St. James Investment Company Updated: 25-Aug-15 · Millennials, for example, buy more liquor...
Transcript of St. James Investment Company Updated: 25-Aug-15 · Millennials, for example, buy more liquor...
St. James Investment Company Updated: 25-Aug-15
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DIAGEO PLC (DEO)
COMPANY DESCRIPTION
Diageo manufactures and distributes premium drinks. Its products include Scotch and Irish
whiskey, gin, vodka, rum, and ready to drink products, as well as beer and spirits, Irish
cream liqueur, wine, tequila, and Canadian and American whiskey. The company operates
in approximately 180 countries worldwide. Diageo was founded in 1886 and is based in
London, the United Kingdom.
INVESTMENT THESIS
We believe that Diageo is uniquely positioned to play a part in the heritage and traditions
involving alcohol. The company owns the number one Scotch whisky in the world, Johnnie
Walker. It also owns the top vodka in the world, Smirnoff, as well as the top tequila in the
world, Don Julio. These markets continue to grow—every day in the United States, ten
thousand Millennials turn twenty-one. Additionally, China now has 2.4 million millionaires—
up 82% since 2012. The Boston Consulting Group (BCG) estimates that China’s affluent
class alone will represent $3.1 trillion in buying power by 2020 and over 70% of this class
drink alcohol. BCG also estimates that between 2013 and 2020, emerging markets will
account for 65% of global economic growth. We are confident that Diageo’s portfolio of
products will grow with these emerging markets.
Unfortunately, Diageo continues to be on the receiving end of bad news. Before the 2008
financial crisis, Diageo enjoyed some of the strongest pricing power in consumer staples as
drinkers paid a premium to trade up to distilled spirits. Disappointingly, the credit crisis hit
initiated a cyclical trend away from premium products. Because Diageo raised prices too
aggressively during the boom years, the company had too few arrows in its quiver to
combat the current lackluster market environment. The hangover of a lower pricing
environment and slower organic growth is currently entering its fourth year. However,
although Diageo is still struggling to reignite volume growth, we are just starting to see the
first signs of price increases. But, compounding Diageo’s hangover, the company made
several badly timed and poorly executed acquisitions. For example, the company acquired
an equity stake in baijiu producer Shui Jing Fang for almost four times sales in 2011, just
before the Chinese government “crack down” on “conspicuous consumption”. Then earlier
this year, Diageo increased its investment in India's United Spirits to 55%, only to discover
almost GBP 150 million in loans made by United Spirits’ previous owner. And then to add
insult to injury, the Securities and Exchange Commission recently announced that it was
looking into channel stuffing by Diageo in the United States.
Diageo's stock reflects the headwinds currently working against the company with DEO
stock continuing to noticeably underperform its peer group within the alcoholic beverages
space. With the stock now trading under $109 per ADR, the company trades at a material
valuation discount to its consumer staples peer group. With our fair value estimate of $133
per ADR, we believe the company’s attractive business economics and low volatility of cash
flows warrant an investment. In the current economic environment of sluggish volume
growth and weak real income growth, we believe that Diageo still remains well-positioned to
generate future revenue growth on a base of investment capital that continues to generate
high returns.
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COMPANY HISTORY
Diageo formed with the merger of Guinness and Grand Metropolitan in 1997. The company
name, Diageo, derives from “Dia”, the Latin word “dies,” meaning day. “Geo” comes from
the Greek word “geo,” meaning world. Diageo therefore translates literally as “celebrating
life, every day, everywhere.” The company traces its roots back to 1749 with Justerini &
Brooks - wine merchants, and blenders of the famous J&B whisky range. Ten years later, in
1759, Arthur Guinness signed the lease on the now world famous St James's Gate brewery
in Dublin.
