diageo - research-doc.credit-suisse.com
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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION®
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29 October 2015
Europe/United Kingdom
Equity Research
Beer & Alcoholic Beverages
Diageo (DGE.L) UPGRADE RATING
Upgrade to Outperform ■ Upgrade to Outperform: We believe DGE's increased focus on volume
growth can help draw a line under two years of earnings downgrades. We
raise our underlying FY17-18E EPS estimates by c2-4%, offset partially by
non-core disposals and FX. We increase our TP to 2100p (from 1780p).
■ Transitioning towards volume growth: We believe DGE's accelerated
focus on mainstream/value spirits is a necessary move to broaden its pricing
architecture, which creates new opportunities whilst addressing consumer
polarisation and the high dependence on premium scotch. After recent
underperformance, execution is the biggest risk, as this emphasis differs
from the previous premiumisation-led model. However, the major
investments in route to market should help address the increased complexity.
■ Margin potential: DGE's evolution comes at a cost – two-thirds of its £500m
gross productivity savings will be re-invested, and there is some negative
mix impact in the short term. Nevertheless, we believe the FY17-19 100bps
margin guidance is at least underpinned by the net savings, with some
potential leeway in the outer years if it delivers on the volume growth.
■ Improving FCF and buyback potential: Operating cash conversion now
has the highest weighting in management remuneration, with the biggest
opportunity in working capital. We estimate £700m, or 12%, potential upside
to our FCF forecasts if DGE can close half the gap versus its consumer
staples peers by FY18. With M&A unlikely and the dividend cover low, we
see scope for share buybacks from FY17 which could be c2% EPS accretive.
■ Scope for a re-rating vs peers: DGE has underperformed its staples peer
group by 15% YTD, and now trades at a 5% P/E discount – successful
execution could lead to a premium rating. This is supported by a 3.3%
dividend yield which, with buybacks, could drive 13% TSR CAGR FY17-19E.
Share price performance
1683
1783
1883
1983
Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15
Price Price relative
The price relative chart measures performance against the
FTSE ALL SHARE INDEX which closed at 3496.19 on
27/10/15. On 27/10/15 the spot exchange rate was £.72/Eu 1. -
Eu .91/US$1
Performance over 1M 3M 12M Absolute (%) 7.4 2.9 4.1 Relative (%) 1.1 6.7 2.0
Financial and valuation metrics
Year 06/15A 06/16E 06/17E 06/18E Revenue (£ m) 10,813.0 10,486.9 10,841.8 11,432.2 EBITDA (£ m) 3,465.00 3,392.93 3,557.83 3,796.31 Pre-tax Profit Adjusted (£ m) 2,829.00 2,828.65 3,051.86 3,323.45 CS adj. EPS (p) 88.47 88.13 94.60 102.30 Prev. EPS (p) — 88.15 94.20 101.10 ROIC (%) 13.46 13.62 13.99 14.59 P/E (adj., x) 21.06 21.14 19.69 18.21 P/E rel. (%) 153.4 134.1 132.5 138.8 EV/EBITDA 18.4 18.4 17.4 16.2
Dividend (06/16E, p) 59.22 IC (06/16E, £ m) 17,985.01 Dividend yield (%) 3.2 EV/IC 3.5 Net debt/equity (06/16E, %) 80.8 Net debt (06/16E, £ m) 8,037.9 Number of shares (m) 2,514.35 Free float (%) 90.81 BV/share (06/16E, £) 3.4
Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates.
Rating (from Neutral) OUTPERFORM* Price (27 Oct 15, p) 1,863.00 Target price (p) (from 1,780.00) 2,100.00¹ Market cap. (£ m) 46,842.42 Enterprise value (£ m) 62,562.4
*Stock ratings are relative to the coverage universe in each
analyst's or each team's respective sector.
¹Target price is for 12 months.
Research Analysts
Sanjeet Aujla
44 20 7888 0353
Pavan Daswani
44 20 7883 0539
Charlie Mills
44 20 7888 0325
29 October 2015
Diageo (DGE.L) 2
Diageo DGE.L Price (27 Oct 15): 1,863.00p, Rating: (from Neutral) OUTPERFORM, Target Price: (from 1,780.00) 2,100.00p
Income statement (£ m) 06/15A 06/16E 06/17E 06/18E
Revenue (£ m) 10,813 10,487 10,842 11,432 EBITDA 3,465 3,393 3,558 3,796 Depr. & amort. (399) (391) (404) (426) EBIT (£) 3,066 3,002 3,154 3,370 Net interest exp. (412) (368) (318) (286) Associates 175 195 216 239 Other adj, — — — — PBT (£) 2,829 2,829 3,052 3,323 Income taxes (466) (508) (569) (628) Profit after tax 2,363 2,321 2,483 2,695 Minorities (87) (89) (100) (117) Preferred dividends — — — — Associates & other (51) (13) — — Net profit 2,225 2,218 2,383 2,578 Other NPAT adjustments 156 (52) — — Reported net income 2,381 2,166 2,383 2,578
Cash flow (£) 06/15A 06/16E 06/17E 06/18E
EBIT 3,066 3,002 3,154 3,370 Net interest (416) (323) (283) (261) Cash taxes paid (489) (508) (569) (628) Change in working capital 117 (53) (171) (209) Other cash & non-cash items 273 442 542 585 Cash flow from operations 2,551 2,560 2,672 2,857 CAPEX (638) (598) (564) (572) Free cashflow adj. (22) (24) (33) (47) Free cash flow to the firm 1,891 1,939 2,075 2,238 Acquisitions (1,283) (140) — — Divestments 978 1,115 50 50 Other investment/(outflows) — — — — Cash flow from investments (943) 377 (514) (522) Net share issue/(repurchase) (7) (5) (5) (5) Dividends paid (1,413) (1,542) (1,597) (1,688) Issuance (retirement) of debt — — — — Other (962) (62) — — Cash flow from financing activities
(2,382) (1,609) (1,602) (1,693) Effect of exchange rates — — — — Changes in Net Cash/Debt (774) 1,328 556 642 . Net debt at start 8,592 9,366 8,038 7,482 Change in net debt 774 (1,328) (556) (642) Net debt at end 9,366 8,038 7,482 6,840
Balance sheet (£ m) 06/15A 06/16E 06/17E 06/18E
Assets Cash and cash equivalents 472 472 472 472 Accounts receivable 2,435 2,377 2,418 2,500 Inventory 4,574 4,679 4,860 5,061 Other current assets 189 189 189 189 Total current assets 7,670 7,717 7,940 8,222 Total fixed assets 3,690 2,972 3,134 3,285 Intangible assets and goodwill 11,231 11,181 11,129 11,074 Investment securities — — — — Other assets 3,213 3,221 3,230 3,240 Total assets 25,804 25,091 25,432 25,820 Liabilities Accounts payable 3,108 3,102 3,154 3,227 Short-term debt 1,921 1,921 1,921 1,921 Other short term liabilities 261 261 261 261 Total current liabilities 5,290 5,284 5,336 5,409 Long-term debt 7,917 6,589 6,033 5,391 Other liabilities 3,341 3,271 3,201 3,131 Total liabilities 16,548 15,144 14,570 13,932 Shareholders' equity 7,771 8,447 9,344 10,351 Minority interest 1,485 1,500 1,518 1,538 Total equity & liabilities 25,804 25,091 25,432 25,820 Net debt (£ m) 9,366 8,038 7,482 6,840
Per share data 06/15A 06/16E 06/17E 06/18E
No. of shares (wtd avg) 2,515 2,517 2,518 2,520 CS adj. EPS (p) 88.47 88.13 94.60 102.30 Prev. EPS (p) — 88.15 94.20 101.10 Dividend (p) 56.40 59.22 62.18 65.29 Div yield 3.03 3.18 3.34 3.50 Dividend payout ratio 63.75 67.19 65.73 63.82 Free cash flow per share (p)
75.19 77.02 82.40 88.82
Key ratios and valuation
06/15A 06/16E 06/17E 06/18E
Growth (%) Sales 5.4 (3.0) 3.4 5.4 EBIT (2.2) (2.1) 5.1 6.9 Net profit (6.6) (0.3) 7.4 8.2 EPS (6.6) (0.4) 7.3 8.1 Margins (%) EBITDA margin 32.0 32.4 32.8 33.2 EBIT margin 28.4 28.6 29.1 29.5 Pretax margin 26.2 27.0 28.1 29.1 Net margin 20.6 21.2 22.0 22.5 Valuation metrics (x) EV/sales 5.9 6.0 5.7 5.4 EV/EBITDA 18.4 18.4 17.4 16.2 EV/EBIT 20.8 20.8 19.7 18.2 P/E 21.1 21.1 19.7 18.2 P/B 6.0 5.6 5.0 4.5 Asset turnover 0.42 0.42 0.43 0.44 ROE analysis (%) ROE stated-return on equity
32.6 26.7 26.8 26.2 ROIC 13.5 13.6 14.0 14.6 Interest burden 0.92 0.94 0.97 0.99 Tax rate 15.9 18.4 18.7 18.9 Financial leverage 1.3 1.0 0.9 0.7 Credit ratios (%) Net debt/equity 101.2 80.8 68.9 57.5 Net debt/EBITDA 2.7 2.4 2.1 1.8 Interest coverage ratio 7.4 8.2 9.9 11.8
Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities
(EUROPE) LTD. Estimates.
