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Diageo plc Rockets Higher On Bid Rumours: Could A Deal Happen?

Shares in drinks giant Diageo (LSE: DGE) (NYSE: DEO.US) rose by more than 7% today after unconfirmed reports that a private equity firm considering a bid for the firm.

An unconfirmed report in the Brazilian news magazine Veja on Friday suggested that Brazil’s richest man, Jorge Paulo Lemann, might be behind a possible offer.

Mr Lemann is a founding partner at private equity firm 3G Capital. The report suggested that he could be in the early stages of considering an offer for Diageo.

Is this realistic?

3G Capital certainly has form when it comes to blockbuster bids for consumer stocks.

In 2013, the firm partnered up with Warren Buffett’s firm Berkshire Hathaway $23bn deal to buy Heinz. 3G is now in the process of merging Heinz with Kraft.

3G also owns Burger King, while Mr Lemann is a controlling shareholder in AB InBev, one of the world’s largest brewers. Mr Lemann and 3G may see potential synergies between Diageo, which brews Guinness and some other beers, and AB InBev.

On the face of it, Diageo seems a likely target, but the deal could be a stretch financially. Diageo’s equity is currently valued at about £47bn. In addition to this, the firm has net debt of about £10bn, suggesting the total cost of an acquisition could be close to £60bn, or $90bn.

However, a deal in conjunction with another investors, such as Warren Buffett, might be a possibility.

Why buy Diageo?

Diageo’s portfolio of leading drinks brands is highly profitable and generates a lot of free cash flow.

Owning brands such as Smirnoff, Johnny Walker and Baileys gives Diageo a natural defensive moat in the booze market. Like smokers, drinkers tend to be loyal, and to aspire to more upmarket brands.

Diageo isn’t cheap, however. The firm’s strong long-term growth and operating margin of 27% make Diageo a premium stock.

Although the firm’s shares had fallen by about 10% from the high of 2,022p seen at the end of January, they still trade on a 2015 forecast P/E of 21. Last year’s reported free cash flow of £1,235m goes some way to justify this valuation, as it would provide a 2.6% yield on the current share price.

Another factor that might appeal to 3G is that Diageo is currently going through a slow spell. Earnings per share for the year ending 30 June 2015 are expected to be around 10% lower than in 2013.

Earnings per share are expected to rise by around 7.5% in 2016, and the long-term outlook looks attractive. Diageo’s products tend to become more popular as average incomes rise in, so there’s lots of potential for growth in emerging markets.

Now could be a good time to buy Diageo, if 3G can find a way of financing such a large deal without diluting its returns too much. I’d put the chances of a deal at about 50%, and intend to hold onto my own Diageo shares.

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Roland Head owns shares of Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.