BUSINESS OVERVIEW
Three aspects to Diageo’s business create the company’s dominant competitive advantage:
brand portfolio, geographic diversity and scale. These advantages underpin the company’s
attractive returns on invested capital. Diageo is not the only company that distills liquor but
it certainly ranks as one of the best within the industry. In 1964, Johnnie Walker became
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the biggest selling Scotch whisky in the world. Fast–forward 50 years, and Johnnie Walker is
still the biggest selling Scotch whisky in the world. Such a long track record demonstrates
the loyalty of Johnnie Walker customers and is why brands are so important in the alcoholic
beverage industry. Brand recognition entails more than just selling a product. Diageo
considers itself the ambassador for each of the brands it owns and carefully develops each
brand in order to maintain the traditions its customers have come to know and expect.
Diageo owns a world–class portfolio of brands, the envy of the industry we believe. One will
instantly recognize some of the brands from the picture below.
According to Impact Databank, Diageo owns seven of the top 20 spirit brands by total retail
value in the world. These are household names. Diageo also distributes famous brands
such as Hennessy, Dom Pérignon, and Moët & Chandon.
Brand Category Distinction
Smirnoff Vodka No. 1 premium vodka in the world
Johnnie Walker Scotch Whisky No. 1 Scotch whisky in the world
Captain Morgan Rum No. 2 rum brand in the world
Guinness Beer No. 1 stout in the world
Baileys Liquor No. 1 liquor brand in the world
Crown Royal Canadian Whisky No. 1 Canadian whisky in the world
J&B Scotch Whisky No. 5 Scotch whisky in the world
Tanqueray Gin No. 1 imported gin in the U.S.
All told, Diageo owns over 75 iconic brands that cover all the major price points.
Category Ultra-Premium Super premium Premium Standard Value
Scotch whisky Johnnie Walker Blue Label The Singleton of Glen Ord Johnnie Walker Black Label JεB VAT69
Other whisky Crown Royal Extra Rare Bulleit Bourbon Bushmills Black Bush Seagram’s 7 Crown Rowson’s Reserve
Vodka Cîroc Ketel One vodka Smirnoff Iced Cake Flavored Vodka
Smirnoff Popov Vodka
Rum Ron Zacapa Centenario XO Pampero Aniversario Ron Extra Añejo
Captain Morgan Private Stock
Captain Morgan Black Spiced
Cacique Moneda De Oro
Liqueur Grand Marnier Cuvée du Cent Cinquantenaire
Grand Marnier Cuvée Louis Alexandre
Sheridan’s Original Layered Liqueur
Baileys Emmets
Tequila DeLeón tequila Tequila Reserva de Don Juilo
Gin Tanqueray No. TEN
Tanqueray Gordon’s Gilbey’s
Local spirits Shui Jing Fang
Yenì Raki Ypióca Vodka Hà Nội
Beer
Kilkenny Guinness Meta Beer Dubic Extra Lager
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With such a strong brand portfolio, Diageo can take advantage of different trends.
Millennials, for example, buy more liquor products and flavors than previous generations.
According to a Nielsen study, 57% of millennials like to explore new products and try new
flavors versus 36.5% of baby boomers. Diageo
is able to capitalize on this trend. The favorite
liquor for millennials is vodka but it does not
matter if the millennial is on a Cîroc budget or
Smirnoff budget, because Diageo serves both
market segments. Since acquiring the Smirnoff
brand in 2006, Diageo has added 39 flavors to
the product line, such as Smirnoff Cherry and
Smirnoff Citrus. These are all unique bottles of
vodka for sale—and this is just one brand.
Diageo is also capitalizing on the
“premiumisation” trend, where consumers trade
up from value and standard brands to premium
and ultra-premium. Millennials can graduate
from Smirnoff to Cîroc, which in turn boost
Diageo’s margins in the process. A bottle of
Smirnoff costs $21.99 and a bottle of Cîroc costs
$59.99, but they cost essentially the same to
make. According to market research firm Ipsos,
premium and ultra-premium spirits brands have
grown faster than standard brands worldwide.
