Diageo's (DGE) first-half results were broadly very positive, and we expect our thesis that the firm's strength in premium categories should position it for solid long-term growth to play out over the next few months. Revenue slightly undershot our expectations, but as a result of gross margin expansion and the positive trends evident in most markets, we think Diageo is on track to meet our full-year forecasts, and we are reiterating our fair value estimate. Although the stock suffered in London trading immediately following the results release, we think it is currently fairly valued.
Internal net sales grew 4% year over year in the first half of fiscal 2011, slightly below our forecasts. As we had expected, revenue growth was led by continued momentum in international markets, where double-digit volume growth in the global travel and Middle East and Latin America segments drove a 13% increase in reported net sales. Diageo remains an emerging markets story, and we see a multidecade growth trajectory in regions such as Africa and Asia, assuming the firm keeps its brands relevant at a local level. Even the sluggish North American market returned to growth in the first half, with a 2% and 3% bounce in volume and revenue, respectively, although we expect volume to flatten toward the end of 2011, when higher prices should drive revenue growth. Europe, however, remained patchy, and while revenue grew 20% in Russia and Eastern Europe, it fell a staggering 38% in Greece. Consumption patterns are changing in some important European markets most affected by government austerity measures, with far less on-premise consumption taking place between the hours of 10 p.m. and 4 a.m., hitherto a critical period for Diageo's volume. We think it may now take slightly longer for these markets to stabilise than we had initially thought. However, Diageo remains an emerging markets story, and its solid growth in developing markets is likely to continue unabated through 2011.
Growth at the top line led to 180 basis points of gross margin expansion in the first half of 2011, and lower total operating expenses resulted in an expansion of 280 basis points at the operating margin, which was 61% in the first half. However, marketing expenses were up double digits in some markets, in part because of higher advertising rates, but also an indication that volume growth and market share gains will become more expensive to generate going forward, in our opinion.
After a solid run over the past six months, Diageo's shares are fairly valued at around 16 times forward earnings and 12 times EV/EBITDA, in our opinion. The firm's scale and vast distribution network give it some sustainable competitive advantages, but with more than 60% of its revenue being derived in mature markets, growth in developing markets will barely move the needle on Diageo's £10 billion top line, and we think a mid- to high teens earnings multiple is appropriate.
