Diageo gets in the party mood

Much of the dissatisfaction with Diageo over recent years has concerned its lacklustre trading in North America, which accounted for a chunky 38 per cent of sales in the half-year to 31 December 2016. However, there are signs that the group is getting on the front foot once more, especially in the key spirits market, which is expected to grow at about 5 per cent a year in the country going forward. A rejuvenated strategy spearheaded by chief executive Ivan Menezes saw net sales of spirits rise 4 per cent in the US in the first half, thanks to volume growth and an advantageous mix of product sales. Strong performers included the important whiskey and scotch portfolios, which grew net sales by 15 per cent and 11 per cent, respectively.

More astute marketing, particularly in the case of Johnnie Walker with its 'Keep Walking America' campaign, has helped improve the appeal of its brands. Importantly, in the US scotch market Diageo has gained market share. Captain Morgan has also gained market share and the good progress with these brands give grounds for hope that Smirnoff's fortunes can be revived across the pond, too.

All in all, first-half growth in organic operating profit from North America came in at 6 per cent, which was nearly double consensus expectations. This helped the group's overall organic operating profit growth hit 4.4 per cent, again double that of consensus predictions. Besides the sales growth, cost efficiencies and procurement savings are helping to boost margins, which management has targeted to improve by 100 basis points during the three years to mid-2019.

The fact the company is finally taking more advantage of all that the land of opportunity has to offer has been reflected in the most recent round of broker upgrades. Importantly, while upgrades during the latter half of 2016 were largely the result of Brexit-driven sterling weakness, the positive revisions made last month, while relatively small, are a result of operational improvements. Indeed, we think there are grounds to believe a lengthy earnings downgrade cycle that began in 2013 may have finally come to an end. 

Outside of North America there are other positives. Gross margins are up in Europe, Turkey and Russia, although volumes are lower. Meanwhile, the company is attempting to get on top of issues in some of its more troubled markets, such as India, which carried out a demonetisation process at the end of 2016 by removing high-value notes from circulation, and Nigeria, where the naira has plunged against the dollar. Management has been restructuring its cost base in the African country and analysts at Berenberg believe margins there can revert to 19.5 per cent in Diageo's 2018 financial year, compared with 13.2 per cent in 2016.

An added allure of backing Diageo's improving fortunes is the scope the group has to boost cash generation. Over recent years, the company has been slower to collect payment on sales than the average achieved by rivals and has spent more on key areas of capital expenditure as a proportion of sales. As this reverses, cash flows should improve and broker Morgan Stanley forecasts that the group's free cash flow yield will hit 5.5 per cent for the 2019 financial year, compared with less than 4 per cent in the current financial year.