Monday, July 21, 2008

Diageo: The Right Mix

Management at Diageo has been focused on their premium drinks business for some time now. As I claimed here, Diageo owns quite a few quality premium spirit brands and might be a current value play. I also suggested in the article here, that the operating margins in the premium spirits business are relatively high. Let's take a closer look at Diageo to see if this claim of higher operating margins in the premium drinks business holds up.

In Diageo's June 2007 annual report, there is a list of major acquisitions and disposals that were made over the past decade. The net effect of these business purchases and sales was to increase the concentration of Diageo's premium drink business holdings. From December 1997 to June 2007, Diageo received £10.5 billion from disposals of non premium drink businesses including Pillsbury, General Mills and Burger King. In this same period, Diageo spent approximatey £5.0 billion on acquisitions of premium drink businesses. The question is what happened to the operating margins during this period of intensifying exposure to premium drinks?

Doing some quick calculations on operating margins just to get an idea of what the trend was, we see an incredibly steady climb from 11% in 1999 to 29% operating margins in 2007. Wow! This tremendous increase in operating margins occurred while management was busy sloughing off lower margin food businesses for higher margin premium drink businesses. The data suggests that increasing exposure to the premium drinks business has helped lift Diageo's operating margins substantially and supports my previous claim.

I believe that Diageo can protect their newfound higher operating margins through their competitive advantaged brands! Using Diageo's average operating margins over the past four years (since these are more consistent with the focus on premium spirits business model) together with a very conservative low term growth rate, I have calculated the intrinsic value of Diageo's stock to be worth around $79 per share.

Disclosure: The author has no position in Diageo

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