Diageo Half-Year Earnings: What Lies Ahead?

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Diageo Plc. (NYSE: DEO) posted weaker half-year earnings on January 29, with operating profits witnessing a 11% decline, on a year-on-year basis, to reach $1,839 million. The leader in alcoholic beverages faced challenging circumstances in the six months, characterized by a slowdown in the U.S. spirits market, economic and political stress in Russia, “anti-extravagance” measures in China, and economic turmoil in Venezuela, which resulted in a 2% decline in volumes. The decline came mostly in global brands such as Johnnie Walker, Smirnoff, Baileys, Captain Morgan’s, and Guinness, which account for almost 30% of the net sales. The worst hit among these was the scotch category in general, and Johnnie Walker in particular, which registered a 9% fall in volumes. Even against this backdrop, reserve brands continued to grow by 10% in both developed and developing markets, and present potential for the company in the future. Here are some key highlights from Diageo’s earnings release along with what can be expected going forward.

Trefis has a $119 price estimate for Diageo, which is in line with the current market price. We will be updating our valuation model and price estimate for Diageo to account for the earnings release.

See Our Complete Analysis For Diageo Here

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Innovation And Tactful Pricing To Aid Growth In North America

North America is an important region for Diageo, since it accounts for over 20% of net sales and 45% of profits. [1]  Net sales in the U.S. remained flat, and operating profits registered a 5% decline on a year-on-year basis, even in the face of better economic prospects. This was primarily because of a 9% decline in scotch sales, which was partially offset by further innovations in flavored vodka and whiskey, with Cîroc Pineapple and Crown Royal Regal Apple. Additionally, new launches in tequila under the Peligroso and DeLeón brands, along with Don Julio and Bulleit Bourbon also registered double-digit growth rates. [2]

We expect Diageo’s sales in the American market to improve marginally in the second half of the fiscal year. Although the U.S. spirits market expanded by 1.5% in 2014, the top five brands lost ground and declined by 1%. [3]  This development can be attributed to uneven economic growth, which has been weakening demand among middle-income groups. [4] At the same time, the U.S. spirits market has also been witnessing a high influx of new distillers, who offer more competitive prices in comparison to Diageo. For instance, Captain Morgan Spiced costs 25% more than the leading white rum, Crown Royal costs 10% more than the leading Tennessee whiskey, and Ketel One  costs 24% more than its biggest competitor. [5] The company has indicated more subtlety in pricing of brands such as Smirnoff and Ketel One. Moreover, marketing campaigns such as ‘Gentlemen this is Vodka’ and ‘Exclusively for everybody,’ along with the introduction of new offerings such as Smirnoff Sours, are expected to spur demand.  ((2014 brunch-time calls with Larry Schwartz, President Diageo North America))

The U.S. is also witnessing a shift away from vodka towards whisky, which is set to grow at 10%, with approximately 70% of the growth coming from flavored whisky, and unflavored bourbon, and rye. ((2014 brunch-time calls with Larry Schwartz, President Diageo North America)) Although Diageo holds the dominant position in scotch with Johnnie Walker, it has little presence when it comes to American whisky. [6] However, the end of the fiscal year saw the introduction of seven flavors in whisky between the $14.99 and $24.99 price points. Moreover, Diageo plans to capitalize on the opportunity that exists in the American whisky domain, as evidenced by the higher investments in distilleries in Kentucky and Louisville. [5]  Hence, higher levels of product innovation and better branding, could contribute to sales increases even in whisky.

