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Diageo (DEO) made big news recently when it sprung for Aviation Gin. It is paying a headline $610 million for the ultra-premium gin brand. There’s more nuance to the deal than just that figure though. Diageo is paying $335 million upfront, with the other $275 million coming into play if Aviation hits certain revenue targets over the next decade. In addition to limiting risk that way, Diageo also acquired numerous other smaller brands along with Aviation in this agreement.
Aviation, for those unfamiliar, was launched to popularity by actor Ryan Reynolds. He used a series of guerrilla marketing tactics to promote Aviation, including a famous ad with “Peloton wife” actress Monica Ruiz last year.
Some people have complained about Aviation deal, saying it’s too expensive for a young brand. Aviation gin had a reported 18,000 cases a year of volume prior to Reynolds’ involvement. Since he took over marketing, the growth rate has topped 100% annually, and I estimate that sales volume is now above 50,000 cases a year.
That may sound tiny, as gin is a 10 million case a year business in the U.S. However, super-premium gin is a far smaller niche within that, and Aviation is taking massive share there. Super-premium has been growing at 18%/year, and Aviation alone has been producing 40% of all the total growth in the super-premium category.
Source: Aviation Gin
As part of the takeover agreement, Ryan Reynolds has agreed to continue to be the face of Aviation Gin for the next decade — and he’ll be motivated to keep promoting the brand, given that the earn-out agreements only pay off if Aviation hits targeted revenues levels in future years.
All that sounds good, but we’re still talking about at least $300 million and potentially up to $610 million. Did Diageo overpay? They didn’t disclose sales and profit margins at the time of the deal, so I can’t offer a concrete assessment.
That said, Diageo gets some benefit of the doubt. Many analysts slammed Diageo for overpaying when it agreed to spend up to a billion dollars for George Clooney’s Casamigos premium tequila. Yet that one has paid off in spades. For full-year 2019 — several years after the takeover already happened — Casamigos has continued to post stunning 68% annual growth:
Source: Diageo’s 2020 20-F
Thus, people predicting that Aviation is going to slump now that Reynolds has cashed out should reconsider that view. It’s worth noting that Reynolds has remaining upside in Aviation with the additional sales volumes-driven incentive payments.
In any case, this is not a large deal in the context of Diageo’s overall business. The company sells $16 billion a year of products and earns after-tax income of around $4 billion annually. So if the deal is a total and complete flop, they’re out $335 million, or just around one month’s worth of normal profits.
Meanwhile, if it hits, they could get another star growth vehicle like Casamigos to add to the fold. In a way, I see this acquisition as Diageo’s equivalent of R&D, spending reasonable sums of money on new and rising brands to see what happens when they get global promotion and distribution. Just like with R&D, not all of Diageo’s projects will work out, but a few big winners like Casamigos make up for the misses.
In other words, I’m totally fine with Diageo doing this sort of bolt-on deal-making. Some investors just want as much dividends and share buybacks as possible — and those are both great — but there’s nothing wrong with investing some capital in a few emerging brands from time to time to freshen up the lineup.
How Does Currency Affect Diageo?
In Ian’s Insider Corner, members often ask me questions about our holdings. Given the sharp moves in the dollar and other currencies recently, a reader asked how all this would play out:
“Ian, if you write about DEO, can you talk about how currency plays into your thoughts about the investment.”
And, to be honest, currency isn’t a huge part of my process for Diageo. It’s the most diversified global liquor company in terms of its geographic reach.
Diageo sales by region. Source: 2020 annual report
It’s not particularly reliant on any one of China/Hong Kong, Latin America, or continental Europe, unlike most of the other spirits companies. So major currency moves in any one market don’t move the needle nearly as much at Diageo as they would at, say, Remy Cointreau (OTCPK:REMYY) where they have outsized exposure to China/Hong Kong.
From the standpoint of a U.S. investor, there can be a bit of performance gain from buying Diageo when the British Pound is weak/dollar is strong. However, it’s not a large impact.
