Today's Buy Opportunity: Diageo

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When I heard that the Fool was planning to purchase 50 stocks over 50 days -- and wanted great ideas from analysts like yours truly (I advise the Fool's dividend service) -- I scanned the quiver of my Income Investor recommendations and shot British liquor company Diageo (NYSE: DEO  ) over their way. Diageo's got me all fizzy, and I'll share why it should do the same for you.

Fast facts on Diageo:

Market Capitalization

$44.4 billion

Industry

All things alcohol

Revenue (TTM)

$14.7 billion

Earnings (TTM)

$2.34 billion

Return on Equity (TTM)

39.7%

Source: Capital IQ, a division of Standard & Poor's. TTM is trailing 12 months.

First off, I don't drink. That may sound weird, but it means I have no emotional connection with Diageo's leading brands: Smirnoff, Johnnie Walker, Guinness, and Captain Morgan, to name a few. And I mean a few: The company boasts eight of the world's 20 top liquor makes, altogether. You see, for me, investing is not about emotion; it's about coldly calculating odds for the best success, so the fact that I like a company despite its products is a green flag.

So why do I like Diageo in the first place, Fool? For starters, Diageo's big-ticket brands allow it to charge big-ticket prices – but for an affordable luxury like liquor, "big-ticket" is still small enough to be affordable for most folks. In developing markets, Diageo's liquors are actually status symbols that signal you've "made it." And developing markets have certainly "made" Diageo's growth story. Whereas developed-market operating profits have been flat to slightly down in the recession (still good considering alcohol is a nonessential good), those from emerging markets were up 16% for the last six months for which Diageo reported them.

Diageo's big brands do more than create future growth. They also drive Diageo's massive 40% return on equity – a measure of profitability per unit of equity dollar given to the company. That's one reason its shares have outperformed the S&P 500 by a dividend-adjusted 188% over the past decade.

Another is cash. I'm a sucker for it myself, and here, Diageo had me at "hello." A full 17% of its sales convert to free cash flow -- the purest measure of both company profitability and ability to pay dividends, better than Anheuser-Busch (NYSE: BUD  ) at 11%, Constellation Brands (NYSE: STZ  ) at 6%, and Brown-Forman (NYSE: BF-B  ) at 16%. They're all good alcohol companies in their own right; I just think Diageo is a little better.

A risk Diageo faces is its debt. Part of the reason it's maintained a strong ROE despite the recession is that debt has risen from 51% of capital to 66% of capital over the past five years. The company's operating income is 3.5 times its interest expense, so I'm comfortable with Diageo's debt, but it remains something to watch.

To hear James talk more about why Diageo is a great addition to your portfolio, watch his video on the company below:

On the positive side, investors have watched Diageo raise its dividend nicely since it began payouts 12 years ago. Diageo doesn't shoot for the moon here, but has maintained a payout growth rate of 5.4% annually over the past half-decade. It yields 3.2% at current prices, and U.S. investors will appreciate that there's no British withholding tax on U.S.-bound dividends. If you're looking for an international investment, it doesn't get much easier than Diageo.

On top of all this, Diageo sports over 20% of potential capital gain upside, according to my model. Combine that with its nice, growing yield, many of the world's top liquor brands, and robust free cash flow, and you've got a cocktail that should make any investor giddy – giddy in a good way.

Come back to Fool.com tomorrow for another great stock pick. There's plenty more great stock advice, and you can find video of each day's recommendation as well! To see the performance of previous recommendations, click here.

"11 O'Clock Stock" is sponsored by Motley Fool Stock Advisor. The Motley Fool will wait at least 24 hours after this publication before purchasing shares of Diageo. To see an FAQ on "Eleven O'Clock Stock," click here.

James owns shares of Diageo. Diageo is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (63)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 28, 2010, at 12:23 PM, samedge wrote:

    An industry that will grow in the best of times...and in the worst of times. Steady growth trajectory, palatable multiples and an outstanding product line (not that I know from experience).

    Normally I'd say that this is a safe, safe pick. However, for a company that generates enormous cash flow, why on earth do they have 8 BILLION in debt? Aside from their debt/equity no ratio jumps out at me, but their balance sheet is an eye-opener.

    Aside form QCOM, I'm noticing highly-leveraged companies on your picks thus far.

  • Report this Comment On July 28, 2010, at 1:03 PM, rd80 wrote:

    Curious if you have any thoughts on CCU vs DEO.

    I like both and have them as CAPS picks, but if I was going to buy one today, I think CCU would get the nod.

