MARKET COMMENT
Happy Hour At Diageo

By James Carlisle
November 19, 2002

The market isn't happy with Diageo (LSE: DGE). The drinks group has revealed problems with its Burger King disposal. Weak trading at the hamburger chain has apparently triggered a clause in the sale agreement enabling a renegotiation of the price. Since the problems were first highlighted on 7th November, Diageo has dropped 6% against a flat FTSE 100. However, if you add in the fishy-looking fall on the day preceding the announcement, the underperformance has been around 10%.

Yet the new valuation being placed on Burger King is apparently $1.5m, compared to $2.3b previously. That lost value of $800m, or £630m, represents just 3% of Diageo's £21.5b market capitalisation. So either the newly-touted valuations of $1.5b are still too high (although Burger King would need to be worth about nothing to justify a 10% fall), or there's something else worrying the market, or the price has over-reacted to the bad news.

It's hard to see Burger King as being worth nothing, the flat performance from Allied Domecq (LSE: ALLD) since the 7th November suggests there's nothing much wrong with the sector and I'm not aware of any other specific gremlins appearing from Diageo since then. So I'm going for the over-reaction option.

Diageo now stands on a PE ratio of 15.5 for pre-exceptional earnings per share of 43.6p for the year ended June 2002. Following a poor trading statement on 29 October, forecasts are widely spread for the next couple of years, ranging from 44p to 51p for 2003 and 51p to 58p 2004. But the bottom of the range still shows a little growth and, nearer the middle, you're looking at 10% or so -- bringing the PE down to around 12.5 times for 2004.

Diageo combines defensive qualities with decent prospects for growth. The current valuation may look like happy hour pricing in a few years' time.