Diageo (LSE:DGE), shares have fallen 25% over the last 12 months, while the FTSE 100 is up 11%. And analysts at Goldman Sachs have downgraded the stock to ‘sell’.
Wholesaler surveys in the US indicate the market for spirits is currently weak. But over the long term, I think selling scotch in the States could be an unusually good business.
The bear case
Diageo generates around 37% of its revenues in the US. So a weak market for vodka and scotch – where it has leading products – is an issue.
The situation looks more promising for Tequila sales. But this makes up a much smaller part of the FTSE 100 company’s top line.
As a result, Goldman’s analysts are forecasting no sales growth in Diageo’s US business for the next couple of years. And the investment bank has reduced its price target for the stock to £24.50.
Investors might have hoped for better resilience from a company with a leading brand portfolio. But I see the current weakness as a buying opportunity.
US dominance
Diageo has the largest share of the US spirits market. That might be a short-term challenge, but I see it as a big advantage for the long term.
Unlike in other countries, retailers don’t deal directly with manufacturers in the US. Instead, the likes of Diageo distribute to wholesalers, who in turn sell to retailers.
This means manufacturers don’t have to negotiate prices with retailers, leading to greater profitability for Diageo. So a dominant position in the States is a valuable thing.
Diageo’s largest competitor is Pernod Ricard, which also has a strong brand portfolio. But the FTSE 100 firm’s stronger US presence has given it an edge in terms of margins.
Competition
Over the long term, a leading position in the US should be an important advantage. And I think Diageo looks well placed to maintain its dominance.
The company’s position in scotch looks especially hard to disrupt. One reason is that only whiskies aged and bottled in Scotland can qualify as scotch.
This means supply is naturally limited, reducing the threat of competition. The time needed to age an 18-year old whisky is another barrier to entry.
Other categories are less restrictive. But Diageo’s size scale gives it the scope to acquire new entrants before they cut into its market share.
A buying opportunity?
Goldman’s analysts think the short-term outlook for Diageo is challenging. But the spirits industry has been through cyclical fluctuations before.
The risk for shareholders is the possibility of this being more than the usual volatility. A prolonged downturn could be a significant issue for investors.
I’m somewhat sceptical, though. Over the long term, the trend towards premium spirits has been a durable one – after each downturn, things have always moved higher.
There’s no guarantee this will continue, but I think Diageo’s long-term strengths put the odds in the company’s favour. That’s why I’ve been buying the stock for my portfolio.