This is happening even in developed economies with slow economic growth which addresses
Diageo’s other competitive advantage—its worldwide distribution reach.
Over the past few years, Diageo went on an acquisition spree that expanded its worldwide
presence. A slide from a company investor presentation highlights key acquisitions Diageo
has made to take advantage of the growth in spirits consumption around the world.
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2006: Acquired Smirnoff—the No. 1 selling vodka in the world
2007: Acquired a stake in Sichuan Chendung Quanxing Group, a producer of baiju—the most popular
alcoholic beverage in China
2012: Acquired Ypióca—Brazil’s leading producer of cachaça spirits
2013: Acquired Shujingfang—producer of white spirits in China
2013: Acquired Mey Icki—Turkey’s leading maker of the national drink raki
2014: Acquired 53.4% stake in United Spirits, India’s largest liquor producer and the second-largest
liquor producer by volume in the world.
Diageo now sells to over 180 countries worldwide, 20% more than its nearest competitor.
The acquisitions themselves are not a competitive advantage. Any company can buy
another company, but not any company can buy this many companies in the same industry
which results in a worldwide presence and geographical diversity that uniquely benefits
Diageo. The benefits to this global footprint are scale, diversification, and future growth
potential. If one region or country experiences a severe decline, Diageo will still do fine
simply because they are still selling products in the rest of the world. A local company,
however, does not have this luxury and may not be able to withstand the decline. The
world’s emerging consumer class will double over the next decade and the buying power of
the 4.2 billion people living in emerging markets will reach $30 trillion per year. According
to Ipsos, emerging market consumers are strong consumers of liquor:
Imported spirits in China grew 265% from 2001 to 2014. Per capita alcohol consumption is growing faster than the broader economy.
Indian imported spirits are growing 25% annually. Exports of Scotch whisky to Brazil increased nearly 50%, according to the Scotch Whisky
Association.
A 2014 Ernst & Young report on emerging markets identified China, Brazil, Russia, India,
Mexico, and Turkey as key growth markets. It estimates these six countries alone will
North America 32%
Europe 24%
Africa 13%
Latin America and Caribbean
10%
Asia Pacific 21%
REVENUE BY GEOGRAPHY
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represent over 200 million households with annual incomes in excess of $35,000. Further,
E&Y expects spending in these countries on products for culture and recreation, like liquor,
to grow twice as fast as spending on food.
Diageo has the span and deep pockets to buy distilleries that cater to each country’s unique
spirit tastes, which in turn enables Diageo to capitalize on the world’s increasing demand for
spirits regardless of which specific spirit that particular country wants to drink. Competitors
simply cannot match Diageo’s recent acquisitions and subsequent ability to sell specific
countries their drink of choice. When we put all this together, we find that Diageo now
controls 27% of global volume market share—three times its nearest competitor, Pernod
Ricard. This huge market share gives Diageo another competitive advantage in scale.
Diageo’s products are sold by nearly every bar, restaurant, and alcohol retailer around the
world and the company’s reach is still expanding. Diageo recently launched its Route-to-
Customer initiative—or another way of saying “improved distribution.” The scale of Diageo’s
worldwide distribution is a key competitive advantage. Competitors cannot match Diageo’s
assets in terms of land, distilleries, and storage warehouses. Diageo’s property, plant, and
equipment are worth $5.8 billion, or more twice that of its nearest competitor Pernod
Ricard. We would note that those numbers are recorded at cost, meaning Diageo’s assets
are actually worth far more. Pernod Ricard would need to invest an amount equal to 20%
of its market capitalization just to close the gap at cost with Diageo.
Additionally, Diageo already has the distribution network in place. The costs to maintain the
company’s distribution network remain relatively fixed. Meaning, as Diageo increases sales,
the operating leverage inherent in the business model allows more of revenue to drop down
to the bottom line. There are additional benefits as well. Diageo can exert greater
influence over major sales accounts, gain deeper product penetration, and continue to build
brand loyalty. Diageo’s scale shows up in other areas as well. The company negotiates
lower raw material costs with suppliers while spreading out overhead costs, like electricity,
over a greater amount of sales. These competitive advantages allow Diageo to remain
more efficient and profitable than their competition.
