Diageo PLC (DEO) 2008 Q2 法說會逐字稿

Good day and welcome to the US analysts and investors conference call of Diageo. For your information, today's conference is being recorded.

At this time, I would like to turn the call over to your host, Mr. Paul Walsh. Please go ahead, sir.

Thank you, Operator, and good morning, everyone, and thanks for joining us. What I'd like to do is give a brief overview of the results that we announced this morning, and then Nick and I will take any questions that you may have.

In a difficult environment, Diageo achieved 3% organic net sales growth, 6% organic operating profit growth, and 21% reported EPS growth. Organic marketing spend decreased 1%, as cost efficiencies were delivered from media-read deflation and spend behind ready-to-drink brands was reduced. Operating margins improved a further 40 basis points.

We've generated strong free cash flow and returned GBP879 million to shareholders, while maintaining our strong financial position. And again, we have increased our interim dividend by 5%. Our brand additions, Ketel One Vodka, Rosenblum Cellars, and Zacapa Rum increased reported net sales by GBP97 million.

If we move to the regions now, in North America, as a result of consumers switching to premium and standard brands, we changed our focus. In the Super and Ultra Premium segments, we focused spend on Ciroc and Don Julio. And in the Premium segment, we increased spend behind our key brands of Smirnoff, Jose Cuervo, and Captain Morgan. The strength of these brands in our Premium Spirits category was the key driver of first-half performance in North America.

While US spirits industry volume growth has slowed, Diageo maintained its 30.4% share and continued to outperform major competitors, delivering volume growth in spirits, excluding ready-to-drink, of 4%. In beer, we have outperformed the import segment, but we have seen some pressure in Guinness, with the shift to the off-trade.

In ready-to-drink, the market remains tough, and we have lost some share. In wine, we faced a challenge, as consumers have been trading down. And as you know, our wines are more premium. Ready-to-drink volumes declined by 12%, driven mainly by the planned stock reduction in malt beers ready-to-drink products and the overall decline in the segment. The introduction of three new Smirnoff Ice flavors and the success of Smirnoff cocktails led to a mix improvement, as net sales decreased by 10%.

In some of our largest markets in Europe, we faced a weakening economic environment and to succeed in this environment, we will focus on the momentum we have in our core mainstream brands. The weakness of the Spanish economy and the impact this has had on consumer demand and customer confidence, had a significant impact on regional performance, with organic operating profit in Europe declining 4%. However, in Russia, a good performance from Johnnie Walker Red and Black Label grew net sales. And in continental Europe, our focus on the biggest growth opportunities for our brands has again delivered top line growth.

The weakness of the beer market in Europe had a negative effect on our performance, although Guinness gained share, both in Great Britain and in the on-trade in Ireland. Spirits brands performed well in Great Britain, especially Smirnoff, Bailey's and Bell's.

Strong performance in Africa and price increases across the Scotch brands in both Latin America and Africa, drove net sales growth up 11% in our international business. The outstanding growth of Guinness in Africa with net sales up 25% and growth in Scotch brands in Latin America, net sales up 5%, were the key drivers in the region.

Operating profit remained at 4% in Latin America, due to tougher economic conditions, but fell slightly in global travel retail in the Middle East. Ready-to-drink volume increased by 1%, and net sales grew 12%, with price increases on Smirnoff ready-to-drink brands in most markets, and volume gains in Latin America, especially Brazil, and in Nigeria. Volume growth in Brazil, Nigeria and duty-free offset a volume decrease in South Africa.

In Asia-Pacific, volume declined 8%, yet net sales grew 2%, as we have seen the benefit of the return to our own in-market distribution in Korea, as that offset the fall in ready-to-drink in Australia, as a result of the duty -- excise duty increase. In the rest of Asia-Pacific, our Scotch pricing strategy led to lower volumes, but net sales increased.

In China, India, and Vietnam, we accelerated our growth and grew share. Growth in China and India has driven overall net sales growth in the region of 2%.

As I said this morning, despite more uncertainty about the wider economic environment, we believe we can deliver organic operating profit growth for the full year in the range of 4% to 6%. And we will continue to preserve our advantaged financial position, and would not envisage reopening the share buyback program in the current calendar year.

I will pause there and open the lines for any questions you may have.

