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Diageo (ADR)

Conrad Gibbins Analyst

June 16, 2009


Undervalued Worlds Premier Spirit Company Excellent Margins Tremendous Emerging Market Growth Opportunities Recession Resistant Great Brand Equity & Market Diversity Strong Cash Position

1 DEO ADR share = 4 DGE shares on LSE 1 GBP = 1.648 USD (06/10/09)

Negative European sales growth Currency Fluctuations Potentially inflated input costs Correlation to discretionary sector Dependence on Emerging Market Economic Expansion

Ticker Exchange Industry Sector Classification Market Cap. 52 Week Price range Recent Price Current P/E Projected 2011 P/E 2009 EPS Q1 Projected 2011 Q1 EPS Dividend Yield Debt Rating Beta

DEO/DGE NYSE/LSE Alcoholic Beverages Consumer Staples Inc & Cap Appreciation 34.89 Billion $40.93-$77.58 $56.50 12.8 15 .627 .80 2.8% S&P = AMoodys = A3 .72

Porters Five Forces: Threat of Competition: Moderate Threat of New Entrants: Low Threat of Substitutes: Low Power of Suppliers: Low Power of Buyers: Moderate

Brief Overview

Diageo plc is engaged in the drinks business with a collection of international brands. Diageo is a participant in the branded beverage alcohol industry and operates on an international scale. The Company produces and distributes a collection of branded premium spirits, beer and wine. It produces and distributes a range of premium brands, including Smirnoff vodka, Johnnie Walker Scotch whiskies, Captain Morgan rum, Baileys Original Irish Cream liqueur, JeB scotch whisky, Tanqueray gin and Guinness stout. In addition it also has the distribution rights for the Jose Cuervo tequila brands in the United States and other countries. Diageo's beer brands include the only global stout brand,Guinness.


The Educational Investment Fund decided to establish a 3% position of Diageo (Ticker: DEO) on the recommendation of Robert Wilkerson on 20 July 2006. Main supporting arguments: Global company Market leader Portfolio of No. 1 and No. 2 category brands Good growth prospects of premium spirit brands (especially in the US) The Educational Investment Fund voted to hold a 3.22% position of Diageo on April 5, 2007 based on the recommendation of Julian Braasch. Main supporting arguments: Industry leadership position Brand portfolio strength Recession hedge Strong cash returns to shareholders through dividends and share repurchases The Educational Investment Fund voted to hold a 3.54% position of Diageo on September 10, 2007 based on the recommendation of Brett Flodder. Main Supporting arguments: Worlds premier spirits company Strong investment and positioning in emerging markets Recession hedge Growth in demand for premium spirits The Educational Investment Fund voted to hold the entire position of Diageo on February 28, 2008 based on the recommendation of Trey Schorgl. Main Supporting arguments: Growth trends in the demand for premium spirits Worlds leader in premium spirits Global priority Brands positions as segment leaders Brand strength and image Recession hedge Diversified product segments Strong investment and positioning in emerging markets(Intelligent Marketing) Efficient supply chain and superior routes to market Strong Pricing Environment Ketel One has strong growth potential

The Educational Investment Fund voted to hold the entire position Diageo on July 09, 2008 based on Jared Shojaians recommendation.

Main supporting arguments: Undervalued using valuation models Diversified product line Multinational company in over 180 markets Industry & company growth potential Industry leader
The Educational Investment Fund voted to hold the entire position of Diageo on November 13, 2008 based on the recommendation of Wes Sullivant.

Main Supporting arguments: Undervalued using valuation models Defensive Holding Strong International Integration Multinational company in over 180 markets Industry & company growth potential Industry leader Premium Strategy is effective and drives margins


Diageo is now considered to be an income and capital appreciation holding because its dividend of $1.58 a share yields only 2.9%. As of June 11th, 2009 Diageo makes up 3.18% of our overall equity holdings. Diageo is categorized in the consumer staples group even though it does have certain consumer discretionary attributes to it. The EIF target weighting for consumer staples is 14%. Were currently underweight our target asset allocation by 48 basis points holding only 13.52% in the staples sector. We are at a middle ground between our target weighting and the S&P 13.05% staples holdings though. Diageo currently makes up 24.5% of our consumer staples sector holdings.

INDUSTRY OVERVIEW (1, 5, 6, 7, 11,13,14)

The alcoholic beverage production and distribution industry is compromised of three general categories, the spirits, wine, and beer sub-industries.

Spirits (US Markets) The spirit sub-industry is aggregately mature with pockets of niche growth opportunities. The spirit sub-industry involves fierce competition between just a few major groups dominating market share. In spirit production and distribution, about 85% of revenue is controlled by the top four companies. The keys to success in the industry are utilization of economies of scale, synergetic alliances, partnerships, and consolidation to acquire new key markets. Supply chain efficiency is of the utmost importance in the spirit industry. The only thing more important is brand equity which is achieved through successfully implemented marketing campaigns. Brand equity and awareness can make the world of difference in the spirits industry, where there is only so much you can do to gain a competitive advantage in the form of the actual end products taste and ingredients. Some of the key market players in the sub-industry besides Diageo are Pernod Ricard (known for Makers Mark and Kahlua), Fortune Brands (known for Jim Beam and Knob Creek), Brown-Forman (known for Jack Daniels and Southern Comfort), and Constellation Brands (with a diverse set of brand names including Skol Vodka). Spirits is a very general and diverse category that includes all forms of well known liquors including whiskey, vodka, rum, tequila, brandy and cognac, gin, and various other spirits. The spirits sub-sector peak to trough average PE multiple is 15.2 and the sector is currently trading at a 12.8 multiple.

North America is Diageos largest market. North American spirit consumption is led by whiskey with 29% market share, vodka with 24%, rum with 12% and tequila with 8.5%. Diageo has the greatest spirit market share in the world as well as in the North American market where they capture 32% of the market. Diageo outperformed

expectations with 4% growth in net sales in the North American markets in the first half 2009, led by its Smirnoff, Captain Morgan, and Crown Royal brands. Spirits sales represented 73% of Diageos overall net sales in 2008.

