I believe that premium alcohol beverage producers are fantastic businesses to own (on the cheap of course). Firstly, premium spirits are associated with strong brand loyalty amongst consumers. Secondly, the premium global spirits industry is quite concentrated (the word "oligopoly" comes to mind). Probably my favorite reason for liking the premium spirit business is that operating margins are generous and demand for the products do not appear to be highly cyclical with economic conditions. The logic of "why not drink more when times are bad" has a certain appeal.
Diageo has been focusing on the premium alcohol beverage business and improving their margins. They are achieving sales growth both organically and via acquisitions. Their operational efforts have been contributing towards an increasing operating margin over the past several years. Their average operating margin over the past 4 years is around 26%. I believe these operating margins are sustainable going forward based on their excellent brands, global operations, customer loyalty and management's operational focus (they have been exiting lower margin fast food businesses).
Diageo has also been buying back its own shares in the company. So if you believe in the "signalling theory" of share buybacks, it is instructive to observe that 141M shares were purchased in 2006-2007 for an average price (including fees) of approximately 996 pence per share. Converting to US dollars and adjusting for the 4:1 ratio between LSE shares and the ADR shares (NYSE: DEO), this would make the share re-purchase price today somewhere in the neighborhood of $79.50 per share. Currently shares are trading for $73.40 on the NYSE. This is a potential indication that the stock is trading cheap to its intrinsic value.
If Diageo repeats the share repurchase of 141M shares, that would represent just over 5% of the total shares outstanding. In addition, Diageo has been increasing their dividend payments over (at least) the last 10 years and is currently yielding a 3.6% dividend payout. If you could buy Diageo stock with a margin of safety on their intrinsic business value and see the share float decrease by 5% and receive a 3.6% dividend, that's not bad!
In my next post I will present my calculation of the intrinsic value of Diageo's earning power to determine if this stock is currently priced attractively in the public markets.
Disclosure: The author has no shares in this company