(Operator Instructions). Todd Duvick, Banc of America.

Good morning, gentlemen. I wanted to ask a couple of questions on the balance sheet, if I may.

Nick, looking at the debtline, I guess the first thing that I saw was reported debt was about GBP11 billion. And then in some of the comments, you said that adverse exchange rate movements accounted for about GBP1.5 billion of that. So, I guess what I'm trying to get to is, is there a large mark-to-market impact on the balance sheet? And could you just kind of walk me through that?

Well, our reported net debt as we would measure it, i.e., net of cash at the end of the year, was about GBP8.4 billion. And the biggest -- you may recall at June of '08, i.e., the end of our last financial year, we finished with about GBP6.4 billion of debt.

The biggest driver of our increase, whether you measure against June or the previous December, is indeed exchange rates, which have added well over GBP1 billion of apparent, if you like, debt on the balance sheet. In addition to that, of course, there has been what I'll call a real expansion in debt, due to the share buy back program that's happened and indeed, year-over-year, due to things like the acquisition of Ketel One.

So we've had some factors that were exchange rate-related. We have had some real expansion factors. And clearly, we've offset those with some free cash flow. But the number to focus on really, in terms of pure net debt, is the GBP8.4 billion that we sit with at the end -- or we sat with at the end of December.

Okay. No, that's fair enough. And then I guess, Paul mentioned about the pause on the share buyback program -- not planning to buy back any shares in 2009. And you will be generating free cash flow. And I think I heard -- or saw some comments from the previous conference call intimating that your plan for the free cash flow this year was to stockpile cash on the balance sheet. Can you confirm that or clarify your plans?

Well, what we did say earlier this morning was that at the moment, we're minded to, if you like, preserve a relatively advantaged financial position. We feel certainly relative to the sector, we're in very good shape in terms of our balance sheet strength. And, if you like, we phrased this as moving from balance sheet efficiency to balance sheet strength. And part of the reason for the share buyback program was to maintain an efficient balance sheet. It was, obviously, also partly because we thought there was great intrinsic value.

In today's world, we feel that our investors and our stakeholders really value Diageo being financially in a strong position. And therefore, our conclusion of all of that thinking was that we would stop the share buyback program and make sure we maintain financial strength.

I think it is true that in the current environment, therefore, if you look at our total dividend payment, even after funding all the things we want to fund in the business, we should have the ability to slowly pay down debt in the absence of any other activity. So, that is all part of our desire to remain financially very strong in these very turbulent times. So, that's kind of how we're thinking about managing the business right now.

Okay. And then just one final question and I'll turn it over to someone else. I saw in the balance sheet section of your write-up statement that I have heard you say many times about your credit ratios, keeping them in line broadly with the A rating category. But the next sentence was a new one -- to me, anyway -- and it may be a pragmatic thing, something that you've had as a policy for a long time, but it was a bit alarming to me. And it basically was talking about strategic initiatives, which I took to mean potentially acquisitions, and for the right strategic initiative, it could have an impact on your credit rating.

Can you just clarify if this is a change in your thinking and policy or just provide a little more color around that statement?

Yes, I mean, we certainly don't think it's a change in our policy, or indeed our thinking, and we have said, and I know Paul has said many times before that, while we have targeted for a long, long time the Single A credit rating and we know that's kept us in a very healthy financial balance sheet position, for the right strategic acquisition, we would certainly consider using some of that balance sheet strength.

And we have said -- that doesn't mean, by the way, a sort of bolt-on acquisition. We don't want our balance sheet or our ratio kind of drifting away for a relatively small bolt-on type acquisition. But if something came up that was strategically so important to Diageo that we wanted to get it done, would we consider flexing our balance sheet strength? We have said that. Now, that doesn't kind of pre-define the outcome at all, but it does say we would consider doing that.

Now, we also usually say, in that same conversation, that there are probably relatively few things that fit into that category. And you've heard us say before that, given our size and given the competition considerations, really there are few things that fall into that category, et cetera, et cetera.

So it isn't actually a new statement. I think it is probably something that we're now kind of adding, if you like, to our disclosures just to be very clear about it. But we have said it many times before; but it really is around something strategically significant to Diageo.

Okay, that's helpful. Thank you very much.