“Anti-Extravagance” Policies Impacts Volumes In China

Diageo’s performance in the first half of the fiscal year also reflects sluggish growth in its developing markets, especially China. In the last decade, the Chinese beer and spirits market recorded unprecedented growth to be established as the largest in terms of total consumption in the world. Keeping in mind the kind of opportunities the market presented, Diageo became a stake holder in the white spirit (“baijiu”) brand, Shui Jing Fang. The introduction of “anti-extravagance” policies under president Xi Jinping, and a consequent fall in “corporate entertaining and gifting” resulted in a drastic 78% decline in sales of Shui Jing Fang over the last fiscal year. ((How China’s ‘anti-extravagance’ laws left Diageo’s glass half empty)) Moreover, the scotch category, which brings in almost 30% of revenues for Diageo suffered in China with sales of Johnnie Walker Black label falling by approximately 20% over the same period. [7] These factors among others, resulted in a steep 7.4% sales decline in Asia Pacific in the first quarter of fiscal 2015, surpassing analyst expectations of a 4.5% decline. [6] Although net sales of Shui King Fang advanced 25% in the second quarter, scotch sales continued to suffer the perils of the “anti-extravagance” policies, and fell 22%, resulting in an overall net sales decline of 4% in the second quarter. With China’s growth rates projected to fall going forward, it seems highly unlikely that there will be any reprieve for Diageo in the market in the short term. [8]

Currency Depreciation And Economic Turmoil In Venezuela and Russia Impacts Performance

Apart from China, the European market also looks dull with operating profits declining 6% on a year-on-year basis mainly due to the ongoing crisis in Russia. [8] A stagnant economy, trade sanctions on Ukraine, and falling oil prices, has led to major depreciation of the Russian ruble against the dollar. Russia’s heavy reliance on imports has made matters worse by resulting in high inflation. There are no signs of reprieve for the Russian economy in the near future with crude oil prices expected to reach $55 a barrel in 2015. [9] Russia’s economic situation has led experts to revise its growth estimates downwards, signalling to the onset of a recession. This has already led to a 6-7% contraction in the Russian beer market. [10] Moreover, government regulation in Russia along with inflationary pressures hit the alcohol industry the hardest, leading to a 15% price increase, which stifled demand for spirits considerably. However, some relief in this respect can be expected going forward with the state agency announcing an approximate 16% slash in vodka prices come February. [11]

Yet another country hit by falling oil prices has been Venezuela, which receives almost 97% of its foreign earning through the export of oil and its derivatives. [12] Between September and now, the price of the Venezuelan oil fell from $96 to $38 a barrel. [13] The consequent fall in export earnings and the high reliance on imports even for basic commodities led to widening fiscal deficits for the government. In order to finance this deficit, the government resorted to printing more currency, which has contributed to high inflation rates of over 60% along with major currency depreciation. The tough economic circumstances in Venezuela resulted in a 40% decline in scotch volumes, contributing to a 47% decline in Latin America and Caribbean (LAC) operating profits. [8] Economists expect circumstances to get worse in Venezuela, projecting inflation to cross 64% in the coming months. [13] The high prices for basic commodities could adversely impact Diageo’s performance in the market by reducing demand for discretionary products such as alcohol, going forward.

Although Diageo is expected to continue facing tough situations over the next quarter, it can be expected to rebound in the medium to long term. Part of this is because it still dominates the alcohol beverage industry with iconic brands such as Johnnie Walker, Smirnoff, and Baileys, whose competitive advantage is sure to remain for a while. Moreover, proposed higher investments in product innovation and marketing in its bigger markets such as the U.S. can be expected to aid sales going forward.

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Notes:
  1. Diageo Annual Report 2014 []
  2. Interim Results 2015 []
  3. Special Report: U.S. Spirits Market Up By 1.5% In 2014, As Fireball Rises High []
  4. Alcoholic drinks in the US []
  5. 2014 brunch-time calls with Larry Schwartz, President Diageo North America [] []
  6. Diageo sales dip 1.7% amid fierce competition [] []
  7. Diageo Net Profit Hit by China Slowdown []
  8. Interim Results, six months ended 31 December 2014 [] [] []
  9. Short-Term Energy Outlook []
  10. Carlsberg freezes hiring citing tough Russian economy []
  11. Russia slashing vodka prices as economy reels []
  12. Of oil and coconut water []
  13. Oil Cash Waning, Venezuelan Shelves Lie Bare [] []