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Stock Strategist

Diageo's Discount Too Deep to Disregard

Best-in-class scale and brand loyalty make this wide-moat firm a consumer staples standout.

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We think  Diageo (DEO)/(DGE) has a wide economic moat due to its importance as a vendor to both on- and off-channel customers as a result of its broad product portfolios in large categories in distilled spirits, and we think it is on trend to benefit from long-term premiumization in alcoholic beverages. A perfect storm of primarily near-term and one-time problems has weighed on performance in recent quarters. Although we would prefer to buy the stock at a wider margin of safety, we believe the current discount to our fair value estimate, which values Diageo at 19 times fiscal 2016 earnings, offers investors an opportunity to kick the tires of this high-quality name.

The punches keep coming for Diageo. In the heady days before the financial crisis, Diageo enjoyed some of the strongest pricing power in consumer staples as drinkers paid a premium to trade up to distilled spirits. When the crisis hit, however, and with the multiyear premiumization trend in reverse, Diageo had few levers to pull, having raised prices too high too quickly in the boom years. The hangover cure of lower pricing and slower organic growth has taken three years to take effect, and although Diageo is still struggling to reignite volume, last year was the first year it achieved real pricing in several years. At the same time that it wrestled with the excesses of the past, Diageo entered into some badly timed and poorly executed acquisitions. The firm acquired a stake in baijiu producer Shui Jing Fang for almost 4 times sales in 2011, just before the Chinese government cracked down on conspicuous consumption. Earlier this year, Diageo increased its investment in India's United Spirits to 55%, only to discover almost GBP 150 million in loans made by the firm to its previous owner for capital needed elsewhere in his business empire. Finally, it was revealed last month that the Securities and Exchange Commission was looking into channel stuffing by Diageo in the United States.

Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.