Diageo (DGE:LSE)

World's largest spirits maker. They make Johnnie Walker, Smirnoff, Guinness, Baileys among others. Most of their products are number 1 or number 2 in their markets:

Competitive Advantage

Diageo's worldwide sales are twice that of their nearest competitor, Pernod Ricard. The third (or forth) largest producer, Barcardi, is privately owned and does not disclose sales. Next come 'Brown & Foreman', and Beam (formerly Fortune Brands), which have 1/3rd or 1/4th of Diageo's sales.
Notes:

• Diageo reports in Pounds, currency conversion values above from here and here.
• Diageo owns 1/3rd of Moet Hennessey.

Diageo's margins seem slightly lower than their competitors:
Notes:

• All exclude excise and corporate taxes, except possibly for MH.
• All include discontinued ops except Beam - the difference is negligible
  

MorningStar believes that Diageo has a strong distribution and sales network in North America (33% of sales, 44% profit in 2011), "resulting in operating margins in North America in excess of 35%, well above the firm's consolidated margin in the high 20s, and higher than most of its competitors."

Cyclical

From the above graph, operating Margins of all companies were affected by the 08/09 recession.

Sales did not fall however (Organic sales growth of zero in 08 and 2% in 09). Organic sales generally rise by high single digits (5-8%) during good times.

Business Model

The company is a cashcow, regularly generating profits and free cashflow year in year out:

How much of their costs are fixed, and how much variable?

From the above graph, many of their costs seem seem to be variable, not fixed:

• I'm not sure how staff costs can be variable.
• For marketing: I guess when times are bad, advertising is cheaper.
• Cannot tell what their 'Others' cost is. 2009's dip can be partially explained by a 1bn loss from the Pension scheme.

This an asset light business. There's very little depreciation or operating leases, and most of asset are brands (intangibles).

High inventories:

• Morningstar notes that: "About one third of Diageo's volume ... is derived from maturing products, which can sit in inventory and age for up to 30 years. ... Diageo expenses these input costs on an actual usage basis, meaning that it could be 10-30 years before today's cost inflation affects the income statement. Therefore, we suggest investors look closely at cash flow in addition to earnings when valuing Diageo."
• They have about 2.7bn of Maturing Inventories, over 80% of it intended to be held more than one year.
  

Beyond future 0-8% organic growth, acquisitions are required. Diageo looks for companies with "strong local routes to market":

• Worldwide: MH is most desirable, but not for sale. Diageo is currently negotiating to buy Jose Curevo.
• Diageo is restricted from entering into Tequila, Cognac and Chapagne, due to their agreements with HM and Jose Curevo. There may also be anti-trust restrictions if it ends up owning to many popular brands in the same category.
• Recently bought a 23.6% stake in Halico, Vietnam's leading spirits maker for £33m. Bought Mey Icki, which controls 80% of the market for Raki, at £1.3bn, at 9.9 times 2010 EBITA.

Balance Sheet

£6.7bn long term debt. Slightly over 3 years profit (before-tax).

Pensions liability underfunded by £838m as of June 2011:

• Their actuarial assumptions (p130. eg: salary increase, inflation) look OK.
• Discount rates are 4.9 to 5.7%. About 40% of the fund is in equities, with an expected return of 8.3%. Probably OK.
• The group expects to make 163m contributions in 2012.

Negligible operating leases: 368m over the next 5 years.

Cashflows

Net Cashflow from Operations (basically CFO minus tax and interest) is usually higher than their reported profit. Outlays on Cash Flow from investment are usually quire small:

Conclusion

I would buy in a recession.