Demand Determinants of the Spirit sub-industry: Brand recognition and the price of spirits relative to substitute alcoholic beverages. Regulatory and legal issues are an important demand determinant especially in the spirits industry, which is more potent than beer, and thus more negatively affected by stricter drinking and driving laws. Income is an important variable in demand of spirits, but not as crucial as it is to the wine industry. Recessions can adversely affect the spirits industry as well though. The 2008-2009 recession has yet to have a significant influence on spirit consumption though. Advertising goes in hand in hand with brand recognition, and is an influential factor on specific brand choices and as well as demand for overall spirit consumption. Market access is also an important factor, because dry counties obviously have lower spirit consumption. Seasonality is also a factor with spirit demand, because demand routinely picks up in the fourth quarter due to holiday purchases and celebrations. Tax laws and international trade relationships are also influential with imported spirits, as excise taxes and tariffs can affect the purchasing price of various imported spirits.

Current Spirit Sub-Industry Revenue Figures

Wine (US Market) The wine sub-industry is much less concentrated than the spirits sub-industry. The four largest companies in the US wine industry still control 57% of the overall market share though. The wine industry is expected to follow the spirit industries lead though, and conform to the inevitable benefits of consolidation and economies of scale. This trend is illustrated by Fortune Brands acquisition of Allied Domecqs wine asset unit as well as Constellation Brands acquisition of Robert Mandavi. The US wine industry is nearly double the size of the US spirits industry, but its been more adversely affected by the recession due to the more discretionary attributes of the sub-industry. The US wine market is only expected to grow in the next 5-10 years as a higher percentage of the population will be aging into the target wine drinking market age.

The major players in the wine sub-industry include E & J Gallo Winery (known for Barelli and Stefani), Constellation Brands Incorporated (known for Franciscan Estates), Fosters Group Limited (known for Beringer and St. Clement), and The Wine Group (known for Corbett Canyon).

The wine sub-industry has a heavier correlation to the consumer discretionary sector than the consumer staple sector as it as seen as a luxury in most cases rather than a necessity. High priced spirits have this same correlation, but not to the same extent as wine, which has a more affluent demographic target market. Basically if consumers have higher disposable income they will go out to dinner more than eat in, which is the predominant market access of wine consumption. High priced spirits are similar, but are to a greater degree a retail purchase at the liquor store. Consumers are more loyal to their grocery and retail habits and brands than they are to eating and drinking out. Wine made up 6% of Diageos overall net sales in 2008. Demand Determinants of the Wine sub-industry: Disposable income is the most important demand determinant for the wine subindustry. Consumer confidence and the economic outlook coincides with disposable income as a crucial factor in the discretionary sub-industry. Relative prices for alcoholic beverage alternatives to wine are an influential demand factor, especially in the lower priced wine market. Consumer preferences are a significant factor which is primarily influenced by marketing campaigns and its relative market appeal compared to substitutes. Government regulations, laws, and societal standards in relation to drinking and driving and public intoxication are always a factor in any alcohol related industry. Health studies and considerations affect consumer demand and wine consumption appeal as well.

Grape production and prices are input costs which affect the price consumers pay and therefore the demand of wine consumption as well.

Current Wine Sub-Industry Revenue Figures

Beer (US Market) This sub-industry is even more concentrated than the spirit production, with the three largest companies controlling 80% of the market share. Anheuser-Busch was acquired by Inbev in July 2008 and controls 48% of the U.S. market share. Miller Brewing was acquired by South African Breweries in 2002 from Phillip Morris. SABMiller a subsidiary of South African Breweries formed a joint venture with Molson Coors in 2007 to combine their businesss in the US market. This joint venture combination was implemented to enhance economies of scale, supply chain efficiency, and other synergetic advantages. As can be duly noted the beer industry has been under an immense consolidation trend like the rest of the alcohol industry.

Anheuser-Busch Inbev is widely known for their Budweiser, Bud-Light, Michelob, and ODouls brands. South African Breweries is known for their Miller-Light, Miller Genuine Draft, Milwaukees Best, and Fosters brands. Molson Coors is known for their Coors Light and Coors Original brands. Diageos beer brands that have US presence include Guinness, Harp Lager, and Red Stripe. Beer made up 21% of Diageos net sales in 2008. Some analysts discourage Diageos increased involvement and capital spending on their beer brands, but their CEO Paul Walsh has routinely disagreed with these analysts defending his move by reminding them of Guinnesss sales growth of 6% last year and 14% growth outside of Ireland. The revenue growth of the beer industry has been relatively stagnant. The trend in the alcoholic beverage industry has been shifting more and more towards spirits and wine.

Demand Determinants of the Beer sub-industry: Price and quality relative to other beer brands. Excise taxes can have a strong affect on the end user price. Demand for all alcoholic beverages increases with households with larger amounts of disposable income, but the trend recently have for there to been a large proportionate amount of that growth in the demand of spirits and wine. Age demographics are a key factor, because the demand of beer in the age group of 21 to 35 is higher. Laws and regulations regarding public intoxication, drinking and driving, and age are a factor with beer demand as well.

Current Beer Sub-Industry Revenue Figures


Diageo was formed in 1997 subsequent to their merger of Grand Metropolitan Public (GrandMet) and Guinness and is headquartered in London. Diageo has a very strong international presence in over 180 markets around the globe. The company is publicly traded on both the New York Stock Exchange under the ticker symbol DEO and the London Stock Exchange under the ticker symbol DGE. Diageo currently employs nearly 25,000 people. Diageo is primarily known for their production and distribution of high end spirits, beer, and wine including Smirnoff, Johnnie Walker, Baileys, J&B, Crown, Royal, Captain Morgan, Jose Cuervo, 7 Crown, Tanqueray, Beaulieu Vineyard and Sterling Vineyards wines, Guinness, and Bushmills Irish whiskey. Diageo owns a significant interest of 34% in Moet Hennessy which is a subsidiary of LVMH Moet Hennessy that produces and distributes various champagnes and cognacs. Diageo also owns a minority interest in ShuiJingFang which is a spirits company in China. In 2008 Diageo also acquired the exclusive rights to market and distribute Ketel One Vodka products further diversifying their spirit brands giving them a premium plus vodka brand to distribute along with their premium brand vodka Smirnoff. Diageo has also disposed of several non-core assets since their incorporating merger date in 1997.

Some of these have resulted in large increases in capital which have strengthened their balance sheet enormously, and realigned their companys core assets to strictly the business of producing and distributing premium grade alcoholic beverages. Some of these divestures include a 4.3 billion valued sale of Pillsbury, a 1.9 billion sale of General Mills shares and .7 billion sale of their interest in Burger King. Diageo has an extremely diversified market and product portfolio line which is illustrated in the graphs below and on the next page.

