An Alcohol Investment With A Lottery Ticket

As I look at the top five hundred or so companies in the world based on size, there are only four or five dozen I can find that could be classified as undervalued at the present moment. And once you remove cyclical companies–particularly the energy stocks–then the list of companies gets even thinner. This isn’t a tragedy, as it only takes one attractive opportunity at a time to put money to use, but it does speak to the homework and research necessary to find companies on sale these days.

One such candidate for consideration is Diageo (DEO), a London company developing deep roots in the emerging markets that became publicly traded in 1886 under the name Arthur Guinness Son & Company. This beer company seems to be a living, breathing example of the great Charlie Munger quote, “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.”

For the past 35 years, Diageo has generated returns on total capital between 17.0% and 23.3%. That is a nice range, coming in quite close to the 26.8% averaged by Coca-Cola over the same time frame. When it reinvests into its business, it generates 10.5% annual returns. This is what the company does. It does not require share buybacks to do this. It does not rely on cost-cutting to achieve this (in fact, it has some of the highest expenses in the alcohol industry.) It is a function of the core economic engine of the company, which is a great sign if you’re looking for a stock worthy of holding for life–it doesn’t take luck or superior management for Diageo to work out as a good investment.

Diageo has a diversified stream of gilt-edged revenue sources. It makes money selling rum through Captain Morgan. It has its foot in the vodka industry with Smirnoff. It sells popular liqueur brand Baileys. It expanded into scotch whiskey with the acquisition of Johnnie Walker. And it even has part of the market for traditional beer with Guinness. There are a lot of other brands, but this collection gives you an idea of Diageo’s dominance across the various alcohol sectors.

It’s doing what it has always done–growing earnings in the range of 8-12% annually on a constant currency basis, although some recent transactions have created hiccups in the earnings figures. Diageo bought United States and the Don Julio brand, sold Desnoes & Geddes to Heineken, and purchased 20% of the Guinness Ghana Breweries distributorship. This unusually high period of asset shifting may have distorted the earnings picture, but Diageo has made $6.33 in the last year.

The current price is only 18x earnings. I regard this valuation as a discount of 10% to 15%, roughly analogous to Coca-Cola if it traded at $35 per share. You get exceptional quality, a whole host of brands, great returns on equity, and a strong growth platform in the emerging markets. This puts Diageo on the list of top few dozen companies in the entire world, and the inherent characteristics of the business plus the ability to raise sales by 6% annually give this company an unusually high growth profile for a large-cap.
Even better, it comes with the possibility of being a takeover candidate by Anheuser-Busch Inbev SABMiller. The current value of Diageo is $78 billion, roughly the same as SABMiller when you adjust for the fact that a premium would need to be paid in order to acquire the business.

The 3G business model requires the constant acquisition of new businesses, as the skill set of the operators only involves the ability to lower costs (rather than grow sales or improve the product in a way that the pricing power can improve.) Brito has indicated a desire to keep the acquisitions in the beer industry as long as possible, suggesting that Diageo would be the obvious next target.

In fact, Diageo experienced a temporary advance in price this summer on the rumor that Lemann instructed Brito to make Diageo the next target for Anheuser-Busch Inbev, but the company ended up acquiring SABMiller instead. In three or four years, once the acquisition of SABMiller is fully digested and the debt level goes from extremely high to unusually high, I would expect Diageo to be a takeover target. Furthermore, the high costs at Diageo would make the company attractive to a company whose primary skill is lowering costs.

I would not make an investment in Diageo with the expectation of a takeover in a few years as the basis for the investment. Instead, I view it as a kicker that involves positioning yourself to either “win over the long term” or get a “big win over the short term.” If there is no acquisition, you have found one of the few large caps that has exceptional quality and the ability to improve earnings per share at a clip near 10% over the long haul, plus you get a dividend near 3%. If there is one, you could find your shares being bought out for $200 in 2018-2019–it’s speculative, but the potential is there.

There are always three things swimming through the head of an investor when deliberating about what to buy. One is quality. Another is the growth profile. And the third is valuation. They’re all intertwined. Diageo has great quality with name brands in a lucrative field with high profit margins. The sales growth is mid single digits, and the company is moving aggressively into emerging markets, suggesting earnings per share growth could near 10% for long periods of time. And the valuation is only 18x earnings. It passes all three tests. Plus, there is the buyout potential in the next few years, which is a lagniappe on an already sweet deal.