Raise a glass to Diageo

Despite the belief that beverages companies are supposed to be defensive, the recession hit the drinks industry hard. In the case of Diageo, the Johnnie Walker whisky to Smirnoff vodka group, its stable of premium brands was sensitive to economic troubles, with consumers cutting consumption or switching to cheaper alternatives. Retail and leisure outlets cut their orders, distributors reduced stocks, making their supply chains more efficient, and discounting increased across the industry, inflicting damage on sales and profitability.

Markets are still tough, with Diageo's organic net sales down 2 per cent in the first half of 2010, but that belies the progress the group has made in an extremely difficult year, and doesn't reflect the strength of Diageo's portfolio of products. Drinkers may have turned away from its premium brands, but the standard brands within Diageo's portfolio meant that it was able to hang on to customers. In fact, over the past year, Diageo has increased its volume share of the market.

What's more, there are signs that the trend towards down-trading is starting to reverse, particularly in the US, which accounts for around 37 per cent of the group's operating profits. Management recently told City analysts that US drinkers are having more nights out and returning to its high-end brands, and that the speed of volume recovery could surprise on the upside. Diageo is spending significantly on marketing to capitalise on the recovery. True, this could hold back profits growth in the short term, but it lays the groundwork for significant volume increases in 2011.

Yet even if the North American recovery stays on course - and there is little doubt that it is wobbling - Europe is likely to remain tough for some time as governments implement austerity measures to get public-sector debt under control. However, Europe is not as important a source of Diageo's profits as the US, with the continent accounting for an estimated 15 per cent of sales and the UK a further 8 per cent. Further European weakness is already anticipated by Diageo, so any surprises are likely to come on the upside. And, as in the US, the group has continued to gain market share in key European markets throughout the downturn.

Besides, market conditions are only part of the story. Analysts think Diageo has failed to fulfil its potential over the years, so there is a much improvement to be squeezed out of the business.

Its new "Ease of Shop" retail initiative in Europe is one example. This involves Diageo making its retail offering, particularly to big supermarkets, as slick as the best fast-moving consumer goods companies, such as Unilever or Reckitt Benckiser. Simon Hales, an analyst at broker Evolution Securities, says the beverages industry has been "lazy" about working with retailers, so it does not fully understand even basic in-store sales drivers. Yet that also means there is the potential to make huge improvements to sales and profits. Diageo will be rolling out its scheme to 30,000 European retailers in the coming year, after early signs that the initiative generates sales increases of up to 30 per cent.

Of course, investors have spotted this and Diageo's share price has risen 50 per cent since bottoming out in March 2009. But, with earnings set to grow strongly next year, that still leaves the shares looking cheap relative to rivals. For example, shares in Pernod Ricard trade on a multiple of 14 times 2011's forecast earnings. True, Pernod Ricard may have a stronger presence in emerging markets, but Diageo is not exactly a slouch in those regions, where the aspirational appeal of drinking premium brands is translating into strong profit growth.