Diageos Net Sales (2008) & Operating Profit (2008) by Geography:

Diageos sales are diverse and have exposure to just about every major economy in the world. Diageo operates in over 180 different countries, and retains the title as the undisputed heavyweight in the spirit industry. Not only are they diverse in market presence but they are diverse in their brand categories as well, and beverage offerings. Diageos business model is very unique because theres really no other premium brand spirit company who also has any significant revenues in both the wine and beer markets as well. Their sales are led by the North American and European markets with each taking 32% of their overall sales. Diageos international revenues refer to emerging market economies for the most part that arent a part of North America, Europe, or Asia. Africa and especially South Africa has seen enormous revenue growth. Diageos emerging market revenue growth has been decelerating recently though. Diageos most profitable market has been the North American market. Its the only market where their operating profit has been significantly higher than their revenue. In all other markets the operating profit figure is either even or less proportionate to the corresponding geographies net sales figures. This is in large part due to the greater retail price North American consumers are willing to pay because of higher GDP per capita figures, as well as more developed infrastructure and marketing outlets in the North American markets. Many analysts believe the European markets are in a state of constant pricing wars, and that this is the reason behind negative sales growth for Diageo in the European markets. Spain was an especially painful market for Diageo in

the aggregate European sales category. Diageos global market exposure lets them maintain perpetual growth and lends them a competitive advantage in these pricing wars because they can offset their losses by other markets revenue generation. Diageo has an ever increasing presence in the BRIC countries (Brazil, Russia, India, and China) whose economies are expected to continue to expand even throughout the global recession. These areas will be increasingly important to Diageos geographic market portfolio as the North American and European markets continue to saturate. Diageos growth strategy hinges on the continual economic expansion in the BRIC countries as well as various other emerging market plays such as Latin America, Africa, East Europe, and a few isolated markets in the Middle East.

Scotch is still Diageos leading revenue generator, accounting for 28% of all their sales. The J&B and Johnnie Walker scotch brands have enormous customer loyalty and elevated intangible asset valuations. Johnnie Walkers target market customers are men who make between $100,000-$150,000 a year in salary and drink on average 2.5 bottles of Johnnie Walker a year. These Diageo brands have held up especially well because of the trend that the target market might have scaled back on a taking another vacation this last year or buying a new car, but they still purchase their same brand of Scotch. The old myth that alcoholic beverage companies are recession proof isnt completely true, but my argument highlights that they are at least recession resistant. Yes there is a discretionary element to premium grade spirit and wine producers and distributors, but for the most part the demand for many of Diageos brands has been fairly inelastic. Diageo has fairly limited exposure to the premium plus brand names that are more discretionary. Smirnoff, Jose Cuervo, Baileys, Captain Morgan, and Crown Royal are more closely aligned to the consumer staple category than their higher end scotch brands and Ketel One vodka. But their scotch brands have continued to hold up better than expected due to their strong brand equity and loyal consumers. Cumulatively spirits make up 73% of their net sales, beer makes up 21%, and wine follows up with 6% of their net sales. Diageo Net Sales (2008) by Beverage Type:


Threat of Competition Moderate Diageo is the world leader in spirits sales and market share. Their brand equity is high in the 180 markets in which they operate. Therefore, Diageo is well-positioned in the face of competition. However, this is a competitive industry in which companies are always fiercely competing for brand recognition and awareness. There are only so many ways to modify the end user product, consequently there are many companies offering very comparable products. The best way to gain a competitive advantage is through brand awareness and appeal, via marketing. Diageo has exemplified this and has positioned itself well by marketing and developing its diverse set of brands in many markets to capitalize on fluctuations in consumers preferences. Threat of competition therefore is present, but not overbearing or interfering with Diageos growth strategies. Threat of New Entrants Low The spirits industry is dominated by those companies which posses brands with high brand equity and market presence. Brand equity and market presence require very capital intensive oriented marketing campaigns to achieve, thus eliminating the threat of new entrants to a great extent. Although the industry has moderate operating capital requirements, millions must be spent on frequent marketing-related projects. The alcoholic beverage industry is highly concentrated with only a few well-positioned companies dominating market share (there are numerous companies in the industry, but the majority of market share is controlled by only a few). To maintain financial stability, an industry player would do well to diversify by broadening their geographical and categorical scope, thereby mitigating currency risk and regional financial downturns. Therefore, companies with broad reach and economies of scale not only deter new entrants, but they are better-positioned to acquire smaller players and avoid takeovers themselves. The industry is also highly regulated and highly taxed due to the risk profile of the product. All of these factors contribute to what has to be categorized as a low threat of new entrants industry. Threat of Substitutes Low The alcohol industry as a whole has almost no substitutes, so the threat of substitutes should be categorized as low. However, the fact that 73% of Diageos revenue comes from spirits suggests that other alcoholic beverages, especially ones lower on the pricing scale, could be substitutes. In particular, since they are primarily premium spirits producers, lower end spirits could outgain the premium category in sales volume. Similarly, only about 21% of Diageos revenues come from beer sales. If consumers tastes and preferences shift more in favor of beer, Diageo could still participate but at a significant revenue reduction, though the current market trend and preference would prove this to be an unlikely scenario. Furthermore, consumers will most likely not

substitute premium and midstream spirits for lower-end brands due to the importance of brand recognition. Finally, the alcoholic beverage industry is generally characterized as selling a primarily inelastic product in economic downturns such as this one, so the industry should not expect consumers to begin favoring non-alcoholic beverages. Therefore, I want to keep this threat at a low level. Power of Suppliers Low Input costs to alcohol-producing companies come from agricultural products (wheat, grain, grapes, etc.). Farm suppliers are geographically-diverse with nearly infinite competition, their prices dictated by supply and demand. Ultimately, suppliers have hardly any pricing power. Rising commodity prices certainly hurt spirits producers margins, but the recent relaxation in such prices have eased such concerns. Additionally, many spirits have to be fermented as much as a decade in advance of end user consumption. This time lapse delays any immediate financial stress and allows for smoothing across financial statements. As a hedge, companies can buy more when agricultural prices are low, and buy less when agricultural prices are high. Due to such opportunities and the limited influence of agricultural producers, the power of suppliers is low. Power of Buyers Moderate Similar to the threat of substitutes, aggregate alcoholic beverage demand is mostly a staple product and fairly inelastic relative to its price. The power of buyers to set prices is low and producers such as Diageo certainly have pricing power. However, if prices rise in one beverage category (beer, wine, spirits), it would not be unusual to see consumers shift their preference to a less expensive alcoholic beverage category. Additionally, since Diageos immediate customers are primarily wholesalers, Diageo may have to rely on promotional discounts and favorable payment terms in order to maintain steady revenues. While many consumers preference will not change, the frequency with which they purchase spirits could decline. Premium-plus brands suffer most from decreased consumption at restaurants and bars, where consumers opt for cheaper brands, or they frequent such venues less and less. Still, Diageo products have among the highest brand equity, and their premium brand pricing strategy borders midstream, or average, prices. Thus, there is only moderate concern in the current economic downturn, and the power of buyers remains as such.


