Diageo CEO Discusses F2Q2011 Results - Earnings Call Transcript

Feb.10.11 | About: Diageo plc (DEO)

Diageo Plc (NYSE:DEO)

F2Q2011 Earnings Conference Call

February 10, 2011 04:00 AM ET

Executives

Paul Walsh – CEO

Deirdre Mahlan – Deputy CFO

Ivan Menezes – President, North America and Chairman, Asia Pacific

Gilbert Ghostine – President, Asia-Pacific

Andrew Morgan – President, Europe

Stuart Fletcher – President, International

Analysts

Ian Shackleton – Nomura

Trevor Stirling – Sanford Bernstein

Ann Gurkin – Davenport

Mitch Collett – Goldman Sachs

Jason DeRise – UBS

Jamie Isenwater – Deutsche Bank

Jonathan Cook – RBS

Chris Pitcher – Redburn Partners

James Edwardes-Jones – Espirito Santo

Nico Lambrechts – Bank of America/Merrill Lynch

Simon Hales – Evolution Securities

Jamie Norman – Evolution Securities

Gerard Rijk – ING Bank

Operator

Good day and welcome to the Diageo Interim Results Conference Call. Your host today is Paul Walsh.

Paul Walsh

(Inaudible) Thank you for your time today. I want to welcome Deirdre Mahlan for her first set of results as Diageo’s CFO. Deirdre will take you through the results that we released this morning in more detail. And then I’ll review the trends we have seen and the investments that we’ve made in the half. Our four regional Presidents, Ivan Menezes; Andrew Morgan; Stuart Fletcher and Gilbert Ghostine; and Andy Fennell, our Chief Marketing Officer, who will then join the two of us to take your questions.

We are building momentum across the clear majority of our markets. Double digit growth in International, stronger performance in North America and improving top and bottom line growth in Asia-Pacific. The global economic recovery is uneven and Europe was weaker. The economy rebounded in Russia, and Eastern Europe and we generated very strong growth.

We grew modestly in markets such as France and Germany, however in the rest of Europe, we did face challenges. Weaker consumer and business confidence in Greece and Spain, import restrictions in Turkey and pressure on margins in GDP from the shift from on to off trade and from spirit to wine. These depressed our performance in Europe in the half. However, mix improvement and focus on cost of good led to gross margin improvement and reinvested significant in marketing up 10% in the half. This increase was focused behind our strategic brands in North America and the growing number of mid class consumers in Latin America, Africa and Asia Pacific.

Operating profit grew 2% and EPS pre-exceptionals grew 9%. While our focus on cash generation again led to strong free cash flow, £775 million in the half.

Our priority is investing to drive growth and we are confident in the strength of our business. Therefore we are increasing our interim dividend by 6%.

And now I’ll hand you over to Deirdre to take you through the figures in more detail.

Deirdre Mahlan

Thank you, Paul, and good morning, everyone. As Paul said, I am now going to take you through the results in more detail. Let’s look first at volume and net sales. Organic and reported volumes grew 3% in the period led by spirits. The organic increase in net sales of 4% reflects the return to volume and growth and improved price mix in North America and our strong volume growth in Asia-Pacific.

By category, scotch and vodka were the biggest drivers of top-line growth while the faster growth of premium and super premium drove positive price mix. The weaker Venezuelan bolivarat had a negative effects impact of £211 million. In H1 last year bolivarat U.S. dollar exchange rate was 2.15 and this year we have moved to 9.

Excluding this impact exchange would have had a positive impact mainly due to appreciation of the U.S. and Australian dollars and the South African rand, although the euro was weaker.

The scope change is the disposal of wine businesses in Europe and North America as we restructure these businesses to improve returns.

Turning now to organic net sales growth on a regional basis. In North America, high levels of unemployment and low income growth continue to restrain consumer confidence and are holding back a broad based recovery in consumer spending. However, there are signs of a gradual recovery in beverage alcohol with an improvement in the on-trade environment and the faster growth of some super premium spirits.

