Diageo share price froth will soon settle

Diageo shareholders remained in good spirits for most of Monday’s session as the firm became the latest in a spate of UK-based corporate giants to see its stock fizz on takeover speculation.

Shares of the world’s largest producer of spirits, which is also the maker of Guinness, traded as much as 8% higher at one point on Monday amid reports Brazilian billionaire Jorge Paulo Lemann and his partners in private equity firm 3G Capital were considering a bid.

It’s possible the provenance of the news might have prevented the speculation from taking hold in the UK market under less M&A-attuned circumstances.

Whispers of Brazilian advances

However, with talk of ambitious potential takeovers rife, including on Monday, a column in a Brazilian news magazine was sufficient to excite traders over Diageo.

Lauro Jardim, a notable columnist in Brazil, writing in Veja, Brazil’s biggest-selling news magazine, said Jorge Paulo Lemann and other executives had begun to explore an acquisition.

Both Diageo and Lemann have declined to comment.

Stoking the market’s enthusiasm, was the thought that 3G has been an inveterate buyer of huge consumer focused brands within the last decade, including acquisitions of H.J. Heinz Co., Tim Hortons Inc. and, earlier this year, Kraft Foods Group Inc., all in partnership with Warren Buffett-controlled Berkshire Hathaway.

Diageo will still be attractive when market sobers

From a soberer point of view—one which global stock markets tend to ignore during times of heightened M&A activity, like right now, it quickly becomes clear the balance of probabilities doesn’t favour a deal between 3G and Diageo, at least not yet.

With a market value that has touched about $73bn on Monday, a deal at a premium to that would tax 3G, especially whilst it continues the always difficult task of consolidating earlier companies it has guzzled up in the last few years.

Diageo also had a not inconsiderable £687m in free cash at the end of its 2014 financial year.

Additionally, whilst the booze maker is expected to report earnings per shares that are as much as 7% softer than the year before, I expect its earnings growth to enter a more edifying trend from 2016 onwards.

From my own calculations, and partly based on consensus forecasts, it very much looks as if Diageo’s earnings growth rate will be faster than the market average over the next five years, taking it to the top of a list including Anheuser-Busch (in which 3G has a large stake), Heineken, SABMiller and others.

Opting for the glass-half-full view

That of course is balanced against a forward price/earnings ratio that is some distance outside the Top 3 of the same group.

All in, my view is that Diageo stock should not be judged particularly harshly from a medium-to-long-term position, though without current speculation, it’s difficult to escape the idea that current relatively fallow earnings are not fully reflected in the stock, which settled just 7% below two-year highs at Monday’s close.

The stock gapped about 150p between Friday’s close and Monday’s open, and that gap now looks vulnerable.

Despite that, DGE’s daily chart still has an underlying constructiveness beyond the frothy momentum—I would expect the support area around 1750p to hold.