Home > Blog > Trader talk > Diageo – A Sterling Stock for 2017

About the Company

Diageo plc produces, distills, and markets alcoholic beverages. The Company offers a wide range of branded beverages, including vodkas, whiskeys, tequilas, gins, and beer.

Our Stance on Diageo

Many investors ask us for equity investments in Sterling. We recently added Diageo to our equity list with a price target of 2500p per share (11% potential upside). I think it is important that we also add consumer staples to the list. Although we are pushing cyclical stocks, I think it also makes sense to have some defensive names in order to mitigate risk in a portfolio. Diageo currently has a beta of 0.96, as opposed to many high beta names in the portfolio.

Today we are confident that the investment case behind Diageo is a solid one. We are banking on two important drivers to increase margins going forward.

The first is Sales. Sales momentum at Diageo is accelerating. Not only is organic sales growth well above most Staples peers but it is also volume and mix driven. This is fundamental going forward as it means sales growth is not just a result of a strength in Emerging Market currencies which is translated into higher sales figures.

The second is reduced costs. Confidence in delivery of its £500m productivity savings plan is also rising and may yet surprise to the upside.

We see Diageo as a core holding in a portfolio. The combination of additional margin upside, incremental cash returns and strategic optionality from possible portfolio change under the new chairman makes for an interesting story.

Investment Rationale

  • With limited phasing issues at the top line and accelerated delivery of savings, margins in H217 are set to expand materially (from lower costs and higher prices & volumes)
  • Scotch sales growth has only started as we see a pick-up in growth from emerging markets (but robust growth across all regions – Europe, US, EM)
  • Johnnie Walker is Diageo's largest Scotch brand, accounting for over 50% of Diageo's Scotch portfolio (a well-known brand)
  • Diageo trades on CY17E P/E of 19.3x versus the European Beverages sector on 21.1x
  • Cost saving exercising is also leading to margin expansion
  • Company is managing to increase both volumes and price
  • Earnings forecasted to increase in years ahead
  • Dividend yield of 2.73%

Conclusion

The world economy seems to be recovering steadily. Expectations of economic growth often accompanied by higher interest rate expectations are having a twofold impact on equity valuations. The twin effect; an expected earnings increases from higher economic growth and the expected rotation from fixed income to equities as a result of higher interest rates, is dramatic.

We expect 2017 to continue to be positive for European Equities. Still, in the short term, elections in the Netherlands and France and the start of Brexit negotiations may increase short-term market volatility.