1683
1783
1883
1983
Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15
Price Price relative
The price relative chart measures performance against the FTSE ALL SHARE
INDEX which closed at 3480.7 on 27/10/15
On 27/10/15 the spot exchange rate was £.72/Eu 1. - Eu .91/US$1
29 October 2015
Diageo (DGE.L) 3
Key charts Figure 1: Diageo's underperformance has been led by
c30% EPS downgrades over the past couple of years –
increased focus on volume growth and mainstream
spirits could give the business more resilience Diageo consensus EPS revisions – pence
Figure 2: Mainstream spirits can help recruit new
consumers into the category, particularly in emerging
markets – Diageo can leverage its beer business in Africa
to improve scale in mainstream spirits Spirits and beer pricing architecture in Africa indexed to 100
2010
2011
2012
20132014
2015
2016
2017
60
70
80
90
100
110
120
130
140
150
Oct
-07
Mar
-08
Aug
-08
Jan-
09
Jun-
09
Nov
-09
Apr
-10
Sep-
10
Feb-
11
Jul-1
1
Dec
-11
May
-12
Oct
-12
Mar
-13
Aug
-13
Jan-
14
Jun-
14
Nov
-14
Apr
-15
Sep-
15
120
100 100
75
50
0
50
100
150
200>300
Source: Thomson Reuters Source: Company data
Figure 3: Diageo's focus on scotch has been too
premium. Following recent weakness, DGE can use
excess scotch capacity to focus on younger liquids at
more affordable price points (and still good margins) Ratio of scotch industry stock/consumption –years
Figure 4: Diageo's 100bps FY17-19E margin guidance is
underpinned by its net cost savings, with potential leeway
in the outer years if it delivers on volume growth Diageo FY17-19 100bps EBIT margin guidance breakdown - bps
6.0
6.5
7.0
7.5
8.0
8.5
9.0
Margin impact 2017E 2018E 2019E Accumulated Comment
Negative geographic margin mix -15 -28 -26 -69Negative impact of lower margin USL
business growing faster than other regions
USL margin expansion 15 16 12 43Group contribution from margin expansion
within USL (c100-150bps pa)
Net geographic mix impact 0 -12 -15 -26
Gross productivity gains 109 149 175 433£500m gross productivity savings over
FY17-19
Re-investment -73 -99 -122 -2952/3rds of productivity gains re-invested
back into the business
Net productivity gains 36 50 52 138
Mix and productivity impact 37 38 38 112 In line with company target of 100bps
Volume leverage 60 60 60 180Operational leverage from c3.5% volume
growth p.a.
Price & mainstream spirits -ve -ve -ve -veNegative impact from weak pricing and initial
roll-out of mainstream spirits
Source: SWIR, Credit Suisse research Source: Credit Suisse estimates
Figure 5: Share buybacks from FY17E could help drive
13% total shareholder return, ahead of consumer staples
peers Diageo FY17-19E potential total shareholder return breakdown - %
Figure 6: Diageo trades on FY16E calendarised 20.5x P/E,
a 5% discount to peers – successful execution could lead
to a premium rating Diageo FY16E calendarised P/E v European consumer staples - x
8%
2%
3%
0%
2%
4%
6%
8%
10%
12%
14%
EPS CAGR Potential buyback
accretion
FY16 dividend yield
10
12
14
16
18
20
22
24
26
28
Source: Credit Suisse estimates Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 4
Table of contents Key charts 3 Introduction 5
Spirits business model is changing 5 Mainstream spirits opportunity 7
1. Focus on mainstream brands is overdue 9 2. Secondary scotch 13 3. India now contributing to growth 15 4. Value brands in North America 17
Can Diageo execute? 18 Route to consumer work supports volume focus 18
Margin potential well underpinned 20 Cash flow improvement 23
Scope for share buybacks 25 Relative valuation looks inexpensive 27
Target price – increase to 2,100p 29 Credit Suisse HOLT® 30 Key risks 32 Company overview 33 Financial Model 34
29 October 2015
Diageo (DGE.L) 5
Introduction Spirits business model is changing
Price/mix used to be the main topline driver
Traditionally, the international spirits companies have relied on price/mix as the most
significant topline growth driver, riding the premiumisation wave in recent years. As shown
in Figure 7 between FY07 and FY14, Diageo delivered c4% average organic revenue
growth, of which c70% was driven by price/mix.
Figure 7: Diageo has averaged 4% organic revenue
growth Diageo organic revenue growth - %
Figure 8: Price/mix was the key driver, accounting for
c70% of organic growth over the period FY07-14 Diageo organic revenue growth split - %
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
Volume Price/mix Organic revenue
2007-14 : DGE delivered 4% organic revenue growth
Volume
30%
Price/mix
70%
Source: Company data Source: Company data, Credit Suisse research
Increased emphasis on volume growth
However, in an increasingly competitive pricing environment, weaker emerging market
growth and a polarisation of the consumer (growth in the high-end and low-end squeezing
the middle), the international spirits companies need to find new growth drivers.
Indeed, Diageo is in the process of addressing its portfolio, acknowledging that it can do
more to increase spirits penetration (taking share from other alcoholic beverages), and
that long-term premiumisation works best with broad-based price ladders, particularly in
emerging markets
At its FY15 results, CEO Ivan Menezes said, "In the emerging markets, GDP growth has
slowed. In addition, currency weakness has made imported premium spirits relatively more
expensive but has opened up the opportunity for Diageo’s mainstream spirits".
Increased focus on the lower end provides the scope to draw in new consumers,
particularly in the challenged emerging markets, by reaching more affordable price points,
and formalising the alcohol category, which has the potential to make the business more
resilient in times of economic difficulties.
We assess four key parts and the implications of Diageo's increased focus on volume
growth:
■ Mainstream and local spirits in emerging markets, particularly Africa
■ Secondary scotch in emerging markets
■ Contribution of the recently acquired United Spirits business in India
■ Value brands in the US
29 October 2015
Diageo (DGE.L) 6
Critically, we believe Diageo's recent investments in its route to market support the
execution of this strategy over coming years after two years of no organic growth.
Figure 9: Diageo's topline weakness has led to c30% EPS
downgrades in consensus over the past couple of years –
increased focus on mainstream spirits could give the
business more resilience Diageo consensus EPS revisions - pence
Figure 10: Diageo has underperformed European
consumer staples by c15% year to date Diageo share price performance v European consumer staples (Jan 2011 = 100)
2010
2011
2012
20132014
2015
2016
2017
60
70
80
90
100
110
120
130
140
150
Oct
-07
Mar
-08
Au
g-0
8
Jan
-09
Jun
-09
No
v-0
9
Ap
r-1
0
Sep
-10
Feb
-11
Jul-
11
De
c-1
1
May
-12
Oct
-12
Mar
-13
Au
g-1
3
Jan
-14
Jun
-14
No
v-1
4
Ap
r-1
5
Sep
-15
90
100
110
120
130
140
150
160
170
180
190
Jan-1
1
Apr-
11
Jul-11
Oct
-11
Jan-1
2
Apr-
12
Jul-12
Oct
-12
Jan-1
3
Apr-
13
Jul-13
Oct
-13
Jan-1
4
Apr-
14
Jul-14
Oct
-14
Jan-1
5
Apr-
15
Jul-15
Oct
-15
Series1 Series2
Source: Thomson Reuters Source: Thomson Reuters
29 October 2015
Diageo (DGE.L) 7
Mainstream spirits opportunity Focus has been too skewed towards premium scotch and beer
Diageo's emerging markets (excluding the recently acquired USL business) have been
driven traditionally by relatively premium scotch and beer (in Africa), which today account
for 42% and 30% of sales in these regions, respectively. However, mainstream affordable
spirits account for just 5% of net sales in these markets (and c15% of volumes).
Figure 11: DGE's emerging markets (ex USL) make up
36% of net sales FY15 Diageo net sales split by region - %
Figure 12: Relatively premium scotch and beer dominate
Diageo's EM business, with mainstream local brands
accounting for 5% of net sales FY15 Diageo emerging market (ex USL) net sales split by category- %
Africa
13%
LatAm
10%
Asia-Pac EM
7%
Eastern Europe
& Turkey
5%
USL
9%
Developed
markets
56%
Scotch
42%
Beer
30%
Mainstream
spirits
5%
Other
23%
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
Diageo's increased focus on mainstream spirits is due partly to the difficulties it has
encountered in beer and premium scotch over the past couple of years.
Beer (predominantly Africa) has underperformed
At the heart of its beer business in Africa lies a conflict of interest – Diageo owns 100% of
its spirits business in the region, although it has significant minority interests in its beer
business. Furthermore, spirits are higher margin and higher return than beer. As such,
management is incentivised to use its beer infrastructure to further leverage its spirits
portfolio.
This has meant that Diageo hasn’t always had the same focus as its 100% beer-focused
competitors such as Heineken and SABMiller, leading to underperformance in volumes
and organic revenue. We estimate Diageo's African beer business has averaged 7%
organic revenue growth since 2009 (with flat volumes), half the rate of SABMiller.
For example, in Nigeria, Diageo focused on its higher-end beer brands allowing the
competition to take meaningful positions in the faster-growing value end as the macro
environment became challenged and competition intensified. The importance of the value
end is critical as this is how the industry draws consumers from the large illicit segment.
29 October 2015
Diageo (DGE.L) 8
Figure 13: Diageo's African business is dominated by
beer FY15 Diageo Africa net sales split
Figure 14: Diageo's beer business has underperformed
peers, due partly to a lack of portfolio focus 2009-14 Diageo Africa beer organic revenue vs peers - %
Beer
66%
Spirits
34%
0%
2%
4%
6%
8%
10%
12%
14%
16%
SABMiller Heineken Diageo beer
Source: Company data Source: Company data, Credit Suisse research
Premium scotch has been impacted by FX moves
Outside of beer in Africa, scotch is the key driver of Diageo's emerging markets,
representing c60% of its EM spirits sales (excluding beer and USL). Once again, Diageo's
focus historically has been on increasing supply in the more premium aged scotch to meet
strong demand from these emerging markets.
Figure 15: Scotch is the main driver of Diageo's emerging
markets outside of beer, accounting for c60% of EM net
sales (ex beer and USL) FY15 Scotch as % of Diageo net sales by region
Figure 16: Diageo's scotch business is relatively premium
and underpenetrated in the value segment 2014 Diageo volume market share in scotch by segment - %
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Africa ex beer LatAm Asia-Pac ex USL
Scotch Other
37%46%
13%
63%54%
87%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Total Premium Value
Diageo Others
Source: Company data, Credit Suisse research Source: Company data
More recently, premium scotch has been negatively impacted by significant currency
declines across these emerging markets—being manufactured and priced in hard
currency, emerging market consumers have effectively experienced big price increases,
leading to volume declines. This has been exacerbated by destocking, as demonstrated
by the underperformance of the relatively premium Johnnie Walker brand within Diageo's
scotch portfolio in Figure 17.