(Operator Instructions). Del Warmington, Delwar Capital Management.

Hi, gents. A quick question on a tax rate. It's now 15%. Should we project that as a tax rate we should use going forward for the rest of '09?

From the full year '09, we're actually expecting it to be 17%. That is, of course, what we call the reported tax rate. We also try and give you what we think is an underlying tax rate, i.e., the rate that you could project forward for a longer period of time.

And that underlying rate we are bringing down, if you like, in this guidance from 25% to 24%, and bringing the underlying cash tax rate down to about 20%. The 15% that we reported in the half is, indeed, just that -- the reported number, and we expect that to be about 17% in the full year.

Okay. Also, in your beer sector, could you review the performance? I mean, particularly as it relates to Guinness and Red Stripe?

First of all, Guinness did very well, sales up overall 7%. That's despite quite a large presence in the UK and Irish beer market that is in decline. Even the -- even in those markets, though, we are gaining share.

Spectacular performance in Africa, up 25%, and also in Southeast Asia, where we were in the mid-teens by way of growth. I'm just looking for the Red Stripe performance -- that was up 12%. So, we're pleased with our beer performance.

Okay. Thanks a million.

[Ellie Sandia], Prudential.

I just wanted to ask you a question regarding the cash on your balance sheet. I know in the fourth quarter, you did two bond offerings -- one was $1.5 billion in US dollars and the other one was EUR1 billion in euros. And that's all sitting on the balance sheet. I only see around $700 million of US dollars maturities in '09. So, I was just wondering, what is the use for this cash flow or what is the anticipated use for this cash that you have raised?

You're right to point that out. We did take the decision in the fourth quarter to effectively pre-fund some of the things we knew we'd need to do in '09. We were concerned that the long-term liquidity, if you like, in the debt markets might dry up. And therefore, we took the opportunity to do those two bonds issues.

We do have maturities, as you rightly pointed out, and of course, we will have a requirement to pay the dividend, which in total throughout the year is more than GBP800 million. So, another $1.2 billion.

So, it really was a relatively defensive action to make sure that we have the liquidity when we could get it. It is sitting on the balance sheet right now. And it will be used, if nothing else, of course, for the dividend payments and the maturing debt profile. So we feel we're in a good position from a safety and liquidity perspective.

Okay, thank you. That was very helpful.

Thomas Russo, Russo Gardner.

Hi. It's Tom Russo, Gardner, Russo, Gardner. Nick and Paul, good morning. Nick or Paul, in the earlier call this morning, you referenced a sharp increase in the use of digital advertising, especially in China and Asia. I'd like you to describe for us just exactly how that's being allocated, directed and then what kind of returns you're seeing from that effort.

First of all, Tom, you're now seeing massive increases in the number of consumers that can access 3G. And with 3G, you basically get a bigger pipe, and therefore, the content that you can deliver is far more sophisticated, far higher quality, and relatively low cost, very, very low cost.

The question that's been on our mind is we know that we can attract the consumer, but how sticky is the messaging through that particular medium. The more we test our way into this, the more encouraged we are. But with that 25 to 35-year-old consumer, this is the medium of choice and therefore, we have to be there.

We are seeing very good return rates. Don't want to publicly say what they are, as it informs benchmarks for our competition, but it is a better return at the mainstream medium. And it is very inexpensive, both from a delivery point of view, but also from a creative point of view. You simply don't have the high creative costs that you have with traditional TV or even outdoor advertising.

So that's what's going on there. That, coupled with -- and by the way, I would say we're seeing about 40% of our above-the-line in Asia will be dedicated to that particular medium.

The other thing we're seeing in the world of advertising is real-time deflation. It varies by channel and it varies by market. In some markets, it's as high as 20%. In the US, I think we talked about 11% media deflation. And we are accessing that very aggressively, and that will serve as well in the balance of the year.

When you actually look at our spend, even though the reported figure is negative 1%, when you back out ready-to-drink, we're actually looking at about a 3% absolute increase for spirits, and that would translate into more activity. So we are confident that our share of voice remains very robust.

And then the other thing you referenced was the recruitment and on premise. And how are you finding those dollars to yield returns?

We are finding it very real, because that is something that you can measure very quickly. And by targeting our funds to specific outlooks, we get a very real, very immediate return.

