Investment Column: Diageo looks set to succeed

The merger of Grand Metropolitan and Guinness to create the biggest drinks company in the world is set to revolutionise the industry and has sent competitors scurrying into huddles to talk about their own mergers. But now Diageo has finally been born should investors enter into the spirit of things and buy the shares?

Prompted by the pedestrian growth in the world's spirits markets, the deal is all about cutting costs. Diageo has already said it will chop pounds 195m off overheads but the final figure promises to be much larger as the two groups get down to the nitty-gritty of restructuring the business.

Critics point out that once the shake-up is finished Diageo will just be left with a bigger slice of a stagnant industry. However, after seven months spent negotiating the regulatory maze, the US and European competition authorities have let Diageo off lightly. The group has been allowed to keep the most powerful array of brands in the industry and an unrivalled distribution network, leaving it well placed to continue to pick up market share and gradually put up prices.

Elsewhere Diageo's growth prospects also look attractive. Pillsbury, the US food business, is benefiting from a buoyant local market, Guinness is growing strongly internationally and Burger King is still winning the burger war against McDonald's.

One dark cloud is the financial crisis in the Far East. The economic slowdown in Asia will hit spirits sales, which analysts reckon could wipe pounds 70m off profits this year. That should be put in the context of a group expected to make annual profits of nearly pounds 2bn a year with less than 10 per cent of business coming from the Far East.

Guinness and GrandMet shares rose by more than a pounds 1 to top 600p when the merger was announced in May. However, turmoil in the Asian markets has seen the price drift downwards and Diageo shares opened at 591.5p and slipped another 9.5p yesterday to close at 580.5p.

Merrill Lynch forecasts pre-tax profits of pounds 1.8bn next year and pounds 1.9bn in 1999, putting the shares on a prospective p/e ratio of 17, falling to 16 the year after. That rating is more than justified, given that Diageo should be able to keep earnings growing at more than 10 per cent a year and the prospect that its strong cash flow will allow more share buy-backs. The shares look good value.