CRITICAL ISSUES (1,3,11,13,14)

Currency Fluctuations and Exchange Rates: Since Diageo operates in over 180 markets worldwide, fluctuating currencies can have a dramatic affect on their real (currency adjusted) input and sales prices. Diageo is based in England and therefore is most adversely affected by Great Britain Pound currency fluctuations. Therefore when the pound appreciates relative to various other markets currencies that Diageo operates in, there are adverse consequences to their bottom line profitability for the company in their primary currency. Only 32% of Diageos sales are from European markets and an even smaller 30% portion of their operating profit is extracted from the European markets though. A depreciating pound against various other currencies including the US Dollar, Japanese Yen, Mexican Peso, Brazilian Real, Russians Ruble, Chinas Yuan, Indias Rupee, and South African Rand would be beneficiary to Diageo. The Pound has appreciated against the US Dollar recently, which has been a hindrance to Diageos further potential profitability in their primary market. A reversal of this trend would have a lot of potential upside to Diageos profitability in the region as that is where they generate their largest portion of operating profits. Basically a weaker domestic currency (GBP) stimulates export activity and would favor a export dominated company such as Diageo. The only benefit of weaker foreign currencies relative to the GBP is that it reduces the costs of marketing and expansion in that market. Needless to say Diageo hedges a large amount of their currency transactions in the foreign exchange futures markets. This is a risk none the less that can have an immense affect on the companys overall profitability. International Government Legal, Regulation, and Excise Tax Considerations: Governments all over the world have stringent rules and regulations regarding the purchase age of alcohol, drinking and driving laws, and the safe use of alcohol. Diageos most important market the United States has come under intense pressure and regulation regarding liquor sales, promoting and marketing tactics, drinking and driving laws, etc. The company faces a considerable threat with their marketing campaigns which have been censored in a minor way up till this point. There are many powerful lobbying groups and agencies that have been gearing up for a crack down on television advertising campaigns which are usually directed at younger age market segments and display images of fun, happiness, and sexual appeal without the warning about many of the possible damaging effects of alcohol consumption and dependence. This could be a potentially a huge issue considering brand equity and awareness is fostered through these campaigns and could be adversely affected by any new regulation. Excise taxes are always a very direct threat, which can strip away Diageos critically important operating margin spreads in their largest market as theyve done in the tobacco industry.

Stagnant European Economic Growth: European growth has become an exceedingly large obstacle for Diageo. Many of the economies in the Europe have socialist and communist leaning governments which arent as friendly to trade agreements and free market economic expansion. This has probably been the largest impediment to European sales growth. Spain in particular has over a 9% unemployment rate and Diageos growth has gone negative in that market where net sales decreased a stunning 18% in the first half of 2009. The worsening economy resulted in a large drop in consumer demand and reduced ability by their Spanish wholesalers to maintain their previous stock levels of Diageos products. The stagnant European growth has become more and more of a liability that various emerging market economies such as Latin America and Africa have had to offset which leads into Diageos next critical issue discussed. Dependence on Emerging Market Demand Growth: Diageos growth opportunities are really limited in scope to the BRIC (Brazil, Russia, India, China) and emerging market countries. The only other real potential growth prospects would be from acquisitions, consolidations, and synergetic alliances and partnerships. The North American market has been Diageos profit cash cow, with their highest margins, but their sales growth there has been fairly conservative. Most of their sales growth has been in the BRIC and emerging market countries. Africa and specifically South Africa, and the Latin American countries have been their strongest growth prospects. The critical issue is the fact that these markets growth rates have been decelerating recently, and that theyve been depended on too greatly recently to offset stagnant European and Asian growth. This critical issue and growth obstacle could be overcome though with a strategic acquisition which many analysts believe may be in the cards in the near future for Diageo. Diageos current cash position of 3 billion, which is six times their 2008 fiscal year cash position of 0.6 billion has many analysts speculating about Diageos possible acquisition targets. Potentially Higher Input Costs: The commodity markets are historically more volatile than the equity markets. The seasonal and cyclical peaks and troughs of the corresponding commodity prices are highly influenced by incremental changes in supply and demand. This has always been a concern and critical issue to Diageo, but more so recently. The commodity markets have been on a bullish tear recently has investors have flocked to non-monetized assets to avoid the inflationary consequences of the massive fiscal stimulus packages that have been implemented by multiple countries federal reserves and administrations. The lower federal funds target rates and cheap money flying around recently has spurred investors to hold non-monetized assets that will benefit from stimulus packages as a hedge to weaker currencies. This has led many of Diageos input costs to rise recently. This has caused sugar input prices to raise from their Dec 2008 lows of 11 cents per pound to nearly 16 per pound, wheat prices from $225 per metric ton to nearly $275 per metric ton, barley prices from $120 per metric ton to nearly $150 per metric

ton. Regardless Diageo has the advantage of buying more of their commodity inputs at times when prices are lower and less when prices are higher. Diageo has this option because of the roughly 10 year fermentation period for most of their spirits, but their beer, and wine production is of more concern when discussing higher input prices.