And it's interesting, in certain markets in Asia, even though maybe the sort of Pearl River Delta part of China is soft, the more northern cities are still vibrant. And we still think there's a lot of growth to be tapped in those cities.

Great. Paul, you referred to do the trade de-stocking really almost around the world. We'd seen sort of a rise from the credit crisis and the impact on retail. Talk for a moment about what you see as that de-stocking resolves itself over time. You're clearly going to have to ship back to normal levels plus demand at some point. And have you seen any evidence of that? Or how will that play through your own inventory plans?

I would say, first of all, Tom, you've seen de-stocking at both the distributor level -- and I mean, excluding the US here -- and you've seen it at the retailer level, and I am including the US in that statement.

The guise of that de-stocking comes in two forms. One is distributors -- in Spain, for example -- just redefining their business model because of their lack of access to credit or their desire to be more efficient.

The second leg of the equation is where we have, of our own volition, elected not to ship product because we are very worried about the creditworthiness. And you've heard me say many times that we would rather take the pain today in the P&L than store up problems for tomorrow on the balance sheet.

So, simply shipping product that books a sale today that results in a debt write-off next year is not where we want to go. And that is why you saw a run-up in our inventory on the balance sheet, because we had a lot of product on credit hold at the end of December.

Our assumptions going forward, I think, are prudent insofar as that we do not expect these inventory levels to be replenished in the near-term. We think those successful distributors and retailers will manage with what they've got because debt is costly, and they will put more demands on us to service them in a more efficient manner. And therefore, our working assumption is that we will have to -- we should assume no snap-back on inventory levels.

What it should do is progressively give us more visibility on consumer uptake. So longer-term, this is no bad thing, but it's certainly created some pain in the short-term.

Thank you very much.

(Operator Instructions) [Mike Larushell], Loomis, Sayles.

It's another dead guy, right?

Mr. Duvick, your line is now open.

Hello?

Hello?

Oh, I'm sorry. I thought that was for someone else. Can you hear me?

We can hear you.

Okay. I apologize. I wanted to follow up with a question on what has been reported in the news about talks with United Spirits. Can you tell us anything about those discussions, confirm whether or not you've had discussions, and if those discussions are for a potential stake in the Company or considering a full acquisition? Anything you can tell us.

Okay. I do have to be cautious, but -- as there has been a lot of media speculation, let me try and clarify the situation.

First of all, we have said that we would like to increase the size of our footprint in India. We believe that there are certain opportunities of which USL is but one, to increase our distribution capability. However, to speculate that we are near to any kind of transaction is premature, very premature.

And clearly, given the nature of the market, given the nature of the company that is being referred to, we will not be rushing this. We will make sure that we exercise full due diligence and research all our options. So, I think what I'm saying is, the press exaggerates the development of the thinking.

Okay. That's fair enough. And then, I guess, just switching back to one additional note on the balance sheet, an earlier caller had asked about the use of cash. And I just wanted to clarify -- it sounds like you've got the flexibility to pay down notes as they come due this year, and that we should probably not -- absent any acquisition or other event -- we should not expect additional issuance in the debt capital markets in 2009.

Possibly, although because, again, as I think we said earlier, we're always trying to keep, as you are, a watchful eye on the development of the access and, clearly, pricing in the long-term debt markets. If we thought that, at a particular point in time, that was very favorably placed for us, both in terms of liquidity and price, we would certainly consider the option again of staying ahead of the curve.

I think the idea that we would only fund when we have to, i.e., when there's a maturity, for me, puts us rather at the kind of exclosure of circumstances and rates and liquidity at that point in time. So, I think one outcome is clearly that we don't have to fund until the next maturity or even the next maturity beyond our fiscal '09 year.

But again, if we thought it was a great time to do so for Diageo, then we wouldn't be adverse to getting ahead of the wave again. So, I think we've got -- all of those options are opened for us.

Okay. And it looks like with the -- I guess you'd be talking about the $1.9 billion of borrowings -- or GBP1.9 billion of borrowings due within a year, that could be -- lead to some potential issuance to term some of that out, is that correct?

Absolutely. That would be the number one priority, yes.

Okay. Very good. Thank you so much.

[Mike Larushell], Loomis, Sayles.

