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Diageo Update Reassures Investors

An update from Diageo's head of North America shows the turnaround in this region is on track, say Morningstar equity analysts

Philip Gorham 30 November, 2017 | 10:29AM

Guinness

Morningstar equity analysts are reiterating the £24 a share fair value estimate for Diageo (DGE) following an update to investors from Deirdre Mahlan, President of Diageo North America. The market has reacted positively – most likely, in our view, in response to bullish commentary about short-term trends – but we think the uptick in brand investments in some key parts of the portfolio supports our thesis that customer acquisition costs are likely to be somewhat inflationary in the medium term.

Unlike some peers in more commoditised categories, Diageo's pricing power, the source of its wide economic moat – or strong competitive advantage –  should help to offset these cost pressures, but we believe that after an impressive rerating over the past 18 months, the shares are slightly overvalued at their current level near £26 a share.

Diageo Leverages Pricing Power

There's a lot for investors to like about Diageo. We believe it has a wide economic moat based on the pricing power that helped it deliver price/mix above its peer group last year; management is executing a zero-based budgeting strategy that should give it greater financial flexibility in the medium term; and the long-awaited turnaround in North America was finally delivered in the last financial year, ended June 2017.

In fact, Mahlan's comment that she expects organic growth in the region to exceed the 3.4% rate achieved last year suggest that recovery has accelerated since then. This will have come as a relief to investors, given that some of the recent data has indicated softness in the mainstream retail channel. Of greater significance to the valuation of the business, in our opinion, is the step-up in brand investments this year.

Mahlan cited greater investments in vodka brands Ketel One and Smirnoff and whisky brand Bulleit in the 2018 financial year. That no material repositioning of any of these brands was announced, yet spending is increasing, suggests to us that increasing competition is raising the customer acquisition cost in the spirits business, and we remain comfortable with our medium-term profit margin assumption of around 33%, only marginally above last year's level.

Furthermore, we are cognisant of challenges on the horizon. The ongoing Brexit process will bring challenges, both in the short term through possible currency volatility, and in the long term through the potential for higher tariffs on scotch whisky exports. We are also keeping a keen eye on the progress of craft in the spirits category, as this could be a structural headwind to long-term cash flow growth, either through continued increases in spending or share loss.

These challenges are by no means limited to spirits, however, and with a portfolio that still appears to carry pricing power at the high end of the global consumer sector, Diageo should be better positioned than some of its competitors in more commoditised categories to deal with the challenges ahead.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Diageo PLC2,641.55 GBX-0.26
About Author

Philip Gorham