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Diageo's move up the value chain brings dividends

A solid trading performance with a rising operating margin was tempered by the spectre of increased input costs
Diageo's move up the value chain brings dividends
  • Underlying operating margin improvement
  • Demographics should support volume growth

Diageo (DGE) continued its run of sales growth and dividend hikes at the half-year mark, while operational performance and cost controls were reflected in a 190 basis point increase in the underlying margin. Management has been tailoring the group's product offering to take account of demographics and changing consumer preferences, so the group continues to benefit from the shift towards more expensive ‘premium’ brands.

Net sales of its brands including Guinness, Smirnoff, Johnnie Walker, and Tanqueray gin, were up 15.8 per cent to £8bn in the six months to the end of December. Diageo’s most expensive ‘premium’ brands were the star performers, contributing 56 per cent of reported net sales and 74 per cent of organic net sales growth.

These drivers look to be well entrenched. Drinks analytics group IWSR predicts that the premium segment of the alcoholic drinks market, which has outperformed the broad alcoholic drinks market growth by 100 per cent between 2015 and 2020, will make up 13 per cent of the total market by 2024. Meanwhile, a rising middle class in Diageo’s fastest growth regions, Africa and Latin America, bodes well for volume growth.

As expected, sales in pubs and restaurants, which have struggled against a backdrop of pandemic restrictions, picked up across Europe and North America in the six months to the end of December. The relaxing of restrictions and a preference for premium alcohol proved a potent combination. Operating profits increased by 22.5 per cent, to £2.7bn, and the firm raised its half-year dividend by 5 per cent to 29.36p a share. Management also confirmed that the second phase of its share buyback programme is expected to be completed no later than 4 March.

Across its largest markets in Europe and the US, inflation is starting to squeeze household budgets. However, Diageo may well be shielded by alcohol’s relative price inelasticity, particularly at the premium end of the liquor market. For many consumers it's clearly a luxury they can afford. Diageo’s brands command enough loyalty to allow them to pass on higher prices without hurting sales. In the half year to the end of December 2021, tequila revenues were up 61 per cent, with the company selling higher volumes, at a higher price despite supply issues in its aged blend.

The chief executive, Ivan Menezes, expects organic sales to continue growing by 5-7 per cent and organic operating profits to grow sustainably within a range of 6-9 per cent over the next three years. “While we expect near-term volatility to remain, including potential impacts from Covid-19, global supply chain constraints and rising cost inflation, I am confident in our ability to successfully navigate these disruptions through the remainder of the year,” said Menezes.

The share price, up by nearly a third over the past 12 months, could gain more traction if the rotation out of growth stocks is sustained. They currently change hands at 27 times Jefferies' forward EPS estimate. Hardly bargain basement territory, and increasing costs for grain and energy could constrict margin growth. However, it is one of the better options in an inflationary environment and the projected forward yield of 2.4 per cent also helps in that regard. Buy.

Last IC View: Buy, 3,640p, 28 Oct 2021 

DIAGEO (DGE)    
ORD PRICE:3,655pMARKET VALUE:£84.8bn
TOUCH:3,655-3,656p12-MONTH HIGH:4,110pLOW: 2,805p
DIVIDEND YIELD:2.0%PE RATIO:28
NET ASSET VALUE:330p*NET DEBT:138%
Half-year to 31 DecTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
202010.42.2067.627.96
202111.82.7284.329.36
% change+13+24+25+5
Ex-div:24 Feb   
Payment:7 Apr   
*Includes intangible assets of £10.9bn, or 471p a share