Diageo Says Adios to Jose Cuervo; Negligible Impact to Fair Value, but Shares Appear Overvalued

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Diageo’s discussions to acquire tequila maker Jose Cuervo have ended, and the spirit makers’ distribution agreement will expire without renewal at the end of June 2013. Jose Cuervo, which was one of Diageo’s 11 strategic brands, saw volume decline 5% during fiscal 2012 to around 4 million 9-liter cases. Overall, Cuervo represented just 2.5% of Diageo’s overall volume, so the loss of the business should have a minimal impact on Diageo’s bottom line, and we are maintaining our fair value estimates of $95 and GBP 15.

Shares are currently trading at a more than a 25% premium to our fair value estimate, which assumes a revenue compound annual growth rate of 6% and operating margins reaching 30.5% over the next five years. We would recommend waiting for a pullback before taking a position in this name.

We believe the severing of the Cuervo talks and distribution agreement makes it much less likely that Diageo will again enter into talks with the tequila maker during the next several years. However, this could result in Diageo’s courting bourbon maker Beam.

Jim Beam Kentucky bourbon, Maker’s Mark bourbon, and Sauza tequila would be excellent additions the world’s largest spirits company. However, Beam’s Pinnacle vodka brand does overlap with Diageo’s Smirnoff, and we wouldn’t be surprised if an eventual Diageo-Beam acquisition would result in the divestment of Pinnacle.

 

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