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PLAYING TO WIN

Diageo is the world's biggest premium drinks company. It dominates its chosen industry unlike any other. It is valued by the market at well over 21 billion, almost six times the size of its nearest quoted rival, Allied Domecq, and owns 19 of the world's top 100 premium drinks brands by volume. Diageo sold 72 million nine-litre case equivalents of spirits, wine and beers in 2001 and in the six months to 31 December 2002 its sales were a monumental 5.4 billion, while its operating profit grew by 23%. But its critics say the drinks giant has been the product of mergers and acquisitions (first of Distillers by Guinness, then the 1997 merger of Guinness with Grand Metropolitan, and finally the 2001 joint takeover of Seagram's in concert with Pernod Ricard). How good is it at organically expanding its business? Chief executive Paul Walsh is in no doubt. We set out our strategy in early 2000: we would build on our position as the leader in the world of premium drinks and focus the business,' he says. At that point we were basically a four-legged stool. Guinness was quite separate to the wine and spirits business, plus we had Pillsbury [packaged foods] and we had Burger King. But increasingly in the world of consumer products you need to be focused. You need to be either the big player or the niche player. You don't want to be in the middle. Both the fast foods and packaged foods businesses were very much in the middle. But we were leaders in premium drinks and therefore my strategy was to focus on premium drinks and build up that position. That was a good time to sell businesses. I'm glad we did it back then and not now. Timing is everything.' Diageo took a loss of $1.4 billion on the sale of Burger King last year, but Walsh says that that was a good result, and one he would take again today. Fortunately, on the way through, the Seagram's opportunity presented itself. I was very determined to prevail with our Seagram's bid, because that just took us to a whole new level.' Walsh says both he and Patrick Ricard knew from the outset exactly how they would carve up the Seagram's portfolio. Winning Captain Morgan and Royal Canadian whiskey means that Diageo now has the leading or second brand in every US spirits category. So, that was the strategy in 2000 and I think we've executed it fairly well for two and a half years. Really, it's now more of the same. With premium drinks, we've tried to bring together our beer brand and our wine and spirits brands. Increasingly, the consumer does not look at spirits, wine and beers; they look at an occasion. If it's a hot weekend and I'm in the garden, a nice cold Guinness hits the spot. On a winter's evening I love a Johnnie Walker Gold Label. People have a broad range of brand repertoires and we have to mix and match our brands to those particular opportunities.' But Walsh does not rule out further acquisitions. Given our size and scope, we're going to have to play the expansion game a little differently to others. For us, acquisitions in spirits will be difficult, but not impossible. They're more likely to be of targeted brands rather than categories, because we've got most of the things we want.' Does that mean Cognac and Champagne? We've got 34% of Mot Hennessy and that gives us pretty much what we need. But if the opportunity presented itself at the right price, then yes. But today, I'm just delighted with the relationship we have. It's a shareholding, where all the cash is returned as a dividend, so we get our fair share of the economic value. I wouldn't necessarily run the business any differently from the way Mot Hennessy is running it. But if [LVMH chief] Monsieur Arnault were to sell that business and go deeper into fashion, or whatever, we would be a logical buyer. It's a very nice position to be in.'

Wine acquisitions if the price is right What about wine? The Seagram's takeover brought with it Sterling Vineyards to join Beaulieu and Blossom Hill, but Diageo is generally reckoned to be under-represented in the market. The wine sector is an interesting one. I like the consumer trends; I've said that for a number of years. I've also said that I was worried about the short-term outlook for wine, particularly the glut of Chardonnay coming down the pipe. The industry will work through that. And therefore, as long as values correct themselves, now could be a reasonable time to look at wine acquisitions. However, you've got to be very cautious about the economics. This is a more capital-intensive business category than spirits, and the way to tip that balance towards being just too capital intensive is to overpay for assets.' Walsh hints that this is why he did not enter the bidding for Montana in 2001 against Allied Domecq. Fantastic brand, but too expensive,' he says. Many people have accused us of sitting on our hands, but we will sit on our hands until the right wine opportunity comes along. Then we will play to win. We've looked at a number of opportunities, but, given our view, reality says we were correct. In the opportunities we've looked at, the brand owners' perception of value has not changed sufficiently - they're still too expensive. But yes,' he admits, there has not been enough focus on wine, and the reason for that is that when you've got all these other brands with the margins they enjoy, that's what you look at. We've made some organisational changes to create a single-minded focus on wine, while still benefiting from the scope and scale of Diageo. So there's something we can build on.'

