KHC - Diageo: A Rare Gift From Mr. Market

2023-03-06 17:39:25 ET

Summary

• Diageo's share price has been underperforming for far too long due to outside factors that have little to do with the business itself.
• The premium brand portfolio in combination with the well-executed acquisition strategy creates a unique opportunity.
• As growth accelerates, the company is well-positioned to retain and even improve its industry-leading margins.

For a long-time, large international consumer staple businesses have been at a disadvantage to other areas of the equity market.

From the excess liquidity within the market to the strong U.S. dollar, which created a major headwind for businesses with large international exposures.

Then the pandemic lockdowns came and wreaked havoc across the valuable high margin on-trade channels. And just as things were turning for the better, the unprecedented cost inflation is now overshadowing the post-pandemic recovery.

Diageo ( DEO ) has been right in the middle of this extremely challenging environment. That is why, in spite of its strong business model, Diageo's share price has been underperforming both the broader equity market and the consumer staples sector.

This performance, however, does not seem to accurately reflect Diageo's potential to grow the business and further improve its industry-leading margins as its strategy fully capitalizes on the strong brand portfolio and large global distribution network.

Premium Brands Lead To Premium Multiples

A strong brand portfolio and a large global scale are by far the most important competitive advantages a consumer staple business could possess.

Having said that, businesses operating in more premium and higher customer loyalty segments, such as alcoholic drinks for example, have much greater advantage over companies selling low margin products with low switching costs.

In that regard, Diageo is among the best-positioned consumer staple businesses. Nearly 60% of sales now come from either premium or super premium product categories.

The two high margin segments have been the highest growth areas within the market for a very long period of time.

At the same time, brand loyalty is among the highest within these two price points and Diageo is fully capitalizing on this through its strong global brand portfolio.

Thus, Diageo's current gross margin of 61% is the highest within its broader peer group, which also includes soft drink manufacturers and breweries.

Sustainability of margins is just as important and in that regard, Diageo's business model has proven its stability over a very long period of time.

The reason why I focus on gross profitability above is that the lack of fixed costs makes gross margins a very good indicator of a product's price premium. Once you have that, all it takes is scale in order to reduce the level of fixed costs and thus attain industry-leading operating profitability.

Operating profitability on the other hand is by far the most important driver of valuation multiples within the sector. As we see in the graph below, Diageo's forward sales multiple is well-supported by its high margins.

But the graph above highlights yet another very important consideration when we use margins to explain differences in valuations. AB InBev ( BUD ), for example, has much lower sales multiple to what its margins would suggest, while Brown-Forman ( BF.B ) is experiencing the opposite.

The reason for this divergence is that AB InBev has been too aggressive in its M&A strategy and cost-cutting efforts to achieve this level of profitability. On one hand this makes margins far less sustainable over the long-run, but on the other it also leads to problems associated with asset impairments, disposals, bloated brand portfolios etc.

On the contrary, Brown-Forman has been expanding primarily through organic growth and much smaller bolt-on acquisitions, which the company then gradually scales up across the globe. This strategy is much more appealing for long term-investors and it also leads to more sustainable return on capital over time.

Acquisition-led Strategy Done Right

With everything said so far, it would be reasonable to expect for Diageo to be in a similar situation to that of AB InBev. The reason being that DEO has been relying heavily on inorganic growth over the years.

The magnitude of Diageo's acquisition activity could be measured by the company's significant increase in intangible assets, the majority of which are recorded on balance sheets following an M&A transaction.

Diageo, however, has also been heavily investing in internal growth. Thus the overall share of intangible assets within the company's total assets has in fact declined from 35% in 2008 to 32% during the first half of fiscal year 2023.

Another very important detail from Diageo's strategy becomes evident once we take a look at the breakdown of these intangibles.

The vast majority of the company's intangible assets or roughly 66% are brands with indefinite useful economic lives, while goodwill represents less than 20%.

The reason why this is so important is because the company has identified, valued and is testing for impairment all of its brands every year. As opposed to the goodwill impairment tests, in this case assumptions about each single brand are tested individually.

Thus, the overall quality of the reporting process - both internally and externally is improved significantly. It also reduces the probability that the management could withhold vital information from the public up until it's too late and massive asset impairments would need to be recorded. A good example of such case was Kraft Heinz ( KHC ), which had most of its intangible assets classified as goodwill.

In addition to the organic growth and the quality of reporting, Diageo also engages in smaller bolt-on acquisitions in strategic areas for the business (see the graph below). Simultaneously to this process, the company also regularly disposes of smaller brands that are not essential for the long-term competitiveness of the business.

When taken together all that makes Diageo's acquisition-led strategy a text book example of how to create shareholder value over the long run.

Taking Local Brands Around The Globe

It is a no-brainer that with larger size, companies could tap into significant economies of scale associated with lower share of fixed income costs and higher asset turnover.

Although this is true, large global scale offers another significant competitive advantage for companies operating in highly branded industries. More specifically, Diageo's global distribution network allows the company to acquire small regional brands and then quickly scale them up across the globe.

When properly executed, this strategy could also be utilized to steer the business into the most attractive segments of the market. Diageo seems to have done exactly that, with the business now having significant exposure across all of its long-term strategic areas.

A very good example of the aforementioned competitive advantage is the premium-plus tequila brand of Don Julio. Back in 2015, Diageo acquired full control over the brand for a relatively small amount.

By having full control, Diageo continued to support the brand over the years and by 2021, the brand had become a centerpiece in the company's growth strategy in the United States.

Also in 2021, Diageo announced a major investment to increase its tequila capacity in Mexico.

From there, the Don Julio brand is now gearing up for higher growth across the globe.

A New Stage For Growth

The last fiscal year was a great success for Diageo with unprecedented sales growth of 21%. More importantly, however, the figure was well-balanced with volume contributing 10% and price increases also playing a key role.

Sales were up 21% with double digit growth across all regions. Growth was balanced with volume of 10% and price/mix growth was 11 points , with price contributing mid single-digit growth .

Source: Diageo FY 2022 Earnings Transcript

Given this strong volume performance, Diageo's management could continue implementing price increases to both offset higher cost inflation and improve margins going forward.

I think what we see going forward is the same. I think we will continue to use our entire suite of revenue growth management, and price will be a level within that .

Source: Diageo FY 2022 Earnings Transcript

At the same time, the business has stepped-up its capital expenditures, which are now at one of its highest levels relative to sales.

In addition to higher capex, Diageo's high margins allow the company to increase its spend on advertising and promotion, which is a major brand building expense.

This is a true testament to the company's superior business model, which allows for increased reinvestment into the business without sacrificing profit margins and during times of record-high inflation.

That is why, the business is very well-positioned to deliver on its medium-term guidance for high organic revenue growth and even higher operating profit growth.

Conclusion

After years of underperforming the broader equity market and consumer staples sector, Diageo is once again set to deliver on its long-term strategy. The business is experiencing high volume growth, while its strong brand portfolio and strategic positioning in key areas of the market would allow for sustained price increases. The latter would allow the company to further improve its industry-leading margins which in turn could result in a multiple repricing opportunity for Diageo's shareholders. Last but not least, Diageo's management could continue to capitalize on its acquisition-led strategy to position the business for the long run.

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