Diageo plc (ADR) (NYSE:DEO) is a leading player in the alcoholic beverages market. Up until the last few years, the company enjoyed great success.
However, consumer trends have started to shift in DEO’s most profitable region – North America. The company has struggled to grow volumes and is now in a bit of a transitional period in an effort to strengthen its long-term growth prospects.
For these reasons, the stock appears to be relatively cheap today and offers investors living off dividends in retirement a safe 3.2% dividend yield and mid-single digit dividend growth potential.
However, is now the time to buy the stock given some of its challenges?
At the end of September (the last reporting period), 25 funds from the Insider Monkey database reported holding shares of Diageo, down from 26 a quarter earlier. In addition, these funds held around $1.15 billion worth of the company’s stock, which represented 1.50% of the company at the end of September. Tom Russo’s Gardner Russo & Gardner, Tom Gayner’s Markel Gayner Asset Management, and Mario Gabelli’s GAMCO Investors are among the investors that reported long positions in Diageo in their last 13F filings.
Business Overview
DEO is the largest producer of spirits in the world and was formed in 1997 after the merger of Guinness and Grand Metropolitan. Some of DEO’s leading global brands include Smirnoff (#1 spirit brand by volume), Captain Morgan, Guinness, Johnnie Walker (#1 spirit brand by value), and Bailey’s. By beverage category, scotch (24% of revenue), beer (18%), and vodka (12%) are DEO’s largest categories (see below).
Source: Diageo’s 2015 Annual Report
By geography, over 40% of revenue comes from emerging markets. However, the United States (45% of operating profit) and Western Europe generate most of the company’s profits today.
Business Analysis
DEO’s key strengths are its global distribution network (products are sold in over 180 countries), well-known brands (many have hundreds of years of history behind them), broad portfolio (sells at every price tier of every category), dominant market share (see below), and large marketing budget (spent over $2.3 billion on marketing last fiscal year).
Source: Diageo’s 2015 Annual Report
With beer and spirits in its portfolio, DEO’s distribution network is massive and would take competitors decades of time and significant cost to replicate. This network allows the company to easily expand sales of its brands across numerous geographies. It also helps the company’s efforts to quickly introduce new or acquired products to the market to meet changing consumer preferences.
DEO has also made several strategic moves in recent years to position itself for stronger long-term growth and profitability. The previous management team relied on acquiring beverage companies across the spirits, beer, and wine markets.
The company is now taking a more focused approach in an effort to become more efficient, focus on its core strengths (e.g. premium spirits), and improve longer-term profitability. It has sold off several low-return wine businesses and beer brands like Red Stripe. Over 60% of the senior leadership team has also been replaced over the last two years.
Whether or not these changes can restore volume growth in North America remains to be seen. Longer-term, DEO’s size and strength should help the company adapt to consumers’ evolving tastes – through both product innovation and smarter brand marketing.
The company also stands to benefit from growth in emerging markets (43% of sales) as consumers in these regions see their incomes rise and are able to consume more spirits. DEO expects one billion new consumers will be able to afford its brands over the next decade and an additional 800 million consumers will reach levels of income where luxury brands are affordable.
All things considered, DEO seems to have many of the characteristics possessed by some of our favorite blue chip dividend stocks – a portfolio of leading brands with hundreds of years of history in some cases, strong and consistent profitability, participation in large and slow-changing markets, and a management team focused on the long term.
