Diageo is the best spirits company on the planet

Following the drinks giant's full-year results yesterday, which, as we expected, revealed soft sales that were more than offset by cost-cutting initiatives, we take a look at Morningstar senior stock analyst Ann Gilpin's assessment of the UK-listed stock. (Click here for our take on the fiscal 2009 numbers).

Fair value estimate: 1,220p ¦ Fair value uncertainty: Medium ¦ Economic moat: Wide

Thesis
In our opinion, Diageo is the best spirits company on the planet. With eight of the world's top 20 brands and unrivaled global distribution scale, the firm generates robust free cash flows and has a wide economic moat, in our opinion.

Diageo is the world's largest spirits maker, and the strength of its portfolio is unmatched. Brands such as Smirnoff, Guinness, Baileys, Tanqueray, Johnnie Walker, and Jose Cuervo are number one in the world in their respective categories. Because of its strong portfolio, Diageo has built a distribution fortress. 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. No other company has come close to replicating this in the United States, where Diageo is twice the size of the next largest competitor, and this exclusivity is highly profitable. Diageo's operating margins in North America are in excess of 36%, well above the company average in the high 20s and higher than most of its other competitors'.

Another of Diageo's strengths is its focus on premium brands. Consumers continue to trade up to higher-priced and better-quality spirits. In emerging markets, many consumers are drawn to Diageo's brands because of their "aspirational" qualities. These consumers perceive that Diageo's brands will identify them as Western and affluent. In more-developed markets, Diageo's brands connote sophistication and tradition because of their higher price points and enduring brand equity. In some markets, Diageo has even pursued a luxury positioning. For example, for roughly $550 one can purchase a 750-milliliter bottle of Johnnie Walker Blue Label King George V Edition that is packaged in a crystal decanter in a plush silk-lined box with a certificate of authenticity. Not surprisingly, such products are highly profitable.

In the near term, we think Diageo's premium positioning may face head winds as a result of weak consumer spending and slower global growth. While most of Diageo's consumers in developed markets are unlikely to forgo higher-priced spirits in economic downturns, other aspirational consumers who are at the margin may trade back down to lower-priced brands. In emerging markets, consumer weakness could ripple into markets like Russia and Latin America, where volume growth may be softer relative to those in recent years.

In the longer term, however, we think consumers will still increasingly demand the affordable luxury of premium spirits, and Diageo is the best positioned to benefit from these demands.

Valuation
We have lowered our fair value estimate to 1,220p per share from 1,426p to account for the appreciation of sterling relative to other currencies, primarily the US dollar. Foreign currencies will continue to cause fluctuations in Diageo's cash flows, and we believe we have accounted for this in our uncertainty rating. On an underlying, currency-neutral basis, we expect Diageo's annual sales growth to average 4%-5% longer term, but we think volume and margins are likely to come under pressure in 2009 and 2010 as a result of macroeconomic head winds such as weaker consumer spending. Prior to the release of the full-year results, we lowered our 2009 fiscal year forecast of operating profit growth to 4% (versus our previous assumption of 7%) because of the weak global economy. Longer term, we forecast operating profits to increase at a faster clip than sales as the firm gains leverage over marketing and advertising in emerging markets. Overall, we forecast operating profits to grow about 6% annually longer term. We have not forecast any acquisitions, but we anticipate that Diageo will make some smaller bolt-on acquisitions from time to time. We don't expect these to move the needle significantly on our valuation.

Strategy
Diageo aims to flex its premium-positioned spirits portfolio to gain distribution leverage in developed markets and gain market share and pursue growth in emerging markets. The company has also introduced several luxury-priced offerings to increase its profits and elevate the image of its brands. We expect Diageo to use cash flow from its highly profitable markets to invest in growth in emerging markets.

Management & stewardship
Paul Walsh, a veteran who started at Grand Metropolitan in 1982 and spent a decade running Pillsbury, stepped into the CEO role in 2000. Walsh has been the driving force behind Diageo's strategy to shed noncore businesses in order to focus on spirits. Franz Humer, a director since 2005, was appointed board chairman in July 2008 following the retirement of James Blyth, who presided as chairman for eight years. We applaud the separation of the chairman and CEO roles and the fact that Diageo's 10-member board is composed of eight independent members. We don't see any red flags in corporate governance. Compensation levels seem consistent with those at comparable companies, and about 75% of compensation is variable, based on both annual and longer-term performance. Management and shareholder interests appear well aligned. The only gripe we have is that directors do not stand for elections annually; we think the company could strengthen its governance policy by removing staggered board elections.

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 Guinness stout, Smirnoff vodka, Tanqueray and Gordon's gins, Captain Morgan rum, Baileys Irish Cream, and Johnnie Walker scotch. Diageo also owns 34% of upscale champagne and cognac maker Moet Hennessy, a subsidiary of French luxury goods maker Moet Hennessy-Louis Vuitton.

Growth
We expect Diageo's annual sales growth to average about 4%-5% over the long run as strong growth in emerging markets offsets flat to low-single-digit growth in Europe.

Profitability
We expect Diageo to generate operating profit growth ahead of sales growth. We forecast operating margins to reach 28.9% in five years, up from 27.4% in 2008 on a comparable basis.

Financial health
Diageo generates very strong cash flows, and its coverage ratios are more than adequate, in our view. For the next five years, we think adjusted free cash flows will average about 18% of net sales.

Bulls say
Diageo is the largest spirits maker in the world, with eight of the world's top 20 brands

Longer term, consumers in the US are likely to continue to trade up to premium spirits brands, where Diageo's portfolio is positioned

Diageo controls exclusive distribution rights where allowed in the US, where no single competitor has achieved a similar feat. This has contributed to above-average profitability in the region

International markets are growing about twice as fast as Diageo's North American operations, and the firm has been quick to establish a foothold in distribution and marketing.

Bears say
Diageo's premium positioning could make near-term top-line growth more difficult amid head winds resulting from consumer weakness and a global macroeconomic slowdown

Diageo manufactures products that contain a potentially addictive drug, leading some people to label the equities of alcohol purveyors as vice stocks; certain classes of investors will not own vice stocks regardless of price

One of the company's largest brands, Jose Cuervo tequila, is not owned by Diageo outright, but is an agency brand manufactured and distributed under license. This license extends through 2013, so this would only be of concern to investors with extremely long holding periods

Consolidation in the spirits industry has created competitors that, once dwarfed by Diageo, are now approaching the company's scale. Pernod Ricard has bulked up considerably after buying V&S (maker of Absolut) and carving up Allied Domecq.

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