Aggregate Commodity Food & Cereal Price Index (Includes Cereals such as Barley, Maize, Wheat & Food such as Grapes and Sugar)

CONCLUSION (1,11,12,13,14)
Diageo is an extremely well positioned and diverse alcoholic beverage company. Diageo is the industry leader in spirits production and distribution and has a great niche market carved out in the beer and wine sub industries. They have a great product line that isnt too highly concentrated in any one price or beverage category. They have great market presence in 180 separate countries. Diageo has been extremely well managed thanks to the brilliance of their CEO Paul Walsh. More importantly at a time when most industry competitors are cash strapped with higher debt obligations year over year, Paul Walsh and company over at Diageo have managed to increase their cash position nearly 3 times over from their June 2008 amount of 0.74 billion to now over 2.088 billion roughly equal to $3.42 billion. This is a substantial amount of cash which leads me to speculate Paul Walsh is contemplating another acquisition or round

of expansion into a new market. I think Diageo is relatively undervalued right now trading at a 12.8 PE multiple, while their PE multiple has traditionally averaged 15 times earnings. Diageos product portfolio mix is strategically aligned with current market trends and preferences which have been increasingly moving towards Diageos product offerings. Premium grade spirits and beer has been where consumers preferences have been turning towards. The US age market demographics in particular have been increasingly falling into Diageos specialty. Diageo is also making the right moves by shifting more of their marketing budget towards the BRIC and emerging market countries which have the largest growth potential and the United States where their margins are the highest. Regulation is a critical issue and fear of Diageo, but I have doubts about any seriously influential regulation coming to fruition in the near future in any of Diageos largest markets. Brand equity and awareness is a major contributor to revenue growth in the alcoholic beverage industry and their brands have continued to be extremely well marketed. Paul Walsh was recently quoted as saying marketing expenditures will expand more than revenue growth in the years to come as they penetrate further into emerging markets, and this is a gamble Diageo can take given their market position. Brand equity and image is everything in the alcoholic beverage industry, and Diageo plans to capitalize on their rivals Brown-Forman and Pernod Ricard by increasing their brand image and thereby market share during this economic downturn. Diageo maintains a relatively strong balance sheet and good cash flow position in the industry, and will more than likely come out of the global recession much stronger than when the recession began. The company has good fundamentals, acquisition opportunities, potential for market share gain, and a diversified product portfolio.

Based on the aforementioned reasons, I have come to the conclusion and recommend that the EIF HOLD our equity position in Diageo (NYSE:DEO). Its definitely undervalued (32% or $18 a share by my valuation model), has adequate fundamentals, has a strong cash position, has ample growth opportunities, heavily diversified, and very well positioned to outperform the alcoholic beverage and consumer staples sector.

Undervalued Worlds Premier Spirit Company Excellent Margins Tremendous Emerging Market Growth Opportunities Recession Resistant Great Brand Equity & Market Diversity Strong Cash Position

Negative European sales growth Currency Fluctuations Potentially inflated input costs Correlation to discretionary sector Dependence on Emerging Market Economic Expansion Relatively Debt levered compared to primary competitors


The MSN poll ranged from a strong buy to a strong sell, with the plurality of analysts recommending a hold. The mean recommendation is a 2.63 coming down from a 2.86 rating a month ago. This recommendation seems to be a bit pessimistic. The mean recommendation on Yahoo! Finance was a 1.5 on a (1 being strong buy 5 strong sell) 1-5 scale. JP Morgan also just upgraded Diageo on May 22nd, 2009 to a market weight rating. The mean price target on Yahoo! Finance is $72.07 a share which would be just under a 29% return from the current market price. My opinion falls somewhere between the Yahoo! Finance and MSN analyst ratings being a strong hold to moderate buy.

Brown-Forman Corporation (NYSE:BF-A): Brown-Forman Corporation is known for their Jack Daniels, Southern Comfort, and Canadian Mist brands. Brown-Formans sales grew 4.4% in the US in 2008 with their ready to drink beverages paving the way with 9% sales growth. 2008 was the first year Brown-Formans sales exceeded the $3 billion mark and they are quickly gaining a part of the international spirits market. Brown-Formans 2008 sales figures illustrated this by the fact that over 50% of their sales being made up from international markets. Unlike Diageo, Brown-Forman has yet to venture into the other two sub-industry categories of wine and beer. Brown-Forman is Diageos largest competitor in the US spirits production and distribution industry with a commanding 30.5% market share in 2009 compared to Diageos 32%.

Pernod Ricard SA: Pernod Ricard is known for their trademark brand names such as Makers Mark, Malibu, and Kalua and Wild Turkey and Seagrams extra dry gin. Pernod Ricard isnt nearly as strong of a competitor as Brown-Forman but they do still have 13% of the US spirits market share. Pernod Ricard had a key acquisition of Allied Domecq in 2005 which helped elevate their market share. Pernod Ricard is based out of Paris, France and also acquired Vin&Spirit in 2008 to better position themselves to compete with Diageos premium Smirnoff brand vodka in the United States. Pernod Ricard had $2.4 billion in sales in the US in 2008 and increased their operating profit by 7.5% in 2008 to $617 million.

Fortune Brands Inc. (NYSE:FO): Fortune Brands Inc. is known for their Jim Beam, Knobs Creek, Calvert, and Kessler brands. Fortune Brands is the smallest of the 4 largest international spirits producers and distributors claiming a 10% market share in the US. Fortune Brands Inc. is based out of Illinois and is very well diversified internationally. Internationally Fortune Brands is the second largest of the big four, but they are only the fourth largest within the United States. In 2007 Fortune Brands had $2.6 billion in revenue and $766 million in operating profit. Fortune Brands sold their wine business during 2007 to Constellation Brands, so they could focus more on their core business model of sprits and lessen their debt obligations.



Profitability Ratios: Profit margins show the amount of income generated from sales, while ROA and ROE show the efficiency in which assets and equity are used to generate net income. From this class of ratios, Diageo is outperforming its the industry averages and their primary competitors in almost every category in nearly every year. Diageo has clearly utilized economics of scale and supply chain efficiencies to cut costs and retain best in industry margins.
Profitability Ratios 2005 2006 2007 2008 Industry FO BF.A

GP Margin Net Margin ROA ROE

45.1% 15.6% 10.0% 30.2%

44.7% 20.3% 14.1% 42.0%

45.2% 15.7% 11.2% 37.3%

45.5% 15.0% 10.0% 38.3%

21.8% 5.7% 4.0% 9.9%

41.0% 7.0% 4.0% 11.%

50.6% 13.0% 12.7% 22.9%

Valuation Ratios: Valuation ratios show the value of a stock relative to some financial/earnings criteria. From the above valuations, Diageo is slightly higher than its peers. However, BrownForman is the most closely related company to Diageo, and BF.A is showing higher valuations than Diageo. I also believe these ratios do not illustrate the full valuation of Diageo. Diageo is undervalued based on its dividend discount model, forecasted alpha, and free cash flow to equity.
Valuation Ratios Price Price : Book Price: Sales Price : Earnings Price : CF 2005 8.21 5.27 2.72 18.16 14.14 2006 9.14 5.55 2.68 13.60 16.28 2007 10.3 6.64 2.79 18.59 17.03 2008 9.14 5.62 2.2 15.41 15.03 Industry 2.36 0.92 5.78 5.12 FO 0.99 0.7 9.05 7.23 BF. A 4.06 2.13 16.75 14.66

