Diageo plc (DGE) Ordinary 28 101/108p

Diageo reported half-year net sales of $11.0bn, down 0.6% on an organic basis. This decline was largely driven by a 23% fall in its Latin America and Caribbean (LAC) region, where customers have been consuming less and downtrading to cheaper alternatives. Trading remained positive across the group's other key regions, largely driven by price hikes.

Operating profit came in 5.4% lower at $3.3bn, driven by the decline in the LAC region which is one of the group's higher-margin markets.

Free cash flow improved from $964mn to $1.5bn, due to improved cash generation from operations. Net debt rose from $17.8bn to $20.0bn.

In the second half, Diageo expects organic net sales and operating profit growth to improve compared to the first half. Medium-term guidance has been maintained, with organic net sales and operating profits both expected to grow in the 5-7% range.

The group declared an interim dividend of 40.50 cents per share, up 5.0%. Share buybacks totalling $0.5bn were also completed in the first half.

The shares fell 3.1% following the announcement.

Our view

After a profit warning back in November, Diageo's half-year results didn't throw any more curveballs at investors. Performance has continued to be held back by its Latin American and Caribbean (LAC) region, where sales have been much weaker than originally anticipated.

Against a tough comparable period, sales in LAC dropped by a staggering 23% as customers here have been consuming less and trading down to cheaper alternatives. Given that LAC is one of its higher-margin territories, it's having an exaggerated impact on the bottom line with first-half organic profits falling at mid-single-digit rates.

The outlook in LAC remains murky, so medium-term operating profit guidance has already been wound back slightly from 6-9% to 5-7% growth. Improvements in this market will be key to help restoring margins but we expect challenges in the region to persist, putting a cap on profits in the near term.

Trading across the group's other main regions has remained positive. Diageo's been leaning on its brand power to help push through price hikes. Last year, the 7.3% higher average prices only led to a small drop in volumes - testament to the impressive catalogue of brands like Guinness, Tanqueray, Don Julio tequila and many more.

Whisky is also in the portfolio and is an especially attractive market because it takes a lot of up-front investment and time for a newcomer to compete. Good whisky needs to be aged, so a new competitor would need to be comfortable waiting for their investment to pay off. Alternatively, they could buy existing distilleries and spend heavily on marketing, but scaling up would be difficult and expensive. Strong brands and barriers to entry have meant attractive margins in normal times.

Diageo's focus is to premiumise its portfolio, offloading a selection of smaller brands to shift the dial towards sales of more lucrative products. That's served the group well in the past, as consumers willing to spend money on premium brands have tended to be more resilient to cost-of-living pressures. But with volumes beginning to stutter, we're seeing the rate of price hikes easing.

The group's inventory levels are being right-sized after the group built them up to avoid future supply chain disruptions. That's boosting free cash flow in the short-term, and helping to fund shareholder returns. As always, there are no guarantees.

Improvements in the LAC market will be key to future margin expansion but to a large extent, that's outside of Diageo's control. And we can't rule out consumer weakness in other regions while economic conditions remain challenging. The group has a world-class stable of brands to fall back on, but investors will need patience to ride out the uncertainty and there are no guarantees.

Environmental, social and governance (ESG) risk

The food and beverage industry tends to be medium-risk in terms of ESG though some segments like agriculture, tobacco and spirits fall into the high-risk category. Product governance is a key risk industry wide especially in areas with strict quality and safety requirements. Labour relations and supply chain management are also industry wide risks, with other issues varying by sub-sector.

According to Sustainalytics, Diageo's management of ESG risk is strong. The group aims to achieve net zero emissions by 2050, or sooner, with Scope 1,2 & 3 emissions targets in place. Diageo has set water reduction targets and deadlines, however, it does not disclose its initiatives to achieve this and there is no external certification for its environmental management activities.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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