During Brexit in 2016, I had been hoping for a big drop in Diageo stock. And in fact, the British Pound slumped more than 10% immediately following the vote. Unfortunately, investors were wise enough to realize that the underlying value of Diageo had barely changed; Diageo shares denominated in pounds shot up in London following the Brexit vote and thus the U.S. ADR (in dollars on the NYSE) barely declined.
There is some advantage to buying foreign stocks when the dollar is strong (as it had been until this past month). However, when a company gets the largest chunk of its sales from North America and its stock trades as much volume in the U.S. as it does in London, there’s far less currency impact.
A large number of investors buying and valuing Diageo operate in dollars, and thus price the stock accordingly. That’s not the case with something like a Pernod Ricard (OTCPK:PDRDY) or Remy Cointreau, where their businesses are less North America-centered and their shares are not as popular with U.S.-based investors. In those cases, there tends to be more impact from currency swings.
DEO Stock Is Cheap Now
Investors may look at current operating results and conclude Diageo is expensive. The stock is trading for 40x trailing earnings, after all. However, Covid-19 wiped out a large chunk of profits. With bars and restaurants closed, on-premise alcohol consumption dried up. That will be coming back in future quarters.
Prior to the virus, Diageo earned around $6-$6.50 per share a year in profits. That puts the stock around 21-22x normal earnings. That’s really cheap for a spirits company. Other major liquor names like Brown-Forman (BF.A) (BF.B) and Remy Cointreau are in the 30s even now, despite the economic headwinds.
Nick Train, fund manager of Britain’s Lindsell Train, put it eloquently a few years ago:
To me it appears that exceptional companies with durable competitive advantages are in fact cheap almost all the time.
The point is such companies are rare. It is plain wrong to expect them to be valued similarly to what is the vast majority of ephemeral, low value-added businesses. I like to think about the conundrum of 20. Many investors presented with a stock on 20 times earnings – Diageo for instance – will say that’s expensive, relative to, for example, the long-term average P/E multiple for Anglo-Saxon markets of 15.
However if I offered those same skeptical investors the opportunity to invest in an asset with a guaranteed 5 per cent yield, with likely protection against inflation over the next 25 years, with some real, above inflation growth thrown in too, they’d fall over themselves to buy. Diageo seems to me to offer such potential, by the way, yet, of course, the ‘high’ P/E of 20 and the attractive real yield of 5 per cent are one and the same.
Source: Interview with Wealth Insight magazine, February 2016.
Since 2016, Diageo stock has produced a total return of nearly 50%, yet the stock continues to sell for around the same normalized P/E ratio as it did back then. Diageo reliably increases its earnings quickly enough to offset stock price appreciation.
What’s funny is that interest rates have fallen even lower than they had been in recent years. Thus, in comparison to bonds, the value of Diageo’s low-risk steadily-increasing cash flows should be going up. Instead, short-term focused investors are missing the forest for the trees, instead worrying about a transitory drop in bar and restaurant revenues. Oddly enough, this same effect hasn’t happened at the other spirits stocks:
Data by YCharts
While Diageo stock is still down 19% year-to-date, the other spirits stocks are essentially flat or even showing gains. Thus, Diageo is an easy buy here. It will catch up with the other spirits stocks as it usually does.
Fast forward to next year, when earnings rise to $7 and DEO stock returns to a 25x P/E ratio (remember, Brown-Forman is coming up on 40x earnings by comparison) and Diageo should be going for $175. That’s some solid upside from the current $135, particularly given its low-risk blue chip nature.
With the stock market back at highly-valued levels, it’s a great time to pick up defensive holding Diageo at a more-than-fair price.
This is an Ian’s Insider Corner report published August 23rd for our service’s subscribers. If you enjoyed this, consider our service to enjoy access to similar initiation reports for all the new stocks that we buy. Membership also includes an active chat room, weekly updates, and my responses to your questions.
Disclosure: I am/we are long DEO,BF.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.