Diageo Stock: Welcome To The Lucrative Area Of Alcohol Investing

As of right now, the price to acquire 1/628 millionth ownership position in Diageo stock costs $115 each. Because of the one-off items that the company has undertaken to cut costs, there is a discrepancy between reported profits over the past twelve months and the actual long-term normal profit base going forward that is indicative of the alcoholic company’s true earnings power. It’s a great way to scoop up blue-chip stocks at a discount or at least a fair price because a lot of people out there don’t have the time or patience to study the company and realize that the numbers spit out by stock screeners don’t tell you the truth about the company.

I first realized how lucrative this could be when I studied Johnson & Johnson during its multi-year stretch of prolonged manufacturing recalls in which the company appeared to be reporting profits in the high $3 per share range but the real profit base was somewhere around $5 per share. The stock was somewhere in the $60s at the time; now, it reports “clean” numbers in the $5.70 per share range, and the price of the stock hovers around $100 per share. When companies with diverse product bases, high profit margins, and strong moats are being criticized and devalued in financial commentary, it’s worth a look to see if it’s a good time to buy.

A less dramatic example of this same principle, at today’s stock prices, is the alcoholic producer: Diageo. It’s not a name that rings off a lot of bells in many people’s heads, but the corporate history is rich: The first stock offering came in the October of 1886 as Arthur Guinness Son & Company. You can already guess which brand of alcohol they sell. The bland Diageo name recognizes that they are not just Guinness anymore—they have come to represent brands with strong brand-name recognition across the spectrum of ethanol-based things you could put in your body:  in addition to Guinness beer, Diageo owns Smirnoff vodka, Johnnie Walker scotch, Jose Cuervo tequila, and Captain Morgan rum.

Buffett himself once bought 38,500,000 million shares of the then named Guinness stock in 1991 and 1992, and sold it shortly thereafter for a quick profit. I wonder if he is satisfied with his near double, though, because had he stuck around for the next 20+ years he could found himself in the nice position of seeing the investment value of his position octuple (that counts dividends paid out but not reinvested, so the results could have been even more impressive).

Right now, when someone studies Diageo, they are seeing numbers affected by cost cuts and an asset swap with Casa Cuervo in which Diageo traded the Bushmill Irish Whiskey business to Casa Cuervo and received $408 million, the rights to own the Smirnoff brand in Mexico, and the Don Julio brand that sells tequila. That means that some stock screeners show Diageo making $4.76 in profit and trading at a valuation of over 24x earnings. In reality, Diageo’s profits are around $3.8 billion per year once you look past the clouded accounting figures, which means that Diageo earns $6.33 per share in profit. At the current price of $115, that works out to a true valuation of 18x profits.

Is the stock trading at a deep discount to fair value? No. But it gives you a fair deal, which is a good place to be in a stock market that has seen most leading firms possess six straight years of stock market growth (at least directionally, if not cleanly annually). It is a nice deal when you take into account the 9.5% earnings growth and the 8.5% annual dividend growth going forward. And anytime you can buy a company with operating margins above 30% for year after year, you know you’re looking at the kind of company that you can hold for a long time. It also has the intuitively obvious appeal—these are strong alcoholic brands in an industry that isn’t going anywhere and it has been able to create a substantial gap between the ingredient and shipping costs of the alcohol and the retail price at bars, gas stations, and grocery stores dating back to the 1800s. Heck, Guinness had been selling to customers before gas stations as we know it even existed.

What I like about Diageo is that analysts expect revenue gains somewhere in the 5% or 6% range over the coming five to ten years because Diageo naturally grows in its own markets and is expanding rapidly enough into third world countries, and that makes me think that Diageo is one of those companies that will grow profits 8-12% annually (with dividend growth lagging earnings growth by a point or two over the long haul). To me, this is the typical ground for finding a stock you can hold for life: (1) find something with stable profits that are easy to understand and ideally has a long track record of making shareholders rich, (2) pay special attention to the companies with the higher earnings per share growth rates in that category of companies, and (3) then buy them when you can get a price of fair value or better. Diageo goes back to the 1800s, makes people rich at a double-digit clip, and is trading at 18x earnings. That’s not bad.

Why, then, doesn’t everyone stuff their portfolios with more and more Diageo stock? I have two speculations. First, American investors prefer companies that raise their dividends each and every year. I obviously understand the appeal of this because it taps into the satisfaction part of the brain that likes to see forward progress, and a growing dividend income stream obviously meets this. The catch is that European companies don’t share that cultural trait that is apparent at Coca-Cola, Johnson & Johnson, and Colgate-Palmolive; you get treated like a business owner and sometimes the profits are higher and the occasional year the dividend is lower—you also have to deal with the currency translations that affect this figure, so that explains why Diageo shareholders saw their annual income decline from $2.73 in 2008 to $2.37 in 2009 to $2.28 in 2010.

Some people don’t like seeing their dividend income cut during a recession. Fair enough. I find this tolerable, though, because you can look through and see Diageo making $2.6 billion in profits in 2008, $2.4 billion in 2009, and $3.0 billion in 2010. If you looked, the business itself was doing well. And the one advantage of the European model if dividends is that the dividend growth comes at a faster clip during economic recoveries. That $2.28 dividend in 2010 sprung up to $3.54 by the end of 2014.

The other reason why some investors might hesitate before buying Diageo has to deal with the dividend yield, which tends to hover around 3%. There will always be shinier objects with higher yields available. Yet, that $35 share bought in 2002 is now paying out $3.54 in dividends, for a 10% annual payment of money invested twelve years ago (as a reward for your patience, you got to see the price of the stock triple on its own, without even taking into account the effects of the dividend).

From a pure dividend growth perspective, the ride of owning Diageo isn’t as smooth as some of the highest caliber companies that I typically mention. However, the dividend gets where it needs to be eventually—you just get higher dividend growth in the good years than you’d get from an American company reporting the same profit growth. Considering the company itself is still quite profitable when the dividend payment goes down, I find this tolerable. At 18x earnings for a well-branded company that grows in the high single digits according to analyst estimates, we are talking about one of the better deals out there as far as the highest quality companies go.