We took the decision to reduce discounts on our brands in U.S. spirits. We knew it would lead to share loss but that would contribute to better price mix and this is what happened. The overall economic and consumer environment in Europe continues to be weak. In Greece and Spain the financial crisis has led to a further decline in consumer confidence and reduce the availability of working capital for local businesses, which led to trade de-stocking. In Ireland the ongoing contraction of the on-trade led to a decline in our predominantly beer business.

In G.B. net sales growth was driven by the growth of wine which reduce margins as that the very competitive pricing environment on spirits. In contrast, the consumer recovery in Russia and bounce back in Easter Europe aided by some wholesaler restocking led to strong double-digit growth in these emerging markets.

We continue to drive double-digit top line growth in international benefiting from our brand range and strong distribution. In Latin America and the Caribbean Johnnie Walker grew over 20% maintaining its leadership of the scotch category in the region. Our strategy of widening the brand range beyond scotch to appeal to the emerging middle class is now contributing to growth. Smirnoff and Captain Morgan both responded well to an increase in market spend and delivered exceptional growth and we will continue to invest in these emerging middle class opportunities.

In Africa, our range of beer brands at various price points again provided strong growth. The performance of Asia-pacific improved in the half. The emerging markets primarily India, Thailand, Vietnam and Taiwan grew very strongly, offsetting a flat performance in Australia, which represents nearly 30% of the regions sales. We extended our number one position in scotch in the region with share gains at all markets. We have returned to positive price mix up one percentage point.

In North America, the stunting growth on Cîroc and to a lesser extent scotch led to net sales growth of the premium and above premium segments in the high single digits. While the value and standard segments recorded a small decline. This improved mix combined with reduced promotional activity drove positive price mix.

In Europe, there was negative price mix as the slowdown of the on-trade in southern Europe and Ireland led to declines on scotch and beer, respectively. Overall, though the delivery of price mix at a Diageo level reflect the strength of international which now as the scale to impact overall performance.

Price mix was primarily driven by favorable brand mix as super deluxe scotch grew double digit and by prices increases primarily in Venezuela to keep step with local inflation.

Although there was faster growth of premium and super premium brands in Asia-Pacific, this positive mix impact was offset by some price reductions and it intends promotional environment in Australia, our largest market in the region.

Now looking at net sales growth to the lengths of price segments, the stronger growth of scotch in emerging markets and Ciroc in North America meant the super-premium segment grew strongly and was the fastest growing segment in each of our four regions.

The premium segment also grew well mainly due to Johnnie Walker Black Label in the emerging markets and Crown Royal North America. The standard segment was held by declines in scotch primarily Johnnie Walker Red Label and J & B Rare in Spain increased and whiskey and wine in North America offset by the growth of Jonnie Walker Red Label in Latin America.

The value segment comprises just 3% of total net sales and growth in the half was very localized, over half coming from increased distribution of Senator beer in Kenya. Overall this data is encouraging, suggesting that some consumers are again moving up the price ladder but it is very market specific and category specific, and as the performance of the Ciroc demonstrates sometimes brand specific.

Looking at the growth of our business by category, our spirit brands in total drove over 80% of our growth in the half and the largest categories of scotch and vodka made the biggest contribution. Within scotch Jonnie Walker grew net sales 10% overall with growth of over 20% in emerging markets as the “Walk with Giants” platform was activated across the globe.

Other Diageo Scotch brands also performed strongly with double-digit net sales growth in the premium segment on the strength of Windsor in Asia and Buchanan’s in Latin America and Caribbean.

In the standard and value segments, White Horse VAT 69, Johnny Walker Red Label and Black & White, all grew very strongly, as emerging market consumers across the globe were turned to the category.

Growth in Vodka was led by North America, mainly Ciroc and the launch of Roc and Moon Mountain Vodka. Smirnoff grew very strongly emerging markets, but performance was held back in the highly competitive off-trade led markets of Great Britain, Australia and the United States.

Our Beer brands remain a growth engine for Diageo, but it’s a story of two regions. Once again our local Lager brands in Africa all set the decline of Guinness which was impacted by the continuing contraction of the on-trade in Ireland and Great Britain.