Hi, guys. My questions were just answered. Thank you.

Jeff Kanter, UBS O'Connor.

A question for you all. So, you had 6% organic operating profit growth in the first half. And now it's 4% to 6%. Can you just explain what the deltas are to take you to a much slower second half relative to the first half, that's baked into your guidance? Can you be a little more specific, please?

Are you talking about raw numbers? Do you want the arithmetic or the circumstances?

The circumstances, please.

I think, first of all, let me say that it's very difficult in the current environment to offer guidance. However, we felt that not offering guidance would create far too wide a range of outcomes. And therefore, coming off what we feel is a strong first half, we had the confidence to give the range that we gave.

That said, there is no question that sort of late November and through December, we saw some deceleration in momentum. We felt that the de-stock situation that was quite apparent, we could not assume that there would not be further pressure around trade inventories as the year unfolded, and therefore, we have some caution over the next four months.

All that said, we are confident that we can orchestrate growth and therefore, that is what has led to the 4% to 6% range.

Okay. And that's prudent, but just to kind of dive, perhaps, a little bit deeper into the de-stocking, how much -- the de-stocking is a function of just inventories that were just too high? Or is it just that demand has fallen off? Or a combination of the two?

Because, obviously, we see your shipment trends in your release, but we don't see your consumption trends. So, is the change in guidance just for what's going on in the chain to the consumer? Or is it based on the consumer itself?

I think it's a combination. The reality is that we are concerned that we are seeing softening consumer confidence. Many distributors are highly fixed cost operations. And if you look in Spain, when you've seen the magnitude of fall-off in demand, their infrastructure is not capable of variable-izing costs at the speed they need to. And that puts them on the edge of viability. And as I said earlier, that's why we have not shipped to them.

But when you look at the trends that we are anticipating in the balance of the year, it is born of further weakness in consumer, but still growing in aggregate, and the potential for further de-stocking at the distributor level.

Okay. Understand. And just another question, please. Where are your -- how have your share trends been in your regions? Because the investment community obviously is very, very upset with the change in guidance. But I kind of think that share trends and reinvestment in difficult times kind of matters for the longer-term. So, if you could discuss share trends, either by region or in key markets, that would be helpful.

Well, I'm very upset about the deteriorating state of the global economy; hence, why I've had to revise guidance.

The reality is that our shares are very healthy. If you look in the US, we are the only company to have held marketshare at 30.4%. All the full-line spirit suppliers have seen share loss. And we have built share at the Premium -- in the Premium segment. We've seen about 20 basis points.

If you look in many of our markets, we are holding or gaining share. Sure, you can find some markets where we may be modestly losing share, but in the aggregate, overall, I am very confident of our share position.

Okay. And just last question, perhaps I missed this -- what was your -- the rationale for suspending the share repurchase? Is it just simply the uncertainty of the global environment?

Absolutely. We're moving, in our language, from balance sheet efficiency to maintaining our balance sheet strength. And we think in the current environment that's appreciated by all of our constituents and stakeholders.

Okay. And how do you think about currencies? Obviously, it's a tailwind to your earnings line, and it's a headwind for many of your competitors that are located here in the United States. So, do you -- will you use currencies as an advantage to increase share voice, if necessary? How do you kind of think about that?

First of all, you have to recognize that there is a competitive set. There is a category dynamic around pricing. And therefore, as we've had some currency headwind from a sterling perspective, that has not influenced how we run our business in our overseas markets.

On the one hand, you can look at reported EPS of 21% growth and say, that's got some currency benefit in it, clearly have. But it's also real money. It's also real benefit coming into sterling. And it will improve our financial ratios. But as regards actually running the business, we are very minded by the competitive set, market by market. And we all saw, as you've seen in Latin America, feel that we need to watch dollar pricing on a global basis.

Okay. Well, thank you very much, gentlemen.

[Jonathan White], Evergreen.

A couple quick questions. First, just on the balance sheet -- I know you mentioned a couple of times about inventory de-stocking, but the GBP147 million increase or use of cash and working capital, is that where that's primarily coming from?

Yes. I mean, there are two components there. By far, the biggest is the one that Paul referred to, which is our refusal, if you like, to ship some of the stock. That's orders that we've taken and actually produced; but between producing and, if you like, shipping, we decided for largely credit reasons not to proceed. And we do, therefore, have more inventory in the business than we would normally have.