29 October 2015
Diageo (DGE.L) 9
Figure 17: Premium scotch volumes (Johnnie Walker)
have significantly underperformed over the past couple of
years Avg FY14-15 Johnnie Walker volume growth vs total DGE scotch volume - %
Figure 18: This has been magnified by slower EM growth
and currency volatility, which has led to significant
effective price increases for EM consumers Currency move in top 10 scotch industry emerging market (by volume) versus £ since Jan 2013
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
Africa LatAm Asia-Pac
Johnnie Walker Total
-50%
-45%
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
Source: Company data Source: Thomson Reuters
1. Focus on mainstream brands is overdue
Africa is the biggest opportunity for mainstream spirits
Diageo is putting incremental resources behind mainstream spirits, to help formalise further
the alcohol category in emerging markets—we believe the biggest opportunity is in Africa.
Figure 19 shows that Africans consume as many litres of pure alcohol as the global
average. The issue is that informal alcohol still represents c70% of volumes in Africa,
which is mostly made up of local brews and home-made spirits.
Figure 19: Total alcohol consumption in Africa is
estimated to be in line with the global average Pure alcohol consumption per capita - litres
Figure 20: However, informal alcohol still represents a
disproportionate amount of total consumption Informal alcohol consumption as % total
0.0
2.0
4.0
6.0
8.0
10.0
12.0
Europe North America Latin America
& Caribbean
Africa Asia
25%
74%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
North America C&E Europe LatAm Africa
Informal alcohol Spirits Wine Beer
Source: World Health Organisation Source: Company data
Mainstream spirits are priced at around a third of premium spirits, thus helping target the
consumer at a lower, more affordable price point. Ultimately, we believe mainstream spirits are
just as good as, if not better, in terms of formalising the alcohol industry in Africa than beer.
We note SABMiller has recently stepped up its focus on mainstream beer across its
emerging markets, trying to reach consumers at more affordable price points, which has
led to an acceleration in volume growth in Africa and LatAm despite deteriorating macros.
29 October 2015
Diageo (DGE.L) 10
Figure 21: Mainstream spirits can help formalise the
alcohol category by reaching lower price points, which is
the biggest volume opportunity Price ladder of spirits by segment in Africa
Figure 22: SABMiller's increased focus on mainstream
beer at affordable price points has led to an acceleration
in volume growth despite weakening emerging markets SABMiller Africa and LatAm organic lager volume (March year end) - %
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
2013 2014 2015 H1 2016
Africa LatAm
Source: Company data Source: Company data
Mainstream hasn’t been a big focus in the past
We believe Diageo has not focused sufficiently on mainstream and value brands in the
past, although this is in the process of being addressed.
■ Mainstream spirits represent 75% of total spirits market volumes in Africa (see Figure
23). The category is relatively fragmented, with many small players.
■ Diageo has, on average, a 60% market share in international premium spirits across
its main spirits markets in Africa, comparable with SABMiller's presence in the beer
category across the region. However, it only has a meaningful mainstream spirits
presence in three of its nine key African spirits markets (Kenya, Uganda and South
Africa).
■ Between 2003 and 2013, Diageo's mainstream spirits business recorded a volume
CAGR of c7%, only in line with its international premium spirits business.
Figure 23: Diageo's main African spirits markets are
dominated by mainstream spirits, which represent c75%
of market volumes Share of market volume within spirits - % serves
Figure 24: However, Diageo remains significantly under-
represented in mainstream spirits, contrasting with its
strong positions in premium spirits Diageo market share in international premium and mainstream spirits - %
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Kenya Tanzania Uganda Nigeria Cameroon Ghana
International Premium Mainstream
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
International Premium Mainstream
Source: Company data Source: Company data
29 October 2015
Diageo (DGE.L) 11
Figure 25: DGE's mainstream spirits volumes have only
grown in line with international premium spirits over the
past decade 2003-13 DGE Africa spirits volume CAGR - %
Figure 26: Even SABMiller is targeting the mainstream
spirits opportunity – its Tanzanian subsidiary has seen
strong growth in mainstream spirits 2010-15 SABMiller Tanzania revenue growth in beer versus mainstream spirits
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
International Premium Mainstream Reserve
13%
27%
0%
5%
10%
15%
20%
25%
30%
Beer Spirits
Source: Company data Source: Company data
Even the brewers are participating in mainstream spirits
The extent to which the mainstream spirits category in Africa has been underpenetrated by
the big spirits companies is characterised by SABMiller (Africa's largest brewer), stepping
up its focus on the mainstream spirits category in recent months given the growth potential
and relative fragmentation of the category.
SABMiller has an existing mainstream spirits business in Tanzania which has grown to
represent c20% of its local operations at relatively attractive margins. The company is
taking this expertise and now investing in local spirits operations in South Sudan, Ethiopia
and Nigeria.
Diageo can leverage its beer business to push mainstream spirits further
We believe Diageo should be able to leverage its beer scale in markets such as Nigeria,
Ghana, Cameroon, Ethiopia and Tanzania to gain a bigger presence in mainstream
spirits—given that beer and mainstream spirits have comparable price points (on a unit
alcohol basis), there is an overlap in outlet coverage universe and route to market, which
has worked well in East Africa. In particular, Diageo has used its beer scale to establish a
strong presence in mainstream spirits across Kenya and Uganda (c60% market share),
with market-leading brands such as Kenya Cane, Warigi (gin in Uganda) and Jebel (gin in
Kenya).
The results achieved in South Africa over the past decade also support our view that
Diageo can better leverage its beer assets in the region to gain scale in mainstream spirits.
In 2004, brandhouse was established, a cost-sharing JV between Diageo, Heineken and
Namibian Breweries, to sell Diageo's spirits, RTDs, ciders and Guinness as well as
Heineken and NBL's beer portfolio.
The scale and investment in the combined entity helped Diageo to gain significant market
share in spirits, rising to 40% in 2014 from 26% in 2005, and it became the market leader.
Diageo now believes it has sufficient scale to operate its spirits business on a standalone
basis, leading to the sale of its share of the JV to Heineken in July 2015.
29 October 2015
Diageo (DGE.L) 12
Figure 27: Beer and mainstream spirits offer comparable
price points and hence route to market overlaps Price ladder of beer and spirits by segment in Africa (mainstream = 100)
Figure 28: Diageo can do more in its beer markets to help
push mainstream spirits – Kenya and Uganda have
demonstrated this potential Diageo beer v mainstream spirits market shares (2014) - %
120
100 100
75
50
0
50
100
150
200>300
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Kenya Ghana Uganda Tanzania Nigeria Ethiopia Cameroon
Beer Mainstream spirits
Source: Company data, Credit Suisse research Source: Company data, Canadean, Credit Suisse research
Figure 29: Up until recently, Diageo had a total beverage
alcohol JV in South Africa with Heineken and Namibian
Breweries 2005-15 Diageo South Africa joint venture structure
Figure 30: Diageo leveraged the scale of the South
African JV to raise its spirits market share to 40% from
26% in 2005 Diageo South Africa spirits market share - %
0%
5%
10%
15%
20%
25%
30%
35%
40%
2005 2014
Source: Company data Source: Company data
Mainstream spirits peers have generated strong growth at good margins
We believe incremental focus on mainstream spirits should help drive an acceleration in
Diageo's topline growth. We note mainstream spirits businesses such as Tanzania
distilleries, a subsidiary of SABMiller, and African Distillers in Zimbabwe have experienced
c20-25% sales growth over the past five years, despite macro issues.
Critically, we do not expect a significant margin dilution from growing mainstream spirits in
Africa, given the lower unit cost of production and A&P spend. We note:
■ Tanzania Distilleries generates c30% EBIT margins (on gross sales) in mainstream
spirits, helped somewhat by leveraging the beer business, where it has a c70-80%
market share;
■ ThaiBev generates c25% EBIT margins (on gross sales) in its spirits business, which
consists predominantly of local mainstream brands; and
■ African Distillers and Distell generate lower EBIT margins (c15%), due partly to scale.
We believe incorporating mainstream spirits into Diageo's existing infrastructure
29 October 2015
Diageo (DGE.L) 13
should allow it to generate better margins in mainstream spirits than these standalone
players.
From a manufacturing standpoint, Diageo is rolling out a low-cost portable spirits
production unit called 'the Cube', which can be attached to a brewery, requiring access to
just electricity and water. This helps to keep capex and unit production costs relatively low,
allowing it to reach affordable price points at attractive margins.
Diageo has stated in the past that the margins generated on mainstream spirits are
comparable with international premium spirits, whilst spirits margins in aggregate are
higher than those of beer.
As such, faster growth in spirits than beer overall should be margin accretive to the
business.
Figure 31: Other mainstream spirits businesses have
grown c2x the pace of Diageo's African spirits business 2010-15 DGE Africa spirits organic revenue CAGR vs mainstream spirits peers
Figure 32: …and generate relatively attractive margins
when done at scale FY15 DGE Africa EBIT margin vs mainstream spirits peers
0%
5%
10%
15%
20%
25%
30%
DGE spirits Tanzania Distilleries African Distillers
0%
5%
10%
15%
20%
25%
30%
Diageo Africa Tanzania
Distilleries
ThaiBev African
Distillers
Distell
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
*Note Tanzania Distilleries and ThaiBev margins are based on gross
sales
2. Secondary scotch
Recent scotch weakness frees up supply to reshape the scotch portfolio
The weakness in Diageo's scotch business in the past couple of years has coincided with
a planned increase in scotch investment. In June 2012, the company announced a £1bn
investment in scotch, of which half would be used to expand capacity, with the balance for
working capital purposes. This investment was predicated on scotch category volume
growth of 4-5%; however, this was revised recently to 2-3% in light of industry weakness.
The result is that the targeted investment for distilling capacity will be pushed further out
when demand returns to the category.
Although in the past Diageo has been focused on increasing supply in the more premium
aged scotch to meet strong demand, the company can now take advantage of industry
weakness to reshape its portfolio to younger liquids and therefore better target entry-level
scotch consumption at more affordable price points in emerging markets, further
leveraging its brands such as Black & White, VAT 69 and White Horse.
