We are raising our fair value estimate for Diageo to incorporate overall results that are beating our expectations due to the benefits of foreign currency exchange rates, which are more than offsetting weaker underlying results. However, as foreign currencies have become more volatile, Diageo's cash flows have become more difficult to predict. As a result, we are raising our fair value uncertainty rating to medium from low.
From a valuation perspective, even though Diageo's underlying results are underperforming our expectations for the year, the huge benefits of an appreciating US dollar and euro more than offset the weaker fundamentals, which accounts for the increase in our fair value estimate. For example, in the US, Diageo's underlying organic operating profit grew 8% in the first half of the year, but foreign currency alone lifted operating profits by 22%. We have updated our model to account for the cash-flow benefits Diageo will incur due to the appreciation of other foreign currencies, mostly in its North American and Europe segments, but we have lowered our annual forecast for underlying business. We were previously forecasting 7% underlying organic operating profit growth (which was at the low end of management's guidance of 7%-9%), but we have now lowered our assumption to 4% (management is now guiding 4%-6% growth for the year).
From a margin of safety perspective, we have run various scenarios testing the variability in Diageo's cash flows based on foreign currency fluctuations. Because this adds an additional layer of uncertainty to our cash-flow projections, we are increasing our uncertainty rating. It is important to note that our uncertainty rating is not based on exchange-rate sensitivities for the ADRs—it is only based on the variability in forecasting Diageo's cash flows. As such, an investor who purchases Diageo's ADRs unhedged will remain exposed to fluctuations in the GBP/USD exchange rate.
Ann Gilpin is an equity analyst at Morningstar US.