Obviously, our opportunity from a cash flow perspective is to work that out of the business over the next six months. And you can be assured that's our aim.

There is also a small part within that [GPB140-odd million] that is increase in maturing stock of Scotch. And you've heard us talk now probably for almost two years about our desire to make sure that we are building today enough maturing stock for, let's say, 10, 12 years in the future, when we see, overall, a pretty bright future for Deluxe Scotch.

That's not taking away the here and now, and the difficulty now, but we think over the long term, Scotch, particularly Deluxe Scotch, has a very bright future. And we need to kind of lay down for that today. So, some of that GBP147 million is incremental maturing Scotch stock.

Okay. So, if you were to look forward six months from now, you're not expecting a similar use of cash and working capital?

No, because I'm expecting that we will work to take that inventory out and therefore, working capital will be growing more broadly in line with the business. So we shouldn't need to see another, yet another, GBP150 million in the second half, no.

Okay, great. Just one other quick question. And I didn't get a chance to review the call earlier that you did in the UK, but -- the Australian RTD impact, if you could just sort of walk through the mechanics of how that happened, what the impact was in your business.

And then, from an excise tax perspective, when you look globally, are there other areas that you see similar risks to what happened in Australia? And then just risk in general to excise tax increases, given what's going on with the global economy. That'd be great.

Well, first of all, in Australia, I think the industry was quite surprised that the duty increase was as substantial on ready-to-drink as it was. And clearly, we then had to reflect that in pricing, which proved to put the ready-to-drink offering at a very disadvantaged price-per-unit versus other long alcohol drinks, such as beer.

So, we priced to cover the duty and we saw consumer demand contract. We have other things in train to now take costs out of the product -- reformulation, re-packaging, et cetera, et cetera -- that may allow a sharper price point, but that's the situation we found ourselves in Australia.

Regarding duty increases generally, clearly, we are aware that there are many countries around the world that are in need of revenues. But also taxing up alcohol is never very popular with the voters. So they have to be very mindful of that.

Secondly, there is an elasticity issue, whereby do you price it up to a point whereby you don't get the initial return or indeed, it turns negative. Our point of view is that we work very closely with governments. And as long as we can have equivalents -- so, spirits are not penalized versus beer or wine, we think we can weather most of the increases that are being muted.

But the reality is that in many situations, we're able to put a strong cash forward to defeat such tax increases. And recently, in one state in the US, there's been a tax reduction on one category. So, in the round, we think it's manageable, but it's certainly something we've got to pay a lot of attention to.

Okay, great. Thanks very much.

Now we take our last question from Richard Shepley of Deutsche Asset Management. Please go ahead.

Can you gave a little bit more color on the health of the spirits category in the US, and in particular, the pricing outlook for 2009?

And then secondly, just to clarify in terms of your guidance, what are you assuming for advertising or marketing spend for the year as a whole, as a percent of sales or growth in that line? Thank you.

First of all, if you look at the spirits category in the US, it is still growing. Volume growth has moderated from maybe 1% to 2% to about 1%; price mix was probably tracking about 3%; that may have moderated to 2%, but we're still in growth. We still see opportunities for share growth.

I do believe that the pricing environment is going to toughen. I do not believe that that will translate to price reduction, but I think we're going to have to be more mindful of price increases in the near-term. And that's why you've seen us announce today our plans to take costs out of the business -- not only in the US, on a global basis.

I would say the major shift has been from on-premise to off-premise. We're seeing that in other developed markets as well as the US. However, in the off-premise, the scale and breadth of our portfolio, together with our route to market, gives us real advantage. So we are confident in that regard.

So overall, the growth has definitely come off, but it is still in growth and we expect that it will continue to be in growth.

Regarding advertising as a percent of sales, given media deflation, I expect it to reduce marginally, particularly in the second half. We are accessing savings of 10% on average; in some markets, substantially more than that. So we believe that we can actually continue to get more activity with less spend.

Thanks.

With that, can I thank everyone for their support and time this afternoon. And I know that I will be talking to some of you in coming weeks. Thank you.

Ladies and gentlemen, that will conclude today's conference call. Thank you for your participation. You may now disconnect.