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Morningstar | Raising Diageo's FVE Slightly Higher on Weaker Sterling; Shares a Little Rich

We have raised our fair value estimate of Diageo to GBX 2,800 from GBX 2,700 to account for the benefit of the recent weakness in sterling against most major currencies and for the time value of money, in roughly equal measure. We now expect 5.8% reported revenue growth in 2019, based on current rates, 180 basis points above our previous estimate. We are retaining our wide moat for Diageo, a business we think is among the better positioned in the long term for the intensifying threats in the consumer goods industry, although we believe near-term expectations are slightly frothy and the stock is a little overvalued at current levels.

We estimate Diageo's medium-term organic net sales growth to be roughly 5%. This is about 1 percentage point higher than our benchmark estimate for the sector because of favourable secular trends in the spirits industry. Comments by CEO Ivan Menezes at a recent Investor Day support our thesis. Menezes said 50% of innovation projects are aimed at recruiting new customers, with the remainder aimed at re-recruiting existing customers in a brand. Based on our analysis of premiumisation in the beverages industry, we believe the opportunity to expand the customer base is higher in spirits than in most other consumer product categories because even in the developed markets, consumers are trading up from beer and wine. This gives distillers stronger volume drivers in developed markets than the more mature food and mainstream personal care categories.

The aspirational nature of spirits, however, creates greater volatility in demand relative to the broader consumer staples industry. As demonstrated during the global financial crisis a decade ago, demand for spirits can be less defensive than other staple products. While we have a high conviction in the above-sector medium-term growth prospects of Diageo, we believe the market is overlooking the risk of demand weakness as we approach the end of the current cycle.