St. James Investment Company Updated: 25-Aug-15 · Millennials, for example, buy more liquor...

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St. James Investment Company Updated: 25-Aug-15 1 | Page D IAGEO 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.

Transcript of St. James Investment Company Updated: 25-Aug-15 · Millennials, for example, buy more liquor...

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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$

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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%

Page 13: St. James Investment Company Updated: 25-Aug-15 · Millennials, for example, buy more liquor products and flavors than previous generations. According to a Nielsen study, 57% of millennials

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