Is Diageo a Buy?

Buoyed by rising sales and stronger earnings, global distiller Diageo plc (NYSE: DEO) announced in July that it would be buying back $2.6 billion worth of stock. Coming as it does after a $1.5 billion stock repurchase in the current fiscal year, the new authorization amounts to a big return of capital to shareholders.

But investors seem less than thrilled with both the company's earnings report (covering the fiscal 2018 year ending on June 30) and the buyback plan, as Diageo's stock has fallen 8% since the announcement, and remains off 5% year to date. So let's see if the distiller's new lower price point is a reason to buy.

It's the world's leading spirits distributor

Regardless of category, Diageo owns some of the most distinctive brands, with top-shelf billing in markets around the globe. Johnnie Walker is the No. 1 Scotch whisky in the world, Smirnoff is the world's top-selling premium vodka, Captain Morgan is the second-best-selling rum worldwide, and Baileys is the world's leading liqueur.

But Diageo makes most of its money selling Scotch whisky, primarily under the Johnnie Walker label, which represents 25% of its near $16 billion in annual net sales. And while Scotch enjoyed a 2% gain in organic net sales in fiscal 2018, it was tequila and gin that helped fuel growth, rising 35% and 17%, respectively, though starting from much smaller bases. Together, the two only account for around 7% of total sales. No other spirits category saw double-digit increases.

It wants to buy the good stuff

The key to Diageo's success has more to do with the premium trend fully underway in alcohol than the kind of spirits being sold. When it comes to variety, the distiller wants to ensure it only has top-shelf offerings.

Diageo was recently said to be interested in dumping about $1 billion worth of brands from its portfolio because they didn't fit into the premium and super-premium categories it wants to focus on. Among these brands are Seagram's VO, Myers's rum, Goldschlager, and Popov vodka, all of which can be considered value brands. Data from Nielsen shows high-end spirits now account for 55% of total industry spirits volume and 62% of dollar sales, with ultra-premium spirits growing the fastest.

And over the past few years, Diageo has acquired some of the top spirits, such as Ciroc vodka, DeLeon tequila, and, more recently, actor George Clooney's Casamigos tequila, which it paid $1 billion for.

It dominates the most important markets

What many might find surprising is that India is the world's largest whisky market at roughly 1.5 billion liters annually, or about half the world's consumption. Through its ownership of United Spirits, Diageo has a 40% share of the Indian market by volume. A large, youthful population and a growing middle class give Diageo the potential to tap into the premium trend of foreign brands in this important market.

In the U.S., the world's biggest spirits market overall, Diageo delivered net sales growth of 4% in fiscal 2018, enjoying growth across all categories except vodka. The white spirit has been troubled for several years, but the browns continue their inexorable rise.

The Distilled Spirits Council says revenue for high-end premium bourbon and Tennessee whiskey was up 46% last year in the U.S., while super-premium revenue rose 148% for distillers.

Its valuation is compelling

At 25 times trailing earnings and 18 times next year's estimates, Diageo trades at a discount to rival Brown-Forman, which owns the Jack Daniel's brand, though it does trade above Constellation Brands, which owns Svedka vodka and Black Velvet Canadian whisky. But Constellation has delved deeply into the beer market, and much of its growth has been predicated on its acquisition of the Corona brand.

It's probable Diageo will also follow Constellation into what may become the newest trend for distillers: cannabis-infused beverages. Constellation has invested heavily in the space, and others are maneuvering for position, too, so it likely won't be long before Diageo stakes its claim.

Diageo remains the leading distiller, with opportunities in some of the world's biggest markets to capitalize on the premium-brand trend. Diageo also pays a dividend that yields a healthy 3% annually, so the beverage giant would be worth the price even if it was trading at a premium to other spirits companies. But as it trades at a discount, Diageo is definitely a buy.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool recommends Diageo. The Motley Fool has a disclosure policy.