29 October 2015
Diageo (DGE.L) 14
Figure 33: Scotch industry capacity has increased by
around 30% over the past decade Scotch industry stock – m litres of pure alcohol
Figure 34: Combined with weak demand in recent years,
this has led to excess industry capacity, leading to an
increase in the average age of stocks Ratio of scotch industry stock to consumption –years
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
6.0
6.5
7.0
7.5
8.0
8.5
9.0
Source: SWIR, Credit Suisse research Source: SWIR, Credit Suisse research
Figure 35: Excess supply can be used for younger liquids
(3-5yr old scotch) in emerging markets over the next few
years as the % of 1-3yr-old scotch inventory has
increased Scotch industry inventory by age - %
Figure 36: Diageo's scotch portfolio is extremely skewed
to the premium Johnnie Walker franchise. We see scope
to broaden price points and category participation Diageo Scotch portfolio volume split - %
40% 43% 46% 46% 44% 43% 44% 47%
17% 16% 16% 17% 19% 20% 19% 16%
24% 21% 19% 17% 17% 19% 21% 23%
19% 20% 20% 21% 20% 18% 16% 14%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2006 2007 2008 2009 2010 2011 2012 2013
1-3yr 3-5yr 5-9yr 10+yr
JW Red Label
33%
JW Black Label
19%
JW Super De
Luxe
3%
J&B
10%
Bell's Extra
special
7%
Black & White
4%
VAT 69
3%
White Horse
4%
Other Blends
14%
Single Malts
3%
Source: SWA, Credit Suisse research Source: Scotch Whiskey Industry Review
Secondary scotch is not significantly margin dilutive
With younger qualities of scotch at more affordable price points, Diageo still has to distil
the liquid in Scotland, although these liquids can be shipped in bulk to end markets and
bottled locally. This reduces significantly the unit cost of production (lower packaging and
labour costs), whilst holding costs are quite comparable—thus enabling a lower price
point. While gross margins on secondary scotch are lower, so are the A&P requirements,
which leads to comparable profit after A&P margins.
Given the lack of scale in these brands, structure costs are higher as a percentage of net
sales. However, even on this basis, we estimate secondary scotch generates higher EBIT
margins than the rest of Diageo's group spirits portfolio, and thus is accretive to group
margins.
29 October 2015
Diageo (DGE.L) 15
Figure 37: Secondary scotch has slightly lower EBIT margins than premium scotch while
still generates higher margins than the rest of the business outside Scotch Diageo Scotch P&L structure versus other spirits (relative to premium Scotch net revenue of 100)
Per case
Premium
scotch
Secondary
scotch
Other
Spirits (ex
USL)
Net revenue 100 55 70
COGs -24 -18 -30
Gross profit 76 37 40
Gross profit margin - % 76.4% 67.9% 57.1%
A&P -23 -7 -9
as % net sales 23% 14% 13%
Profit after A&P 54 30 31
as % net sales 54% 54% 44%
Structure costs -13 -11 -10
as % net sales 13% 21% 14%
EBIT 41 19 21
EBIT margin - % 41% 34% 30%
Source: Credit Suisse research
3. India now contributing to growth
United Spirits represents around 9% of Diageo's FY15 consolidated net revenue, and will
start contributing to group organic growth from FY16. This business is made up of locally
manufactured Indian Made Foreign Liquor (IMFL), which generates £10 per case in net
revenue, around a sixth of the rest of Diageo's business.
Figure 38: USL represents c40% of Diageo's volume, and
c10% of net revenue Contribution of USL to Diageo's FY15 financials - %
Figure 39: USL generates significantly lower net revenue
per case given focus on local Indian whiskies Diageo net revenue per case by region - £
38%
9% 2%0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Volume Net revenue EBIT
USL Rest of group
0
10
20
30
40
50
60
70
80
90
100
Asia-Pacific North
America
Europe Africa Latin
America and
Caribbean
USL
Source: Company data Source: Company data
In contrast to Diageo's other emerging markets, USL is already highly skewed towards the
low-priced segment, which accounts for c70% of its volumes. Therefore, the emphasis is
on growing the premium portfolio, which has a 2x higher price point and has grown in
double digits over the past three years to reach 30% of volumes.
29 October 2015
Diageo (DGE.L) 16
The key element of the USL strategy is to focus all marketing efforts in 10% of its 150
brands, predominantly prestige and above, which should drive further premiumisation and
profitability
Furthermore, USL is now selling some Diageo brands, which should benefit from USL's
distribution system (Smirnoff and Captain Morgan will be manufactured locally). Whilst still
small, these brands can ramp up quickly and are very margin accretive. In particular, we
believe there is a strong opportunity for Captain Morgan, noting that the rum category
represents c20% of India's IMFL market; however, we note there are no premium brands
in the market.
Overall, we do not expect significant volume growth from USL (c2-3%), as double-digit
volume growth out of the premium portfolio (prestige and above) continues to be offset by
some rationalisation within the regular portfolio. However, we believe this portfolio
transition should drive strong price/mix benefits (c7-10%).
As such, USL should be able to deliver double-digit growth, which we estimate could
contribute c1-1.5ppt to Diageo's group organic growth over the next few years.
Figure 40: The USL brand portfolio is premiumising USL volume mix by segment
Figure 41: USL's premium brands are priced at 2x regular
brands, thereby driving positive mix and margins Price of key IMFL brands based in Delhi (Indian Rupees)
21% 23% 27% 30% 34% 39%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2012 2013 2014 2015 2016E 2017E
Prestige Regular
based on Delhi prices
Type Owner Brand Price (Rupees)
Bottled in Origin Pernod Chivas Regal >3000
Bottled in India Pernod 100 Pipers 1200
Indian Made Foreign Liquor
Premium Pernod Blenders Pride 650-1000
Sub Premium Pernod Royal Stag 400-650
USL McDowell's No 1 300-400
Pernod Imperial Blue 300-400
Regular USL Bagpiper 200-300
ABD Officer's Choice 200-300
Economy Jagatjit Jagatjit Aristocrat <200
Source: Company data, Credit Suisse estimates Source: Credit Suisse research
Figure 42: USL's organic revenue is sequentially
improving, led by price/mix United Spirits organic revenue (March year end) - %
Figure 43: We estimate USL to contribute c1.0-1.5pp to
group organic revenue growth over the next few years USL growth contribution to Diageo - %
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Q2 15 Q3 15 Q4 15 Q1 16
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
2016E 2017E 2018E 2019E
Source: Company data Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 17
4. Value brands in North America
Diageo's increased focus on the lower-end portfolio isn't focused solely on emerging
markets. Even in North America, Diageo is keen to improve volume growth in brands such
as Popov, Gordon's and Seagram's 7.
We believe Diageo has taken too much pricing in recent years on this part of its portfolio,
resulting in significant volume declines (see Figure 46), as these brands inherently have
higher price elasticity. However, the uneven macro recovery in the US suggests that there
is still consumer interest in this part of the portfolio if priced appropriately.
Once again, the margins of these brands appear favourable—while the lower price points
imply lower gross margins, the lower A&P requirements drive comparable profitability with
the rest of the portfolio.
Figure 44: Diageo took too much pricing FY12-14,
particularly in its low-end portfolio Diageo US spirits price/mix versus CPI - %
Figure 45: Value brands in the US represent c15% of
volumes Diageo value brands as % US volumes (2015)
0%
1%
2%
3%
4%
5%
6%
2011 2012 2013 2014 2015
Price/mix CPI
Value brands
15%
Rest of portfolio
85%
Source: Company data Source: Company data, AC Nielsen, Credit Suisse research
Figure 46: The decline in these brands has had a c1.5pp
negative impact on Diageo's US volumes growth Diageo volume growth of value brands v rest of portfolio - %
Figure 47: We estimate value brands in the US generate
comparable profitability to the rest of the portfolio given
low A&P requirements and provide some operating
leverage Hypothetical P&L structure of US value brands vs rest of portfolio (based on other spirits brands net revenue = 100)
-25%
-20%
-15%
-10%
-5%
0%
5%
2014 2015
Popov Gordon's Seagram 7 Crown Rest
Value
brands
Other
Spirits
Net revenue 59 100
COGs -21 -27
Gross profit 39 73
Gross profit margin - % 65% 73%
A&P -2 -17
as % net sales 4% 17%
Profit after A&P 36 56
as % net sales 61% 56%
Structure costs -11 -12
as % net sales 18% 12%
EBIT 25 44
EBIT margin - % 43% 44%
Source: AC Nielsen Source: Credit Suisse research
29 October 2015
Diageo (DGE.L) 18
Can Diageo execute? Diageo's increased emphasis on volume growth, with particular focus on its lower-end
mainstream brands, is a change in mindset versus previous years, which was generally all
about premiumisation to the higher-end portfolio and maximising price/mix.
This change in emphasis creates opportunities on one hand, while adding higher
complexity to the business model on the other. In particular, the strategy calls for a more
'push-driven' model, in contrast to the premiumisation 'pull-driven' model. This begs the
question – is Diageo's management capable of executing?
We believe Diageo has been making the necessary adjustments to its organisation over
the past 12-18 months in its route to market, with further investments to come.
Furthermore, the integration of USL brings with it an established mainstream spirits
business operating at scale, which provides some knowledge and expertise to the rest of
the organisation.
Route to consumer work supports volume focus
Substantial investment, biggest benefits to come in FY17
Diageo's 'route to consumer' project began in May 2013, with the aim of profitably driving
greater penetration of distribution across its target markets. We believe these practices are
not revolutionary and are already implemented by best-in-class global consumer products
companies. As such, this investment is addressing the under-investment of previous
years. Nevertheless, we still expect some tangible benefits to arise.
The key initiatives of Diageo's route to consumer investment include:
■ Maximise direct and distributor dedicated outlet universe coverage in a
profitable way. This requires identification of the total outlet universe, and then
estimating the profit potential from each outlet to assess in which of those outlets
Diageo should participate.
■ Efficient resource allocation to profitable, growing customers and channels.
Better optimise salesforce time, discounts, point-of-sale materials to the most
profitable and highest-growth customers/channels.
■ Measure and reward distribution penetration and rate of sale better. Enforce and
reward key KPIs such as salesforce productivity (e.g. calls per day), activation metrics
(number of display cases, share of shelf), and 'out of stocks'.
■ Create a sell-out culture. Since the start of FY14, Diageo has spent more time
tracking depletions (sell-out, measuring underlying consumer demand) as opposed to
shipments (sell-in, measuring sales to distributors), reviewing salesforce coverage and
brand distribution data. It is depletions, not shipments, that now form a key part of the
GM's annual bonus.
The project moved from the design phase (identifying outlet universe, revenue potential
and cost to serve) to implementation in calendar H1 2014, with the initial focus on 10
'Wave 1' markets (c£4bn of net sales or 35-40% of group total), where according to
management the opportunity is greatest – see Figure 48.