Debt Utilization Ratios: Debt utilization ratios show the proportion of debt used in financing activities. Diageo is utilizing debt financing more than its competitors based on these figures. Diageo is spending more on marketing, buy backs and related activities and is using debt to finance their expenditures. This is probably the most fundamentally worrisome fundamentals about Diageo. They are relatively highly leveraged compared to their biggest competitors and have taken on a sizable amount of long term debt obligations.

Debt Utilization Ratios Debt: Equity Financial Leverage

2005 0.98 3.01

2006 1.02 2.98

2007 1.13 3.35

2008 1.53 3.84

Industry 0.57 2.45

FO 0.85 2.88

BF.A 0.57 1.80

Liquidity Ratios: Liquidity ratios show the companys short-term solvency and financial flexibility. Diageo is fairly comparable with its peers in this category. There is not much disparity.
Liquidity Ratios Current Ratio Quick Ratio 2005 1.31 0.66 2006 1.45 0.73 2007 1.24 0.65 2008 1.2 0.61 Industry 2.31 1.72 FO 1.46 0.65 BF.A 1.48 0.77

Asset Utilization Ratios: Asset utilization ratios show the efficiency in which assets generate sales. This is similar to ROA, but using sales instead of net income. Inventory turnover also shows the efficiency in which inventory generates sales. Once again, Diageo is fairly comparable, but a little bit better than its peers.
Asset Utilization Asset Turnover Inventory Turnover 2005 0.64 1.12 2006 0.70 1.22 2007 0.71 1.22 2008 0.66 1.18 Industry 0.54 0.79 FO 0.57 2.30 BF.A 0.98 2.30

Du Pont Analysis: Du Pont Analysis shows the factors that affect return on equity. Since Diageo has stellar profitability ratios and high margins, their Du Pont Analysis looks much more attractive than the major competitors.
DuPont Analysis Net Profit Margin Asset Turnover Financial Leverage ROE 2005 15.6% 0.64 3.01 30.2% 2006 20.2% 0.70 2.98 42.0% 2007 15.7% 0.71 3.35 37.3% 2008 15.0% 0.66 3.84 38.3% Industry 5.7% 0.54 2.45 9.9% FO 7.0% 0.57 2.88 11.5% BF.A 13.0% 0.98 1.80 22.9%


Revenue For 2009 and 2010 I used a growth rate of 7% and for 2011 I used a growth rate of 11%. My revenue growth rates were moderate with some variations from analyst averages. Most analysts had their 2009 revenue growth at a higher level and their 2010 revenue growth rate at a lower level, and 2011 growth rates of most analysts were at a slightly lower level. I may have had fairly high revenue growth rates with the exception of 2009 compared to analysts, but I more than offset this with being more conservative and estimating larger marketing expenses.

Excise taxes I stuck with the same excise tax rates that were used in the last Diageo report by Wes Sullivant. Historically excise taxes have been in the 24-30% range for companies in the industry, and I used a 24.5% excise tax rate, as I dont believe any new excise taxes will come to fruition in the current environment. COGS I used traditional industry average rates of 31% and 30% of sales. Commodities had a steep sell off when the recession began, but as of recently commodities and other non monetary assets have come back into favor as inflation hedges. This could be a variable to watch out with in the future as Ive mentioned in my critical issues section.

Operating Expenses & Operating Profit I used a more conservative marketing expense figure as I believe Diageos CEO Paul Walsh will continue to be aggressive in trying to steal market share from competitors via marketing campaigns in emerging market economies as well as the US. I used 14-15% of sales figure to estimate upcoming marketing expenses. This led to a higher operating expense figure than most analysts calculations, but I believe this is very likely to happen with the way management has been speaking. Operating profit stayed mostly in line with historic averages at roughly 20% of sales even though marketing expenses went up.

Income Taxes I kept the income tax level even at 25% of EBT with past analyst reports and recommendations. This is something that could obviously change if corporate tax rates are raised and various deductibles are removed under the Obama Administration.

Dividends I also retained previous dividend growth rate estimations of 5% in my calculations. This has been their traditional dividend growth rate and it seems like a conservative estimate of future rates.

Shares outstanding Diageos share buyback program has been put on hold but I included a very minimal buyback option in case management changes their guidance. I included less than a .5% share buyback program per year.

Risk Free Rate


For the risk free rate I used 4.5%, which is in line the average 30 year Treasury yield. Market Risk Premium I used the EIF market risk premium of 5.7%.

Beta I used a beta of .72 which was in line with most analysts estimates. The beta has definitely gone up since the last EIF analysts report, and that can be duly noted as a result of the volatility of Diageos stock. The aggregate spirit sector beta is modestly higher than this, but in general the alcoholic beverage industry is a fairly recession resistant industry, which isnt as volatile as numerous other sectors. Diageo is slightly less volatile of an equity than its peers more than likely because of their international and diverse market exposure as well as multitude of product offerings ranging across all three primary alcoholic beverage categories. P/E Multiples I project an average P/E multiple of 13 for 2009, 14 for 2010, with a return to their historical average P/E multiple of 15 in 2011. These estimates are more conservative than past analysts reports, but I have chosen these because I am trying to follow conservatism valuation principles. Diageo isnt a completely saturated company either. They still have a plethora of growth opportunities available to them which could easily increase the PE multiple if their prospects start heating up. Diageos P/E multiple during the peak of 2007 soared to 29 times earnings. I dont think this is a realistic multiple for them to achieve in the near future, but I do think it shows the capability of analysts to heavily over value Diageo during times of great expansion which could be just around the corner. I think that these facts along with the growth prospects of Diageo make it safe to assume they wont continue to trade at 12.8 times earnings for much longer if economic activity picks back up. EPS As is the case with my P/E multiples I choose to error on the side of conservatism. I have chosen slightly lower EPS estimates than other analysts. In 2009 I have EPS growing at a modest 2% rate which is below most analysts expectations. In 2010 I have EPS growing at near 12% with plenty of further potential upside in the future if theres an acquisition. In 2011 I have EPS growing at a rate of 7%. Diageo has continued to implement their focus on high margin markets such as the US and aggressive growth strategies in emerging market economies. Diageo also has promising prospects especially with their wine and premium plus brand spirits which have more discretionary attributes to them if the recession recedes and economic expansion resumes. My 2009 EPS estimate is slightly below most analysts expectations and my 2010 is slightly above most analysts expectations, and my 2011 is right in line. Closing Price & FX Assumptions I used the closing price from Friday, June 12th in my report. My report and valuation models are all in pounds so they must be converted back to US dollars using the Friday, June 12th reported exchange rate of $1.64 equals 1. 1 Diageo New York Stock

