Diageo (DEO)

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WHAT HAS CHANGED?

  1. Coronavirus and Stock Price
    • Diageo's stock has rallied just over 30% since late March (vs. about 50% for the S&P 500) to its current level of almost $135 (as on 13th September 2020), after falling to a low of $103 in late March as a rapid increase in the number of Covid-19 cases outside China spooked investors and resulted in heightened fears of an imminent global economic downturn. The stock remains about 17% below the $162 level it reached in mid-February. The company’s business has taken a hit due to lower demand and global supply bottlenecks, and this will be reflected in its FY 2020 results. The investors will likely focus their attention on H1 2021 (ending December 2020) results helping Diageo’s stock to remain elevated at the current level, with a full recovery to the pre-crisis level looking unlikely anytime soon
  2. Latest Earnings
    • The company reported its preliminary results for H1 2020 in February 2020. Diageo reported net sales and operating profit growth of 4.2% and 0.5%, respectively. Top-line growth also included slight negative impacts of the sale of a portfolio of 19 brands to Sazerac in December 2018. Organic sales also rose 4.2%, benefiting from broad-based sales growth across all regions and categories, as well as rise in organic volume. This was, however, offset by challenges in India, Latin America and the Caribbean, and weak Travel Retail. Notably, organic volume was up 0.2% and price/mix grew 4%. Volume growth was mainly attributed to rapid growth in tequila, Canadian whiskey and Chinese white spirits. Price/mix was particularly aided by premiumization, improved revenue-management capabilities and sustained innovation, with the launch of Crown Royal Regal Apple and Tanqueray Flor de Sevilla in the prior years. Earnings per share improved 4.2% year over year, backed by higher operating profits and the capital return program. However, Diageo’s stock dipped 1.5% after the announcement as it cut the net sales view for fiscal 2020 on the ongoing trade conflicts in key markets and the spread of Coronavirus in China. The company expects the persistence of increased levels of volatility in India, Latin America and the Caribbean, and Travel Retail to hurt sales for fiscal 2020.
  3. Latest Annual Earnings
    • The company reported its preliminary results for FY 2019 in July 2019. Reported net sales increased 5.8%, with organic growth being partially offset by disposals. Organic net sales growth came in at 6.1% with organic volume up 2.3%, with the growth being contributed by all geographic segments. Organic operating profit grew 9.0%, much better than top line organic growth, driven by improved price/mix and productivity benefits from everyday cost efficiencies, partially offset by cost inflation and higher marketing investment. Basic EPS increased by 7.4%, driven by higher operating profit and lower finance charges, which more than offset an increased tax charge.
  4. Productivity Initiatives Result In Margin Improvement
    • Diageo completed 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 has helped in reducing the overheads as a percent of sales, and this has been a big driver in the margin improvement posted by the company. During FY 2019, the company delivered an organic operating margin expansion of 110 basis points. 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.
  5. Interest Builds Up In The Premium Tequila Market
    • Tequila is no longer an alcohol intended to be hidden in cocktails, and is gaining popularity as a drink to be sipped. This gathering momentum has been evident in the tremendous rise in the sales of tequila, and in particular of the super-premium varieties. The sales of this alcoholic beverage in North America have been growing at a faster rate than the overall drinks market, as the premium brands help to improve the image of tequila. The increasing interest is also reflected in the growing M&A activity in this industry. Recently, Bacardi agreed to purchase Patron Spirits, maker of high-end tequila, valuing the latter at $5.1 billion. This news even sent shares of the Jose Cuervo maker, Becle SAB, to a near-record high. The deal also follows the Pernod Ricard buying out Avion Tequila, and Diageo acquiring Casamigos tequila.
    • Diageo has also had considerable success following the purchase of another super premium brand Don Julio. In FY 2017 (year ended June 2017), the brand reported a net sales improvement of 43%, with organic volume growth of 25%, and organic sales growth of 25%. Tequila represents just 2% of Diageo's sales. However, its organic sales growth of 26% in the aforementioned period, driven by double-digit growth in the US and Mexico, far outstripped the numbers witnessed in its other categories.
  6. Possibility of Entering The Cannabis Space
    • Shares of marijuana stocks spiked amid rumors regarding Diageo's interest in entering the cannabis space. This latest development does not come as much of a surprise and follows close on the heels of a massive $4 billion (~CAD 5 billion) investment by alcoholic beverage giant Constellation Brands into pot company Canopy Growth Corp. Other beer makers are also entering the space, such as Molson Coors Brewing Co and Heineken, in order to produce marijuana-infused beverages. During the company's FY 2018 (year ended June 2018) earnings call, while Diageo's management did state that they are closely tracking the space, no development was reported. However, according to Bloomberg, the liquor giant is in talks with at least three major marijuana producers.

POTENTIAL UPSIDE & DOWNSIDE TO TREFIS PRICE

Below are key drivers of Diageo that present opportunities for upside or downside to the current Trefis price estimate:

North America Revenue per Unit

North American revenue per unit has benefited from the growth in sales of Scotch and North American whiskey. Moreover, the increased premiumization has resulted in improving this metric. Although the revenue per unit underwent a decline in 2015, as a result of intense competition in the spirits market, the figure has rebounded since then. We expect the metric to grow through the Trefis forecast period, driven by the higher sales of premium products.

Asia Pacific Volumes

India is considered a key growth area for Diageo, the main reason the company acquired a majority stake in United Spirits Ltd, and is the second largest revenue contributor to Diageo. Moreover, the stellar performance in China, in particular in the Chinese White Spirits, have helped to spur Diageo's revenue growth. These two markets are expected to contribute significantly to Diageo's fortunes in the future. We expect the metric to increase from 90.5 million units in FY 2018 to 101.92 million units by the end of FY 2026.

