There’s no risk of a hangover for shareholders of Diageo (LSE: DGE) and SABMiller (LSE: SAB), but a bottom-fishing investor must be tempted to choose the spirits-maker over the brewer.
Out Of Favour
Neither Diageo nor SAB — whose fortunes hinge on growth in less developed economies — have been immune to downside in recent times. Emerging markets’ weakness weighed on their equity valuations, yet both offer appealing features and could prove resilient if volatility in developed markets springs back.
Their operating profitability is similar, their fundamentals are strong, and their debts are manageable. But a recent rally in SAB stock doesn’t seem to justify the premium at which SAB is currently trading versus Diageo, whose risk profile is more enticing right now.
Dismal Performance
In the last twelve months, Diageo stock has lost 9.5% of value, while SAB’s has plunged by 12%. Both hit rock bottom in early February, when investors had to swallow an absolute one-year low of -15% (Diageo) and -27% (SAB), respectively.
As one might expect, the growth rates of these two stocks aren’t very different. Indeed, the two have moved in synch over the last year. SAB’s valuation, however, has rallied much faster than Diageo’s since the end of April.
The spread between the growth rate of Diageo and SAB — which had been in place for almost a year and had widened up to 17 full percentage points — closed in late April, as investors decided to bet on a stock whose value had plummeted well beyond the underlying performance of the business.
As a result, both companies’ enterprise values (EV) of 13x earnings before interest, taxes, depreciation, and amortization (EBITDA) have surged, but SAB is now trading at 14.7x EV/EBITDA, while Diageo’s multiple stands at 13.5x.
It’s a catch-up game and SAB seems to be running way too fast, as the integration of Foster’s isn’t as smooth as executives may have thought. Furthermore, it’s hard to counter the view that SAB is pricey based on its relative valuation against rivals and due to the lack of meaningful catalysts, as analysts call events that may positively impact a stock in future.
Debt Stuff
Diageo is looking to exploit favourable market trends for fundraising. Its latest financing round proves that it can profit from loose credit market conditions.
While some have recently questioned whether its capital structure is properly balanced, it must be noted that Diageo’s net leverage is lower than its median since 2008, while EBITDA has grown to £3.9 bn from £2.9bn in less then four years.
Diageo issued €1.7bn of debt this week, which represents about 20% of its total net debt position. “The issue consists of €850m of bonds due May 2019 with a coupon of 1.125% and €850m of bonds due May 2026 with a coupon of 2.375%,” the spirits maker said. Analysts may have to knock off a few basis points from Diageo’s weighted average cost of capital.
Talking of net leverage, SAB’s stands at 3x, i.e. 50% above the level the brewer recorded in 2008. SAB throws out so much cash that de-leveraging will pose no problem in the next couple of years – yet is that properly reflected in its stock price?
A Merger Of Equals
Diageo has a market cap of £46bn and an enterprise value of £56bn; SAB has a market cap of £52bn and an enterprise value of £62bn. As unconceivable as it may seem, a merger of equals would make sense.
A merger between SAB and Diageo would give the market a total beverage alcohol player, which Diageo aims to create in the long term. Whether a deal is actually going to happen is another matter.
The problem with such a tie-up — as SAB’s previous CEO Graham Mackay reminded us a few years ago — is that the life span of different products could cause hangovers and problems with procurement cycles and distribution.
Also, the market has other ideas. Foster’s was the last scalable, listed asset in the beer industry. Since SAB acquired it, analysts have speculated about a possible takeover of SAB by the world’s leader Anheuser-Busch InBev. If recent trends for such a rumour are anything to go by, we’ll likely have another decade to speculate on that.