Wave 1 implementation is not yet complete; however by the end of FY15, these markets
had benefited from:
■ A 10% increase in the number of sales people (from 3,500 to 3,800)
■ A 30% increase in the number of outlets served (or 80k)
29 October 2015
Diageo (DGE.L) 19
This contributed c£90m to net sales in FY15, implying a c2.3% increase to the Wave 1
markets and 0.8% contribution to the group.
Overall, management expects annual gains coming through to FY18, with the biggest
annual increment coming in FY17, by which time all Wave 1 markets, as well as some
Wave 2 markets, should have completed and the full benefits realised.
Figure 48: Diageo targeted route to consumer investments by market
Source: Company data
29 October 2015
Diageo (DGE.L) 20
Margin potential well underpinned Target 100bps margin expansion in FY17-19
Diageo targets 100bps group EBIT margin expansion in FY17-19, which is in line with
consensus expectations.
Below we attempt to break down this guidance, which has various moving parts.
Geographic mix impact
First, we expect Diageo's lower-margin regions to drive the greatest organic growth over
the period – in particular, we expect USL to see double-digit organic growth (contributing
c1.0-1.5pp to group organic revenue); however its underlying EBIT margins are c8%,
below the group average of 28%, which we estimate to be a c20-30bp negative drag on
group margins per annum – i.e. every c5pp topline growth at USL has a c10bp negative
group margin impact.
However, we believe this can be largely offset by margin expansion within the USL
business. Our USL analyst Arnab Mitra models a c100-150bp annual margin expansion,
as its incremental growth is coming from the higher-margin premium segment, whilst it is
rationalising its lower-end portfolio (see page 16/17).
Figure 49: Diageo's lowest-margin regions have the
fastest growth prospects. We estimate growth from USL
has a c20-30bp negative group margin impact Diageo FY17-19E organic growth vs FY15 EBIT margin by region
Figure 50: However, this is offset partly by margin
expansion within USL, as the incremental growth is
coming from the higher-margin prestige segment, which
generates 2x higher net sales per case USL volume mix - %
North America
Europe
LatAm
Africa
Other Asia-Pacfic
USL
0%
2%
4%
6%
8%
10%
12%
14%
0% 10% 20% 30% 40% 50%
FY
17-1
9E
Org
an
ic g
row
th
FY15 EBIT margin - %
21% 23% 27% 30% 34% 39%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2012 2013 2014 2015 2016E 2017E
Prestige Regular
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Cost savings and re-investment
Diageo has committed to £500m of gross productivity gains in FY17-19 (c440bps of
margin), which we expect to be slightly more back-end loaded. The company hasn’t yet
revealed the precise details of the programme, although we expect a significant
contribution from more efficient trade spend.
The company aims to re-invest around two-thirds of this back into the business over the
period, which implies scope for a c140bp margin contribution from net cost savings after
300bps re-investment.
29 October 2015
Diageo (DGE.L) 21
Figure 51: We estimate net cost savings to positively impact margins by 140bps, with
c300bps re-invested back into the business Diageo margin impact of net savings and re-investment of £500m programme - bps
36
50
52
13873
99
122
295
0
50
100
150
200
250
300
350
400
450
500
2017 2018 2019 Accumulated
Net saving Re-investment
Source: Credit Suisse estimates
Volume leverage
If Diageo can successfully execute on delivering improving volume growth over the next
few years, we believe this could drive some good operational leverage, particularly as the
business builds scale in mainstream spirits.
Other things being equal, we estimate 1% volume growth drives c20bps margin
expansion. On this basis, our forecast of 3.5% volume growth could generate c60bps
margin expansion per annum.
Figure 52: Each 1% volume growth could improve margins by 20bps, other things being
equal Diageo hypothetical operating leverage analysis
DGE P&L
1% volume
impact Fixed Variable
Net sales 100.0 101.0
Cost of sales -42.4 -42.7 30% 70%
Gross profit 57.6 58.3
Gross profit margin - % 57.6% 57.7%
chge - bps 11
Marketing -15.1 -15.2 20% 80%
Other operating expenses -14.1 -14.1 60% 40%
EBIT 28.4 28.9
EBIT margin - % 28.4% 28.6%
chge - bps 21 Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 22
Overall assessment of Diageo's margin target
In Figure 53, we attempt to break down the impact of the various drivers of Diageo's
margin guidance. The missing part to our analysis is the negative impact of weak pricing
(due to the competitive environment) and the initial impact from incremental volume
growth of mainstream spirits.
As we have pointed out previously in this report, these mainstream brands typically
generate comparable margins (after A&P spend); however, given Diageo's relatively low
scale at the moment, they incur higher structure costs, which brings down their EBIT
margin contribution. Therefore, there could be some initial margin dilution (perhaps
offsetting the volume leverage in FY17), but this should subside as Diageo then begins to
leverage its scale.
Therefore, we can conclude that Diageo's margin guidance is underpinned by the
productivity savings, at least in FY17.
Thereafter, we suspect that the guidance may have some leeway for volume leverage to
drop through to margins – however investors need to see some delivery of the volume
growth for this argument to gain traction.
Figure 53: Diageo's margin targets are at least underpinned by the productivity savings, with some leeway in the outer
years if it delivers on volume growth Diageo EBIT margin forecast breakdown by geographic mix, cost savings and topline growth - bps
2017E 2018E 2019E Accumulated Comment
Negative geographic margin mix -15 -28 -26 -69 Negative impact of lower margin USL business growing faster than other regions
USL margin expansion 15 16 12 43 Group contribution from margin expansion within USL (c100-150bps pa)
a Net geographic mix impact 0 -12 -15 -26
Gross productivity gains 109 149 175 433 £500m gross productivity programme over FY17-19
Re-investment -73 -99 -122 -295 2/3rds ofproductivity gains re-invested back into the business
b Net productivity gains 36 50 52 138
a+b Mix and productivity impact 37 38 38 112 In line with company target of 100bps
Volume leverage 60 60 60 180 Operational leverage from c3.5% volume growth p.a.
Price & mainstream spirits -ve -ve -ve -ve Negative impact from weak pricing and initial roll-out of mainstream spirits Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 23
Cash flow improvement Historically, free cash flow conversion has been weak
Diageo's FCF conversion had weakened considerably in FY11-14, dropping from 82% to
50% over the period. This was driven predominantly by working capital (a step-up in
maturing stock, but also trade receivables), restructuring costs (supporting recent cost-
savings programme) and increasing capex (increased investments in EM).
Figure 54: Diageo's FCF conversion was relatively weak in
FY11-14, with improvements in FY15 as working capital
became a key feature of management remuneration Diageo FCF conversion (company definition) - %
Figure 55: Diageo's FCF has been impacted by working
capital (maturing stock), restructuring costs, pension
costs and higher capex FY10-15 free cash flow breakdown - £m
0%
20%
40%
60%
80%
100%
120%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
2010 2011 2012 2013 2014 2015
EBIT 2,751 2,884 3,198 3,530 3,134 3,066
Depreciation & amortisation 291 286 323 330 365 399
Working capital 329 -110 -529 -553 -597 117
Dividends received 111 138 166 203 228 183
Post employment payments -114 -119 -200 -498 -196 -70
Cash exceptionals -145 -259 -158 -61 -104 -191
Other items -48 39 205 80 -139 -48
Cash from operations 3,175 2,859 3,005 3,031 2,691 3,456
Net interest expense -305 -311 -391 -427 -432 -416
Tax expense -474 -365 -521 -556 -469 -489
Capex -374 -419 -484 -643 -642 -638
Asset disposals 143 47 39 39 80 52
Movement in loans -43 1 -1 16 7 -2
Free cash flow 2,122 1,812 1,647 1,460 1,235 1,963 Source: Company data Source: Company data
Improvement in FY15 as operating cash conversion incorporated in remuneration
Diageo management increased its focus on operating cash conversion (a company-
defined measure excluding maturing stock, pension costs, restructuring costs and dividend
income) in FY15 by introducing it as a key metric in management's annual incentive plan,
leading to a significant improvement in FCF conversion in FY15.
From FY16, operating cash conversion is the most important metric in Diageo's annual
incentive plan, with a weighting of c30%.
Figure 56: Operating cash conversion has the highest weighting in Diageo's annual
incentive plan Diageo annual management incentive plan structure
FY14 FY15 FY16
Net sales growth 30% 30% 25%
Profit growth 30% 35% 25%
Operating cash conversion 25% 30%
Individual business objectives 20% 10% 20%
Free cash flow 10%
Avg working capital as % net sales 10%
Total 100% 100% 100% Source: Company data
29 October 2015
Diageo (DGE.L) 24
Scope for further improvement
We believe Diageo has room for improvement in its working capital metrics. We note that:
■ Trade receivables as a percentage of net sales are among the highest in the
consumer staples peer group; however this is generally the case for spirits companies,
which have a higher exposure to i) a fragmented universe of on-trade outlets, and ii)
the US three-tier distribution system, both of which have structurally higher debtor
days.
■ Trade payables as a percentage of net sales are among the lowest versus consumer
staples peers—we believe this is where Diageo perhaps has the biggest opportunity,
as it isn't using its scale fully to improve terms with suppliers.
We expect Diageo to continue to invest in maturing stock to the tune of £160m per annum
(including £85m holding costs), which implies c4% growth per annum.
Other inventories also have scope to improve (eg, finished stock), as Diageo is changing
its approach to innovation, away from big pipeline fills, to one of a replenishment cycle,
particularly in the US market. Furthermore, the business as a whole is more incentivised
on sell-out than sell-in, is improving its forecasting capability and should be helped further
by its increased focus on trade terms.
