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3 Reasons Why You Must Hold Diageo (DEO) in Your Portfolio

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Diageo plc DEO has been benefiting from efforts to quickly respond to increased off-trade channel demand and changes in consumer occasions as well as investments in opportunities. Also, strong consumer demand, market share growth in the spirits category and positive category mix have been aiding sales in North America. Its recent investments in the ready-to-drink (RTD) category have further buoyed optimism on the stock. However, disruptions in Travel Retail and on-trade businesses have been concerning.

Notably, the Zacks Rank #3 (Hold) stock has rallied 16.8% in the past three months compared with the industry’s growth of 11.9%. Also, the company’s shares have comfortably outpaced the Zacks Consumer Staples sector’s growth of 4.5%.

The Zacks Consensus Estimate for its current financial-year sales and earnings suggests growth of 5.9% and 17.6%, respectively, from the year-ago period.

Zacks Investment Research
Zacks Investment Research

Image Source: Zacks Investment Research

Key Industry Trends

While the on-trade channel suffered closures, e-commerce has boosted alcohol sales like never before in the United States in 2020. A lot of credit for this goes to companies’ actions to quickly invest in e-commerce portals. An ISWR report shows that online alcohol sales rose 42% globally to $24 billion in 2020, with the United States contributing majorly to this growth. Online alcohol sales accelerated 80% in the United States to $5.5 billion in 2020.

Apart from e-commerce, increased demand for spirits, particularly RTD cocktails, has caught pace amid the pandemic. Notably, RTDs have been the fastest-growing category, given the increased demand for low- or no-alcohol drinks due to health consciousness amid the pandemic. The desire for the consumption of refreshing, flavorful and premixed bar-like cocktails at home as restaurants and bars remained closed primarily drove growth of the RTD category. As a result, most beverage companies are now switching focus to innovate and develop products to take advantage of the ongoing RTD boom.

Backed by the increasing consumer appeal for flavors, the RTD category in the United States recorded growth of 62.3% in 2020. This growth was also led by the Hard Seltzers sub-category, which surged 130%. Notably, the RTD category is expected to become the second-largest beverage alcohol category in the United States, in terms of volume consumption. The category has already outpaced the spirits volume and is likely to surpass wine by the end of 2021.

Now let us discuss at length what makes Diageo a stock to watch.

Positive Trends in North America

We suggest holding on to the Diageo stock, driven by its solid fundamentals and robust current business trends. The company has been lately witnessing robust trends in North America, its largest market. Sales in North America accelerated 12.3% in the first half of fiscal 2021. Strong consumer demand, market share growth in the spirits category, positive category mix, and uninterrupted stock replenishments by distributors and retailers have been key drivers for the region’s growth.

On the first half of fiscal 2021 earnings call, the company stated that it expects momentum in North America to continue. Meanwhile, it anticipated the pace of recovery in other regions to be more closely associated with the reopening of the on-trade channel and the level of restrictions applied. The company predicted organic operating margin in the second half of fiscal 2021 to be ahead of organic net sales across all regions (except for North America) due to weak operating margin in the comparable period. Notably, North America witnessed organic operating margin growth in the second half of fiscal 2020.

Digital Investments Bode Well

Diageo is one of those companies that have worked relentlessly to leverage its existing e-commerce capabilities and accelerate investments in the online platform to cater to the pandemic-driven shift in consumer shopping behavior. The company has diverted its efforts to connect with consumers and maintain brand relevance by responding to increased opportunities for at-home consumption occasions. This included new occasions like wanting to enjoy bar-quality drinks at home.

Further, the company has inspired consumers with cocktail recipes, new serves and ways to enjoy its brands with food. It also rapidly responded to the increased demand for home delivery. In the United States and Latin America, it reached customers with new “cocktail to go’ programs. In East Africa, the company explored new ways to get products delivered to consumers’ homes through partnerships with motorbike delivery companies, known as boda-bodas.

Expansion in RTDs to Gain Share

Diageo is positioned to capitalize on the shift in consumption trends to RTD bar-quality cocktails through the launch of its Crown Royal ready-to-drink canned cocktail line. This marks the Crown Royal Whiskey brand’s debut in the ready-to-drink cocktail space. Some of Diageo’s recent launches in the canned cocktail space are Ketel One Botanical vodka spritz, Tanqueray crafted gin drinks and Crown Royal cocktails along with Smirnoff seltzers in the Hard Seltzer category. Additionally, in April 2021, it purchased Loyal 9, which mixes vodka and lemonade in a can.

Also, Diageo announced plans to expand its manufacturing capability by installing two can lines at a new facility in Plainfield, IL. The facility, which will be worth roughly $80 million, comes with the capacity to produce more than 25 million cans of RTDs and will be ready for commercial production by the summer of 2021.

Possible Deterrents

Despite the positive business trends, the company is not free from the COVID-related impacts. Diageo has been witnessing significant pressure from cost inflation, which is hurting margins. Notably, everyday cost efficiencies led to productivity gains in the first half of fiscal 2021, which was partly offset by the cost of goods sold inflation. Adverse channel and product mix, particularly in the Guinness beer business as well as declines in the high-margin Travel Retail business led to a gross margin decline.

Moreover, the company continues to witness headwinds due to disruptions in Travel Retail and on-trade businesses. Continued customer destocking in Travel Retail has been hurting the top line. Also, the widespread closure of bars and restaurants around the world (on-trade channel) has marred sales. Notably, the on-trade segment, which sells alcoholic beverages in licensed premises, accounts for nearly 40-50% of Diageo’s revenues.

Though trends in the on-trade channel are picking up due to the reopening of restaurants and bars, the company expects the level of restrictions to vary regionally. Moreover, it expects the Travel Retail business to be largely impacted due to lesser travelers in the second half of fiscal 2021.

Better-Ranked Stocks to Watch

Heineken NV HEINY has an expected long-term earnings growth rate of 5.2%. It currently has a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Chewy Inc. CHWY has an expected long-term earnings growth rate of 20%. It currently carries a Zacks Rank #2.

Archer Daniels Midland Company ADM, also a Zacks Rank #2 stock, has an expected long-term earnings growth rate of 6.2%.

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