Morningstar analysts have raised the fair value estimate for global drinks maker Diageo (DGE) to £27 from £25, against a current price of around £27.60.
We forecast 4.5% sales growth this year, reflecting relatively robust price/mix and steady volume growth of 1.7%. This is roughly in line with our steady state growth assumption of 4.8%. Although slightly lower than our previous estimate, this is at the high end of the consumer staples industry, which we think is justified by Diageo’s pricing power. We expect price/mix will be a more powerful driver for Diageo going forward than in more competitive categories such as food
Strong brands and a cost advantage are at the heart of Diageo's wide economic moat, or competitive advantage. While we believe the firm's total alcohol product portfolio is far from complete, it contains 12 of the top 50 global premium distilled spirits brands, according to Brand Finance, and four of the top 10. Its presence with number-one or number-two brands in most of the major spirits categories would be difficult for a new entrant to replicate.
Diageo's positioning in most of the leading categories means that its brands have high churn in bars and significant shelf space in supermarkets. This makes Diageo an important partner for bars, restaurants, and retailers, and the firm works closely with its customers to optimise product displays, promotions, and pricing at retail. We believe this is a competitive edge over less valued distillers.
Diageo Benefits From Luxury Trends
Diageo was created in 1997 following the merger of Grand Metropolitan and Guinness. Mergers and acquisitions remain part of the firm's DNA, and subsequent transactions have established Diageo as the global industry leader. Although the industry is fairly concentrated, we believe there is more consolidation to come. Outside the top five firms, the industry is highly fragmented, and local players often dominate in niche product categories or local markets. These firms present a new wave of merger opportunities for the industry consolidators, including Diageo, to strengthen their presence in emerging markets.
Another incentive for Diageo to continue consolidating is the broadening of its product portfolio. Volume in the spirits industry is fairly stable – albeit more cyclical than beer – but trends are transient. For example, the current shift away from white spirits such as vodka to brown spirits is a reversal of the 1990s trend. Diageo's broad presence across categories with both global strategic and local niche brands mitigates some of the risk to volume from such shifting consumer tastes and preferences.
Diageo is undertaking a “premiumisation” strategy – encouraging drinkers to upgrade to more luxury brands – which we think will be a significant long-term tailwind to both volumes and price/mix. Today in mature markets, spirits are taking share from beer and wine as consumers trade up. In both the United Kingdom and the United States, the distilled spirits category has added an average of around 20 basis points from other categories every year for the past decade; a continuation of that trend could support Diageo's volume in developed markets, despite an underlying headwind of falling alcohol consumption.
With regard to price/mix, the way Diageo has laddered the pricing structure of brands such as Johnnie Walker demonstrates that there is almost unlimited scope for premiumising some of the core brands in the portfolio, a luxury that most consumer staples companies do not share.
