So-called “sin” stocks can certainly be great investments; just look at Diageo (NYSE:DEO). Over the past 12 months, the company’s shares are up an impressive 28% — more than double the broader market.
And this is no fluke. The company’s average annual return for the past three years is in the same ballpark.
Hey, who wouldn’t drink to that?
Then again, the spirits industry is fairly mature — and the competition is intense. Just a few other big-name operators include SABMiller (PINK:SBMRY), Beam Global Spirits & Wine, Constellation Brands (NYSE:STZ) and Pernod Ricard.
With that in mind, the question is whether or not Diageo can keep up the momentum. To see, let’s take a look at the pros and cons:
Pros
Powerhouse. Diageo is the largest spirits company in the world thanks to a presence in North America, Asia Pacific, Latin America and the Caribbean. And for the most part, the company’s brands are high-end. Examples include CIROC, Ketal One, Johnnie Walker, J&B, Smirnoff, Guinness, Baileys and Harp. Because of this, the company is able to routinely increase prices and maintain juicy operating margins, which currently are just under 30%.
The Wealthy Class. Plus, the rich are getting richer — certainly a good thing for Diageo, as the company continues to innovate its product line to cater to the luxury market. Recently, it’s added Johnnie Walker Platinum (launched in Asia) and Crown Royal Maple (launched in the U.S.). These two products contributed over 10% of the net sales growth in the last six months of last year. Diageo has also been bolstering its premium brands with creative promotions like “money can’t buy” events. For example, the company has launched the John Walker & Sons Voyager, which is a luxury yacht trip that goes around the world.
Africa. Consider that half of the world’s fastest growing countries are in Africa. To capture this opportunity, Diageo has been investing aggressively in the continent, especially with its beers. It has established local operations in key countries — like Tanzania, Ghana, South Africa, Kenya and Cameroon — to better respond to unique customer tastes. And according to research group Canadean, the market is expected to grow 5% per year through 2016 — twice as much as the global average.
Cons
Acquisitions. This has been a key for growth at Diageo. Some of its recent deals include Shui Jing Fang (China), Yeni Raki (Turkey) and Hanoi vodka (Vietnam). Yet acquisitions can be extremely risky — especially in emerging markets. It is never easy to integrate operations when there are different cultures and approaches. In fact, there is also lots of competition for deals, which has driven up valuations. This could reduce overall returns. Just last year, Diageo called off its deal to acquire Cuervo because the parties could not come to terms.
Southern Europe. Diageo’s global scale is certainly a big advantage. But it also means that the company is not immune from downturns in certain regions. As should be no surprise, the company is experiencing big problems in southern Europe. Last year, sales plunged by about 9%. And as seen with the recent problem in Cyprus, the deterioration could continue to get worse and mute some growth for Diageo.
Valuation. The shares are far from cheap, coming to a price 19 times trailing and 17 times forward earnings. The dividend is also a meager 1.9%. It’s true that a top company like Diageo will often trade at a premium, but if there is a slowdown in its growth — which could easily happen thanks to Europe — the stock could easily suffer a material drop in price.
Verdict
For more than a decade, Diageo’s CEO Paul Walsh has made lots of smart moves. He effectively sold off non-core businesses, such as Burger King (NYSE:BKW) and Pillsbury, and has built a global platform of premium brands. With steady growth and the rise of the wealthy across the globe, Diageo should continue to ramp at a steady rate. There should also be long-term opportunities in Africa.
Even though the valuation is a bit pricey, it’s still reasonable in light of the company’s track record. So all in all, the pros outweigh the cons on the stock — especially if the stock pulls back.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of “How to Create the Next Facebook” and “High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders.”Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.