Exchange ADR share quoted as DEO equals 4 Diageo shares on the London Stock Exchange quoted as DGE.


Ann Gilpin -- Morningstar On Friday June 12, 2009, 4:00 pm EDT True or false: alcoholic beverages companies are recession-proof? Contrary to popular belief, technically, the answer is false. We would argue that alcoholic beverages companies are recession-resilient rather than recessionproof as they still experience cyclical demand. However, while consumers are trading down to lower-priced brands and curbing their consumption, especially at bars and restaurants, most alcohol companies are still highly profitable--evidence of the moats within the industry. Given the right brands and adequate scale, producing and selling alcoholic beverages is a beautiful business: brand loyalty is high, growth is stable, and profits are robust in good times and bad. In fact, despite the effects of trading down, alcohol has comprised a very steady percentage of the United States consumer's total food budget for over 130 years, save for Prohibition, which lasted from 1919 to 1933. Fortunately, the market appears to be overly discounting the attractive attributes of our alcohol beverage company coverage list. After baking the impacts of a stronger dollar and a weaker consumer environment into our valuations, the industry looks undervalued, trading at an average price/fair value estimate of 0.88 as of June 8, 2009. We do have a few favorites, which we'll detail later in the article. First we'd like to take a closer look at some issues facing the alcoholic beverages industry. What Goes up Must Come Down For the better part of the last decade, trading up has been a welcome tail wind for alcoholic beverages companies. In the domestic beer market, mainstream beers like Budweiser (made by Anheuser-Busch InBev) and Coors Light (made by Molson Coors ) have been losing share to premium-positioned beers such as imports and crafts, like Sam Adams, a brand made by Boston Beer . (We recently added coverage of Anheuser-Busch/InBev. To find out more about Morningstar Institutional Equity Research, click here.) Even in 2008, craft beer grew 5%-6% while the total beer category grew just 1%-2%. It seemed that no amount of innovation (anyone remember AB's caffeine-infused beer, B-to-the-E?) or marketing could change that trend.

In spirits and wine, sales have gone nowhere but up over the past decade, increasing 6.0% annually on average since 2000. Consumers have been trading up to more sophisticated and premium-priced brands and in some cases forgoing beer consumption altogether in favor of spirits and wine. In certain categories, like super-premium vodka, companies were making up new brands, like Constellation Brands' Effen vodka, and fetching high prices through advertising and bottle design even though the quality differential between super-premium and value products was quite minimal. To see the images associated with this article, please click here: Not surprisingly, however, these trends have hit the brakes. With the economy enduring a deep recession, consumers have become more selective with their purchases in virtually every category. Suddenly, more expensive craft beer doesn't seem worth the higher price. This price differential has been especially exacerbated as craft brewers, due to their lack of scale, are forced to take higher percentage price increases compared to their larger competitors to offset input cost pressures. This has only widened the price gap between, say, Sam Adams and Bud Light. For example, during Boston Beer's latest conference call, Jim Koch, founder and chairman of the company, noted that he was in a convenience store recently where a 6-pack of Sam Adams sold for $8.99 and a 30-pack of mass domestic beer sold for $7.99. With price discrepancies like that, it's not surprising that value brands are one of the fastest-growing categories in beer today. The recession has also led to trading down to lower-priced brands in spirits and wine, where the premiumization trend was more pronounced. In addition, growth in spirits consumption has slowed as consumers shift their consumption from on-premise (like bars and restaurants) to offpremise (grocery stores) channels. As consumers spend more of their alcohol dollars off-premise, they are more likely to purchase beer over spirits due to its lower price point and lack of the need to buy mixers. Would You Rather Sell Keystone Light or Sam Adams? What's the result of the weak consumer environment? A-B/InBev and Molson Coors, which have medium to lower-end priced brands, are reporting great performance in the U.S. A-B is finally growing volumes again, and for Molson Coors, Keystone Light is growing faster than Blue Moon. Imports and crafts have been the losers for the most part across the beer space. For example, Boston Beer, a company used to posting quarter after quarter of double-digit volume growth, reported a 13% decline in core shipments last quarter. While there are winners and losers in beer, all companies in the spirits industry have seen their underlying sales growth slip, and most have lowered their forecasts for the year as consumers pull back on premium products. However, we have been very impressed with the robust cash flow and operating margins being reported by the better-run operators like Diageo and BrownForman (bf.b.B) despite weakening top-line growth. Meanwhile, Constellation Brands and Fortune Brands , which we consider weaker competitors, have seen their margins pressured.

