Diageo's (DGE) nine-month trading update revealed that sales in the third quarter of fiscal 2011 were in line with our expectations, and the firm is on track to meet our full-year forecasts. Our fair value estimates of 1,250p per share, as well as our longer term outlook, remain intact. We expect the fourth quarter of fiscal 2011 to be fairly strong, although the second half of calendar 2011 could be more challenging. We see limited upside to the stock on a discounted cash flow basis, but we recommend Diageo to investors who are particularly concerned about rising commodity cost inflation.
Internal net sales grew 5% in the nine months to the end of March 2011, with sales in the Asia Pacific and other international markets driving growth. Sales in North America grew 3%, despite pressure from the stronger British pound, but sales in Europe remained weak, falling 3%. Diageo remains an emerging-markets story, and we see a multi-decade growth trajectory in regions such as Africa and Asia, assuming the firm keeps its brands relevant at a local level. We expect sales growth to continue unabated through the remainder of calendar 2011. Europe, however, is likely to remain troubled, particularly in those markets experiencing high unemployment or austerity measures. We suspect that volume will not return to historical norms in the medium term in Spain, as consumption patterns are changing, with far less on-premise consumption taking place between the hours of 10 p.m. and 4 a.m., 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.
After a solid run over the past nine months, Diageo's shares appear fairly valued. 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 in the near term, and we think a mid- to high-teens earnings multiple is appropriate. The shares could benefit from further momentum, however, if commodity cost inflation affects other consumer staples firms' profitability over the next few months. The multi-year maturing process of spirits such as scotch, rum, and tequila means that it could be many years before today's rising costs feed through to Diageo's profit and loss account.