Wine grew 5%, driven mainly by growth in Great Britain, partially offset by the decline of wine in the U.S. You will have seen from this morning’s release that we have changed the way in which we report brand performance. Over the last year we have moved to a category approach to ensure we have brands at each profitable price point and each major category.

Our 14 strategic brands will replace our global priority brands which we introduced in 2002 following the Seagram acquisition. We are reporting in this way because it better reflects the way we manage our brands. It is a natural evolution having dropped the classification of local priority and category brands this time last year.

Turning now to operating profit, on a reported basis the FX benefit to operating profit was £70 million. A transaction benefit of £96 million and a £2 million benefit under IAS 21 were offset by the negative translation impact of £28 million, again relating principally to the Venezuelan Bolívar.

I am now going to take you through the main drivers of the 2% growth in operating profit by region. I will start with corporate, as you know, the performance by region is reported using budget transaction exchange rates, and the difference between the budget and actual exchange rates is taken to corporate.

For H1, F11, this amounted to an adverse movement of £39 million, corporate cost amount to about £200 million a year. In the half, they were £94 million, down £4 million against H1 last year.

Since I was appointed to the senior leadership team in Diageo, and of course, since I became CFO, my focus has been on how we can consistently improve the efficiency of our P&L. We will do this most effectively if we manage the drivers of gross margin, the effectiveness of our marketing spend and our investment in other operating expenses.

I am now going to show you the effect these three had on operating margin by region. Gross margin improved on an organic basis in the half, up 50 basis points. There was a four percentage point increase in North America, led by cost of good reductions and an improved brand mix led by Cîroc and Crown Royal.

The gross margin decline in Europe was driven by margin decline in Greece and Turkey and in Great Britain driven by the growth of wine there and the shift to the off-trade. In the rest of Europe gross margin increased.

In international the faster growth of premium and upper premium scotch delivered significant price mix leading to 70 basis points of gross margin improvement. In Asia-Pacific the one percentage point of negative price mix referred to earlier was the main driver of the gross margin decline.

Marketing spend increased significantly in the period which reduced operating margin by 80 basis points. It was focused by region and category, investing where our future growth will come from.

In fact over 60% of our incremental marketing spend was focused in the emerging markets and 35% was targeted at driving growth of our strategic brands in the United States. In addition, we are focused by category. In the half over 90% of the incremental marketing spend was behind scotch and vodka which as you saw on the previous slide with the greatest contributors to overall net sales growth.

Outside of these categories, the global rollout of Captain Morgan continued using prudent driver. Almost 50% of the incremental spend on the brand was in markets outside North America. In these markets the brand grew 37% and now accounts for over 20% of total sales.

Of course, in being selective we have chosen we are not invest and this led to some shop reductions in Iberia and Southern Europe with the returns on activities such as on-trade consumer promotions are no longer attractive.

I would expect that we will also see marketing spend grow ahead of net sales growth in H2.

The negative impact on margin of increased overheads is exaggerated by the inclusion of budget to actual FX movement, which is included in corporate and which I referred to you earlier. Overheads reduced in North America and Asia Pacific and grew less than sales in International. In Europe, overheads were up as a percentage of sales although overheads were reduced in Greece and Spain.

In summary, despite double-digit marketing spend increases, the operating margins of North America, International and Asia Pacific all grew within period. Negative price mix in the developed markets of Europe and in increasing marketing investment in Russia and Eastern Europe led to weaker margins in Europe.

Moving on to the other lines of the income statement. Associate income increased by £10 million mainly Moët Hennessy. Net finance charges fell £28 million. The net interest charge was broadly flat. The effective interest rate was 4.9% up 20 basis points from H1 fiscal 2010 on lower average net debt of £7.5 billion as against £8 billion last year. This gave a pre IAS 39 interest charge of £184 million. The IAS 39 impact increased the interest charge by £12 million.

Net other finance charges were 27 million lower than last year with the main driver being the lower IAS 19 charge for post-employment plans. Other finance charges were £10 million comprising 8 million for the unwinding of discounts on liabilities. For the full year I would expect our interest charge to be about 5%. It increases in the second half as we move to a higher proportion of fixed rate debt. Last year in the second half, we benefited from the sale of interest rate swaps which will not recur this year.