By any measure, the company generates attractive cash flows for its shareholders. Because
of its scale, Diageo is the most efficient and profitable operator in the spirits industry.
Compare the company’s operating margins with its two largest competitors, Pernod Ricard
15%
20%
25%
30%
35%
40%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
OPERATING MARGIN COMPARISION
Diageo
Pernod Ricard
Brown-Forman
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and Brown Forman. Operating margins are the percentage of revenues left after paying for
raw materials and the variable costs to run the business. Diageo benefits from spreading
these operating costs over a larger asset base. We draw attention to items on the chart
above showing operating margins: 1) beginning in 2009, Brown Forman produces higher
operating margins is better and 2) Diageo’s operating margin declined in the past couple of
years. Although the decline appears steep, the important takeaway is the consistency of
Diageo’s operating margins over the past ten years. Diageo has consistently produced
operating margins of 30%—a tangible benefit of operating as the low–cost producer in the
industry. Two additional points: Diageo is five times larger than Brown-Forman; and
therein lays the opportunity—we believe that Diageo’s margin growth will eventually
reaccelerate.
The chart below illustrates Diageo’s profit margin versus Pernod Ricard and Brown Forman.
Profit margins show what percentage of sales a company retains as earnings, or profit.
Diageo continuously reinvests its profits by acquiring more brands. These acquired brands
continue to fuel the company’s existing brand asset portfolio growth and increase its
already-dominant market share. In addition to business reinvestment, management returns
the remaining excess cash directly to shareholders in the form of a stream of growing
dividend payments, and stock repurchases when merited. Ideally, we want to own
dominant companies that consistently demonstrate a history of rewarding shareholders.
Diageo’s shareholder efficiency, or the total combined amount of dividends paid and stock
repurchased divided by a company’s gross profits, far exceeds its direct competitors. For
example, a company with $10 million in gross profits that returns $1 million in dividends
and buybacks has a shareholder efficiency of 10%. Every company must allocate capital to
production or service; however, shareholder efficiency demonstrates how a company uses
its capital after producing and selling its products. The chart below shows the 10-year
average shareholder efficiency of Diageo versus its competitors.
10%
12%
14%
16%
18%
20%
22%
24%
26%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
PROFIT MARGIN COMPARISION
Diageo
Pernod Ricard
Brown-Forman
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Over the past ten years, Diageo has returned over 30% of its gross profits to shareholders
through dividends and buybacks—more than Brown Forman and Pernod Ricard. Diageo’s
shareholder efficiency also outpaces other beverage companies such as Molson-Coors and
Dr. Pepper Snapple. The company was not always in a position to return this much cash to
shareholders. When Guinness and Grand Metropolitan merged in 1998, the company
consisted of a group of disparate businesses. Besides liquor and beer, the new Diageo also
owned lower-margin food companies like Pillsbury and Burger King. The company made a
strategic decision to narrow its focus to premium drinks. Between 1998 and 2000, the
company made the correct choice and sold Pillsbury, Burger King, and eight
underperforming whisky brands. This boosted profitability—which funded increasing
dividends.
Diageo has increased its dividend at an annual rate of 6.7% since 1999. As the company
spends less on acquisitions, we expect it will be able to raise dividends at an increasing rate.
At the end of 2013, CEO Ivan Menezes publicly stated that Diageo would end the company’s
Diageo
Pernod Ricard
Brown-Forman
0%
5%
10%
15%
20%
25%
30%
35%
40%
SHAREHOLDER EFFICIENCY
2016
£0.00
£0.10
£0.20
£0.30
£0.40
£0.50
£0.60
£0.70
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
DIAGEO'S HISTORICAL DIVIDENDS PAID
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fast pace of acquisition. He did not rule out future acquisitions, but stated they would be
smaller and more strategic in nature.
