News Analysis date published New: 
Monday, August 6, 2012 - 11:00
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Monday, August 6, 2012 - 11:00
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Monday, August 6, 2012 - 11:00

A Rock-Solid Stock for a Slow Recovery

Monday, August 6, 2012 - 11:00am

When there's a recession or when the economy is sluggish like now, consumers look for ways to save their hard-earned money anyway they can. They can do so by putting off buying a new car, for example, or "staycationing" rather than taking an expensive trip. They try to save on everyday purchases too. Buying more in bulk, settling for generic products and cutting out nonessentials, say a daily newspaper or gym membership has become the norm.

But let's face it, except for very few people, the majority of consumers don't really cut back on alcohol consumption.

In fact, alcoholic beverage sales expanded in the latest recession, rising by 9% in 2008, the first full year of the economic downturn. Sales were up again in 2009, though only by 1%. But they picked up speed in 2010, climbing 10% that year. (I know 2010 wasn't officially a recession year, but with unemployment rate still at 9 - 10%, many people probably consider it one.)

Clearly, investing in the alcoholic beverage industry makes good sense. And one of the best ways to gain the exposure to this solid industry is by purchasing shares of Diageo PLC (NYSE: DEO).

It's not exactly a household name, but Diageo is a behemoth, boasting a market capitalization of $73 billion, as well as about 24,000 employees and operations in 180 countries. I'm sure you'd recognize at least a couple of the company's brands, which include top names like Bailey's Irish Cream, Guinness stout, Johnnie Walker scotch and Smirnoff vodka.

Like the overall alcoholic beverages industry, Diageo has seen sales grow nicely, climbing from $7.5 billion to $10.4 billion a year between June 2007 and August 2012 -- good for an annualized growth rate of 6.8%. Per-share earnings were respectable during this time, too, rising 3.8% per year, from $2.20 to $2.65. Stock returns were very solid: Diageo shares have delivered 7.9% a year in the past five years, compared with only 1.1% for the S&P 500.

Sounds pretty good, especially these days, right? Well, I think the stock has the ability to do just as well -- or even better -- in years to come, even if economic growth continues to be paltry.

A big reason why? Cash -- and lots of it.

Right now, Diageo has free cash flow of $1.5 billion, even after spending that amount on acquisitions and another $1.2 billion on dividends during the past 12 months. Thus, there's ample cash to continue pursuing a strategy of growth through acquisitions.

Management knows exactly where to look for the best opportunities, if recent deals are any indication.

On June 14, for instance, Diageo bought another 11% of the Hanoi Liquor Joint Stock Co. (Halico) for $21.9 million, raising its stake in the firm to 46%. Halico, Vietnam's largest spirits company, remains under the control of the state-owned Hanoi Beverage Co., which still holds a 54% stake. On May 28, Diageo finished a far-larger deal, $453-million buyout of Ypioca, Brazil's second-leading brand of the popular sugar cane-based liquor cachaca, from the Brazilian spirits firm Ypioca Agroindustrial Limitada.

In the past couple years or so, Diageo has made about 12 acquisitions in developing countries (other examples include Turkey, China and Ethiopia). It's also believed to be working on a deal to acquire leading Mexican tequila maker Jose Cuervo. The goal is to increase revenue from emerging markets to 50% of the annual total by 2015, compared with about 40% now, according to the company's management.

The strategy is pretty much a no-brainer, in my opinion, especially for a big multinational like Diageo. Going forward, the greatest profits should be available in emerging markets, because those regions tend to have growing middle classes with rising disposable incomes, whereas the United States, Europe and other developed regions have shrinking middle classes, much higher debt and slower growth prospects.

Risks to Consider: Because Diageo operates in 180 countries, it's exposed to many currencies -- meaning exchange rate fluctuations could negatively affect financial results. In the past 12 months, for example, unfavorable exchange rates cost the company $52 million. Losses from unfavorable exchange rates have typically amounted to a mere 1-3% of annual net income. But there have been plenty of times when exchange rates benefitted Diageo, like 2009, when generally favorable rates made the company $66 million.

Action to Take--> Since Diageo so proactively pursues growth in all the right places, I agree with analysts that earnings per share could rise by nearly 14% a year, from about $4.45 in 2012 to $8.50 in 2017. This implies the stock could climb 44% during this time, from $106 a share now to around $153, assuming the price-to-earnings ratio remains at the historical level of 18 (18 x $8.50 = $153).

The yield, now a solid 2.5%, could improve, too, based on analyst projections for dividends to grow by nearly 10% a year, from $2.60 a share in 2011 to about $4.50 a share in 2017. If my estimate of the stock's price growth is on target, then the yield at that time would be about 2.9% ($4.50/$153 = 2.9%) -- pretty attractive by today's standards.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.