Figure 57: Diageo has one of the highest trade
receivables ratios versus peers, although this is generally
the case for spirits companies 2014 calendarised trade receivables as a % net sales
Figure 58: Diageo has the lowest trade payables ratios in
the sector, wherein lies the biggest opportunity 2014 calendarised trade payables as % net sales
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
0%
5%
10%
15%
20%
25%
30%
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
Note Pernod excludes factoring
Figure 59: Diageo's trade receivables have increased in
recent years (note FY15 impacted by USL consolidation) Diageo average trade receivables as a % of net sales
Figure 60: Diageo's trade payables have increased in
recent years, more can be done (note FY15 impacted by
USL consolidation) Diageo average trade payables as a % of net sales
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research
29 October 2015
Diageo (DGE.L) 25
Figure 61: Diageo could release c.£700m of working capital to our current forecasts
(12% uplift to FCF) if it closes half the gap versus consumer staples peers Diageo potential working capital improvement scenario - £m
CS estimate
Potential if
close half the
gap with peers
2015 2018E 2018E
Net sales 10,813 11,425 11,425
Maturing stock 3,586 4,066 4,066
Other inventories 988 994 800
Trade receivables 1,933 1,997 1,764
Trade payables -883 -1,001 -1,295
Net working capital 5,624 6,055 5,335
Net working capital ex maturing stock 2,038 1,989 1,269
as % net sales
Maturing stock 33.2% 35.6% 35.6%
Other inventories 9.1% 8.7% 7.0%
Trade receivables 17.9% 17.5% 15.4%
Trade payables 8.2% 8.8% 11.3%
Net working capital 52.0% 53.0% 46.7%
Net working capital ex maturing stock 18.8% 17.4% 11.1%
Change - £m
Maturing stock 0
Other inventories 194
Trade receivables 233
Trade payables 293
Net working capital 720
Net working capital ex maturing stock 720
Accumulated FCF to equityholder (FY16-18E) 6,252
Potential uplift - % 12% Source: Company data, Credit Suisse estimates
Scope for share buybacks
Share buybacks from FY17 could be 2% EPS accretive
We note that Diageo's balance sheet will de-lever to below its target range of 2.5x-3.0x net
debt/EBITDA by the end of FY16, helped by recent disposals of non-core assets. As such,
with our expectations of a sequential improvement in growth and margins in FY17, and
M&A unlikely, we believe management could look to increase returns to shareholders.
This is unlikely to be via dividends, as the dividend cover has fallen to c1.5x, leading
management to slow dividend growth to 'mid-single digit' until its target 1.8-2.2x dividend
cover is restored over coming years.
As such, we expect further cash returns to come in the form of share buybacks – we
estimate a £1.5bn annual share buyback at current valuation levels and cost of debt would
be 2% EPS accretive.
29 October 2015
Diageo (DGE.L) 26
Figure 62: Diageo's balance sheet is will de-lever to below
its target of 2.5x-3.0x net debt/EBITDA – with M&A
unlikely, management could raise cash returns Diageo net debt/EBITDA - x
Figure 63: This is unlikely through dividends, as we
expect the dividend cover to be restored to the
company's target level of 1.8-2.2x over coming years Diageo dividend cover - x
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5Target 2.5-3.0x
Historical average 2.3x
0.0
0.5
1.0
1.5
2.0
2.5
Historical average 1.9x Target 1.8-2.2x
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Figure 64: This implies any increased cash returns are likely through share buybacks,
which were commonplace pre-financial crisis and years of M&A activity Diageo cash returns (LHS - £m) versus net debt/EBITDA (RHS – x)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
0
500
1,000
1,500
2,000
2,500
Dividend Buyback Net debt/EBITDA (RHS) - x
£4.7bn spent on M&A
Source: Company data, Credit Suisse estimates
Figure 65: We estimate share buybacks from FY17 could be at least 2% EPS accretive per annum Impact of £1.5bn annual share buyback on Diageo's FY17-19E EPS
Comment
2016E 2017E 2018E 2019E 2017E 2018E 2019E 2017E 2018E 2019E
EBIT 3,002 3,154 3,370 3,610 3,154 3,370 3,610
Net interest cost -323 -283 -261 -235 -30 -60 -90 -313 -321 -325
Net other finance charges -45 -35 -25 -25 -35 -25 -25
Share of associates/JVs 195 216 239 264 216 239 264
PBT 2,829 3,052 3,323 3,614 -30 -60 -90 3,022 3,263 3,524
Tax expense -521 -569 -628 -693 6 12 19 -563 -616 -674
Tax rate - % 19.8% 20.1% 20.4% 20.7% 20.1% 20.4% 20.7% 20.1% 20.4% 20.7%
Minority interest -89 -100 -117 -137 -100 -117 -137
Net income 2,218 2,383 2,578 2,785 -24 -48 -71 2,359 2,530 2,713
Average number of shares - diluted 2,517 2,519 2,520 2,522 -73 -140 -200 2,445 2,380 2,321
Adjusted EPS - fully diluted 88.1 94.6 102.3 110.4 96.5 106.3 116.9
EPS accretion - % 2% 4% 6%
Balance sheet impact
Net debt 8,199 7,643 7,001 6,220 1,500 3,000 4,500 9,143 10,001 10,720
EBITDA 3,393 3,558 3,796 4,060 3,558 3,796 4,060
Net debt/EBITDA - x 2.4 2.1 1.8 1.5 2.6 2.6 2.6 DGE targets 2.5-3x net debt/EBIDA
Share buyback impact
Share buyback - £m 1,500 1,500 1,500 Assume £1.5bn buyback pa
Share price - pence 2,049 2,254 2,480 Assume share price increases 10% pa from current 1,863p
Number of shares acquired - m 73 67 60
Cost of debt 2.0% 2.0% 2.0% Recent debt issues in sector have been at c2% interest
Incremental net interest expense -30 -30 -30
Pre share buyback Cumulative buyback impact Post share buyback
Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 27
Relative valuation looks inexpensive Figure 66: Diageo has underperformed European
consumer staples by c15% year to date Diageo share price performance v European consumer staples (Jan 2011 = 100)
Figure 67: Diageo's underperformance has been driven by
c30% consensus EPS downgrades over the past couple
of years Diageo consensus EPS revisions - pence
90
100
110
120
130
140
150
160
170
180
190
Jan-1
1
Apr-
11
Jul-11
Oct
-11
Jan-1
2
Apr-
12
Jul-12
Oct
-12
Jan-1
3
Apr-
13
Jul-13
Oct
-13
Jan-1
4
Apr-
14
Jul-14
Oct
-14
Jan-1
5
Apr-
15
Jul-15
Oct
-15
Diageo European consumer staples
2010
2011
2012
20132014
2015
2016
2017
60
70
80
90
100
110
120
130
140
150
Oct
-07
Mar
-08
Au
g-0
8
Jan
-09
Jun
-09
No
v-0
9
Ap
r-1
0
Sep
-10
Feb
-11
Jul-
11
De
c-1
1
May
-12
Oct
-12
Mar
-13
Au
g-1
3
Jan
-14
Jun
-14
No
v-1
4
Ap
r-1
5
Sep
-15
Source: Thomson Reuters Source: Thomson Reuters
Figure 68: Diageo now trades on FY16E calendarised
20.4x P/E, a c5% discount to European consumer staples Diageo FY16E calendarised P/E v European consumer staples - x
Figure 69: Diageo traded at a sector premium when it was
hitting its previous targets in FY12-13 Diageo 12m forward P/E relative to European consumer staples
10
12
14
16
18
20
22
24
26
28
80
85
90
95
100
105
110
Jan
-03
Sep
-03
May
-04
Jan
-05
Sep
-05
May
-06
Jan
-07
Sep
-07
May
-08
Jan
-09
Sep
-09
May
-10
Jan
-11
Sep
-11
May
-12
Jan
-13
Sep
-13
May
-14
Jan
-15
Sep
-15
Source: Credit Suisse estimates Source: Thomson Reuters
29 October 2015
Diageo (DGE.L) 28
Figure 70: We expect Diageo to moderate its growth in
maturing stock to c4% per annum Diageo maturing stock - £m
Figure 71: Diageo's trades on a FY16E 14.5x EV/maturing
stock, a c10% discount to its historical average Diageo EV/maturing stock - x
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
8% CAGR 2006-15
4% CAGR 2016-19
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates
Figure 72: Diageo has guided to a slowdown in its
dividend growth to mid-single digits, from 8% growth in
recent years Diageo dividend per share - pence
Figure 73: Even on this basis, Diageo's 3.3% dividend
yield is among the highest in European consumer staples
outside of the tobacco stocks, backed by stronger FCF Calendarised FY16E dividend yield - %
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
8% CAGR
5% CAGR
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
Source: Company data, Credit Suisse estimates Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 29
Target price – increase to 2,100p
We raise our target price to 2,100p from 1,780p, driven by an improvement in our free cash flow forecasts.
We make the following assumptions;
■ Revenue growth: as per our explicit forecasts out to FY20, beyond which the growth rate fades to 2.5% (consistent with peers)
■ EBIT margin: We assume 30-40bps margin expansion per annum out to FY20, beyond which we assume 30bps
■ Capex/depreciation: This declines from 1.5x in FY16E to 1.2x in FY20E, consistent
with guidance of medium-term capex at 4-5% of net sales. Beyond FY20, we assume
capex/depreciation fades to 1.15x (consistent with peers)
■ Tax rate: We assume the tax rate slightly increases per annum to 21% in FY20 and remains at this level thereafter.
■ Balance sheet: We value the tax shield based on net debt/EBITDA at 2.75x, at the mid-point of management's target of 2.5-3.0x.
■ Valuation of associates: We value Diageo's 34% stake in Moet Hennessey based on the fair value derived in LVMH's recent accounts (which is based upon valuation multiples of comparable firms), with the remaining assets at book value, which implies an effective 24x P/E on Diageo's share of income from associates & JVs.
■ Valuation of minority interests: We value Diageo's minority interests excluding USL (mainly Guinness Nigeria, EABL, and Ketel One) on a valuation multiple consistent with Diageo, whilst we value the minority stake in United Spirits at 35x P/E (a 50% discount to its market valuation).
Figure 74: We raise out target price to 2,100p Diageo adjusted present value calculation - £m
Assumptions
Cost of equity 8.0%
Perpetuity growth rate 2.5%
Cost of debt 3.5%
Tax rate 19.8%
Cost of debt (post tax) 2.8%
Terminal capex/depreciation 1.15
Adjusted present value
Free cash flow NPV 27,342
Terminal value 28,533
Value of tax shield 3,830
Enterprise value 59,705
Net debt (calendarised) -9,092
Minority interest -3,121
Associates 4,767
Equity value - £m 52,258
Number of shares - m 2,515
Equity value per share - pence 2,078
Current share price 1,863
Upside/(downside) - % 12% Priced as of 27 October 2015
Source: Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 30
Credit Suisse HOLT® Based on Credit Suisse HOLT, we derive a fair value of £19.53 per share for Diageo,
suggesting c5% upside potential.