Southcorp and RTDs Is Diageo interested in Southcorp? I don't think it is the right opportunity for us now,' says Walsh, but it's got some great brands. Don't forget, we had them in the UK and Southcorp pulled them back. That's a great example of how the sales component of a business can be overlooked. Unless you have a good route to market you will not optimise the performance of the brand.' Walsh is expecting his rivals to attempt to join forces. But we will have great fun for two years while they do,' he says. What he means is that anything other than loose joint-venture marketing deals, especially in spirits, will face big regulatory hurdles in Brussels and Washington, and by the time an approved deal is in place, Diageo will have increased its market share further, because of the strength of its brands and the huge investment that goes into them. What makes brands great is budgets. We now have 60% of our volume coming from the Global Priority Brands and they get a disproportionate amount of advertising spending. The best example of that is Bailey's. People forget that it is a big brand. It sells over six million cases and we're increasing that by 12% a year. We're also doing very well on Smirnoff and I'm proud of our progress with Johnnie Walker, especially in Latin America, where times are very tough. The brands where I want to see us step it up a bit are Jose Cuervo and Tanqueray.' Are they ripe for the ready-to-drink treatment that has been such a driver for Smirnoff, especially in America, where Walsh admits the margins have been fantastic'? When there is a gap, then we innovate. That's what we did with RTDs. We identified that the consumer wants refreshment and likes the imagery of a spirits brand - it's a bit more cool. The flavour is a bit better than beer, and therefore we went after that opportunity with RTD. Smirnoff Ice has been a great success,' he says, and RTD on a global basis continues to do very well. We suffered in the UK with the tax hike last year. That gave us a big price gap to premium packaged beer, which I think is rather unfair, because it's the same alcohol content. That hurt some of our profit margin and our ability to promote the product. A year ago, competition was mounting in the US. Now it is going the other way. It was getting hotter six months ago. Everybody saw the success of Ice and rushed to that particular horse trough. With Captain Morgan Gold [which was withdrawn at a cost of 18 million] we went too soon, as others did, and you are now seeing a lot of those products pulled back; they are contracting from national distribution. In six months' time many of them won't be there. It's a lot easier to produce an RTD with a white spirit. Brown spirits or anything with a very strong aroma immediately alienate a certain group of consumers. Therefore, you are fishing in a much smaller pool. That does not mean, though, that you will never have a win on a brown spirit. Sauza's Diablo hasn't made it, but [a Tequila-flavoured RTD] is part of the development programme. Even a gin has that aroma. That's why Gordon's Edge [recently withdrawn in the UK] didn't quite do what we were hoping. But Gordon's Edge revived the gin and tonic and totally revived the brand call for Gordon's and tonic. RTDs have a "halo" effect on the mother brand. Their sales are incremental.' But despite the fallout of new products, Walsh admits that RTD margins are under pressure. If you want a product to behave like a beer [Ice in the US is a malt-based drink containing no vodka], if you want a product to have the support of a beer and the price point of a beer, you shouldn't be surprised to find that the margin is more like that of beer. That's what I think you are seeing. We had phenomenal margins in the early days; we've seen them come down and they are now levelling in the low twenties, from the high twenties.' A further problem for RTDs is the US Government probe into the taxing of the category, prompted by the big brewers, whose market share they are eroding. We'll probably hear on that in the next five or six weeks. The issue is the amount of malt that you put in. We will register an argument of "reliance". There was a set of laws and we complied with them. They moved the goalposts once people had put the plant in place. We relied on those for our business model and they've changed it. They're now proposing one of two ways to go: either 51% alcohol from malt, or 90%. We were always concerned about this. Had we been talking about this a year ago, I would have been very concerned; not from a cost point of view, but from whether we could replicate the flavour profile [of Smirnoff Ice] that we currently enjoy. We can now do that. So, we can produce the product whichever way the ruling goes. The issue is one of cost, because we have to go through some fairly aggressive filtration techniques. We expect to hear from the Government in the next six weeks. Usually, you've got 18 months after that to comply. So we're optimistic. There will be a cost issue and we won't let that go away, but in the overall context of Diageo, it's not vital at all.'

