How Diageo Is Serving Up Higher Profits with a Focus on Premium Spirits

February 2023
Bottles of various alcohols

As the largest Western-style spirits producer, Diageo ticks off a lot of boxes for the Jensen Global Quality Growth Strategy. It has many attractive growth drivers, particularly within consumer staples.

Go to any bar around the world, and you’ll see the usual suspects shimmering from the top shelf: Johnnie Walker whisky, Cîroc vodka, Don Julio tequila, and Tanqueray gin. What do all those bottles of social elixir have in common? They’re all owned by Diageo (DEO).

With so many well-known names sitting on the top shelf, the Jensen Global Quality Growth investment team was drawn to Diageo’s strong stable of premium liquors that continue to find a following in developing markets and among young adults. When the team was launching the international strategy in early 2020, they naturally looked to Diageo.

As the largest Western-style spirits producer, Diageo ticks off a lot of boxes for the Jensen Global Quality Growth Strategy. It has many attractive growth drivers, particularly within consumer staples.

Jensen’s trademark quality requirement leads portfolio managers and analysts to companies that have sustainable competitive advantages that are projected to weather different economic climates. To qualify for inclusion, companies must demonstrate returns on equity of at least 15% in each of the past 10 years. It’s a high bar, and only some companies manage to do it. But Diageo’s brands—some, like Johnnie Walker Scotch whisky, are over 150 years old—and loyal customer base put the drinks maker in an enviable spot.

Shifting toward premium

In the last few years, Diageo has adopted a “premiumization” strategy by prioritizing its premium and super-premium spirits classified internally under the Reserve label. Names in this category, which include Scotch malts, Don Julio tequila, and Bulleit bourbon, carry higher price tags. That contributes to Diageo’s strong free cash flow generation and company-wide operating margin of around 30%.

Craft brands might gain prominence within a niche regionally, but it’s hard for them to take significant market share around the world. Diageo can. With its marketing and distribution muscle, Diageo can get its products in stores and bars everywhere. What’s more, they have developed consumer insights to identify artisanal brands that have already built a following and add them to the existing portfolio.

Today, premium brands make up more than half of Diageo’s sales.

Tequila is a faster-growing category than other spirits. Diageo was able to spot this trend early.

Viva tequila

Noticing a growing trend in tequila consumption in the United States, Diageo has been buying up tequila makers in recent years, including its acquisition of Don Julio in 2015, followed by Casamigos in 2017. In early 2022, Diageo snapped up 21 Seeds, a female-founded maker of flavored tequila.

“Tequila is a faster-growing category than other spirits,” notes the investment team. “Diageo was able to spot this trend early. Some of these trends can continue for a long period of time because they are driven by demographic and generational preferences.”

At the same time, Diageo has been busy offloading slower-growing products and other non-core assets. Its 2018 sale of 19 brands to American distiller Sazerac included Seagram’s whiskey, Romana Sambuca, and Booth’s gin, allowing the company to shift its focus to segments with the potential for more growth. The sale focused management attention on higher-priority brands, in addition to providing capital to distribute to shareholders in the form of share buybacks and dividends, both of which Diageo has consistently undertaken.

A pandemic winner

During the COVID-19 shutdowns, when local health regulations dealt severe blows to bars and restaurants, Diageo saw a significant step up in home consumption, particularly in the United States. Rather than rely only on what’s known as “on-trade” sales, those that take place in bars, restaurants, hotels, and so on, Diageo also sees significant sales in its “off-trade” channel, namely stores and supermarkets.

In the United States, 20% of spirits are consumed outside the home. But in other countries, bars and restaurants account for a larger proportion of where people consume spirits. Because of Diageo’s diversified sales channels, the spirits maker was able to pivot to off-trade sales and even benefitted from consumers trading up to more expensive brands.

With COVID-19 restrictions receding, Diageo is again seeing sales surge as bars and restaurants restock in anticipation of higher traffic, the result of two years of pent-up demand for socializing. In the second half of 2022, Diageo’s organic net sales grew 9% globally.

Rather than rely only on what’s known as “on-trade” sales, those that take place in bars, restaurants, hotels, and so on, Diageo also sees significant sales in its “off-trade” channel, namely stores and supermarkets.

Prepared for tougher times

Like most businesses, Diageo is mindful of the headwinds that could be coming from inflationary pressures and a possible global economic slowdown. But with its long history, Diageo has weathered such economic headwinds before and knows how to navigate them.

A focus on its premium brands can also help insulate Diageo from hard times, to some extent. While high-income earners can typically maintain their purchasing patterns, the current low-unemployment environment and the commensurate wage gains, especially for those not traditionally considered high-income earners, has improved relative purchasing power and creates an opportunity for expansion of Diageo’s customer base for its premium brands.

Time and again, Diageo has proven that it knows how to build iconic brands and defend its position. These are exactly the type of companies that Jensen seeks.

Please click here to view a list of the Jensen Global Quality Growth Strategy’s current holdings.

All data used for this article is as of February 8, 2023, unless otherwise indicated.

The company discussions in this article are solely intended to illustrate the application of our investment approach and are not to be considered a recommendation by Jensen. Our views expressed herein are subject to change and should not be construed as a recommendation or offer to buy or sell any security and are not designed or intended as a basis or determination for making any investment decision for any security. Our discussions should not be construed as an indication that an investment in a security has been or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of any security discussed herein.

Past performance is no guarantee of future results. The information contained herein represents management’s current expectation of how the Jensen Global Quality Growth Strategy will continue to be operated in the near term; however, management’s plans and policies in this respect may change in the future. In particular, (i) policies and approaches to portfolio monitoring, risk management, and asset allocation may change in the future without notice and (ii) economic, market and other conditions could cause the strategy and accounts invested in the strategy to deviate from stated investment objectives, guidelines, and conclusions stated herein.

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