Diageo [Di’a djo] came about by way of a giant merger 22 years ago and owns a number of the world’s most famous liquors and spirits. The company has overcome a few difficult years and is once again delivering growth rates and earnings that we, as co-owners, can appreciate. The company’s prospects are very much in line with the global increase in prosperity. Most of us probably did not know that India is the world’s largest whisky market – and this is something that Diageo benefits from greatly.
If you drink alcohol, you are probably familiar with one or more of Diageo’s more than 200 brands, which are sold in 180 countries. Diageo sells for more than 12 billion British pounds a year, has a market share of around 25 percent of the global spirits market and is 50 percent larger than its closest competitor.
Even though Diageo has more than 200 different brands, a large part of its revenue is from its six largest brands: Johnnie Walker, Smirnoff, Baileys, Captain Morgan, Tanqueray and Guinness. These six brands combined is what Diageo refers to as their ‘global giants’, and they represent over 40 percent of revenue. Johnnie Walker, Smirnoff, Baileys and Captain Morgan are all the best or next-best selling brands within, respectively, Scotch, vodka, liquor and rum. In addition, Guinness is the leading brand for stout beers, while Tanqueray is the third-best selling gin brand.
These strong brands are the main reason why Diageo has significant market shares in the various spirits categories. When it comes to Scotch whisky, they have a unique position as Diageo has a market share of over 30 percent. Scotch whisky is also Diageo’s largest spirits category, and it represents more than one out of every four pounds in revenue.
The revenue is mainly from Diageo’s largest and most important brand (in terms of sales and profitability) – Johnnie Walker. Diageo is gaining market shares and has shown accelerating growth rates in the last three years after having gotten past some difficult years. Strong and stable growth in the majority of the spirits categories is supplemented by a high-growth market for gin. Here, Diageo’s flagship brand, Tanqueray, is growing revenues at a rate of 20 percent per year. The largest growth is in the tequila category, which is roaring ahead, and amounts to approximately three percent of the total sales. The segment with the luxury tequila, Don Julio, is seeing organic growth of 30 percent. Tequila thus contributed with approximately one percentage point of Diageo’s total sales growth of 7 percent when management last reported.
Tequila with high growth rates
Geographically, Diageo is well-diversified and has a global presence. The North American market is the largest and most profitable for Diageo, being over a third of the company’s total revenue and almost half of its operating income. Next in line are Europe, Asia, Africa, and Latin and South America when measured by sales. The company holds a unique market position in Africa compared to its closest competitors, and in particular the sales of beer is doing well. Diageo’s total beer sales, which amount to just over 15 percent of the company’s total sales, is growing nicely while other breweries have seen declining sales.
Diageo’s geographic position and global network provide the company with good opportunities for optimising their distribution. This is because Diageo’s spirits can be delivered via the same trucks as their beers – and as beers have faster turnover, and are thus delivered at shorter intervals, the spirits can be as well. These economies of scale provide the company with greater flexibility than many of its competitors.
Overall, the company is expecting to grow sales organically by four to six percent on an annual basis. Growth is to come from increases in population and increases in wealth. The increasing prosperity around the world allows for consumers to afford finer and more expensive alcohol. In the developing world, growing prosperity increases the availability of spirits where large parts of the alcohol consumed are still from non-commercial brands – and perhaps, even illegal.
In addition to growing sales organically, Diageo also acquires smaller spirits companies in the most attractive categories where Diageo assesses that they can create more value than the previous owners. An example of this is when Diageo acquired the tequila brand Casamigos in 2017. Casamigos, which was founded by George Clooney, Rande Gerber and Mike Meldman in 2013 grew by over 70 percent last year. This is a quickly growing tequila brand in an attractive category, and with Diageo’s global presence, the company can grow the brand faster and more efficiently than its previous owners.
However, Diageo is managing the growth of the brand with a firm hand – therefore it can only be bought at carefully chosen locations. We are generally not fans of acquisitions, but Diageo’s management, which has been headed by CEO Ivan Menezes since 2013, has become more disciplined in their capital allocation. They have also divested brands such as Seagram’s and categories such as their wine business, which were not deemed to be worth keeping. The profits from these divested brands in the first half of 2019 of 340 million pounds, will be distributed to the company’s shareholders by increasing the share buyback programme to a total of 3 billion pounds, amounting to approximately 4.5 percent of the market value. Today, the debt amounts to almost two times operating income before depreciation and amortisation.