Moving now to exceptional items, operating exceptional charges were £9 million, comprising the global supply and Ireland brewing restructuring programs. For the full year, I would expect total exceptional charges in respect of restructuring programs to be approximately £45 million, while the cash expenditure is likely to be £150 million.

The overall tax charge increased by £42 million, the underlying tax rate remained at broadly 22% as per last year. And we expect to maintain this going forward. The impact of higher reported operating profit growth together with lower finance charges and exceptional costs delivered 16% growth in profit for the period.

There was a continued focus on cash delivery in the half; increased operating profit and lower interest and tax paid all contributed to a strong free cash flow in the half. As this slide shows we have reduced working capital as a percentage of sales over the last two years. And in the half, it reduced from 4.6% in H1 last year to 2.3% this year.

Moving now to EPS, EPS pre-exceptional is £48.2 per share, compare to £44.2 last year, an increase of 9%. Foreign exchange benefits drove five percentage points of this growth, while organic operating profit drove 3 percentage points of EPS growth and the lower post-employment charges under IAS 19 added 2 percentage points.

In summary, in my first set of results I can say that Diageo has performed well in a world which is presenting both opportunities and challenges. There have been some exceptional performances both by brand and geography, Ciroc in North America, and Jonnie Walker in Latin America and Global Travel and particular highlights. Europe was weaker, as some markets have been operating in environments which have significantly more challenging than last year.

Overall the return of positive price mix to our business although small is an encouraging sign. This mixed improvement and efficiency programs in to our supply business to reduce underlying cost of goods per case led to a further gross margin increase. And we continue to invest in those brands and markets that we believe will drive growth.

Primarily this has been in emerging markets and in North America where we see signs of a fragile recovery. We have kept our focus on cash and maintained working capital efficiencies, improved return on invested capital by 50 basis points, and economic profit by £69 million. This improved performance and the investments we have made give us the confidence to increase the interim dividend by 6%.

And now I will hand back to Paul.

Paul Walsh

Thank you, Deirdre. The world economy and therefore our performance in the first half was uneven. Double-digit net sales growth in emerging markets improved trading in North America and the challenging economic situation in Europe.

Now last year I outlined the ways in which we had strengthened our business in the tough environment we faced. In this half as the global economy recovers albeit at a very uneven pace, we are moving into growth mode. And we’ve done this in four ways, increased marketing spend ahead of net sales with over 60% of the incremental investment directed to emerging markets and the with the balance being behind our strategic brands in North America.

And innovation program tail it to different opportunities around the globe, which delivers a steady stream of sustainable growth from a balanced pipeline of over 180 new ideas. Building new routes to markets particularly focused on the middle class consumer in emerging markets and continuing to build customer relationships which identify new growth opportunities both in developed and emerging markets.

And finally making those changes and investments which will improve our supply footprint and deliver further cost savings. Diageo’s strengths continue to provide us with a platform for consistent growth. Our global reach and brand range give us the diversity needed to win in this environment. We are investing to drive top-line growth behind the opportunities presented by the emerging middle class in Latin America, Africa and Asia and behind specific brand and category opportunities in the developed markets. Our operational strength is underpinned by our financial strength, which we have enhanced again this half with strong cash flow and improved returns.

I’m now going to look at how we are using our strengths to deliver growth in this new global environment. As this slide shows, our investment profile is changing, as we give greater focus to the emerging market opportunity. Marketing spend in the half reflects the focus we have placed behind brand building in emerging markets.

In developed markets, we focus spend in North America behind our leading brands as signs of recovery emerge. In recent years, operating expenses have represented a larger proportion of net sales in emerging markets, as we built infrastructure.

In the half, we’ve continued to invest in the infrastructure we have in emerging market, but here overheads were down as a proportion of net sales as we generated leverage through the P&L. In developed markets, we are focus on driving efficiency from the overhead base we already have in place.

