Diageo’s heroes remain cautious due to the multiple challenges in the “uncertain world” even when its investors are cheering for the company’s impressive performance this year.
Since formed from the merger of Guinness and Grand Metropolitan in 1997, Diageo has been committing itself to building up premium brands and enlarging its size by setting foot in food industry.
With the successful operations on the top lines like Smirnoff, Johnnie Walker and Guinness, Diageo’s venture in Burger King, however, turned out to be its heartburn, rather than exhilarant. The world leading distiller didn’t really impressed the City until two years ago when the company, under the leadership of new CEO Paul Walsh, disposed of non-core businesses such as Burger King and Pillsbury and refocused on quality alcohol brands.
Chart 1: Diageo five years share price changes
This shift is clearly depicted in the company`s five year share price changes. (see chart one) Diageo`s share price climbed up by one third over the last five years, from 750p per share in 2002 to about 1000p now.
The year of 2005 is an obvious turning point. Before that, the share price experienced a significant fall by 40% in the first quarter of 2002 and reached a trough of around 575p in spring 2003. The company then spent two years recovering. Not until at the beginning of 2005 did the share price managed to regain the same level in 2002. After that, the share price grew remarkably by 30% in two years time and hit a three-and-half-year high of nearly 1000p in November 2006.
If the considerable trading volume in 2002 means that shareholders can not wait to sell Diageo`s shares in their hands, the enormous trading volumes in 2005 and 2006 may suggest that the investors have faith in making good money by means of buying and selling Diageo`s value-increasing shares.
This rebound of share price is largely because of Burger King’s sale in 2004. The share price change tells the story that the company’s decision of focusing spirits business has doubtlessly earned the respect of many City followers who admire its size and ambition.
Generally speaking, Diageo has outpaced the market quite nicely in the past five years despite all the ups and downs. As chart one shows, the company’s shares have been trading at a price that is roughly 5% or more higher than that of FTSE 100`s, which strongly indicates that Diageo is likely to be a buy.
Chart 2: Diageo Turnover and Operating Profit Growth Rate
Again, Diageo`s turnover and operating profit growth in the last five years reflect the investors` behaviors in capitalist market.
The total turnover declined dramatically by 18% from ￡10900 million in 2002 to ￡8891 million in 2004. In the following 2005 and 2006 fiscal year, the revenue pick up by 2% and 7% relatively. The revenue decreased by 11% in the last five years.
This is partly due to Diageo`s transformation into a pure drinks company by means of selling its food sections like Pillsbury and Burger King in 2000. Despite the sales made the company’s share price bullish, the overall revenue were in downward tendency due to the lack of food section’s contribution in 2001 to 2004.
However, this did not bother the distiller to increase its turnover of premium drinks in that period, up moderately by 1% to 3% each year. Growth soared by 7% to ￡9704 million in the year ended 30 June 2006, compared to that of ￡9036 million in 2005, thanks to the company’s strong sales in North America and International markets.
Likewise, 2005 is also the key fiscal year for Diageo to turn the table of its operating profit. The company’s operating profit (before exceptional items) had been decreasing for three successive years from ￡2000 million in 2002 to ￡1911 million in 2004. But the figure then increased by 2% and 5% relatively in 2005 and 2006.
This rebound attributes to the significant rises in operating profit of Diageo`s three markets—North America, Europe and International market. In 2006 fiscal year, the profits of both the North America and Europe grow 6% and the figure of International market is 9%. Notably, the profit of the worsening European market rises by 6% while the revenue of this region falls by 1% in 2006, as the result of 4% down in marketing investment.
Besides, Diageo achieves profit growth through successful operating cost control, through which 7% of employees are dismissed in three years time.
The earnings per share show similar changes to the revenue and profit ups and downs. Diageo`s EPS enjoys a rocket rise in 2006 fiscal years through its buy backs programme, increasing by 45% from 46.3p in 2005 to 67.2p in 2006.
While investors have largely chased shares in high-growth companies for the last year or so, the mood is now shifting in favor of steady companies with strong cash flows. Diageo produced free cash flow in 2003, as well as paying out a very responsible dividend through its buy backs scheme. Hence, even though earnings growth is not impressive enough in the last five year, the group can still attract the City followers` attention.
The company is likely to continue fueling its buy backs scheme through strong cash flow. Paul Walsh, the chief executive officer of the company, promised to increase shareholders benefits with￡1.4 billion buy backs in 2007 fiscal year.
Chart 3: Geography Sales Comparison
Despite the good news from buy back programme, the investors should bear in mind of a variety of factors that may influence the company’s performance, such as economic and political conditions of different markets (terrorism, airport, Lebanon), substantial competitors, consumer preferences, changes in the legal and regulatory environment and so on. Geographic revenue growth and brands strength, among others, are the keys to boost Diageo`s capitalist market.
Diageo`s shareholders may be somewhat disappointed by the 7% organic sales growth forecast of 2007 fiscal year, which is in line of this years performance, announced by Mr. Walsh in August. But the cautious estimate comes for reasons.
North America has been Diageo`s single profit growth contributor for the last five years. However, the profits from this market were hit by rising oil prices and the impact of last year’s hurricanes in the southern states. What’s worse, the slowdown of America’s economy and weak greenback hit revenue and profit growth and are likely to post serious threat to the company in the future.
European and Ireland, in contrast to North American market, has long been Diageo`s hard nut to crack. Ireland is suffering due to the combined pressures of a smoking ban in bars, increases in duty and a shift in drinkers` tastes away from Guinness. Continental Europe is also difficult. Sluggish economic growth, weak consumer spending power and stiff competition from cheap own-label spirits is holding back consumption. The group had also been hit by the downturn in ready-to-drink volumes.
Duty-free sales of International market, which were showing strong double-digit growth before, are hit by terror alerts in August and new airport security measures. Its sales are not better than flat now.
Besides, the company suffers from changes in legislation and fierce competition. In recent years, there has been increased social and political attention directed to the beverage alcohol industry. At least nine nearly identical putative class actions are pending in state and federal courts in the
United States against Diageo. Pernod Ricard, its major rival, took over Allied Domecq last year, which has brought together two rivals.
Although all these downsides make Diageo`s leaders tread on eggs, there are optimistic aspects for its shareholders to hold on to. Turnover of International market, as chart 3 shows, contributes 29% of the distiller’s premium drinks revenue in 2006, 3% increase in contrast to that of 2004, offsetting the 3% decline of share in Europe. The fast-growing BRIC regions become Diageo`s increasingly significant growth engines. It is benefiting from its investment in emerging markets such as Russia and China, where its sales increased 80%. Mr. Paul Walsh expects sales to those countries to be“extremely profitable in the future”, sales volumes in the BRIC markets could double over the next few years.
To be fair, as in a mature, low-growth consumer goods industry, Diageo is performing pretty impressive in 2006 fiscal year. Taking into account its incomparable market capitalization, dividend yield, the industry-leading position, and the well-known brands, such as Smirnoff, Johnnie Walker and Guinness, Diageo is likely to be the investors` way to go.
For the fist time after it shed excessive fat and craving for a focused spirits business, Diageo finally shows some signs of strong growth and outpaces its rival Pernod in recent two years. Facing the same extrinsic uncertainty such as political and economic conditions, the drinks giant seems to outperform others a little bit due to its big size and spadeful of world famous brands. It is now just about to get back on the track of world leading distiller that is worthy of its name.(1526 words)
