In recent news, Diageo (LSE: DGE) (NYSE: DEO.US) plans to take full global ownership and control of Tequila Don Julio from Casa Cuervo, a firm that currently also partners with Diageo to produce and distribute the Smirnoff brand in Mexico.
As part of the deal, Casa Cuervo will give up Smirnoff and gain another Diageo brand, Bushmills, instead.
Going for the highest growth
The transaction will swell Diageo’s coffers to the tune of $408 million and should complete during early 2015. However, although the firm plans to pay down some of its debt with the money, it’s not really about the cash, it’s about Diageo pursuing its fastest-growth options.
Diageo’s Chief Executive reckons the deal secures the company’s place in the growing super and ultra-premium segments of the tequila category and further strengthens Diageo’s leading position in Mexico, where the growth of spirits is one of the drinks sector’s biggest growth opportunities.
Headwinds in emerging markets have stalled growth of late, so adjusting the firm’s portfolio for value seems like an astute move. Diageo sees its future in up-and-coming areas such as Mexico and in fledgling markets generally. Around 36% of operating profit came from fast-growing markets last year, so progress in newly affluent regions of the world is significant for Diageo shareholders.
Cash flow needs to catch up
The price for Diageo’s often-acquisitive progress in growth markets seems to be lacklustre cash flow and rising debt, so the recent Mexican deal delivers some welcome capital to pay down debt:
|
Year to June |
2010 |
2011 |
2012 |
2013 |
2014 |
|
Net cash from operations (£m) |
2298 |
2183 |
2093 |
2048 |
1790 |
|
Borrowings (£m) |
8764 |
8195 |
8629 |
10,091 |
9214 |
|
Debt divided by cash flow |
3.8 |
3.8 |
4.1 |
4.9 |
5.2 |
The share price is back down to where it was around two years ago at today’s 1818p. It seems that sluggish cash flow and downbeat forward numbers for earnings’ growth is forcing Diageo’s valuation compression.
Perhaps the Tequila deal will be one element that helps to reinvigorate Diageo’s cash flow performance in the coming years. In the meantime, P/E reduction could drag against capital-growth for Diageo investors with no short-term relief on the horizon as the catalysts for a near- term recovery of consumer spend in the emerging markets remain weak.
Power brands
Yet, despite short-term trading weakness, the future growth drivers for the industry remain undiminished and Diageo’s powerful brands such as Johnnie Walker, Crown Royal, J&B, Buchanan’s, Windsor, Ketel One Vodka, Ciroc, Captain Morgan, Baileys, Tanqueray and Guinness, with their cast iron repeat-purchase credentials, should drive cash-flow growth in the medium- and long-term.
The forward P/E rating runs at just under 19 for 2015 and there’s a forward dividend yield of 3%. That doesn’t sound cheap for a business expecting to grow its earnings just 1% that year, but Diageo remains a quality investment proposition and quality comes at a price.