The CFROI® chart at the top of Figure 75 is a reflection of our forecasts for sales, margins
and asset turns. Our assumptions result in a 2016 CFROI of 22.7%, reducing slightly to
c22.4% in FY18 before rebounding to 23.3% by FY20. This is driven by a steady increase
in EBITDA margins and asset turns.
Figure 75 shows our model for Diageo in terms of sales, margins and turns. Our estimates
indicate a long-term topline growth rate of c5.5%. We expect asset turns to grow steadily
over the explicit period reaching 0.79 in FY20 and 0.83 in FY25.
Beyond the 10-year window, HOLT assumes the CFROI and discount rate fade to 6.0%,
while the asset growth fades to 2.5%—incorporating the economic reality of competition
and causing high returns and growth to regress to the mean.
By way of sensitivity, assuming that Diageo's CFROI fades by 7.5% per annum instead of
10% (consumer staples companies have a track record of being able to sustain their
relatively high CFROIs for a longer period of time), the HOLT warranted value rise to
£22.73, suggesting 22% upside from current levels.
29 October 2015
Diageo (DGE.L) 31
Figure 75: Credit Suisse HOLT suggests 5%potential upside from current levels in £millions, unless otherwise stated
Current Price: GBP 18.63 Warranted Price: GBP 19.53 Valuation date: 28-Oct-15
Sales Growth (parallel % point change to forecasts) Jun 14A Jun 15A Jun 16E Jun 17E Jun 18E
GBP -2.0% -1.0% 0.0% 1.0% 2.0% Sales Growth, % -10.3 5.4 -3.0 3.4 5.4
EBITDA Mgn, % 33.6 31.5 32.4 32.8 33.2
Asset Turns, x 0.78 0.8 0.8 0.8 0.8
CFROI®, % 24.3 23.3 22.7 22.4 22.5
Disc Rate, % 4.3 3.3 3.3 3.3 3.3
Asset Grth, % -9.8 3.3 -5.1 3.0 3.4
Value/Cost, x 4.6 5.2 4.3 4.1 3.9
Economic PE, x 19.1 22.1 18.8 18.2 17.2
Leverage, % 20.8 18.1 16.5 15.8 14.9
HO
LT
-
C
red
it S
uis
se
An
aly
st
Sc
en
ari
o D
ata
DIAGEO PLC (DGE)
EB
ITD
A M
arg
in (
para
llel
% p
oin
t ch
an
ge
to f
ore
cas
ts)
-2.0% -24% -14% -4% 8%
32%
21%
-1.0% -20% -10% 0% 13% 26%
0.0% -16% -6% 5% 17%
42%
1.0% -13% -2% 9% 22% 37%
2.0% -9% 2% 14% 27%
For display purposes, these charts have been capped as follows. CFROI levels are kept within 0% and 15%.
More than
10%
downside
Within 10%More than
10% upside
Source: Credit Suisse HOLT®. CFROI and HOLTare trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries.
-15
-10
-5
0
5
10
2011 2013 2015 2017 2019 2021 2023 2025
Sales Growth (%)
0
5
10
15
20
25
30
35
40
2011 2013 2015 2017 2019 2021 2023 2025
EBITDA Margin
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
2011 2013 2015 2017 2019 2021 2023 2025
Asset Turns (x)
0
5
10
15
20
25
30
2011 2013 2015 2017 2019 2021 2023 2025
Historical CFROI Historical Transaction CFROI Forecast CFROI
Forecast CFROI CFROI Discount Rate
CFROI & Discount Rate (in %)
-15
-10
-5
0
5
10
15
20
2011 2013 2015 2017 2019 2021 2023 2025
Historical Asset Growth Rate Forecast Growth Forecast Growth
RAGR Normalised Growth Rate
Asset Growth (in %)
Source: Company data, Credit Suisse HOLT, Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 32
Key risks ■ The return of target setting: Diageo has returned to setting group targets of mid-
single-digit organic growth and 100bps margin in FY17-19. Back in FY11, the
company set a target of 6% medium-term organic growth and a 200bp margin
expansion in FY11, which became a constraint on the business as economic
conditions changed, particularly in emerging markets. However, we believe Diageo is
now better invested, with a bigger focus on volume growth in the mainstream/value
segment, which is less economically sensitive.
■ Currency movements: Significant currency depreciation across emerging markets
have led to destocking, particularly of imported premium spirits, which are priced and
manufactured in hard currency. Whilst management has guided to a completion of
destocking over the next few months, any further currency volatility could lead to
further destocking by distributors in emerging markets.
■ Rise of craft spirits: As we wrote in our report "Rising threat of US craft spirits, July
2015", the US spirits market faces a growing threat of substitution. A market that had
been characterised by large-scale national brands is becoming increasingly focused
on local, authentic, small-batch production. We believe Diageo could be more exposed
than Pernod (the US represents c40% of group EBIT), and our forecasts for North
America capture continued market share losses.
29 October 2015
Diageo (DGE.L) 33
Company overview Figure 76: Diageo company overview in £millions, unless otherwise stated
Diageo (DGE.L) Shareholder structure
FY 2015 (y/e Jun) North America Europe LatAm Africa Asia Pacific Corporate Total Segment
Volumes (m cases) 47.3 44.1 21.6 26.2 107.0 - 246.2
% Volumes 19% 18% 9% 11% 43% -
Revenue 3,455 2,617 1,033 1,415 2,213 80 10,813
% of total revenue 32% 24% 10% 13% 20% 1%
EBIT Underlying 1,448 804 263 318 356 -123 3,066
EBIT margin - % 41.9% 30.7% 25.5% 22.5% 16.1% - 28%
% of total EBIT 45% 25% 8% 10% 11%
Key Markets
USA, Canada UK, Germany, Spain,
Russia, Turkey
Brazil, Mexico,
Argentina, Venezuela
Nigeria, Kenya, South
Africa
China, Australia, India,
Japan, Thailand, Korea
Main Brands
Smirnoff, Ciroc,
Captain Morgans,
Baileys, Popov, Ketel
One, Guinness
Smirnoff, Baileys,
J&B, Cuervo,
Guinness,
Tanqueray
Smirnoff, Buchanan's,
Ciroc, Captain
Morgans, Johnnie
Walker
Smirnoff, Bells, Black
& White, Guinness,
J&B, Johnnie Walker Johnnie Walker, Buchanan's
Competitors
Pernod, Beam Inc,
Brown Forman,
Bacardi,
Pernod, Bacardi,
Campari, LVMH
Bacardi, Pernod
Ricard, Lascelles
Demercado, LVMH,
Beam, Remy
Pernod Ricard, Remy,
Bacardi
Pernod Ricard, LVMH, Remy
Cointreau, Brown Forman
Segment
Diageo is the global leader in international spirits with dominant positions in N
America, LatAm, Africa and Europe. Created by the merger of Guinness and
Grand MET in 1997. Diageo's products are sold in over 180 countries.
Diageo is 100% free-float. The company has a 34% stake in Moet Hennessy, which it
accounts for as an associate
TOTAL COMPANY
Revenues EBIT Volumes
North America
32%
Europe24%
LatAm10%
Africa13%
Asia Pacific21%
North America
46%
Europe25%
LatAm8%
Africa10%
Asia Pacific11%
North America
19%
Europe18%
LatAm9%Africa
11%
Asia Pacific43%
Source: Company data, Credit Suisse research
29 October 2015
Diageo (DGE.L) 34
Financial Model Figure 77: Diageo forecasts by region in £millions, unless otherwise stated
2015 2016E 2017E 2018E
Revenue analysis
Volume -1.3% 1.8% 2.9% 3.7%
Price/mix 1.3% 1.5% 1.9% 1.7%
Organic revenue 0.0% 3.3% 4.8% 5.4%
M&A 8.7% -2.4% -1.5% 0.0%
FX -3.3% -3.9% 0.1% 0.0%
Total 5.4% -3.0% 3.4% 5.4%
Net sales 10,813 10,487 10,842 11,432
EBIT 3,066 3,002 3,154 3,370
EBIT margin - % 28.4% 28.6% 29.1% 29.5%
organic change - bps 24 9 32 39
change - bps -220 27 46 39
Organic EBIT 0.7% 3.6% 6.0% 6.9%
M&A 2.2% -1.7% -1.1% 0.0%
FX -5.1% -4.0% 0.2% 0.0%
Total -2.2% -2.1% 5.1% 6.9%
Net sales
North America 3,455 3,478 3,511 3,634
Europe 2,617 2,382 2,371 2,407
Africa 1,415 1,397 1,536 1,690
Latin America and Caribbean 1,033 945 994 1,069
Asia Pacific 2,213 2,253 2,397 2,601
Corporate 80 32 32 32
Total 10,813 10,487 10,842 11,432
Organic revenue - %
North America -1.4% 2.6% 3.5% 3.5%
Europe 0.1% 0.7% 1.5% 1.5%
Africa 6.4% 7.3% 10.0% 10.0%
Latin America and Caribbean -1.1% 4.3% 7.5% 7.5%
Asia Pacific -2.4% 4.6% 6.0% 8.5%
Corporate 3.2% 0.0% 0.0% 0.0%
Total 0.0% 3.3% 4.8% 5.4%
EBIT
North America 1,448 1,487 1,531 1,599
Europe 804 731 745 768
Africa 318 309 345 387
Latin America and Caribbean 263 235 252 277
Asia Pacific 356 352 392 443
Corporate -123 -113 -110 -104
Total 3,066 3,002 3,154 3,370
EBIT margin - %
North America 41.9% 42.8% 43.6% 44.0%
Europe 30.7% 30.7% 31.4% 31.9%
Africa 22.5% 22.1% 22.4% 22.9%
Latin America and Caribbean 25.5% 24.9% 25.3% 25.9%
Asia Pacific 16.1% 15.6% 16.3% 17.0%
Total 28.4% 28.6% 29.1% 29.5% Source: Company data, Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 35
Figure 78: Diageo P&L forecasts in £millions, per share data in pence, unless otherwise stated
2015 2016E 2017E 2018E
Net sales 10,813 10,487 10,842 11,432
EBITDA 3,465 3,393 3,558 3,796
Depreciation & amortisation -399 -391 -404 -426
Adjusted EBIT 3,066 3,002 3,154 3,370
Exceptional items -269 -65 0 0
EBIT - reported 2,797 2,937 3,154 3,370
Sales of businesses 373 0 0 0
Net interest cost -360 -323 -283 -261
Net other finance charges -52 -45 -35 -25
Share of profits from associates/JVs 175 195 216 239
Clean profit before tax 2,829 2,829 3,052 3,323
Profit before tax 2,933 2,764 3,052 3,323
Underlying tax expense -517 -521 -569 -628
Tax on exceptionals 51 13 0 0
Total tax expense -466 -508 -569 -628
Effective tax rate - % 19.5% 19.8% 20.1% 20.4%
Tax rate - % 18.3% 18.4% 18.7% 18.9%
Clean profit after tax 2,312 2,308 2,483 2,695
Profit after tax 2,467 2,256 2,483 2,695
Minority interests -87 -89 -100 -117
Adjusted net income 2,225 2,218 2,383 2,578
Net income 2,381 2,166 2,383 2,578
Average number of shares - basic 2,505 2,507 2,509 2,510
Average number of shares - diluted 2,515 2,517 2,519 2,520
Adjusted EPS - fully diluted 88.5 88.1 94.6 102.3
Adjusted EPS - basic 88.8 88.5 95.0 102.7
EPS - fully diluted 94.7 86.1 94.6 102.3
EPS - basic 95.0 86.4 95.0 102.7
DPS 56.4 59.2 62.2 65.3
Dividend cover - x 1.6 1.5 1.5 1.6 Source: Company data, Credit Suisse estimates
29 October 2015
Diageo (DGE.L) 36
Figure 79: Diageo cash flow forecasts in £ millions, unless otherwise stated
2015 2016E 2017E 2018E
EBIT 3,066 3,002 3,154 3,370
Depreciation & amortisation 399 391 404 426
Working capital 117 -53 -171 -209
Dividends received 183 186 208 229
Post employment payments -70 -70 -70 -70
Cash exceptionals -191 -65 0 0
Other items -48 0 0 0
Cash from operations 3,456 3,392 3,525 3,746
Net interest expense -416 -323 -283 -261
