Morgan Stanley recommends 'overweight' rating for Diageo

Morgan Stanley issued an ‘overweight’ rating on Diageo on Tuesday, saying the company was its “top pick” among beverage makers.

The financial services firm said it expects Diageo to increase is its share in the US spirits market and demand to pick up sharply in Asia and Latin America.

“Diageo continues to deleverage and focus on its core spirits portfolio. This leads to +6% organic sales growth in full year 2016 and 8% organic earnings before interest and tax growth (EBIT),” said Morgan Stanley analysts Olivier Nicolai and Richard Felton.

The analysts said the maker of vodka brand Smirnoff should see EBIT margins improving 100 basis points between 2017 and 2019 following a £500m cost savings programme in July.

They also expect positive transactional foreign exchange in the US to add £60 to EBIT before reinvestment as they estimate 55% of Diageo's sales are imported products.

The strong balance sheet, with net debt expected to fall in 2016, also offers buy back optionality in the next 12 months, they added.

“We are 5% ahead of consensus for full year 2017 and believe earnings upgrades should trigger a re-rating. Diageo trades on 18.5x calendar year 2017 price to earnings ratio and offers 5% free cash flow yield and 3% dividend yield.”

Morgan Stanley set a target price of 2,200p, based on a discounted cash flow valuation in which they assume a 6.5% weighted average cost of capital and a 1.5% terminal growth rate.

Shares fell 0.26% to 1,892.50p at 1028 BST.