VALUATION HIGHLIGHTS

1. North America constitutes 43% of the Trefis price estimate for Diageo's stock.
2. Europe constitutes 21% of the Trefis price estimate for Diageo's stock.
3. Asia Pacific constitutes 15% of the Trefis price estimate for Diageo's stock.

WHAT HAS CHANGED?

1. DEO Stock Performance
   • DEO stock has seen a decline of 10% from levels of $160 in early January 2021 to around $140 now (mid-April 2024), vs. an increase of about 35% for the S&P 500 over this roughly three-year period.
   • However, the decrease in DEO stock has been far from consistent. Returns for the stock were 39% in 2021, -19% in 2022, and -18% in 2023. In comparison, returns for the S&P 500 have been 27% in 2021, -19% in 2022, and 24% in 2023 — indicating that DEO underperformed the S&P in 2023.

2. Latest Earnings (FY23)
   • In FY23, Diageo reported net sales of £17.1 billion, marking a y-o-y growth of 10.7%. Organic volume was down 0.8%, while price/mix contributed 7.3% to the organic growth of 6.5%. The reported sales growth reflects favorable foreign currency translation due to the strengthening of the US dollar. Reported EPS increased 18% y-o-y driven by net sales recovery, positive price interventions, and productivity initiatives.

3. Interest Builds Up In The Premium Tequila Market
   • Tequila is no longer alcohol intended to be hidden in cocktails and is gaining popularity as a drink to be sipped. This gathering momentum has been evident in the tremendous rise in the sales of tequila, and in particular in the super-premium varieties. The sales of this alcoholic beverage in North America have been growing at a faster rate than the overall drinks market, as the premium brands help to improve the image of tequila. The increasing interest is also reflected in the growing M&A activity in this industry. Recently, Bacardi agreed to purchase Patron Spirits, maker of high-end tequila, valuing the latter at $5.1 billion. This news even sent shares of the Jose Cuervo maker, Becle SAB, to a near-record high. The deal also follows Pernod Ricard buying out Avion Tequila, and Diageo acquiring Casamigos tequila.
   • Diageo has also had considerable success following the purchase of another super-premium brand, Don Julio. In FY 2022, the brand reported a net sales improvement of 38%, with organic volume growth of 30%. Tequila represents 10% of Diageo's sales, and this contribution is expected to rise over the coming years.

POTENTIAL UPSIDE & DOWNSIDE TO TREFIS PRICE

Below are key drivers of Diageo that present opportunities for upside or downside to the current Trefis price estimate:

North America Revenue per Unit

North American revenue per unit has benefited from the growth in sales of Scotch and North American whiskey. Moreover, the increased premiumization has resulted in improving this metric. Although the revenue per unit saw slower growth between 2018 and 2020, the growth has been strong since then. We expect the metric to grow at a steady rate throughout the Trefis forecast period, driven by the higher sales of premium products.

Asia Pacific Volumes

India is considered a key growth area for Diageo, the main reason the company acquired a majority stake in United Spirits Ltd, and is the second-largest revenue contributor to Diageo. Moreover, the stellar performance in China, in particular in the Chinese White Spirits, has helped to spur Diageo's revenue growth. These two markets are expected to contribute significantly to Diageo's fortunes in the future. We expect the metric to increase from 94 million units in FY 2022 to over 115 million units by the end of FY 2029.

BUSINESS SUMMARY

Diageo is a multinational alcoholic beverage company and is the world's leading premium drinks business. The company is headquartered in London, England, and is listed on the London Stock Exchange (LSE: DGE), as well as on the New York Stock Exchange (NYSE: DEO). The company is the world's largest producer of spirits and a major producer of beer and wine, and its brands include Smirnoff (the world's best-selling vodka), Johnnie Walker (the world's #1 blended scotch whiskey), Baileys (the world's best-selling liqueur), and Guinness (the world's #1 stout). Diageo is the world's largest whiskey producer, with 28 malt distilleries.

Diageo was formed as a result of a merger between the Grand Metropolitan Public Limited Company (GrandMet) and Guinness PLC (Guinness Group) in December 1997. Diageo owned Pillsbury, which was sold to General Mills in 2000. Moreover, Diageo sold Burger King, the American fast food restaurant chain, to a U.S firm, Texas Pacific, in 2002. In 2011, Diageo acquired the Turkish liquor company Mey Icki for $2.1 billion, and in 2012, it acquired Ypioca, Brazil's largest-selling brand of premium cachaca, for $300 million. In November 2012, the company acquired a 53.4% stake in the Indian company United Spirits for $1.28 billion. The company also has a 34% stake in the Moet Hennessy drinks division of the French company LVMH. Every year, the company produces its brands from 143 sites, selling in 180 countries.

