Diageo faced by stuttering US growth

Could it be said that Diageo (DGE) benefits from what’s termed a ‘competitive moat?’ Shareholders in the stock might point to the value of its iconic brands, such as Guinness and Johnnie Walker, the latter of which accounts for over one-fifth of all Scotch whiskies sold worldwide. And sheer scale, itself, can ward off meaningful competition; it’s easy enough to start up a hooch business, but it’s nigh impossible to go up against a global business with material advantages in marketing, pricing power and logistics. You get some idea of that pricing power through an average five-year operating margin of 30.7 per cent.

Admittedly, inflationary and foreign exchange effects weighed on the reported operating margin, down 92 basis points at the half-year mark, but the group still saw margin expansion on an organic basis. With input prices rising at their fastest clip in decades, the onus was on effective cost management, but the ability to pass through price increases to punters provides the main armour-plating.

Another sign that a business has maintained competitive advantages to protect market share is a consistently high ratio of free cash flow to sales. Diageo has always impressed on this front, as evidenced by an average five-year free cash flow ratio of 19.3 per cent. Throw in an average return on equity of 33 per cent and you probably have yourself a moat.

And yet the group’s interim figures didn’t find favour with the market even though sales figures trumped expectations, with growth across most product categories, including scotch and beer. Why is this so, given that the alcohol market has been resilient amid a global cost-of-living crisis? Worries are growing over a prospective slowdown in North America, with negative volume movements reported in the US market. Management noted that organic net sales growth would continue to “normalise through the second half of [the 2023 fiscal year], compared to the double-digit growth in the prior period”. Growth rates in Europe are also predicted to moderate in the second half, although comparators will be slightly skewed as the group laps the on-trade reopening recovery.

The sell-off on results day is significant given the group has traded within a relatively narrow band over the past 12 months, but the group, perhaps counter-intuitively, continues to benefit from its premiumisation strategy, suggesting that drinkers are willing to splash out on life’s little luxuries even with the economy tanking. A forward rating of 20 times forecast earnings also suggests the market is up with events. Hold.

Last IC view: Hold, 3,771p, 28 Jul 2022