9,000-year long lease agreement
Diageo came into its current form when Grand Metropolitan and Guinness merged in 1997, and therefore the name itself is not particularly old. However, the majority of the brands have a long history. One of the oldest of these is Guinness, which was founded by Arthur Guinness in 1759. While it is definitely fair to say that Arthur Guinness had high hopes for his ale right from the start (seeing as how he signed a 9,000-year lease for the property wherein it was produced), he had probably not imagined just how large Guinness would end up becoming, both as an individual brand, but also as part of a greater Diageo.
Many of Diageo’s spirit brands are highly reputable and have been around for more than 150 years, and this makes it difficult for new spirits producers to match them. The company is trying to take advantage of this familiarity with their brands by introducing consumers to the brands as quickly as possible. This hopefully creates a certain degree of customer loyalty towards the brand, why the relationship hopefully lasts longer.
The relationship with the consumers is important – including when consumers find themselves with more disposable income making them able to afford better and finer drinks. This is a focus area for Diageo: making the consumers, over time, buy more expensive brands while at the same time remaining loyal to the brand they already know. This transition to pricier categories is easier to manage when the consumers are familiar with a brand and can then upgrade their purchasing habits to a pricier and better product of the same brand. For the spirits producer, it is thus important to have products that make it easier and more of an obvious choice for consumers to switch from the less-exclusive product to a more exclusive one, and this is something Diageo is very good at. An obvious example is Johnnie Walker. Johnny Walker makes eight different kinds of Scotch whisky that range from the lower-priced Johnnie Walker Red Label to more expensive and exclusive labels – such as the prestigious Blue Label.
Diageo holds a leading market position in what is termed the premium category which covers the most exclusive spirits. As time goes by, most consumers’ drinking habits often move towards better and more expensive brands as consumers generally decrease their consumption while in return appreciating finer quality spirits more. And it should be noted, they are willing to pay more for this higher quality.
India – the world’s largest market for whisky
Besides the familiarity and association with Diageo’s brands, a large part of Diageo’s revenue is protected by natural competitive advantages. Scotch is a protected trademark, and the making needs to meet several criterias before it can be marketed as Scotch. This includes that the whisky must be distilled in Scotland and be aged there for at least three years. The aging process grants Diageo and other producers of Scotch an advantage. The aging process makes the whisky better year by year, and this process can quite naturally not be accelerated. Thus, new producers of aged spirits cannot compete with the existing products right away. At the same time, it means that the Scotch that the producers have stored does not lose value over time.
Similar protections benefit categories such as Champagne and Cognac, as both of these are protected by the French Appelation d’origine contrôlée certification – this means that only producers in the Champagne and Cognac regions, respectively, can call their products Champagne and Cognac. Diageo has no direct ownership stake in these categories but has an indirect ownership via its one third ownership stake in Möet Hennessy. LVMH, which we are also co-owners of, owns the remainder of the company. The co-ownership of Möet Hennessy thus gives access to attractive and protected Champagne and Cognac brands.
The co-ownership of Möet Hennessy is not Diageo’s only important outside ownership; their ownership share of the Indian United Spirits Limited is also highly important. Diageo owns 55 percent of United Spirits Limited, which mainly operates out of India. India is the third-largest whisky market in the world – three times larger than the US market. The sale of whisky in India has grown at an annual rate of 15 percent over the last five years, and the sale of Scotch is also growing. India is now the third-largest market for Scotch in the world.
The heritage and history of these spirits brands do not, however, mean that marketing is superfluous. The company has increased its marketing investments as a percentage of revenue since 2016. As a result of an increased focus on cost cutting, Diageo has introduced a new streamlining programme that, combined with a larger share of revenue from pricier products, is to increase the operating margin by 1.75 percentage points from 2016 to 2019. In this context, two thirds of the savings have been earmarked for reinvestment in the brands, and we find this to be reasonable for a company that generates returns on invested capital of almost 17 percent. The remaining savings should flow to the bottom line and strengthen Diageo’s free cash flows, which for the 2018 financial year were over 2.5 billion pounds.
Diageo’s strong and diverse product portfolio of liquors and spirits and its unique size make us confident about the company’s future opportunities for value creation – a value creation that we, as co-owners, will look forward to benefitting from. At the same time, as shareholders we receive dividends corresponding to just over two percent of the market value each year in addition to the share buybacks. These dividends can be savoured together with one of the many fine spirits that the company produces.