Diageo Plc (DEO - Free Report) seems to be on steady growth path, courtesy of strong fundamentals, continuous innovation and focus on expansion despite soft industry trends. These factors largely fueled the company’s results in recent years.
Notably, the stock has gained 21.4% in the past year against the industry’s decline of 22.9%. Moreover, this Zacks Rank #3 (Hold) company has recorded superb 13.5% growth since reporting earnings on Jan 31, 2019. Further, its Growth Score of A and long-term earnings growth rate of 8.4% indicate that it is poised for improvement in the future.
However, we cannot fully ignore the industry-wide turmoil of higher input and transportation costs, which have been a major setback for the company. This might slightly mar the gross margin in the second half of fiscal 2019. Additionally, adverse currency rates are hurting Diageo’s sales, which are likely to continue in fiscal 2019.
That said, let’s analyze the reasons why we must retain the stock.
Premium Brands to Drive Growth
Diageo remains focused on expanding fastest-growing premium spirit brands by resource optimization, which should drive growth and boost shareholders value. In sync, the company recently signed a deal to sell 19 brands from its portfolio to Sazerac for $550 million. The 19 brands slated for divestiture are Seagram’s VO, Myers’s, Seagram’s 83, Seagram’s Five Star, Relska, Yukon Jack, Parrot Bay, Popov, Goldschlager, Piehole, Stirrings, The Club, Scoresby, Black Haus, Peligroso, Grind, Romana Sambuca, Booth’s and John Begg.
Moreover, Diageo agreed to supply five of these brands for ten years each. However, the rest of the brands will be transferred in a year from the completion. The company expects to use proceeds from the divestiture to enhance shareholder value via share buybacks.
Acquisitions to Bolster Market Share
Diageo explores opportunities to expand geographically through acquisitions. In sync with this strategy, the company acquired the fastest-growing premium tequila brand in the United States, Casamigos, in August 2017, which boosted its market share in the tequila category. Further, Diageo enhanced the portfolio with the acquisition of 26% stake in India’s leading brewer, United Spirits Limited (in July 2014), and the premium brand, De Leon Comb Wine & Spirits (in fiscal 2014).
Additionally, the company’s distribution deal with Minnesota-based broker — United Brokerage, Inc. — in 2013 solidifies its position in traditional markets. Moreover, it launched a partial tender offer for Shui Jing Fang (in fiscal 2018), which should expand the company’s shareholding from approximately 40% to 60%. This will enhance Diageo’s exposure in the premium Baijiu segment.
Emerging Markets — Attractive Growth Avenue
Diageo, like most other multinationals, is turning attention to emerging markets. It is the leading international spirits company in the emerging markets of Africa, Latin America and Asia. Moreover, the company caters to local tastes of these regions. Its products like Johnnie Walker Blue Label bottle testify this strategy. It was designed through a series of exclusive private tasting in China, India, Thailand, Vietnam, Brazil and Mexico with local cultural relevance.
Moreover, the acquisition of United Spirits in July 2014 extended its reach to one of the most populous countries, with growing middle class and beer consumption trends. With the opening of the first Johnnie Walker House in Seoul in October 2013, Diageo was able to boost sales in Korea.
Robust Performance & Outlook
Diageo reported strong results for the first half of fiscal 2019, wherein sales and earnings improved year over year. Earnings gained from higher organic operating profit and reduced finance costs. Meanwhile, the top-line improvement was backed by solid organic growth, benefiting from broad-based volume and sales growth across all regions and categories.
Moving ahead, Diageo expects synergies from productivity initiatives to persist in fiscal 2019. The company anticipates net sales growth in the second half of fiscal 2019 to be lower than the first half. However, it now expects organic net sales for fiscal 2019 to be at the high-end of the previously mentioned mid-single-digit growth. Driven by the productivity program, the company expects to deliver on its targeted operating margin expansion of 175 bps for the three years, ending Jun 30, 2019.
How Industry Trends are Hurting Performance
Though these positives are likely to place the company for growth in the long term, inflationary cost pressure from commodity and transportation, and currency headwinds concern investors. During the first half of fiscal 2019, the company witnessed inflationary pressure from commodity costs, including Agave, cereals, utilities and glass. Furthermore, higher transportation costs in the United States slightly offset gross margin gains. Additionally, input cost inflation and higher marketing expenses continued to have a bearing on the operating margin.
Moreover, the company expects inflationary cost pressures from commodity and transportation to continue in the second half of fiscal 2019. This should continue to slightly weigh on the gross margin. Further, it expects operating margin growth to be muted in the second half, owing to the phasing of productivity costs and marketing expenses.
Additionally, as a substantial portion of Diageo’s business comes from international operations, exchange rate fluctuations have been hampering sales. This was clearly evident from the company’s results in the first half of fiscal 2019, wherein currency headwinds impacted sales by £91 million. This was mainly due to the weakening of emerging market currencies, mainly the Turkish lira, Indian rupee and Brazilian real, partly mitigated by the strengthening of the U.S. Dollar. Based on current rates, the company expects currency headwinds to impact net sales and operating profit in fiscal 2019 by nearly £80 million and £10 million, respectively.
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