VALUATION
We forecast 5% revenue growth for the next three fiscal years. On an organic basis, sales
should grow at 2% which takes account of our estimate of volume declines approaching 2%.
Beyond fiscal 2017, we believe that Diageo should return to a normalized revenue growth
rate of 5%. We forecast this revenue growth by modeling positive pricing in each of the
company’s markets, coupled with per capita consumption growth in emerging markets,
although we slightly offset this emerging market sales growth estimate by factoring in a
negative mix as new consumers enter the market at low price points. In developed
markets, we expect the distillers to be somewhat insulated from the secular decline in
alcohol consumption by trading up from beer and wine.
Volume growth should allow Diageo to leverage its cost base—an area where we continue to
believe that the company holds a competitive advantage. We think lower average cost of
input costs will increase gross margin expansion while the company’s ability to leverage its
fixed costs should create a further margin expansion.
A potential positive that we have not factored in to our model is that we see immediate
opportunities for revenue growth with Diageo clearing the company’s pipeline inventory. If
Diageo simply reduces its inventory pipeline over the next two quarters, we would expect to
see positive volume growth going forward. Other areas where we are closely watching is
acquisitions. We would prefer to see management not chase near-term consumer trends in
order to manage its very strong brand portfolio for the long term. The company’s brand
portfolio is where we see the company’s true intangible value. Additionally, any activist
interest in Diageo could address the company’s lack of a coherent strategy on beer in Africa.
Divesting the beer portfolio would probably unlock near-term value. Diageo does not
disclose EBITDA by category, but we have read estimates that at 2.5 times sales, the beer
business could be worth GBP 6.5 billion, capital that could be redeployed in higher return on
invested capital areas. Regardless, we believe there is substantial long-term value in
Diageo's shares at current levels.
Diageo should easily ride any improvement in the global economy—a factor we are not
incorporating. However, we see a continuation of the long-term trend of trading up through
categories in developed markets, in which distilled spirits are taking share from beer and
Barley 33%
Maize 22%
Wheat 14%
Grapes 14%
Sorghum 5%
Sugar 5%
Molasses 5%
Dairy 1%
Other 1 1%
GLOBAL RAW MATERIALS BY VOLUME
Glass 86%
Corrugate 6%
Cartons 2% Cans 2% Labels
and sleeves
1% PET 1%
Crowns 1%
Closures 1%
GLOBAL PACKAGING MATERIALS BY VOLUME
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wine. This trend is sensitive to disposable incomes and can be temporarily reversed in times
of economic downturns. For example, the primary cause of the weak volume growth of the
past three years in North America has been that the slow economic rebound restrains trade-
up among American millennial consumers. Growth appears to be concentrated in the
reserve brands, suggesting that only the high-income consumer is trading up. The
“aspirational” middle-income consumer has not returned to the category in any meaningful
way, but when economic growth accelerates, we expect Diageo's volume growth to return
as consumers resume the trade-up to spirits.
Diageo has generated at least high-teens returns on invested capital (ROIC), after adding
back goodwill and removing excess cash, every year for more than a decade. We expect
this to continue going forward. These returns are well in excess of the firm's weighted
average cost of capital, which we estimate to be 8.5%, and the consistency of the excess
returns, even during the financial crisis, supports our conviction that Diageo possesses a
sustainable competitive advantage. We use a fixed exchange rate of $1.55 to purchase 1
GBP.
We valued Diageo from several different approaches. Using a discounted free cash flow
model, the company’s long-term intrinsic value is $137 per US ADR. However, when we
valued the company using an economic valued added approach which discounts future
economic profit (the spread between return on invested capital and the company’s cost of
capital) and adds current invested capital, we valued the company at $129 per US ADR.