BUSINESS SUMMARY

Diageo is a multinational alcoholic beverages company and is the world’s leading premium drinks business. The company is headquartered in London, England and is listed on the London Stock Exchange (LSE: DGE), as well as on the New York Stock Exchange (NYSE: DEO). The company is the world’s largest producer of spirits and a major producer of beer and wine, and its brands include Smirnoff (the world’s best-selling vodka), Johnnie Walker (the world’s #1 blended scotch whiskey), Baileys (the world’s best-selling liqueur), and Guinness (the world’s #1 stout). Diageo is the world’s largest whiskey producer with 28 malt distilleries.

Diageo was formed as a result of a merger between the Grand Metropolitan Public Limited Company (GrandMet) and Guinness PLC (Guinness Group) in December 1997. Diageo owned Pillsbury, which was sold to General Mills in 2000. Moreover, Diageo sold Burger King, the American fast food restaurant chain to a U.S firm, Texas Pacific, in 2002. In 2011, Diageo acquired the Turkish liquor company, Mey Icki for $2.1 billion, and in 2012, it acquired Ypioca, Brazil’s largest selling brand of premium cachaca, for $300 million. In November 2012, the company acquired a 53.4% stake in the Indian company United Spirits for $1.28 billion. The company also has a 34% stake in the Moet Hennessy drinks division of the French company LVMH. Every year, the company produces its brands from 143 sites, selling in 180 countries.

SOURCES OF VALUE

Diageo, which is the world’s largest spirit producer by volume, primarily derives value from its North America segment, which includes U.S. Spirits & Wines, Diageo-Guinness U.S.A. (DGUSA), and Canada. North America accounted for 34% of the company’s net sales and over 49% of the operating profit in FY18. With a majority 55% stake in UB Group’s United Spirits, Diageo accounts for 25% of the global volume share of premium spirits. Global giants represent 41% of Diageo's net sales. These include brand families of Johnnie Walker, Smirnoff, Captain Morgan, Baileys, Tanqueray, and Guinness.

Strong brand marketing and increasing popularity of ultra premium and premium brands to boost Diageo's volumes

Diageo has a premium brand positioning worldwide, with the U.S. being the company's largest market. With an increase in advertising, popularity, and improvement in spending limits, consumers might shift to more expensive alcohol brands, boosting the company's volumes as well as revenues per unit volume.


  1. North America accounts for roughly 20% of the volume share of the company. The company's strong brand positioning in this region is mainly due to its dominance in the vodka and whiskey category, as well as a growing market share in rum. Sales of US Spirits increased 3.3% in FY 2018 (year ended June 2018), 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 4.5%. 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. DEO is targeting the super-premium vodka segment to drive the U.S. spirits performance.

  2. Diageo leads the spirits market in the U.K. and Greece with a 26% and 27% value share respectively. Also in Ireland, Diageo is the second leading spirits brand with a 30% market share closely following Ireland distillers. In Ireland, Smirnoff Red, and Captain Morgan, are the company's top performing brands.

  3. Diageo's Smirnoff vodka brand is one of the top vodka brands in Eastern Europe. Premium scotch and rum brands are also gaining huge popularity in these regions.

  4. In India, Diageo completed its full integration with United Spirits Limited, the largest spirits company to lead the Indian spirits market. Moreover, in Vietnam, Hanoi Liquor Joint Stock Company led the spirits market, where Diageo holds a 45% stake. In Australia also, Diageo leads the spirits market.

  5. KEY TRENDS

    India's growth potential

    India is considered to be a big opportunity for the company and is a key focus area in the medium term. Diageo has made good progress in accelerating growth as it focuses on the long-term opportunity, while mitigating short-term impacts of events and legislation. Net sales improved 9% in India, reflecting an acceleration in the second half of the year. The company's strategy in the country is to grow its Prestige and above brands, which now represent two-thirds of the company's portfolio in the country, and grew 12% in the year. Sales growth and accelerated productivity also helped to improve gross margins in the country by 300 basis points, notwithstanding the impact of inflation and the recently launched goods and service tax (GST). For greater cost efficiency, the company's tram-lining, which involves breaking down the individual costs involved in a product, and comparing them to other products in the market, as well as internal benchmarks, has helped to reduce glass costs, through light-weighting and a more effective sourcing strategy. Furthermore, Zero-based budgeting has reduced indirect costs. While the country is its second largest market in terms of value and volume, the region accounts for only 1.5% of its operating profit. However, Diageo CEO Ivan Menezes expects the margins in the region to improve from the 10% currently to high teens within five years.

    Strong growth in China

    The stellar performance of Chinese White Spirits, which grew a scarcely believable 63%, helped in the 25% sales growth reported in the Greater China region. 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.

    Emerging middle class in Africa

    An emerging and thirsty middle class has made Africa one of the most lucrative markets for the wine and spirits industry, as the market has been expanding at five times the global average, in 24 sub-Saharan African countries, according to IWSR, a British wine consultancy. Furthermore, saturated beer markets across North America and Europe have resulted in breweries rushing to set themselves up in the rewarding, yet risky, markets in Africa. Countries in sub-Saharan Africa are also experiencing significant rates of urbanization, with the U.N. forecasting the urbanization rate to reach 45.9% by 2030. An increasing level of disposable income will be to the advantage of liquor companies, as moving into the middle class allows consumers to go for more quality. Furthermore, while Africans drink nine liters of beer per head per year, the global average is 45. With an increase in disposable incomes, the rate of beer consumption is set to grow significantly.

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