Finally, capital expenditure, in the developed markets, CapEx was driven by changes to drive efficiencies, primarily in Europe, in contrast, in the emerging markets, CapEx is driving growth, primarily through expanding our beer supply footprint in Africa.

Despite the different pace of growth across the market effective marketing remains key to driving growth in both developed and emerging markets. We have focused spend in these four ways. Firstly we have aggressively increased spend behind our proven growth drivers, skewing the spend to categories, brands, and markets where we see the greatest opportunity. For example, Nightlife Exchange for Smirnoff and Jonnie Walker “Keep Walking” Campaign, Graham (inaudible) free sponsorship and the highly successful (inaudible) program.

Diageo was an early adopter of digital channels for media. Broadband penetration on PC and mobile is high almost everywhere. Marketing is now digital. We built strong relationships with technology companies of Silicon Valley and with entertainment providers around the world.

The fundamentals of great marketing haven’t changed but our approach has. For example, in Kenya, Guinness is the producer of a peak time football based TV show, 5 million people have directly participated either by appearing on the show or by texting into it.

In November 14 cities swap nightlife Smirnoff partnered with MTV, Facebook and 50,000 consumers to create the content. In the last two months in China 12 films were created under the keep walking campaign in partnership with the celebrated Chinese film maker. Five million people have engaged with the content in less than eight weeks.

Downloading the films, discussing them and commenting on them on what they should do next, these are all just a few examples of how we intend to stay of the cutting edge of marketing in the digital era.

Scotch has been a key driver of our performance in the half. Increased spend has driven growth in the emerging markets. In addition we have spent more on brands such as Black & White, VAT 69 and White Horse to reach the increasing number of middle class consumers in the emerging markets.

And the fourth pillar is increased spend on reserve brands which has delivered 40% of our growth this half. This isn’t global it is in a targeted marketed way and supports the dedicated sales teams that we have for reserve brands in a number of cities.

As Deirdre showed the growth of our super premium brands has outstripped the growth of premium and standard brands in the half. As the global economy continues to recover, this will become an increasingly important growth driver for us. Our innovation pipeline is delivering a steady stream of sustainable growth and again there are four pillars to our innovation strategy.

First premiumization. We have been successful across a range of brands and price points in bringing new premium offerings to consumers who desire the quality assurance of our brands but while still looking for something new. In the half Johnnie Walker Double Black in global travel and Crown Royal Black in North America were key contributors to brand performance and overall growth.

In emerging markets innovation is geared to increasing accessibility and building categories as these markets develop. In Africa, we’ve introduced 20 sales formats for our market leading international spirits brands, which has brought these brands to new consumers and allowed us to participate with spirits in main stream beer led outlets.

In Columbia, Hague Supreme is providing deluxe whisky packaging at a standard whisky price point to capture the emerging middle class consumer looking to celebrate a special occasion.

In developed markets, innovation is driving growth in new consumer occasion and maintaining consumer interest in mainstream categories, by broadening our offering. For example, Bundaberg beer, premix in Australia leverage the trend for low carb beers and diet soft drinks and offers consumers Bundaberg premix rum with no sugar cola.

And finally, we’re building a pipeline for the future, while most of our focus is on keeping our current brands fresh and dynamic. It is important to have a broad and powerful pipeline of ideas and new to world brands, especially as we reach out to the new emerging middle class. These are brands such as the test we’re running on Blackburn blended whisky in Mexico.

We have entered into a number of strategic partnerships to grow our business and enhance the range of brands we offer to consumers. Again, primarily in emerging markets, some have been in place a number of year, although we are trying to deepen them for example, our interest in ShuiJingFang in China and our exclusive arrangement for Zacapa rum.

More recently we’ve announced a new strategic partnership in Vietnam and the acquisition of the controlling interest in Serengeti Breweries in Tanzania, as we extend our footprint in emerging Africa. And where we’ve established routes to market, we have also continued to improve our operating model. For example the new arrangements we have with the Glaziers in North America.

Here, we’ve enhanced our dedicated sales force model with the more efficient leadership structure and increased the resources behind our key priorities, the on-trade multicultural consumers and innovation. Stronger customer collaboration is also part of the way we do business in emerging markets.