Another variation of using ROIC to discount future economic profit valued the company at
$131 per US ADR. Finally, we used a dividend discount model and determined that fair
value resides around $136 per US ADR.
Therefore, we average our fair value estimates and believe Diageo is worth roughly $133
per US ADR (Ticker: DEO on the NYSE). Our fair value estimate implies a multiple of 18
times Value Line’s estimate of 2016 cash flow from operations. Considering the company’s
ability to grow its revenue at 4% coupled with returns on invested capital of approximately
20%, we find the company’s low business risk an attractive investment at our estimate of
fair value. Our 8.5% cost of capital reflects the low risk associated with the company’s long
term portfolio of timeless spirits.
DISCOUNTED CASH FLOW ANALYSIS 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Cash flow from operations 2,208 2,736 2,507 2,935 3,231 3,555 3,912 4,304 4,736 5,151
plus: Tax-adjusted interest expense 490 448 463 501 472 472 472 472 472 472
less: Cash flow from investing (638) (453) (479) (520) (575) (562) (550) (538) (526) (515)
Free cash flow 2,060 2,731 2,491 2,916 3,128 3,465 3,833 4,238 4,681 5,108
Terminal Multiple (5% LT growth rate) 20.0x
Terminal value 102,167
Discount rate 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Discount factor 0.9535 0.8668 0.7880 0.7164 0.6512 0.5920 0.5382 0.4893 0.4448 0.4044
Discounted free cash flows £1,964 £2,367 £1,963 £2,089 £2,037 £2,051 £2,063 £2,073 £2,082 £43,378
PV of discounted free cash flows £62,069
plus: Cash £1,500
less: Debt -£7,638
Equity Valuation £55,931
Shares outstanding 2,528
Estimated Intrinsic Value 2,212p
$/ADR 137$
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The model above values Diageo at roughly $129 per share using discounted economic profit
based on the spread between returns on invested capital and cost of capital. As is our
practice, we discount economic profit (difference between returns on invested capital and
cost of capital) by 10%. We believe additional investment is warranted below $106, a level
which should afford a sufficient margin of safety to our estimate of Diageo’s fair value.
DISCOUNTED ECONOMIC PROFIT 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Invested Capital
Current assets (ex-excess cash) 6,129 6,140 6,725 7,511 7,451 7,803 9,263 10,533 11,147 11,752 12,302 12,878 13,481 14,112
Less: Current liabilities (3,944) (4,915) (4,784) (5,519) (4,851) (4,569) (6,120) (5,979) (6,441) (6,046) (6,250) (6,461) (6,679) (6,904)
Plus: Net PP&E 2,404 2,552 2,972 3,425 3,433 3,433 4,526 4,646 4,785 4,959 5,243 5,543 5,861 6,196
Plus: Goodwill & Other LT Operating Assets 6,726 6,545 8,821 9,013 7,891 7,891 7,841 7,791 7,741 7,691 7,644 7,598 7,552 7,506
Less: Other LT operating liabilities (1,330) (939) (1,192) (971) (820) (820) (829) (846) (853) (860) (866) (872) (878) (884)
Invested Capital 9,985 9,383 12,542 13,459 13,104 13,738 14,681 16,145 16,380 17,497 18,074 18,687 19,336 20,026
Net Operating Profit After-Tax (NOPAT)
Operating income 2,574 2,595 3,108 3,380 2,707 3,066 3,391 3,473 3,761 4,054 4,378 4,728 5,106 5,515
Plus: Impairments 0 0 0 0 0 0 0 0 0 0 0 0 0 0
Less: Income tax expense (477) (343) (1,011) (507) (447) (466) (483) (525) (567) (623) (656) (689) (725) (762)
NOPAT 2,097 2,252 2,097 2,873 2,260 2,600 2,908 2,948 3,193 3,431 3,723 4,039 4,382 4,752
