Diageo: Toast to emerging markets

by Paul Tracy, editor High-Yield International

Diageo (DEO) is the world's leading alcoholic spirits company, with market-leading brands including Smirnoff, Johnnie Walker, J&B, Baileys, Captain Morgan and Tanqueray.

Beer sales are primarily driven by the top-selling global stout brand, Guinness. The company also owns a 34% stake in Moet Hennessy, the firm behind a number of luxury cognacs and champagnes.

By geography the group derives its revenues 33% from North America, 26% from Europe and 40% from the rest of the world.

The most appealing feature of Diageo is that although the company has around 45 brands of alcoholic drinks in its portfolio, 81% of its earnings come from its 14 strategic global priority brands.

This allows the firm to focus marketing dollars and management attention on a handful of core key brands while benefiting from the strength of its smaller brands in more niche markets.

In the past nine months the company has increased marketing expenses in an effort to capture market share, especially in fast-growing emerging markets. Currently marketing expenses represent around 15.6% of revenue, and are expected to surpass 16% of revenue by next year.

More than 60% of this total will be spent in emerging markets in an effort to maintain double-digit growth. Management expects that in the next four years, emerging markets, led by Asia, will comfortably represent 50% of sales for Diageo.

Diageo has also been aggressive in acquiring companies in emerging markets to boost its market share and improve local distribution. Last year it bought Mey Icki, one of Turkey's biggest spirit companies, for $2.1 billion.

Baiju is a spirit that accounts for 30% of mainland China's alcoholic drinks market, and thanks to a recent acquisition, Diageo now controls the Sichuan Chengdu Quanxing Group, owner of one of the leading brands.

Finally, the company paid around $225 million earlier this year to buy the Meta Abo Brewery Company, the second largest beer company in Ethiopia, a small but fast-growing market.

While the company's growth potential in mature markets isn't as compelling, the company is also forecasting solid organic growth in that segment, led by North America where growth is expected to be around 6% annualized over the next five years.

Although the company has steadily paid solid dividends, management has also said that acquiring other companies is still high on its agenda.

Acquisitions are a logical strategy when you consider that buying a powerful local brand can be the easiest and fastest way of entering a new market.

The company also has a long history of share buybacks though it halted the policy at the height of the financial crisis in 2008.

Given its low debt and healthy and predictable cash flows, Diageo is likely to both increase its dividends and restart its buyback. Over the past three years, the firm has increased its payout at a nearly 5% annualized basis.

Based on the firm's last two payouts, the yield is 2.4% but if it continues to boost that payout as I expect, Diageo could pay out close to a 3% yield this year based on current prices. The U.K. does not have a withholding tax for U.S. shareholders.

Risks to Consider: A larger-than-expected economic slowdown for key emerging markets such as China could stunt Diageo's growth and impact its ability to grow dividends and increase buybacks.

Action to Take --> A world leader with an unmatched portfolio of brands and a compelling emerging market growth strategy, Diageo rates a buy under $105 with low risk.

Learn more about this financial newsletter at Paul Tracy's High-Yield International.

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