  • Report this Comment On July 28, 2010, at 1:21 PM, conjoblo wrote:

    i was not able to play the video

  • Report this Comment On July 28, 2010, at 1:37 PM, aussieguy73160 wrote:

    http://www.theage.com.au/national/stunning-50m-legal-coup-fo...

    Interesting perspective of this company.

    Worth a look, if you consider corporate actions as part of your basis for investment.

    They had a long and often dark history with thalidomide in the 60's, however, this latest action now shows this company in a new light.

  • Report this Comment On July 28, 2010, at 3:00 PM, samedge wrote:

    Eric,

    Thanks for your response. I wouldn't say I avoid companies with debt entirely, but I like to see them actively manage it (downwardly is ideal, of course). For many growing and asset-heavy enterprises, I understand some amount of debt is required.

    It's only when leveraged capital vastly exceeds equity in funding company operations - in this case by 239% - that I consider steering clear of an investment. For intents and purposes, Diageo is a holding company that has leveraged themselves to the hilt to attain their market position.

    Unless Islamic fundamentalism sweeps the world in the next couple of years, it will likely work out for them. Unfortunately, I won't be along for the ride. Best,

    Sam

  • Report this Comment On July 28, 2010, at 5:53 PM, spadeknight wrote:

    No question here just wanted to say thnks again for the great stock advice. Look forward to coming home everyday and seeing the next pick.

  • Report this Comment On July 28, 2010, at 9:42 PM, Manticorr wrote:

    I would think that a company that specialized in alcohol would have a Beta of over 0.70 and would be hoping for above 1.0. The low beta is nice in a bear market but if the bull starts up again than it slows the price down. Just learning about CAPM, Fama-French etc. and am trying to apply it. What is the R squared for DEO?

    Manticorr

  • Report this Comment On July 28, 2010, at 9:42 PM, TMFRhino wrote:

    Thanks spadeknight. We hope people are enjoying the series.

  • Report this Comment On July 28, 2010, at 9:56 PM, TMFRhino wrote:

    Hi Matnicorr,

    Beta's .71, why would you want it to be above 1.0? The company's tremendous out performance with what's traditionally been a relatively low beta is a selling point, if anything.

    As someone who's completed his fair share of finance work (CFA curriculum and finance degree), I'd warn not to rely too much on beta as an indication of "growth opportunity" if the market fires back up. Beta is a backward looking regression and doesn't necessarily reflect forward opportunity and risk. Also, a company could have a low beta and have consistently outperformed. Here at the Motley Fool, while beta can factor into an investment decision (especially through valuation), the first places we look at are competitive advantages and the company's valuation.

  • Report this Comment On July 28, 2010, at 10:14 PM, Manticorr wrote:

    TMFRhino,

    I am about halfway through an MBA in project management so please forgive the curiosity on the usage of the stats etc.

    The competitive advantages of Branding, and the company's valuation (as pointed out good but leveraged) do make the case for DEO. I was actually curious if the beta was low against the market because of inappropriate comparison hence the R squared question. The posting of the recommendation certainly would not qualify as an event study as the stock declined by over 2% today.

    Thanks for the recommendation,

    Manticorr

  • Report this Comment On July 28, 2010, at 10:25 PM, TMFRhino wrote:

    Manticorr,

    Hey, no forgiving needed, curiosity is always welcomed, and I don't have all the answers ;)!

    I'm at home right now and trying to type this out on my phone, but if you'd like, I'll post tomorrow about R squared.

    Good luck with the MBA program! Hope you'll keep tuning in with the series.

    Fool on!

    Eric Bleeker (TMFRhino)

  • Report this Comment On July 28, 2010, at 10:29 PM, Manticorr wrote:

    Please do post the R-squared!

    Thanks Again,

    Manticorr

  • Report this Comment On August 19, 2010, at 9:17 PM, cordwood wrote:

    James,

    "....alcohol is a nonessential good"....

    From an historical point, and John Waynes' lexicon :

    Of course the Pilgrims would have disagreed w/ you, on that point......so I will refrain from addressing you as "Pilgrim" :-]

  • Report this Comment On September 23, 2010, at 7:04 PM, jayaamit wrote:

    Hello Eric,

    Do you know if Canadians are hit with a non-resident tax on the dividends on Diageo in their retirement accounts (RRSPs) like other stocks are (example, foreign stocks like SQM, or the MLPs in USA)?

    Thanks for the analysis.

    - Amit.

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