Diageo (DEO): International Flavors ~ market folly

Friday, April 25, 2008

Diageo (DEO): International Flavors

DEO: International Flavors
Posted 0 days ago on 4/24/08
Buy: DEO, Target Price: $98, Time Frame: 1 year

A while back, I wrote an analysis on DEO with an $87 price target to be achieved in 6 months. And, I was pleasantly surprised to see that it reached that target in less than 3 months time. As a matter of fact, it surged an additional 6 points to 93 before settling back down. So, looking at the rationale behind buying DEO the first time, I noticed that the fundamental story behind DEO still holds true and there's no reason for this name not to perform well throughout next year. So, let's re-examine DEO. It's been a few months and we've let it cool off and digest its big move. After consolidating and dropping off like the rest of the market, DEO has formed a nice base and has begun trending back up higher. It's a great time to load up on this international company.

If you're unfamiliar with what Diageo does (as I was when I first heard about them a few years ago), Diageo (DEO) makes alcohol, that's all there is to it. Their brands include Captain Morgan, Smirnoff Vodka, Johnnie Walker Whiskeys, Baileys, Guinness, Crown Royal, and most recently, Absolut Vodka. People have vices, and DEO is their supplier. People all around the world obviously love alcohol and so its one of those recessionary proof names. So, regardless, this is a good name to have in the portfolio. DEO truly has a global presence and caters to nearly every type of alcohol drinker with their diverse line of products. This is a recessionary name because its alcohol (think Altria/MO/PhilipMorrisInternational/PM). At the same time it's a great multinational company due to its large international exposure. And, its just simply a well-run company.

To prove that, all you have to do is look and see that DEO has actually been stealing market share from traditional beer producers such as Anheuser Busch. The trend so far is a decrease in beer consumption and an increase in wine and spirit consumption. Specifically, in regards to the domestic beer market, consumers have been shifting from the typical names such as Budweiser and Coors and have been shifting to the craft and specialty beers, which obviously benefits DEO. Now, at the same time, don't expect domestic beers to just drop off the planet all of a sudden, but there has been a noticeable shift and it seems to favor Diageo and hurt the likes of Anheuser Busch. And, unlike Anheuser, Diageo has a vary diverse product offering, ranging from wines to liquors to spirits, etc.

Fundamentals: Currently, DEO has a market cap of $53 billion and a trailing PE of 17 and a forward PE of 15. DEO's price to sales ratio is very attractive at 3.49, well below the undervalued region of 5. DEO's PEG ratio could be better though, coming in at a slightly high 1.62. But, this is a 5 year predicted growth rate and we will only be playing this name for the next year, so we could technically calculate a whole different PEG for our purposes. Turning to operating margins we see that DEO enjoys healthy margins of 28.75% (slightly increasing quarterly too). Also, DEO's return on equity comes in at a strong 36% (accelerating rate as well). These numbers are very strong and are helping fuel DEO's bottom line. The only major negative with DEO is their debt. They currently have 13 billion worth of debt, and only 1.75 billion in cash. So, keep this in mind when considering this name. Keeping track of how DEO manages this debt is essential to their continued success. If you are a true fundamentalist, then this ratio of debt/equity might completely steer you clear of this name, which is understandable. It is indeed a lot of debt. But, at this stage, given my time frame, I'm looking more at their international exposure and diversified product base.

Next, let's turn to another major reason to buy DEO. Originally, when I first analyzed DEO, the technical signals were very bullish and were a main reason behind the buy then. This time around, they tell a slightly different story. Currently, DEO is in a slight uptrending, but still below its 200 day moving average. One positive though, is that it is currently trading above its 50 day moving average and is using this line as support. So, as long as this uptrend stays in tact, DEO should be crossing above its 200 day moving average, giving it a completely bullish chart. Given the market conditions currently (overbought, due for a correction) it is a very real possibility that DEO will trade sideways or even below its 200 day moving average. I mainly just wanted to write about this name now before I forgot about it. So, right this second is not necessarily the best time to buy DEO. Sure, the uptrending pattern from its recent low in January is a great sign, but ideally I'd like to see it break above its 200 day moving average. DEO seems to trade in a distinct range on the chart, using its moving averages and bollinger bands as support lines. There are obviously a lot of technical traders/investors who play this name since it seems to always bounce right where it should based on technicals; call it a self-fulfilling prophecy.

Looking at the institutional ownership aspect of DEO, we see that there are some big names with big stakes in this company. Lazard Asset Management, Renaissance Technologies, Fidelity, Barclays, Wachovia, Bank of America, Keybank, Fidelity, and Legg Mason all have major positions in this name. Each of these companies has invested at least $172 million into DEO, with Renaissance Technologies investing as much as $328 million into DEO. And, no, Renaissance is not actually a technology company, but rather one of the most consistent and successful hedge funds in the game. They are known for dominating the market and achieving excessive returns on a yearly basis. So, when they take a large stake in a company, you want to take notice. Their confidence in DEO should instill confidence in the everyday investor regarding this name.

As I said earlier, it might be a little early to get into this name so watch it carefully; I just wanted to write about it before I forgot. Its currently in a great slow and steady uptrend over the last 3 months and is sitting on the 50 day moving average as support. If it breaks above the 200 day moving average at around $84 then you can be a strong buyer. Right now I'd only scale into it until we get confirmation of the trend and that the support line holds. Last time the technicals worked perfectly as it reached my 6 month target in just 2 months. So, let's see if DEO can continue its uptrend as investors pile into a name they know is safe when uncertainty surrounding the US markets and economy increases. Play DEO for its product line and international exposure and maybe we'll get lucky again and have it reach the price target in a fifth of the time again.

Buy: DEO, Target Price: $98, Time Frame: 1 year