STZ - Diageo's Valuation Has Improved But Spirits Volumes And Market Share Are Shakier Now

2023-10-24 08:24:23 ET

Summary

• Alcoholic beverage companies, including Diageo, are facing challenges in the spirits market as customers start trading down while costs remain elevated.
• Diageo has been losing market share in the US recently, but the losses seem more tied to brand value positioning and post-pandemic abnormalities and shouldn't be permanent.
• Changing consumer tastes are always a threat, but spirits have continued to gain share and Diageo has an uncommonly well-balanced portfolio.
• Long-term revenue growth around 4% and FCF growth of around 6-7%, as well as margins in the low-30%s can support a higher share price.

Alcoholic beverage companies, spirit manufacturers in particular, have long enjoyed a solid reputation with investors - almost to the point of many regarding them as "buy and forget" stocks given strong brand value and rich margins. Still, I'm the stubborn type who thinks that valuation still matters, and not many spirits companies have kept pace with the S&P 500 since my last update on today's subject, Diageo ( DEO ).

I thought valuation was the main issue with Diageo then, and while the performance has been pretty good relative to other spirits companies. Remy Cointreau ( REMYY ) and Brown-Forman ( BF.B ) have been quite weak (I thought both were too expensive here and here ), while my preferred ideas Pernod Ricard ( PRNDY ) and Constellation ( STZ ) (not a spirits company, but I'm including it anyway) occasionally outperformed and then underperformed relative to Diageo since my last articles on them (Pernod here , Constellation here ), with Constellation on top now, followed by Diageo and then Pernod.

Valuation isn't my main concern now, and I'm surprised to be writing that. What concerns me more is a slowing spirits market and evidence of share loss at Diageo within that slowing market. I don't think there's anything broken, I think a lot of it is just due to market "wobbles" and Diageo's brand positioning relative to those wobbles, and if mid-single-digit growth with low-30%s margins is still a valid outlook, these shares offer enough upside to merit a closer look.

Not Much To Toast In Recent Industry Numbers

Recent numbers in the spirits space haven't been particularly positive. Nielsen data indicated low single-digit growth in September excluding ready-to-drink products, but volume was just barely positive and the market has been softening, with ready evidence of customers trading down to cheaper brands. Although numbers are still not bad relative to pre-pandemic norms, it looks like the tailwinds from the intervening period (including more disposable income) are petering out.

Some of this softness is also evident in recent results. While Diageo only reports twice a year, others report on a more frequent schedule, including Pernod-Ricard and LVMH Moët Hennessy - Louis Vuitton ( LVMUY ). Pernod reported a 2.4% decline in organic sales in its fiscal Q1 (calendar Q3'23) with volume down about 9%, while LVMH reported a 14% decline in its wine/spirits business and a 19% decline in its cognac/spirits segment, citing "normalization of demand", "high retail inventory", and the "economic environment".

Diageo's most recent comment was a statement put out in late September in conjunction with the annual general meeting, with management saying there were no changes to their expectations for FY'24 - which basically means a modest improvement from F2H'23 (which saw sales growth of about 3% on a 3% volume decline)) and more improvement in the second half of FY'24.

Share Loss Is A Cause For Concern

I do have some concerns here despite that otherwise reassuring statement.

Depletions in the U.S. were down slightly in the last half-year, and there's evidence that there's too much inventory on the shelves of retailers. Along those same lines, Diageo has been losing share for some time, with Diageo lagging the spirits market by more than 600bp in September (and lagging by about 300bp in the beer market). All told, between Nielsen and NABCA data, it looks like Diageo may have lost about a point of market share in the U.S. over the last year.

That may look even more concerning given that tequila and whiskey, areas where Diageo is fairly well-leveraged, have both been areas of strength. Details matter, though. While American whiskey has been strong (up about 8% recently) and tequila has seen similar growth, Diageo isn't situated where the growth is right now.

American whisky has been strong, but that's less than 20% of Diageo's whisky mix, while Canadian whisky (where Diageo is strong) is only up about 1%, and scotch (likewise an area of strength) is up even less. In tequila, most of the growth has been in lower-priced brands where Diageo is less well-positioned.

If this trading-down process continues, then, I see a risk of further erosion in depletions and a period of retailer destocking that will compromise organic revenue growth and margins. I'd also note that sell-side expectations are counting on strong growth in Asia - upwards of 9% in FY'24 in many cases. While this region was stronger in 2H'23, up about 8%, volume was negative and I have concerns that a protracted economic downturn in China will hurt demand for premium spirits - to that end, Pernod reported an 8% decline in China in this last quarter, and while management was pretty constructive on market conditions, LVMH wasn't.

The Outlook

Longer term, I also see risks to every spirits company from changing tastes. While spirit consumption has increased steadily over the last decade-plus (from around 30% of U.S. alcohol consumption to 36%), tastes are trend-driven. There was a time when you couldn't find a premium gin, and now it's a fairly hot area. Likewise, vodka used to be all the rage, but has lost share to whiskey and many other spirit categories.

I mention this largely because Diageo has made some meaningful commitments to tequila, including growing its own agave. It takes time for agave to mature, and Diageo isn't targeting total self-reliance, but at least part of some bullish theses on Diageo is a margin tailwind in future years from substituting outsourced agave with internal production; if the market for tequila slows significantly, that could actually be a headwind. Offsetting this risk is the fact that Diageo is pretty well-diversified across liquor types and has the balance sheet capacity to buy up strong emerging brands, like it did with Aviation gin and Casamigos and 21Seeds tequilas.

I'm below-Street for FY'24 and FY'25 by about 3% and 7%, respectively, but more in line on a longer-term basis, and I'm expecting long-term revenue growth in the 4%-5% range. I previously thought that Diageo could get to mid-30%s operating margins by 2025, but with cost inflation that seems less likely and I've dialed back my expectations to the low-30%s. Still, that drives a high-teens free cash flow margin for the next few years, and I think a low-20%s margin is attainable over time (driving adjusted growth in the 6%-7% range).

Diageo ends up looking undervalued on both discounted free cash flow and margin/return-driven EV/EBITDA. The former suggests a long-term annualized total potential return in the high single-digits, and a nearer-term fair value about 10% above today's price, while the latter leads me to a 16.75x forward EBITDA and a fair value about 20% above today's price.

The Bottom Line

Consumer staples haven't been strong this year, as the Street has fretted about pricing persistence and margins in the face of trading down and higher production/input costs. Alcohol is more "staples-adjacent" in terms of how it performs, but I still see many of the same concerns.

My biggest hesitation in recommending Diageo is that I do see more risk to depletions/inventory and the risk that sell-side estimates fall and that the shares are disproportionately punished ("buy and forget" stocks get hit hard when they disappoint). Still, for investors willing to accept that risk, or willing to consider buying some now and maybe adding more if there's a further pullback, this is a name to consider.

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