When stripping out the noise from currency, the United Spirits acquisition, and trade inventory movements from Diageo's (DGE) first quarter trading update, we believe fourth-quarter trends remain intact. Volumes appears to be stabilising in many markets, while Diageo continues to work through more structural challenges in China and Europe. Beyond those regions, many of Diageo's current struggles appear to be cyclical in nature and do not impact our wide economic moat rating or our £19.50 fair value estimate for the leading global producer of distilled spirits.
Organic first-quarter net sales fell 1.5%, with volumes down 3.5%. This was a sequential slowdown from the 0.8% increase in sales in the fourth quarter of fiscal 2014, but the waters were muddied by several non-recurring factors. North America had appeared to have turned the corner by the end of last year, but organic sales slowed to just 0.1% growth in the first quarter. However, the firm was cycling 5.1% organic growth from the previous year, and we believe the growth rate of around 2.5% per year implied by the two-year stacked growth rate is a fair reflection of the state of the North American industry. We think there is medium term upside to the volume performance in North America, as consumers tend to trade up into the spirits category in times of economic prosperity at the expense of beer and wine.
Europe remained weak, with organic sales down 1.4%. This was in line with recent trends, as fiscal year 2014 sales were down 1.5%. We believe those economies most affected by the macro crisis are significantly underperforming some of the stronger economies. Weak volumes in Europe can partly be attributed to cyclical factors, but we do not expect markets such as Spain and Greece to recover to their former levels, and we believe a growth level in line with GDP is appropriate for the Western Europe segment going forward.
The Asia Pacific region was another weak spot, and we think organic sales contraction of 7.4% following a flat comp from a year ago is indicative of the structural decline in China. The crackdown on bribery within government circles is continuing to have a negative effect on Diageo's sales of baiju and scotch, and management disclosed that organic revenue declines had moderated to 20% in mainland China. The extent to which these declines will continue will depend on government policy, but we believe long-term investors will be rewarded when sales in China stabilize and return to growth in the medium term.
Sluggish macroeconomic growth is likely to continue to weigh on Diageo's volumes, but on the evidence of these results, we believe that pricing power remains intact, and volume growth will return as the global economy improves, and as consumers resume their taste for trading up in beverages as their incomes grow. With the stock appearing modestly undervalued, and with one overhang for the stock now removed - the threat of Scottish independence - we believe Diageo is one of the more interesting investment stories in consumer staples at the present time.
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