Global drinks company Diageo (DGE) delivered a strong first half to its financial year. Morningstar equity analysts are nudging up their fair value estimate for the shares to £25 from £24 on higher profit margin assumptions, despite unfavourable currency movements. We still regard the shares, which rose today to above £25.54, as fairly valued.
Sales, which rose by 1.7% to £6.5 billion in the six months to the end of 2017, were in line with our forecasts. After a stodgy few years, organic growth has rebounded to what we view as normalised levels due to improved demand and better product ranges. Our forecasts had underestimated the impact of the recent strength of the British pound, however, which trimmed growth, and we are lowering our growth forecasts for the next 12 months as a result.
The underlying business appears to be performing better than it has in several years, particularly in North America. We believe this is sustainable due to volume growth in premium sectors and fairly strong pricing power, the source of the firm's wide economic moat, or strong competitive advantage.
We applaud Diageo on its improved profit margins. Although we think higher marketing and advertising costs may be the new normal in mature markets, we now believe we were slightly conservative in our assumption in how much of the cost savings could trickle down to profits.
Diageo's financial performance has not been this consistent in several years, and it seems likely that an increasingly rare combination of organic growth and profit margin expansion is possible in the short to medium term. This appears fully priced into the stock, however, and the story is not without risks. 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 exports.
We are also keeping a keen eye on the progress of “craft” spirits category, as this could hold back long-term cash flow growth, either through continued spending increases or loss of market share to boutique distillers. With a portfolio that still appears to carry pricing power at the high end of the global consumer sector, and a wide economic moat, Diageo should be better positioned than some of its competitors in more commoditised categories to deal with the challenges ahead, and at a more attractive market valuation, we would recommend investors take a look at Diageo.
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