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Morningstar | We Raise a Glass to Diageo's Strong First-Half 2019 but Expect Growth to Slow in Medium Term

Diageo modestly beat our forecasts in the first half of the fiscal year 2019 thanks to a strong operating margin performance. Both volume and price/mix were in line with our forecasts. We are reiterating our GBP 27 fair value estimate and wide moat rating. We believe the market is fairly valuing Diageo at current levels, and although the business is firing on almost all cylinders at present, we would wait for a margin of safety before investing.

First-half organic sales growth of 7.5% is excellent and likely to be one of the strongest performances among large cap consumer products companies this reporting season. Equally pleasing was the balance between volume growth (up 3.5% organically) and price/mix (up 4%), supporting our view that distillers' price/mix is structurally higher than that of other consumer product categories because of the pricing power of spirits brands. It is above our midcycle growth estimate, however, of just under 5%. Diageo's largest market, North America, grew by 6% organically, evenly split between volumes and pricing. The driver of the recovery in the region remains scotch, which grew by 10% in value terms, but the stabilization of vodka, which was flat year over year, is also pleasing. The only downside surprise on the top line was a 1% volume decline in Latin America, although this seems to be somewhat isolated to the troubled Argentina market.

Diageo also performed very well at the EBIT margin, with emerging markets posting a particularly strong performance. In spite of an increase in marketing expenses, which should bode well for near-term growth, the organic operating margin expanded by 152 basis points in the first half. Of that expansion, 50 basis points came at the gross margin, mainly driven by positive mix. An impressive 128 basis points came from operating cost efficiencies. The reported EBIT margin of 35.2% is sustainable, in our view, and is only marginally below our medium-term estimate.

Management announced an increase to the ongoing share repurchase program of an incremental GBP 660 million, bringing the total share repurchase program for the fiscal year to GBP 3 billion. However, with Diageo trading close to our fair value estimate, we reiterate our opinion that share repurchases are not currently the best use of capital. We would have preferred the company to have used its excess cash to increase its stakes in its emerging-market subsidiaries in order to harness its long-term growth opportunities.