Diageo plc
Q2 2013 Earnings Call Transcript

Published: 31 Jan 2013

[Paul S. Walsh:]

Good morning, and welcome to our interim results webcast. Deirdre and I are going to speak for about 40 minutes on the key highlights of these results. At 9

[Deirdre A. Mahlan:]

Thank you, Paul, and good morning. As Paul said, our half year results again demonstrate the success of our growth strategy. Focus on the strategic brands, on our strength in North America and the increasing presence we are building in the faster growing markets of the world is driving strong top line growth and margin improvement. I'll quickly recap the key performance measures before I go into the detail. Net sales grew 5%, with price/mix the biggest driver. Price made the biggest contribution. Mix impact was limited because despite our strong growth of our reserve brands, up 18% in the half, the weak performance of the Korean scotch market negatively impacted mix. Price, together with procurement savings and the efficiencies we've made in our supply footprint in Scotland, Ireland and North America, drove gross margin expansion of 70 basis points. And that 70-basis-point gross margin improvement, together with the GBP 25 million savings from our operating model review, produced organic operating margin expansion of 110 basis points during the half. We generated strong organic operating profit growth. The 9% growth, together with a modest rise in finance charges, drove a 9% increase in pre-exceptionals EPS. Our free cash flow was GBP 700 million in the half, up more than GBP 125 million from last year, showing the strength of our business across the markets. Now I'll move on to the detail underlying our results. We'll start with volume growth. We produced an overall volume increase of 1%, driven primarily by an 8% increase in strategic brands in faster growth markets. North America volumes also increased despite higher pricing. These increases were largely offset by weaker trading volumes in Western Europe. By category, scotch and vodka were the key drivers. By brand, Johnnie Walker and Smirnoff led the way with the biggest volume growth. We increased North America volumes by 1%. In the U.S., our focus is on the strategic brands. Marketing and innovation were big contributors to growth. The most successful launches were the 2 new Smirnoff confectionary flavors, Iced Cake and Kissed Caramel and Crown Royal Maple Finished. The volume decline we saw in Western Europe is the result of the continued weakness in Southern Europe and France. Volume decline was substantial in Spain at 20%. That was mainly due to customers destocking about 3-week sales. Volume in France also declined over 20%. The decline in France combines both the impact of last year's customer buy-in ahead of the excise tax increase and the decline in consumption following that tax rise. So volume in Western Europe overall was down 5% despite very solid double-digit increases in the Netherlands and Germany. In developed Asia, Korea was down 19% as the whiskey category contracted at an accelerated pace in the half. Diageo's stronger pricing there led to a loss of share. Net sales growth was 5%, driven by 4 percentage points of positive price/mix. The faster growth markets drove the majority of our price/mix benefits, delivering 14% net sales growth there. We got a 2% to 3% average headline price increase across the spirit portfolio in North America. And those price increases, together with favorable mix from the stronger performance of super premium brands such as Cîroc, Johnnie Walker and Buchanan's, led to 4 percentage points of positive price/mix in our biggest market. So North America drove 30% of our total net sales growth and more than 30% of our price/mix. In Western Europe, net sales declined 5%. That was the result of soft volumes and increased price competition, as well as negative channel and country mix. And that was despite 7% growth in reserve brands in Western Europe. The double-digit decline of net sales in Korea, being in a big scotch market, drove negative mix. Price increases we put through in Australia, together with the double-digit growth of beer and vodka in Japan and Korea, did not offset the scotch decline in Korea. Reported net sales were up 5%, in line with organic net sales growth. The 2 percentage points of growth from our recent acquisitions was offset by negative exchange because almost all currencies weakened against the pound. All 5 regions delivered positive price/mix during the first 6 months. Negative gearing in Western Europe was more than compensated for by positive price/mix in the faster growing markets of Eastern Europe and Turkey. Nearly 90% of the positive gearing was a result of more confident pricing across markets. North America and Latin America made the biggest contributions to mix, and scotch was the biggest contributor by category. Net sales from acquisitions are Shui Jing Fang in China, Mey Içki in Turkey, Meta Abo in Ethiopia and our latest acquisition in Brazil, Ypióca. We started to consolidate the results of Shui Jing Fang this period as we gained de facto control of the company at the end of last year through our step-up acquisition. Two months of Mey Içki's performance were accounted for as an acquisition because, as you'll recall, we acquired the company at the end of August last year. As you know, marketing represents our most significant investment. We invest strongly and consistently behind our brands. Our goal is to enhance our brand equities and drive future growth. Again this half, marketing spend was up 5%, right in line with net sales growth. For several years now, we have made significant investments to target consumers in the faster growing markets. But 2 years ago, we accelerated the pace of those investments. This half, marketing spend in faster growth markets was again up double-digit. We are targeting our investment at driving growth in our scotch and reserved brands. In China, we are achieving more critical mass. Investments, such as the 2 Johnnie Walker Houses, allow us to streamline our sponsorship platforms. In North America, our focus is on delivering further efficiencies in marketing investment. These efficiencies have supported significant increases in media spend behind brands such as Ketel One vodka, Cîroc and Bulleit Bourbon. We have also increased our investment behind gin and super premium tequila. Don Julio had its first ever through-the-line summer campaign, which, together with a new gifting platform, drove 9% net sales growth for the brand. Since we changed the operating model, marketing and back-office functions in Western Europe are conducted centrally. The centralization of activities has allowed us to improve the effectiveness of our marketing spend there. We also