Return on Invested Capital (ROIC) 21.0% 24.0% 16.7% 21.3% 17.2% 18.9% 19.8% 18.3% 19.5% 19.6% 20.6% 21.6% 22.7% 23.7%
Cost of Investment Capital 8.3% 8.5% 8.6% 8.6% 8.6% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%
Debt 8,177 6,748 7,399 8,217 7,638 9,150 9,090 8,740 8,730 8,548 8,548 8,548 8,548 8,548
Equity 29,514 35,162 44,832 50,349 46,522 44,114 44,114 43,506 42,937 42,413 42,413 42,413 42,413 42,413
Cost of Debt 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
Cost of Equity 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
Economic Profit 1,263 1,453 1,022 1,718 1,136 1,434 1,662 1,576 1,802 1,944 2,187 2,451 2,739 3,051
Terminal Value 87,165
Discount Factor 10% 0.9535 0.8668 0.7880 0.7164 0.6512 0.5920 0.5382 0.4893 0.4448 0.4044
Present Value 1,083 1,243 1,309 1,129 1,174 1,151 1,177 1,199 1,218 1,234
Sum of Present Value 11,918 22.6%
Terminal Value 35,246 66.9%
Invested Capital 13,738 26.1%
Excess Cash 896 1.7%
Total Debt, Leases & Obligations -9,150 -17.4%
Total 52,648 100.0%
Shares Outstanding 2,528
Estimated Intrinsic Value 2,083$
$/ADR 129$
Diageo PLC 4.5% 37.0% 18.0% 4.4% 3.9% 0.7% 10.0%
Change in
Adjusted Change in Working Discount Discounted
Period Revenues NOP Taxes NOPAT CapX Deprec. Investment Capital FCFF Factor FCFF
0 16,650
1 17,407 6,440 (1,159) 5,281 766 (679) 87 122 5,072 0.9091 4,611
2 18,198 6,733 (1,212) 5,521 801 (710) 91 127 5,303 0.8264 4,383
3 19,025 7,039 (1,267) 5,772 837 (742) 95 133 5,544 0.7513 4,165
4 19,890 7,359 (1,325) 6,035 875 (776) 99 139 5,796 0.6830 3,959
5 20,794 7,694 (1,385) 6,309 915 (811) 104 146 6,059 0.6209 3,762
6 21,739 8,043 (1,448) 6,596 957 (848) 109 152 6,335 0.5645 3,576
7 22,727 8,409 (1,514) 6,895 1,000 (886) 114 159 6,623 0.5132 3,398
8 23,760 8,791 (1,582) 7,209 1,045 (927) 119 166 6,924 0.4665 3,230
9 24,840 9,191 (1,654) 7,536 1,093 (969) 124 174 7,238 0.4241 3,070
10 25,969 9,608 (1,730) 7,879 1,143 (1,013) 130 182 7,567 0.3855 2,917
11 27,149 10,045 (1,808) 8,237 1,195 (1,059) 136 190 7,911 0.3505 2,773
12 28,383 10,502 (1,890) 8,611 1,249 (1,107) 142 199 8,271 0.3186 2,635
13 29,673 10,979 (1,976) 9,003 1,306 (1,157) 148 208 8,647 0.2897 2,505
14 31,021 11,478 (2,066) 9,412 1,365 (1,210) 155 217 9,040 0.2633 2,380
15 32,431 12,000 (2,160) 9,840 1,427 (1,265) 162 227 9,450 0.2394 2,262
16 33,905 12,545 (2,258) 10,287 1,492 (1,322) 170 237 9,880 0.2176 2,150
17 35,446 13,115 (2,361) 10,754 1,560 (1,382) 177 248 10,329 0.1978 2,044
18 37,057 13,711 (2,468) 11,243 1,631 (1,445) 185 259 10,798 0.1799 1,942
19 38,741 14,334 (2,580) 11,754 1,705 (1,511) 194 271 11,289 0.1635 1,846
20 40,502 14,986 (2,697) 12,288 1,782 (1,580) 203 284 11,802 0.1486 1,754
Terminal Value 216,359 32,160
Discounted Excess Return Period FCFF 59,363 Total Corporate Value 104,295
Discounted Corporate Residual Value 32,160 Less Debt (12,950)
Short-Term Assets 12,772 Less Preferred Stock -
Total Corporate Value 104,295 Less Short-Term Liabilities (8,295)
Total Value to Common Equity 83,050
Intrinsic Stock Value 131$
St. James Investment Company Updated: 25-Aug-15
12 | Page
RISK TO INVESTMENT
Spirits companies are subject to heavy regulation and taxation. Governments may enact
policies that place restrictions on Diageo's business activities or increase liquor taxes,
resulting in less demand. For example, recently the Chinese government's cracked down on
gifts to government officials which in turn has led to drastic drops in demand and price in
scotch and the ultra-premium baijiu segment.
