We are initiating coverage of Diageo plc (DEO), a leading alcoholic beverage company, with a buy rating; we have a positive view of its strong brands, leading position in many spirits categories, and relatively low-cost structure, asserts Jim Kelleher, analyst with independent Wall Street research firm research Argus Research.
Over the last several years, the company has generated above-peer-average revenue growth by working closely with bars, restaurants and retailers on both pricing and promotions.
It is also gaining market share as more consumers trade up from beer and wine to spirits (whiskey, gin, vodka, etc.), as well as from less expensive spirits to premium brands. Looking ahead, we also expect the company to benefit from its large dedicated sales force in the U.S., as well as from its increasing investments in emerging markets.
Following a slight decline in FY17 reported sales, we look for net sales to increase 5% in both FY18 and FY19, to $16.0 billion and $16.8 billion, respectively.
Despite currency headwinds in fiscal 1H18, net sales benefited from 7% organic growth in both Latin America and the Asia-Pacific region, with revenue in China up 32%. We expect the growth of the middle class in China, as well as a recovery in India, to boost sales going forward.
We expect Diageo's use of zero-based budgeting, focus on cost cutting, and productivity gains to result in higher operating margins over the next two years. We expect the company to maintain margins in the 33-34% range over the next several years. In FY18, we project earnings of $6.90 per share, rising to $7.40 in FY19.
DEO shares are trading at 19.9-times our FY19 EPS estimate, below the peer average of 24.0. However, we believe that they merit a higher valuation given the company's solid returns on invested capital and prospects for high single-digit earnings growth over the next five years.
Our target price of $168 implies a multiple of 22.7-times our FY19 earnings forecast, still below the peer average, and a potential return, including the dividend, of 17% from current levels.
