Foreign Currency Headwinds Impact Otherwise Upbeat Earnings For Diageo

Diageo (NYSE:DEO) reported organic sales growth of 4.2% in the first half of FY 2018 (six months ended December 2017), beating consensus estimates of a 3.7% rise, stirred on by volume growth and strong price mix, with broad-based growth across categories and regions, particularly of baiju white spirits in China. The company was also able to deliver 81 basis points of organic operating margin expansion, again ahead of expectations, as a result of the productivity work undertaken. These factors, together with lower finance charges, helped in the rise of pre-exceptional EPS by 9.4%. However, the pound, which had been weak since the 2016 Brexit vote — helping provide a boost to British companies that derived a big chunk of their sales from the US, including Diageo — has been resurgent of late, which has, in turn, dampened the earnings. The adverse exchange rate had a negative impact on sales by £134 million, and on operating profit by £15 million. For the full financial year, the company expects a hit of £460 million to its sales and £60 million to the operating profit. On the other hand, the company received a one-time tax benefit of £360 million from the tax cuts implemented by the Trump administration. Below we’ll list some of the key highlights of the half year.

We have a $158 price estimate for Diageo, which is higher than the current market price. The charts below have been made using our new, interactive platform. You can click here to change the different driver assumptions, such as EBITDA Margin and Volumes, to see their impact on the valuation and price per share metric. Please note that we convert the earnings of Diageo from pounds to dollars in our model, and hence, the charts display figures in dollars.

Productivity Initiatives Result In Margin Improvement

Diageo is in its second year of implementing Zero-Based Budgeting (ZBB), as part of its wider plan to be more ‘cost conscious.’  This means that the company’s finance managers will have to plan the budget of various departments from scratch, rather than them being based on the previous year’s spending, as is the case normally. This helped in reducing the overheads, which was a big driver in the margin improvement posted by the company.

Diageo is on track to deliver margin expansion of 175 basis points for the three years ended June 2019. Based on the impressive productivity savings already realized, the company had, last July, increased its savings goal to £700 million from £500 million estimated earlier, two-thirds of which will be reinvested in the business. According to our projections as well, the EBITDA and EBITDA margin growth is set to continue in the medium term.

US Spirits Continues Its Growth

Sales of US Spirits increased 3% in the first half, with the growth slowing as compared to the corresponding period in the prior year, as a result of a tough comparison. The company continued its focus on the recruiting of millennials and multi-cultural consumers, using a mix of traditional and digital channels for marketing. While all key brands were able to gain value share, vodka still remains a weakness. Excluding Cîroc and Ketel One vodka, net sales grew 5.5%. The company is undertaking a number of initiatives to return these brands to positive growth, such as focusing on the three core variants of Cîroc — Blue, Apple, and Peach — and the launch of the new flavor, French Vanilla, and highlighting the fact that Ketel One is 100% non-GMO.

Setbacks In India Impact Growth, Strong Baiju Sales More Than Offset Later Timing Of Chinese New Year

Net sales improved 2% in the first half in India, an improvement over the flat growth reported in the corresponding prior year period. However, the growth was negatively affected by a Supreme Court ruling that prohibited the sale of alcohol within 500 meters of a highway. The company’s strategy in the country is to grow its Prestige and above brands, which grew 6% in the first half, and now represents 65% of its business. Sales growth and accelerated productivity also helped to improve gross margins in the country by 200 basis points, notwithstanding the impact of inflation and the newly launched goods and service tax (GST).

Despite the later timing of the Chinese New year, which was expected to have a negative impact on the sales, the stellar performance of Chinese White Spirits, which grew a scarcely believable 80% in the first half, helped in the 32% sales growth reported in the country. The company had taken a hit in China a few years back as a result of the anti-extravagance drive in the country. However, Diageo has managed to strengthen the business, with improvements noted in the route to market, and the sales and distribution system. While the company cannot be expected to maintain this massive growth in the future, strong double-digit growth can be anticipated, driven by whiskey and its white spirits brands, Shui Jing Fang in particular.

See Our Complete Analysis For Diageo Here

Have more questions on Diageo? See the links below:

• Interest Builds Up In The Premium Tequila Market
• Why Are We Bullish On Diageo?
• Why Is India Considered A Key Growth Market For Diageo?
• Diageo Takes Inspiration From Japan To Revive South Korea’s Whiskey Market

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