Project: Next Generation Growth What is going much better in the US for Walsh is project Next Generation Growth. This seeks to improve the distribution system imposed after Prohibition, which ruled that all brands must be distributed through independent (or state-appointed) wholesalers. Diageo is rationalising its network to one distributor per state, with a team dedicated to its portfolio. That's gone very well. We've now got about 70%-plus of our volume going through the new distribution houses. By pulling it together with a dedicated sales force, by the time this is finished we are going to have 2,500 dedicated sales people working on our brands. I believe that has to drive growth. We've converted 70% of our system without having to deal with any major legal issues. Has there been sabre rattling? Of course. Will there be people that we have had to "compensate"? Of course. But I feel pretty good about it. The rest of it will change over by the end of this year.' And what of this financial year? Walsh has already conceded that the first half (to Christmas) was very tough' and that Diageo won't make what his finance director called aspirational' targets of a double-digit rise in operating profit and an 8-10% increase in net sales. After a tough first six months I can't give you forecasts,' says Walsh. Iraq and Sars are having an effect, but it's hard to see how long-term that will be. This has been, for any business, a bloody tough year. We started with the crisis in South America: the political strike in Venezuela went on and on. They then put in exchange controls. We then went into the whole Iraq situation and now Sars. I heard from a credible source that hotel occupancy in Hong Kong over Easter was 10%. That's staggering. I'm worried that Sars could have a massive impact on the airlines, which are already under massive pressure. All that affects global duty free. The good news for Diageo is that we scaled back global duty free a couple of years ago, when all the tax laws changed. The margins were just not quite what we'd like. So we are not as big in that area as other people. But this will still be a tough year. There are reasons to hope that the second half [January to July] will have been a bit better than the first. And I'm still hoping. But the economies have not got any easier and the environment has got more challenging. But what delights and surprises me is that spirits consumption in the US, which represents 30% of our business, is very robust. And there are no real signs that people are trading down. They may not go out as much and therefore may not consume as much, but if you are a Johnnie Walker Black Label consumer you're not going to drop to a cheaper brand. Do you want to save $3 a bottle and let everybody know you have traded down? That's what the consumer research is telling us. The US, overall, is in pretty good shape. The Far East is not in such good shape. Let's face it, Japan has not been in good shape for quite a while. South Korea has its own problems, such as its neighbour to the north, and the country relies on imported energy. When oil went to $30 per barrel, they put in austerity measures, which had an impact on the business. Although we all go through economic cycles, we are still growing and will continue to grow. We're generating cash and supporting our brands, and we have not seen any increases in duties, even though we are aware that many governments are on the lookout for extra taxes.' Walsh also confirms that share buybacks will continue. Diageo returned 552 million to shareholders via this route in the first half. We are doing as much as we can to take up the slack,' he says. That must be coupled with appropriate dividend increases. We gave a 6.5% increase at the interim and there is scope to improve that. Shareholders should measure us against the great brand owners, such as Coca-Cola or Colgate-Palmolive. This business has got a certain parameter of growth. In reasonable economic times we can get high single digits, and, as we've demonstrated, in good times we can get to double digits. In down times, clearly we cannot get that number. But we can get growth in good times and bad times. We are very cash-generative. These brands endure. We are continuing to build them. It may not be as sexy as a dotcom business, but I kind of like the cash flow.'

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