Diageo: Weak Demand for Spirits to be Offset by Forex Impact, Cost Efficiencies

Diageo Stock price (LSE): p962 (approx. $1,558)
Conclusion: Both our investment case and valuation (p980-1050/$1,588-$1,701) remain unchanged following Q1 trading update. Stock fairly priced.

Q1 sales down 6% like for like. F10 guidance confirmed: low single digit growth in operating profit.

Q1 confirmed what we were expecting: a tough start in spirits due to weak demand, continuing trade destocking and high comparison base. We might have to wait for Q3 and Q4 to see a return to positive numbers. We don’t change our forecast of -1-2% decrease in sales this year.

Bottom line will benefit from costs savings (£120m/$194m) added to a positive forex impact (£80m/$129.6). In addition, Diageo benefited in Q1 from “efficiencies” in marketing spending and media rates, implying a further decline in expenses. As a result, EBIT and EPS could increase by around 4% in F10 despite the negative operating leverage from lower sales.

Diageo trades at 15x and 14x P/E, based on calendarised 2009 and 2010 estimates, which is not expensive compared with brewers or food companies. Nevertheless, we believe Pernod Ricard (PDRDF.PK) offers superior long term growth following the acquisition of Absolut. Although, Diageo management confirmed that they would be interested in taking the full control of Moet-Hennessy, we doubt that LVMH would sell at the bottom of the cycle.