160 (+136 to the benchmark). The 2035 bond was originally issued by Foster’s Brewing which was acquired by SAB at the end of 2011.

Diageo’s Results in Line With Expectations; Shares Remain Slightly Overvalued

On Thursday Diageo DEO provided investors with its Interim management statement for the nine months ended March 31, 2013. The update shows that the wide-moat firm continues to steadily grow revenues as its strong portfolio of brands continues to maintain its pricing power. During the first nine months volumes organically grew 1% and sales climbed 5% as the company raised prices and consumers increasingly opted for more premium spirits. Given that the company’s performance is largely in line with expectations, we are maintaining our GBX 1,700/$109 fair value estimates on the firm’s shares/U.S. listed ADSs and believe the shares are slightly overvalued at this time.

For the first nine months, Diageo has experienced organic sales growth in its Latin America and Caribbean (+14%), Africa/Eastern Europe/Turkey (+9%), North America (+6%), and Asia-Pacific (+4%) regions. However, sales in Europe have fallen by 4%, largely as a result of heightened economic uncertainty and excise tax increases in France. Overall, Diageo CEO Paul Walsh remains confident that the firm’s financial performance remains on track and that itscadre of brands (including Johnnie Walker) is well poised for steady growth across North America, Africa, and Latin America. Longer term we continue to believe that Diageo will be able to leverage its prior acquisitions in Brazil (Ypioca), China (Shui Jing Fang), and Turkey (Mey Icki). By acquiring strong local brands which cater to local tastes and enjoy more developed distribution systems, Diageo is able to increase the availability of its other premium spirits. We believe that Diageo has the financial prowess to consummate similar transactions in the coming years as it looks to broaden its portfolio and maintain its global leadership in the spirits category. Diageo Says Adios to Jose Cuervo; Negligible Impact to Fair Value, but Shares Appear Overvalued 11 Dec 2012 Diageo’s DEO discussions to acquire tequila maker Jose Cuervo have ended, and the spirit makers’ distribution agreement will expire without renewal at the end of June 2013. Jose Cuervo, which was one of Diageo’s 11 strategic brands, saw volume decline 5% during fiscal 2012 to around 4 million 9-liter cases. Overall, Cuervo represented just 2.5% of Diageo’s overall volume, so the loss of the business should have a minimal impact on Diageo’s bottom line, and we are maintaining our fair value estimates of $95 and GBP 15. Shares are currently trading at a more than a 25% premium to our fair value estimate, which assumes a revenue compound annual growth rate of 6% and operating margins reaching 30.5% over the next five years. We would recommend waiting for a pullback before taking a position in this name. We believe the severing of the Cuervo talks and distribution agreement makes it much less likely that Diageo will again enter into talks with the tequila maker during the next several years. However, this could result in Diageo’s courting bourbon maker Beam BEAM . Jim Beam Kentucky bourbon, Maker’s Mark bourbon, and Sauza tequila would be excellent additions the world’s largest spirits company. However, Beam’s Pinnacle vodka brand does overlap with Diageo’s Smirnoff, and we wouldn’t be surprised if an eventual Diageo-Beam acquisition would result in the divestment of Pinnacle.

Diageo Acquires Stake in India’s United Spirits Limited

Diageo DEO has agreed to acquire a sizable stake in India’s largest spirits company, United Spirits Limited, for INR 1,440 per share, a 15% premium to the recent share price of INR 1,250. Diageo will buy 27.4% of USL for INR 57.3 billion (GBP 660 million or $1.05 billion) from United Breweries Holdings Limited and USL Benefit Trust, as well as some shares that have yet to be issued. This purchase agreement will trigger an obligation for Diageo to launch a mandatory tender offer to the public, during which it will offer the same INR 1,440 per share, which should net Diageo another 26% of the company. If shareholders do not tender enough shares to give Diageo majority control, UBHL has agreed to vote its remaining shares as directed by Diageo for the next four years. Should the tender be fully subscribed, Diageo will ultimately pay INR 112 billion (GBP 1.29 billion or $2.05 billion). The deal is valued at 20 times USL’s EBITDA for the year ended March 2012. Diageo expects the deal to be accretive to earnings per share in the second year of ownership and deliver positive economic profit in the sixth year of ownership (using a 12% weighted average cost of capital). Given that positive economic profit for the deal is several years away, we are maintaining our fair value estimates of GBX 1,500 and $95 for Diageo.

Unlike many other markets, the Indian alcohol market is predominantly skewed toward spirits and away from beer and wine, and USL operates as the leading spirits company (41% share, which exceeds the combined share of the next five largest players) with net sales of INR 91.9 billion (GBP 1.1 billion). The firm sold 122 million 9-liter cases last year (versus Diageo’s 156.5 million cases), services 64,000 retail outlets, and has more than 22 brands that sell more than a million cases a year. India’s demographics are also appealing; Diageo expects that its middle class will grow from 120 million people today to 600 million by 2025. This is a key reason the Indian alcohol market is expected to grow 15% per year over the next five years.

USL’s McDowell’s is the largest spirits brand in the world, selling 44 million 9-liter cases in fiscal 2012 across three categories: whiskey, brandy, and rum. Whiskey is popular in India, and USL has numerous whiskey brands across a variety of price points to meet consumers’ tastes (Bagpiper, Signature, Royal Challenge, Black Dog, and Whyte & Mackay). We believe this deal will enable Diageo to steadily increase its sales of Johnnie Walker Scotch in India. By combining Diageo’s premium worldwide brands (especially Johnnie Walker) with USL’s enormous distribution system, Diageo’s revenue/liter in India should steadily climb during the next decade, in our opinion.


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