SOURCES OF VALUE

Diageo, which is the world's largest spirit producer by volume, primarily derives value from its North America segment, which includes U.S. Spirits & Wines, Diageo-Guinness U.S.A. (DGUSA), and Canada. North America accounted for 34% of the company's net sales and over 49% of the operating profit in FY18. With a majority 55% stake in UB Group's United Spirits, Diageo accounts for 25% of the global volume share of premium spirits. Global giants represent 41% of Diageo's net sales. These include brand families of Johnnie Walker, Smirnoff, Captain Morgan, Baileys, Tanqueray, and Guinness.

Strong brand marketing and increasing popularity of ultra premium and premium brands to boost Diageo's volumes

Diageo has a premium brand positioning worldwide, with the U.S. being the company's largest market. With an increase in advertising, popularity, and improvement in spending limits, consumers might shift to more expensive alcohol brands, boosting the company's volumes as well as revenues per unit volume.

1. North America accounts for roughly 20% of the volume share of the company. The company's strong brand positioning in this region is mainly due to its dominance in the vodka and whiskey category, as well as a growing market share in rum. The volume in the North America region increased by 3% in FY 2022 (year ended June 2022). The company continued its focus on recruiting of millennials and multi-cultural consumers, using a mix of traditional and digital channels for marketing. While all key brands were able to gain value share, vodka still remains a weakness. The company is undertaking a number of initiatives to return these brands to positive growth, such as focusing on the core variants of Cîroc — Blue, Apple, Peach, and French Vanilla and highlighting the fact that Ketel One is 100% non-GMO. DEO is targeting the super-premium vodka segment to drive the U.S. spirits performance.


2. Diageo leads the spirits market in the U.K. and Greece. In Ireland, Diageo is the second leading spirits brand with nearly a one-third market share, closely following Ireland distillers. In Ireland, Smirnoff Red, and Captain Morgan, are the company's top-performing brands.


3. Diageo's Smirnoff vodka brand is one of the top vodka brands in Eastern Europe. Premium scotch and rum brands are also gaining huge popularity in these regions.


4. In India, Diageo completed its full integration with United Spirits Limited, the largest spirits company to lead the Indian spirits market. Moreover, in Vietnam, Hanoi Liquor Joint Stock Company led the spirits market, where Diageo holds a 56% stake. In Australia also, Diageo leads the spirits market.



KEY TRENDS

India's growth potential

India is considered to be a big opportunity for the company and is a key focus area in the medium term. Diageo has made good progress in accelerating growth as it focuses on long-term opportunities while mitigating short-term impacts of events and legislation. Net sales improved by 16% in India (FY 2022), reflecting a rise in both volume and pricing. The company's strategy in the country is to grow its Prestige and above brands, which now represent two-thirds of the company's portfolio in the country. Sales growth and accelerated productivity have bolstered the gross margins in the country. For greater cost efficiency, the company's tram-lining, which involves breaking down the individual costs involved in a product, and comparing them to other products in the market, as well as internal benchmarks, has helped to reduce glass costs through light-weighting and a more effective sourcing strategy. Furthermore, Zero-based budgeting has reduced indirect costs.


Strong growth in China

The company had taken a hit in China a few years back as a result of the anti-extravagance drive in the country. However, Diageo has managed to strengthen the business, with improvements noted in the route to market and the sales and distribution system. While the company cannot be expected to maintain this massive growth in the future, strong double-digit growth can be anticipated, driven by whiskey and its white spirits brands, Shui Jing Fang, in particular.


Emerging middle class in Africa

An emerging and thirsty middle class has made Africa one of the most lucrative markets for the wine and spirits industry, as the market has been expanding at five times the global average, in 24 sub-Saharan African countries, according to IWSR, a British wine consultancy. Furthermore, saturated beer markets across North America and Europe have resulted in breweries rushing to set themselves up in the rewarding yet risky markets in Africa. Countries in sub-Saharan Africa are also experiencing significant rates of urbanization, with the U.N. forecasting the urbanization rate to reach 45.9% by 2030. An increasing level of disposable income will be to the advantage of liquor companies, as moving into the middle class allows consumers to go for more quality. Furthermore, while Africans drink nine liters of beer per head per year, the global average is 45. With an increase in disposable incomes, the rate of beer consumption is set to grow significantly.