Inside Wall Street: Diageo's Stock May Be Headed for a Hangover

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ohnnie Walker, Smirnoff, Guinness and Baileys are among the most well-known names in spirits -- and they're all owned and produced by Diageo (DEO), the world's leading premium alcoholic drinks company. The London-based entity's stock has been in, well, high spirits since Apr. 28, 2009, when it was down in the cellar at a 52-week low of $45 a share. The stock has since flown to a 52-week high of $71.99 on Apr. 14 and closed at $70.23 on April 23.

But don't bet on the stock continuing its upward spiral. According to some close watchers of Diageo and the spirits market, the stock is doomed to sputter and tumble from its lofty perch. "We expect the stock to perform well below the broader market," says Zacks Investment Research in a note to clients. "The global economic downturn has negatively impacted demand for Diageo's premium products," it says, which would depress the company's revenues and earnings.

Results in the first half of fiscal 2010, ending June 30, are already showing a significant earnings decline.

The Situation Doesn't Bode Well

Diageo, which also produces a broad array of other popular drinks, such as Tanqueray gin, Jose Cuervo tequila, Captain Morgan rum, Sterling wine and Red Stripe lager, operates in 180 countries. It owns and operates distilleries, as well as brewing, bottling and packaging facilities. Some 35.3% of Diageo's sales come from North America, and Europe accounts for 29.5%. Latin America, the Caribbean and Africa generate 24.5% of sales, and Asia (including China, Australia, Japan and India) pulls in 9.8%. The rest comes from separate corporate sales.

North America and Europe posted weak results in the first half of fiscal 2010 (it ends on June 30) because of the downturn, notes Zacks. With just a sluggish recovery expected in those markets, the situation doesn't bode well for Diageo. Zacks also points to fierce competition in the spirits business from such rivals as Pernod Ricard (PDRDF), Fortune Brands (FO) and Brown-Forman (BF.B), as well as from local and regional players. And competitors in the beer sector, including Anheuser-Busch InBev (BUD), Heineken (HINKY) and SABMiller (SAB) have also been gaining market share, says Zacks.

As a result, Diageo is "under severe pressure to maintain profitability," warns Zacks. The seasonal business generates a high proportion of sales in the last four months of the calendar year, mainly because of the festive holiday season. Consequently, Diageo could suffer if the holiday periods fail to deliver expected operating performance.

Long-Term Underperform

In the first half of fiscal 2010, Diageo reported net income of $1.78 billion from continuing operations, down from $2.1 billion in the year-ago period. Earnings per share declined to $2.69 a share, down from $3.13 per ADR (American Depositary Receipts). But favorable currency exchange rates resulted in higher sales, which increased 2.7% to $8.5 billion.

Zacks, which rates the stock as long-term underperform with a price target of just $64 a share, forecasts earnings of $4.55 per ADR in fiscal 2010 on sales of $15.3 billion, and $5.07 in fiscal 2011 on sales of $16 billion.

Zacks is pretty clear about its negative outlook on Diageo, even though it isn't much shared on Wall Street. According to Bloomberg, analysts at Sanford C. Bernstein and Bank of America Merrill Lynch have buy recommendations and those at two other securities firms -- EVA Dimensions and Davenport -- rate it a hold.

Analyst Carl Short at Standard & Poor's (which isn't included in the Bloomberg survey) is bullish on Diageo, rating it a buy with a price target of $81 a share. However, his fiscal 2010 earnings forecast of $4.22 per ADR is lower than the Zacks estimate of $4.55.

Bailing Out

Some big institutional holders have shaved their holdings as of Dec. 31, 2009, led by Barrow Hanley, the largest shareholder with a 1.8% stake, which sold more than 1 million shares. Fidelity Management unloaded 747,500 shares, and BlackRock Advisers sold 201,700 shares. Among those that added to their holdings was Bank of America, which bought 417,305 shares.

In downgrading Diageo to long-term underperform from neutral, Zacks's position clearly isn't the mainstream opinion on the stock. But those big stakeholders that have unloaded shares are evidently aware of Zacks's reasoning -- and individual investors should be, too.