Overall, we are not surprised to see the companies with the best brand equity and the portfolios with the widest moats in the spirits business fare well. For example, in the U.S. the typical consumer of Johnnie Walker Black Label (made by Diageo) has an income of $100,000$120,000 and consumes 2.5 bottles per year. It appears that this consumer is forgoing a vacation or a new car this year, but is not so strapped for cash that he or she is forgoing the affordable luxury of premium Scotch whisky. For Brown-Forman it seems that the enduring brand equity of Jack Daniel's and its "aspirational" qualities in emerging markets have helped to distinguish it from other brands and thus preserve its robust cash generation in good times and bad. Bottoms up to These Picks Overall, the alcoholic beverages companies are not immune from the weak consumer environment in this recession. However, we think the market has placed several of them at attractive prices. Generally, we would steer investors away from stocks with high financial leverage, such as Fortune Brands, Constellation Brands, and A-B/InBev and toward the highest quality, more stable names. In general, the premium spirits companies we like, Brown-Forman and Diageo, are trading at attractive valuations in spite of the low sales growth we foresee for them in the near term. Finally, we like Molson Coors as it benefits from the trade-down phenomenon and should continue to generate cost savings through the MillerCoors joint venture. Diageo Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.68 | 5 Stars Diageo is hands-down the best spirits company on the planet. It has scale, powerful brands, and the best emerging-markets presence. It is also trading at attractive prices. At just 12.0 times earnings and a 4.2% dividend yield, we think this highly profitable wide-moat industry leader, that turns every dollar that comes through the door into 15 cents of free cash flow, makes a great long-term holding. Molson Coors Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.77 | 4 Stars The benefits from the MillerCoors JV have already stood out in Molson Coors' results. In its recently announced first-quarter results, Molson Coors' reported operating income grew 50%, as savings from the MillerCoors JV more than offset tough head winds from a 20% depreciation in the Canadian dollar and a 28% depreciation in the British pound versus the U.S. dollar. The shares rallied and are currently rated 4-stars. We would gladly pound the table on this one if it dipped back into 5-star territory. Brown-Forman Uncertainty Rating: Medium | Price/Fair Value Estimate Ratio: 0.85 | 3 Stars In our opinion, Brown-Forman's biggest opportunity is in international markets. The firm has been especially savvy in tailoring its marketing message for Jack Daniel's in emerging markets. For the first time in the company's history, more than half of fiscal 2008 sales came from markets outside the U.S. (up from 20% in 1994), and in fiscal 2008, the company's sales increased 4% in the U.S., but 17% in Europe and 54% in all other countries, such as Japan and South Africa. We think Brown-Forman will continue to take the cash provided by its very profitable U.S. business and invest it behind expanding its presence internationally. Over time, we think Brown-Forman's mix shift could approach something similar to that of rival Diageo

(split evenly between North America, Europe, and all other countries), although we doubt the firm can gain as much scale due to its smaller portfolio of offerings.

Soft-Drink War Rages in Kenya -- but Not Over Cola After Brewer's Non-Alcoholic Beverage Becomes a Hit, Coke Launches Its Own Version, Backed by Marketing Firepower
By S AR AH CHILDRESS Wall Street Journal

NAIROBI, Kenya -- In March 2008, East African Breweries, a unit of London-based spirits maker Diageo, introduced Alvaro, a non-alcoholic, light-malt drink. A quirky, bare-bones ad campaign helped make the beverage a sensation. Eight months later, Coca-Cola responded by launching its own malt drink, Novida, backed by a major media blitz. It's too soon to tell which brand will come out on top in what has become Kenya's version of the cola wars fought between Coke and PepsiCo. But the battle, among other things, underscores the growing importance of a once-neglected consumer market: sub-Saharan Africa. The global recession is expected to damp consumer demand across the continent, as it has elsewhere. But Africa's population is growing faster than any other major region's, according to the United Nations. And nearly a decade of economic growth has helped foster a middle class that still has money to spend. An ad for Novida, Coke's non-alcoholic, light-malt drink, above, touts it as a refreshing treat. Below, an ad for East African Breweries' Alvaro, which hit the market first, pitches the beverage as an alcohol alternative for sophisticates. Before Alvaro and Novida entered the market, there were plenty of soft drinks, including Coke and its sister brands, but none of these beverages was aimed specifically at adults. That left a niche that East African Breweries sought to fill. According to the brewer's research, about 70% of Kenya's predominantly Christian population doesn't drink alcohol. But in this cosmopolitan city of three million people, much of the socializing, particularly among young professionals, revolves around the pub scene. And many nondrinkers frequent bars to be with their friends. They became Alvaro's target market.

As the pioneer in its category, Alvaro had the advantage, says Ndirangu Maina, managing director for Kenya of market-research firm Consumer Insight Africa. "The non-alcoholic business was owned by Coca-Cola. It's amazing that an alcoholic company would think of that before Coke." East African Breweries markets Alvaro as an alcohol alternative for sophisticates. In its first six months on the market, the company spent only about $600,000 to promote the drink, which is packaged in a distinctive green-glass bottle. The brewer bought ads on billboards, local radio and in print. As a gimmick for the product's launch, it hired limos to drive around the city towing skateboarders, who handed out the green bottles. It also offered chilled samples of the drink at big sporting events. Though its ad spending was limited, it was enough to create a buzz around Alvaro, which was amplified by word of mouth. The drink wasn't distributed very widely, which sometimes made it hard to find. That only added to its cachet. At the time, Coke, whose cola is the dominant non-alcoholic beverage brand in Kenya, was also developing a non-alcoholic malt drink. When Alvaro hit the market, Coke moved up the launch of its drink, Novida, by around 12 to 18 months, says Roger Gauntlett, Coke's marketing director for East and Central Africa. Novida arrived in November, in a curvy green bottle. In the three months following its introduction, Coke spent about $1.5 million on TV, radio and print ads for Novida. Since the market was already primed for malt beverages, the company focused more on what the drink could do. Its pitch: Novida gives you a lift. It's the drink that will refresh you after a long, hard day at work. The company kept up its "lift" theme, decorating taxi cabs with its ads, and homing in on neighborhoods with bars and restaurants, normally strongholds for East African Breweries, which own all of Kenya's major beer brands. In response, the brewer began buying TV ads for Alvaro in December, though Coke has continued to outspend it, according to marketing-research firm Synovate. Coke declined to provide sales figures, so it's difficult to measure either brand's success. Mr. Maina, the market researcher, doesn't think there's room in Kenya for two drinks in the same niche at the same price: about 30 cents for 10 ounces. "But it's still too early," he said. "Who will win the battle can't be said at this stage."

1. Trey Schorgl, DEO EIF Report Spring 2008 2. EIF Portfolio May 12, 2009 3. Google Finance 4. Yahoo! Finance 5. IBIS World Industry Report: Liqueur & Spirits Production in the U.S. 6. IBIS World Industry Report: Wine Production in the U.S. 7. IBIS World Industry Report: Beer Production in the U.S. 8. Diageo Annual Report 9. Morningstar Article 10. MSN Money 11. Morgan Stanley Diageo Analyst Report 12. Credit Suisse Diageo Analyst Report 13. JP Morgan Diageo Analyst Report 14. Jared Shojaian, DEO EIF Report Summer 2008 15. Wall Street Journal Article