Distilled spirits is more cyclical than some other consumer staples industries, including
brewing, and more closely tied to economic growth. Analysts estimate the correlation
between GDP per capita growth and the spirits industry retail value to be 0.8, but only 0.3
between GDP per capita and retail beer sales. As a result of operating in 180 countries,
foreign exchange rate fluctuations can cause large swings in Diageo's financial results. This
is likely to increase over time as the firm looks to expand its emerging-market footprint.
However, we believe this diverse exposure is eventually neutral when valuing the company
over a long period of time.
The company's acquisition strategy remains fraught with risk. The GBP 264 million write-
down at Shui Jing Fang, and the post-acquisition problems at United Spirits are prime
examples of what can go wrong when making acquisitions. Also, most of Diageo's maturing
inventory is stored in Scotland. If this maturing inventory suffers a catastrophic loss due to
contamination, fire, or other natural disaster, Diageo may not be able to satisfy consumer
demand, and insurance may not fully cover the replacement value of the lost inventory.
DIAGEO DIVIDEND DISCOUNT MODEL VALUATION
Two-Stage Dividend Discount Model
Assumptions:
Required rate of return 10.00%
Long-term dividend growth rate 7.25%
Average dividend growth rate 7.60%
Period ending FY 2014 FY 2015E FY 2016E FY 2017E FY 2018E FY 2019E Terminal
Discount factor 1 2 3 4 5
Dividend per share ($) £0.49 £0.53 £0.56 £0.58 £0.63 £0.70 £0.75
Dividend growth rate 8.7% 6.1% 2.5% 9.4% 11.2%
Present value of dividend £0.48 £0.46 £0.43 £0.43 £0.44 £19.30
Value per share 2,200p
136.4$
Dividend Yield
Period ending FY 2014 FY 2015E FY 2016E FY 2017E FY 2018E FY 2019E
Dividend per share ($) $0.49 $0.53 $0.56 $0.58 $0.63 $0.70
Implied dividend yield to current stock price 2.8% 3.0% 3.2% 3.3% 3.6% 4.0%
St. James Investment Company Updated: 25-Aug-15
13 | Page
ST. JAMES INVESTMENT COMPANY
We founded St. James Investment Company in 1999, managing
wealth from our family and friends in the hamlet of St. James. We
are privileged that our neighbors and friends have trusted us for over
a decade to invest alongside our own capital.
The St. James Investment Company is an independent, fee-only, SEC-
Registered Investment Advisory firm, providing customized
portfolio management to individuals, retirement plans and private
companies.
I M P O R T A N T D I S C L A I M E R
Information contained herein has been obtained from sources believed reliable but is not necessarily complete and accuracy is not
guaranteed. Any securities that are mentioned in this issue are not to be construed as investment or trading recommendations
specifically for you. You must consult your advisor for investment or trading advice. The publisher of this report and one or more
of its affiliated persons and entities may have positions in the securities or sectors recommended in this report and may therefore
have a conflict of interest in making the recommendation herein. 4834-9369-8309, v. 1