Constellation Brands (NYSE: STZ) and U.K-based Diageo (NYSE: DEO)(GB: DGE) are two of the highest-quality stocks in the alcohol space. Their portfolio brands are the strongest in the industry.
Diageo owns the world’s best-selling Scotch whisky brand, Johnny Walker, the world’s best-selling premium distilled vodka (Smirnoff), and the world-leading iconic stout (Guinness), among other world-leading brands. Constellation’s brand portfolio is equally renowned, with names such as Corona, WOODBRIDGE, SVEDKA Vodka, and various prominent brands.
Additionally, both companies support strong dividend-growth prospects. However, as has historically been the case in the industry, both Constellation Brands and Diageo trade at rather elevated valuation multiples. Accordingly, I am neutral on both names.
Why Choose Alcohol Stocks in the Current Market Environment?
Alcohol stocks are generally viewed as ideal investments during economic downturns like the one we are currently experiencing. This is due to alcohol consumption being largely uncorrelated with the state of the economy.
In fact, during a recession, consumers are likely to increase alcohol consumption at home, while companies in the space retain fantastic pricing power during such periods. This makes alcohol companies particularly attractive during the current highly-inflationary environment as well.
Do DEO’s & STZ’s Earnings Growth Remain Strong?
Despite the underlying challenges currently impacting the overall economy, both Constellation Brands and Diageo are set to report record earnings this year.
Last week, Constellation Brands reported its Q2 Fiscal 2023 results, with net sales coming in at $2.66 billion, up 12% year-over-year. Operating cash flow amounted to $1.7 billion, while free cash flow reached $1.2 billion, an increase of 8% and 4%, respectively, highlighting the industry’s high margins.
Management expects the company to achieve comparable adjusted earnings per share (excludes losses from Canopy) between $11.20 and $11.60. At the midpoint, it implies a 3.7% increase compared to Fiscal 2022’s $10.99 and another earnings-per-share all-time high for the company.
In late July, Diageo reported its Fiscal 2022 results, with sales growth coming in at 21.4% and adjusted earnings-per-share growth coming in at 29.3% (in British pounds). Fiscal 2023 is also expected to be a fantastic year for Diego, with analysts expecting adjusted earnings per share to land at $8.38, implying growth of nearly 15% versus Fiscal 2022. Similar to Constellation brands, this will mark another record year of profitability for the company.
Earnings Growth to Drive Dividend Growth
Amid robust earnings growth, I expect both companies to continue to grow their dividends at satisfactory rates.
Diageo already features an exceptional dividend-growth track record. The company has increased its dividend annually for 24 consecutive years (in GBP). Its 10-year dividend-per-share CAGR stands at 5.76%. It’s not a spectacular growth rate but quite a pleasant one considering the overall consistency in Diageo’s track record.
Constellation Brands didn’t start paying out dividends until late 2015, but they have since grown quite rapidly. The company’s five-year dividend-per-share CAGR stands at 13.7% despite dividend growth slowing down over the past couple of years.
Based on the midpoint of Constellation Brands’ guidance and Diageo’s consensus earnings-per-share estimates, the two companies feature payout ratios of 28% and 45%, respectively. With earnings set to hit new records this year and both payout ratios appearing comfortable, dividend growth should remain at least in the mid-single digits, going forward.
Are STZ and DEO Shares Reasonably Valued?
High valuations are common among alcohol companies. Acquisitions in the space usually take place at elevated multiples, as the industry features resilient cash flows, strong brand power, and high margins. Accordingly, both Constellation Brands and Diageo have historically traded at a premium.
Both stocks currently trade at forward P/E ratios close to 21-22x. They’re not crazy figures, but they’re certainly quite high ones considering rising interest rates and the ongoing compression in multiples.
Combined with their nice but not great yields of 1.4% and 2.0%, I believe that both stocks offer an undersized margin of safety if their valuations were to actually undergo a compression. Both stocks appear modestly overvalued in the current environment.
What is the Price Target for STZ Stock?
Turning to Wall Street, Constellation Brands has a Strong Buy consensus rating based on eight Buys and two Holds assigned in the past three months. The average Constellation Brands price target of $276.50 suggests 24.9% upside potential.
What is the Price Target for DEO Stock?
Diageo also features similar upside potential, according to Wall Street. The stock has a Moderate Buy consensus rating based on two Buys assigned in the past three months.
The average Diageo price target of $207.50 suggests 26.5% upside potential.
Conclusion: Solid Companies at a Steep Price
Constellation Brands and Diageo enjoy recession and inflation-resistant business models. Alcohol consumption is quite resilient, and both companies are set for another year of record profits ahead.
Dividend growth investors are likely to appreciate both names, and especially Diageo, due to its prolonged dividend-growth record. Still, I find both stocks modestly undervalued in the face of rising rates. Thus, investors should be wary before allocating capital to Constellation Brands and Diageo and avoid overpaying, despite their qualities.