Tax expense -489 -508 -569 -628
Net cash from operating activities 2,551 2,560 2,672 2,857
Capex -638 -598 -564 -572
Asset disposals 52 50 50 50
Movement in loans -2 0 0 0
UK pension escrow payment 0 0 0 0
Free cash flow 1,963 2,012 2,158 2,335
Cash flow from other investing activities
Acquisitions -1,283 -140 0 0
Disposals/other 978 1,065 0 0
Total -305 925 0 0
Cashflow from financing activities
Share issues/(buybacks) -7 -5 -5 -5
Dividends to minority interests -72 -74 -83 -97
Dividends to shareholders -1,341 -1,468 -1,515 -1,591
Total -1,420 -1,547 -1,602 -1,693
Net debt - opening -8,850 -9,527 -8,199 -7,643
Change in cash flows 238 1,390 556 642
Exchange differences -7 -62 0 0
Acquired debt -869 0 0 0
Other non-cash items -39 0 0 0
Net debt - closing -9,527 -8,199 -7,643 -7,001
EBITDA 3,465 3,393 3,558 3,796
Net debt/EBITDA - x 2.7 2.4 2.1 1.8 Source: Company data, Credit Suisse estimates
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Diageo (DGE.L) 37
Companies Mentioned (Price as of 27-Oct-2015)
Anheuser-Busch InBev (ABI.BR, €106.15) Beiersdorf (BEIG.DE, €85.0) British American Tobacco (BATS.L, 3793.5p) Carlsberg (CARLb.CO, Dkr539.0) Danone (DANO.PA, €62.81) Diageo (DGE.L, 1863.0p, OUTPERFORM, TP 2100.0p) Heineken (HEIN.AS, €80.16) Henkel (HNKG_p.F, €98.45) Imperial Tobacco (IMT.L, 3454.0p) L'Oreal (OREP.PA, €171.1) Nestle (NESN.VX, SFr75.2) Pernod-Ricard (PERP.PA, €105.0) Philip Morris International (PM.N, $88.82) Reckitt Benckiser (RB.L, 6294.0p) Unilever (UNc.AS, €41.12) United Spirits Ltd. (UNSP.BO, Rs3143.45)
Disclosure Appendix
Important Global Disclosures
I, Sanjeet Aujla, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
3-Year Price and Rating History for Diageo (DGE.L)
DGE.L Closing Price Target Price
Date (p) (p) Rating
21-Dec-12 1807.50 1900.00 O
04-Mar-13 1975.00 1975.00
07-Mar-13 2000.50 2350.00
18-Apr-13 1978.00 *
11-Jun-13 1906.00 2350.00 O
12-Dec-13 1880.00 2200.00
28-Apr-14 1821.50 1950.00 N
18-Dec-14 1831.00 1850.00
13-Mar-15 1864.00 1700.00 U
20-Apr-15 1870.50 1800.00
08-Jun-15 1880.00 1800.00 N
28-Jul-15 1819.00 *
31-Jul-15 1789.50 1750.00 N
06-Oct-15 1819.00 1780.00
* Asterisk signifies initiation or assumption of coverage.
O U T PERFO RM
N EU T RA L
U N D ERPERFO RM
The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities
As of December 10, 2012 Analysts’ stock rating are defined as follows:
Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark*over the next 12 months.
Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months.
Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months.
*Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's c overage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing t he most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ra tings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin Ame rican and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 1 2-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, wh ich was in operation from 7 July 2011.
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Diageo (DGE.L) 38
Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.
Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.
Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation:
Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months.
Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months.
Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months.
*An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cov er multiple sectors.
Credit Suisse's distribution of stock ratings (and banking clients) is:
Global Ratings Distribution
Rating Versus universe (%) Of which banking clients (%)
Outperform/Buy* 58% (34% banking clients)
Neutral/Hold* 27% (33% banking clients)
Underperform/Sell* 13% (23% banking clients)
Restricted 2%
*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, an d Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdin gs, and other individual factors.
Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein.
Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research-and-analytics/disclaimer/managing_conflicts_disclaimer.html
Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties.
Price Target: (12 months) for Diageo (DGE.L)
Method: Our price target is derived from an APV (adjusted present value) - a hybrid discounted cash flow which splits the value of the tax shield from the operating cash flows (the latter discounted at a cost of equity of 8%). We value Diageo's 34% stake in Moet Hennessey based on the fair value derived in LVMH's recent accounts (which is based upon valuation multiples of comparable firms), with the remaining assets at book value. We value Diageo's minority interests excluding USL (mainly Guinness Nigeria, EABL, and Ketel One) on a valuation multiple consistent with Diageo, whilst we value Diageo's minority stake in United Spirits at a 50% discount to its market valuation.
Risk: Increased regulation in Europe/US. Level of investment required to build international markets. Competitor activity, excessive excise duty increases.
Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections.
See the Companies Mentioned section for full company names
The subject company (DGE.L, HEIN.AS, NESN.VX, BEIG.DE, BATS.L, IMT.L, PM.N, ABI.BR, UNSP.BO) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse.
Credit Suisse provided investment banking services to the subject company (HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N) within the past 12 months.
Credit Suisse provided non-investment banking services to the subject company (NESN.VX) within the past 12 months
Credit Suisse has managed or co-managed a public offering of securities for the subject company (HEIN.AS, NESN.VX, PM.N) within the past 12 months.
Credit Suisse has received investment banking related compensation from the subject company (HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N) within the past 12 months
Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (DGE.L, PERP.PA, HEIN.AS, NESN.VX, DANO.PA, BEIG.DE, BATS.L, IMT.L, PM.N, ABI.BR, UNSP.BO) within the next 3 months.
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Diageo (DGE.L) 39
Credit Suisse has received compensation for products and services other than investment banking services from the subject company (NESN.VX) within the past 12 months
As of the date of this report, Credit Suisse makes a market in the following subject companies (PM.N).
Please visit https://credit-suisse.com/in/researchdisclosure for additional disclosures mandated vide Securities And Exchange Board of India (Research Analysts) Regulations, 2014
Credit Suisse may have interest in (UNSP.BO)
As of the end of the preceding month, Credit Suisse beneficially own 1% or more of a class of common equity securities of (DGE.L, NESN.VX, IMT.L).
Credit Suisse has a material conflict of interest with the subject company (NESN.VX) . Credit Suisse AG is acting as an agent in relation to the company's announced share buy-back program for capital reduction purposes.
For other important disclosures concerning companies featured in this report, including price charts, please visit the website at https://rave.credit-suisse.com/disclosures or call +1 (877) 291-2683.
Important Regional Disclosures
Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report.
The analyst(s) involved in the preparation of this report may participate in events hosted by the subject company, including site visits. Credit Suisse does not accept or permit analysts to accept payment or reimbursement for travel expenses associated with these events.
Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares.
Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report.
For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit https://www.credit-suisse.com/sites/disclaimers-ib/en/canada-research-policy.html.
Credit Suisse Securities (Europe) Limited (Credit Suisse) acts as broker to (IMT.L).
The following disclosed European company/ies have estimates that comply with IFRS: (DGE.L, PERP.PA, HEIN.AS, CARLb.CO, NESN.VX, UNc.AS, DANO.PA, OREP.PA, HNKG_p.F, BEIG.DE, RB.L, BATS.L, IMT.L, ABI.BR).
Credit Suisse has acted as lead manager or syndicate member in a public offering of securities for the subject company (DGE.L, HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N, UNSP.BO) within the past 3 years.
As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report.
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To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
Credit Suisse International ................................................................................................................. Sanjeet Aujla ; Pavan Daswani ; Charlie Mills
Important Credit Suisse HOLT Disclosures
With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm’s compensation was, is, or will be directly related to the specific views disclosed in this report.
The Credit Suisse HOLT methodology does not assign ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the Credit Suisse HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default algorithms available in the Credit Suisse HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. The adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to produce alternative scenarios, any of which could occur.
Additional information about the Credit Suisse HOLT methodology is available on request.
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Diageo (DGE.L) 40
The Credit Suisse HOLT methodology does not assign a price target to a security. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variable may also be adjusted to produce alternative warranted prices, any of which could occur.
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