As I noted in a recent article, the historically defensive universe of so-called "sin" stocks has been on a tear over the past year, as investors have warmed up to the growth opportunities available to these companies in emerging markets. Companies like casino giant MGM Mirage (NYSE: MGM) and cigarette manufacturer Imperial Tobacco Group (NYSE: ITY) have acted more like tech stocks in the halcyon days of the late '90s, advancing an average 44% in 2006, well ahead of the 12% gain managed by the S&P 500.
While some of these stocks might have gotten a bit ahead of themselves, there are a number of companies in this sector that I believe remain attractively valued given their growth potential, and one of my favorite plays is Motley Fool Income Investor pick Diageo (NYSE: DEO).
Diageo
Diageo, formed by the 1997 merger of Grand Metropolitan Public and Guinness Plc, was far and away the world's largest supplier of premium liquors in the fiscal year ended June 30, 2006, in terms of volume (134 million units), net sales ($13.4 billion), and operating profits ($3.8 billion).
According to market research firm Impact, Diageo owns or manages nine of the world's top 20 brands of premium liquors (and 17 out of the top 100), including Smirnoff vodka, the Johnnie Walker family of Scotch whiskies, Tanqueray gin, Captain Morgan rum, Jose Cuervo tequila, J&B Scotch whiskey, and Bailey's Original Irish Cream. In 2006, these top-shelf liquor brands and their lesser ilk represented roughly 75% of the company's sales. Beer (including the premium Guinness brand) comprised 20% of revenue, and wine labels contributed 5%. Geographically, sales were broken down as follows: 31% in North America, 41% in Europe, and 28% in the rest of the world, which the company terms "International."
How's that for a brief synopsis?
Now, the main reason I'm bullish on Diageo is that the company is essentially a "growing bond." Simply put, increased sales to emerging markets supply the growth component of the equation, while the company's operations in more mature markets should continue to generate significant amounts of free cash flow that can be used to increase divided payouts and fund share buybacks.
Think I'm being Foolish? Let's pour ourselves a tall glass of Johnnie Walker, sit by a roaring fire, and take a quick look.
The growth component
Diageo currently derives just less than 30% of its revenue from the rapidly growing emerging markets of Asia, Latin America, Africa, and the Middle East. As the number of middle-class consumers in these developing markets increases -- China, for example, is expected to have a middle-class population of 520 million by 2025 -- so will Diageo's sales and profits. This positive trend is already evident in the fact that, for the fiscal year ended June 30, 2006, Diageo reported that its "International" business saw a 14% increase in volume, a 13% gain in net sales, and a 9% jump in operating profit (held back by a smartly planned 28% increase in marketing expenses). By way of comparison, North America and Europe posted average increases of just 3% and 6%, respectively.
The company has already reaffirmed its 2007 fiscal guidance of at least a 6% increase in organic sales and a minimum 7% gain in operating income.
The "bond" component
In fiscal 2006, Diageo generated free cash flow of $2.5 billion and returned more than $4.3 billion to shareholders through divided payouts and share buybacks. Management has already stated that it intends to repurchase roughly $2.6 billion worth of shares in fiscal 2007 (approximately 4.7% of shares outstanding at current prices), and the dividend payout ratio is likely to increase by at least 5% ... not that the current yield of 3.6% is anything to sneeze at.
Hmmm ... decent sales and profit growth buttressed by a fat dividend and a generous share repurchase program? What else can a defensive-minded investor wish for?
All in all, I believe that with Diageo trading at 16 times forward earnings, the risk/reward ratio is attractive. I come to that conclusion based on an estimated earnings growth rate of 11% in 2007, while adding in the 3.6% yield and the fact that the share buyback will increase earnings by a minimum of 4.7% (assuming no further margin expansion). Essentially, I believe Diageo should at least trade at a multiple in line with this real return rate of 19%, or roughly $91-$92 per share.
Pour another round of Foolishness:
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Fool contributor Will Frankenhoff is enjoying his time writing for the Fool more than reading The Financial Times, rooting for the Jints, or taking a nap. He welcomes your feedback and does not own shares in any of the companies mentioned above. The Fool's disclosure policy is shaken, not stirred.
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