moved spend from the declining scotch category in France, Greece and Spain to other categories. We're supporting gin in Spain and increasing spend in other markets, like Germany and Benelux, where we still see growth potential for our brands. We reduced marketing in Korea, in line with the net sales decline in scotch, but we increased our spend behind vodka and beer there. In Australia, we spent more on marketing for gin and rum as we recruit new consumers to those categories. Turning now to margin. Gross margin improved on an organic basis by 70 basis points, reflecting pricing and mix improvement delivered by the growth of scotch and reserve brands. Input cost inflation of 4% has been partly mitigated through procurement savings of around GBP 50 million together with production efficiencies from the footprint changes we implemented in the last few years. That's particularly true in North America with our new high-speed packaging lines at Relay and the new rum distillery in the U.S. Virgin Islands. And as a result, cost of goods sold per unit increased by only 2%. I expect the same level of increase for the full year. During the half, we got an operating margin benefit of 10 basis points from marketing spend, but I expect this to reverse in the full year as some of our investments are phased into the second half. We continue to invest in our faster growing markets, but as we reach scale in some of these markets, overheads as a percentage of net sales start to reduce. Margin also benefited from some GBP 25 million savings from the operating model review. However, overheads rose as a percentage of sales in Western Europe, which held back operating margin improvement to 30 basis points. In summary, we have increased our gross margin and delivered overhead efficiencies while investing in the long-term growth of the business. We delivered free cash flow of GBP 708 million in the half, an increase of more than GBP 125 million from a year ago. Higher operating profit and the earlier receipt of the interim dividend from Moët Hennessy were the main contributors to the increase. Together, they drove more than GBP 250 million of incremental free cash flow. The increase in our working capital reflects the continued investment in maturing stock to fuel our future growth in scotch, partially offset by lower debtors, including lower overdue debt in Western Europe which we achieved through strict management of debtors. Higher interest payments were driven by the impact of the renegotiation of certain interest rates swaps in the prior period, while lower tax payments are a result of tax settlements last year. CapEx spend was GBP 271 million during the half. That GBP 271 million reflects investments in capacity in Africa, in efficiencies in North America and Ireland and additionally, in our acquisitions in China and Ethiopia. We will continue these investments, so I expect CapEx for the full year to be above GBP 600 million. As a result of the strength of our free cash flow and current favorable financing conditions, we decided that we will make a contribution of GBP 400 million to the principal U.K. pension scheme. This contribution will substantially reduce the current deficit and will reduce volatility from the group's post-employment plans. It will also have a slight EPS benefit. Despite the increased CapEx spend I just described, I expect full year free cash flow to be only GBP 400 million below last year's cash delivery, entirely driven by the pension contribution. Now moving down the income statement. Reported operating profit was up 9%, in line with the organic operating profit growth. Negative foreign exchange of GBP 41 million and GBP 29 million of acquisition transaction costs were offset by the operating profit of our recent acquisitions. The strength of sterling has a more muted impact in the second half. So for the full year, we estimate that the adverse FX movement will reduce operating profit by approximately GBP 20 million. Associate income was up GBP 6 million, driven by the improved performance of Moët Hennessy but partially offset by Shui Jing Fang moving from associate to subsidiary. Net finance charges and noncontrolling interest remained broadly flat. The reduction in average net debt helped to offset the 20-basis-point increase in the effective interest rate as we moved to a higher proportion of fixed debt last year and as we increased the level of local borrowing, supporting our expansion in the faster growing markets. I expect the effective interest rate to stay at 4.9% for the rest of the year. Operating profit was up 9%. And EPS, excluding exceptional items, was also up 9%. As a result of the investments we have made in the past few years, the faster growing markets now make up 40% of our total operating profit. North America remains our biggest region, driving top line growth and margin improvement. The challenges of Western Europe are reflected in its declining weight, and the most troubled Southern Europe markets now contribute only 5% of the group's operating profit. So as Paul said right at the start, Diageo is a strong business getting stronger. We are strengthening our position as the world's leading premium drinks company with world-class marketing and innovation, stronger routes to market and by making acquisitions in the faster growing markets. We are increasing our investments in those brands and markets that we believe will drive growth. Our businesses are driving efficient growth through our pricing strategy, improved mix and operating efficiencies. Our financial strength and consistently strong cash flow is a real source of competitive advantage. That strength gives us confidence in our 9% increase in the interim dividend and, as Paul said earlier, our ability to reiterate the medium-term guidance we've given you. This is a strong set of results. For the second half, I expect continued strong performance from the faster growing markets and from the U.S. I remain cautious and do not expect a material improvement in trading conditions in Western Europe. Whilst in Korea, I expect some improvement as the price increases we implemented have now been followed by the competition. In support of this, marketing spend in the second half will grow at least in line with net sales growth, while incremental overhead savings from the organization review will be lower in the second half. However, operating margin will continue to benefit from the pricing we have taken and from our supply cost efficiencies. And now I'll hand you back to Paul.

[Paul S. Walsh:]

Thank you, Deirdre. As you've seen in these results, we continue to focus on the 3 pillars of our strategy

[Paul S. Walsh:]

Thank you for your time, and I look forward to you joining our live Q&A session at 9