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Why consumer goods giants will pay Clooney-tunes prices for rivals

Diageo’s $1bn acquisition of George Clooney’s tequila company is not the first big-money purchase of a relative newcomer by a consumer giant – and here is why it is unlikely to be the last

07/07/2017

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Diageo’s purchase last month of George Clooney’s tequila company Casamigos (Guardian) was widely hailed as a good deal for all concerned.

Good news for Clooney and his two co-founders because their cuts of the $700m (£541m) purchase price, possibly rising to $1bn, depending on the company’s performance over the next 10 years, are not to be sniffed at – even, presumably, if you are Hollywood royalty.

And good news for Diageo because, as corporate analysts have noted, the deal boosts the drinks giant’s position within the US’s ‘fast-growing super-premium tequila’ sector.

Still, as natural contrarians, here on The Value Perspective, when we see everybody else in agreement, we instinctively start to wonder (much as we do about a world that feels the need for tequila a level above the merely ‘premium’).

Diageo is expecting big growth

According to Credit Suisse analysts, Diageo has paid the equivalent of $4,000 a case for Clooney’s brew, which is four times what it paid for another tequila brand, Don Julio, in 2015.

The same analysis suggests Casamigos will have to grow its sales by between 30% and 35% a year just to break even by year four. Clearly one could argue the epithet ‘super-premium’ is as applicable to the deal’s price-tag as to any tequila.

Interestingly, this is not the first time we have seen a consumer giant pay big money for a relative newcomer.

Take men’s grooming start-up Dollar Shave Club, which was founded in 2012 and bought by Unilever for $1bn (FT) three years later – thereby beating Casamigos to the billion-dollar ‘valuation’ by a year. The deal, the theory ran, would allow Unilever to compete with Procter & Gamble in the North American razor market.

Yet, as we said before, you do have to wonder if there is something more going on here than companies looking to establish or grow their market share.

We have now reached a stage where some investors can look at the likes of Diageo or Unilever – or Danone or Nestlé or whoever – and convince themselves they are able to predict the future.

Do some investors have a crystal ball?

 They see these huge consumer goods companies with their portfolios of global brands generating solid income streams and they tell themselves they know what is going to happen – not just two years but two decades down the line. They believe these businesses are so dominant they will continue to grow their market share and this belief justifies the significant premiums now being paid for shares across the sector.

An alternative interpretation, however, would be that if you have amazing brand power and huge market share and yet you still feel the need to fork out a billion dollars every time a start-up gains some traction in one of your backyards, then that would suggest there is a weakness in your business model. Certainly it is not indicative of a position of strength.

The irony of the Dollar Shave Club story is that the start-up was taking on a sector that has been so successful it has a business model named after it.

The ‘Razor-Razorblade’ (investopedia) method is a tactic where two interdependent items are sold at very different prices – one (a razor, say, or a video game console) comes at a discount while the other (razor blades or video games) retails at a much higher price.

One of the most successful business models of all time it may be but Dollar Shave Club managed to upend – or ‘disrupt’ – the sector it was named after in the space of three years, in the process persuading Unilever, which did not have any share in the US shaving market but wanted to take on the dominant player Procter & Gamble, to pay what most commentators agreed was over the odds for it.

Consumer giants raising their prices leads to their own demise

Here lies the problem. Companies generally increase their prices to increase their profits. Shareholders like companies that increase prices as it causes large profit growth and so the share price goes up. This cycle keeps repeating until the company puts prices up too high.

Once prices are considered too high by the consumer a new competitor is allowed to enter the market as they’ve become uncompetitive.

For example when the big supermarkets put prices up too high and the discounters entered (Lidl, Aldi etc.). Or when the large beer companies started charging over the odds for a pint of beer it allowed smaller craft brewers to enter the market due to the increased margin potential.

The consumer giant then has to show they haven’t lost market share to the new disruptor. So they buy it to protect their existing business, essentially buying back their customers. This purchase is usually for a lot of money as by definition the disruptor is growing fast and the new sexy thing on the market.

Unfortunately, the act of purchasing the disruptor actually destroys shareholder value as the consumer giant has overpaid for the story, overpaid for the growth and overpaid to create the illusion of stability.

Ultimately, there is a limit to the effectiveness of brands and their pricing power. As we have argued before – most recently in The chart that could keep investors in ‘low-risk’ stocks awake at night – these companies are not the one-way bet their investors seem to believe or their valuations appear to imply.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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