Brand loyalty is an asset that Diageo (LSE: DGE) (NYSE: DEO.US) has in abundance and, for me, is a key reason why its shares are so attractive.
Indeed, the popularity of its brands seems to increase with each passing year, with developed markets and now developing markets often favouring Diageo’s products over rivals.
Of course, Diageo invests vast sums of cash in keeping its brands relevant, fresh and constantly in the public eye. Furthermore, the company seems to be able to generate not only first-time customers but is also highly successful at keeping customers, whether through the quality of its drinks or the image that goes with being a user of them (or a mixture of the two).
In essence, Diageo keeps attracting new customers and is superb at keeping them. This means that top-line growth is fairly consistent, while margins rarely come under sustained pressure because the brand loyalty makes demand more inelastic, meaning Diageo can ‘get away with’ charging a higher price should it wish to.
Of course, brand loyalty is not the only reason I’m bullish on Diageo. As a mature company operating in a mature industry, you would expect Diageo to have strong cash flow.
However, its valuation based on free cash flow looks to be more attractive than I had assumed, with shares currently trading on a price to free cash flow ratio of 3%. Although there may be companies with higher (and, therefore, better) ratios than this, the consistency and stability of Diageo’s cash flow is difficult to match.
Allied to this is generous capital expenditure, with it becoming clear that free cash flow could actually be a lot stronger were it not for the substantial reinvestment in the business that the company is currently undertaking.
Furthermore, there appear to be significant barriers to entry within the markets in which Diageo operates, with this being another key reason for my bullish stance on the company.
Indeed, the history, capital costs, quality control and marketing costs associated with launching a new brand of alcoholic beverage mean that new entrants are rare and often unsuccessful. This means that Diageo’s margins and profitability should be relatively well-protected, with the company continuing to enjoy bumper earnings and making me bullish on the stock.
So, I’m extremely impressed with Diageo’s high degree of customer loyalty, which enables it to maintain high and stable margins. Furthermore, I’m upbeat about the company’s valuation and the prospect of few new entrants seeking to compete over the medium to long term.