With Wal-Mart in Mexico we created (inaudible) which makes the beverage alcohol island more appealing to female shoppers. This concept is being rolled out to over 40 Wal-Mart stores in Mexico.

As our operating margin demonstrates, we have an efficient supply organization. However, we are driving further improvements since we build an efficient supply organization which supports our growth agenda.

In November we opened our new rum distillery in the U.S. Virgin Islands. This facility will supply a significant cost of goods benefit for Captain Morgan. That will in turn allow us to fund further marketing spend behind one of our top performing strategic brands.

Our new distillery at Roseisle is now up and running to support the considerable emerging market scotch growth. Looking to the future we will be investing to increase brewing capacity in Nigeria and we already discussing expansion of the new Sedibeng Brewery in South Africa. Whilst we build new capacity to support future demand we’re also improving efficiencies and driving down costs across our 70 manufacturing sites. Before we take your questions let me summarize by region. In North America increased marketing spend behind our strategic brands and continued strong innovation has improved top line growth. Reduced costs in both our supply and our demand organization especially in wine have improved operating margin.

And as the economy improves we will continue this strategy and build our position as the leading spirits company in the U.S. to drive growth in the world’s most profitable beverage alcohol market. In Europe we have scaled and leading brands. The economic situation is changing the consumer environment while some of these changes were dramatic in their scope we can manage the impacts on our business. We will continue to investment behind the growth markets of Eastern Europe and Russia. Specific issues such as import restrictions in Turkey should be resolved with legislative changes now taking place. In Spain and Greece we have seen the impact of further destocking but we have customer programs in place to manage through this and we’ve waited innovation to drive the top line. And while the top line grew in GB, margin and operating profit declined and there were some one-off costs in the half, these costs won’t be repeated and we have plans to improve margin.

In the emerging markets the investments we have made over a number of years are now delivering the top line growth they were designed to generate. We’re reaching a growing number of middle class consumers with lower brands such as (inaudible) in Brazil and Senator in Kenya, with international brands such as White Horse and Guinness and innovations such as Blackburn.

We’re also building our leadership position in scotch in Latin America and Asia to grow premium and super premium brands across all categories. We have great many strengths in Diageo namely our people, our brands and our routes to market and also our balance sheet.

In the second half, we will be focused on the opportunities which will come from improving consumer confidence in North America. From the investments that we’re making in emerging markets and on improving the operating profit performance in Europe. Therefore, I expected us we deliver full year results which improve on the momentum we have delivered in the first half.

And now we’ll take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Ian Shackleton from Nomura. Please go ahead.

Ian Shackleton – Nomura

Yes. Good morning, Ian Shackleton at Nomura. Two questions, Deidre talked about obviously discount momentum slowing for you in North America. I just wonder to what extent you’d seen some of your competitors also moving in the right direction there.

And the second question was really around the free cash flow utilization, you’ve not announced today any renewal of the buyback. I wonder if you can just give us some thoughts about where you see free cash flow being neutralized over the next year or so.

Paul Walsh

Okay. Hi, Ian. Maybe if I take the free cash flow question, then it’s probably better that Ivan speaks to the promotional environment in North America. First of all building on very strong cash flow last year, we are delighted with the performance in the first half. So that has allowed us to actually increase our dividends by another 6%. So you saw a 6% increase last year. We are increasing by 6% on top of that.

We will continue to look at our credit ratios. We will look at our cash generation. And we may change our position as the year unfolds. It depends what opportunities are presented to us. So we are in the mode at the moment of driving cash flow, increasing dividend and keeping all of options open.

Ivan, do you want to speak to...

Ivan Menezes

Sure. Ian, if you look at the recent trends, the level of volume done on promotion for the industry is coming down but the Diageo is reducing discounting and promotion more than the industry is. So we are reducing it even more quickly than the industry. I think more importantly if you look at the overall trends in the last few months, what’s encouraging to see is the premium super premium and ultra-premium tiers are doing better and the overall price mix momentum is improving in North America as well as the on-premise coming back. So I am feeling much better right now about the environment.

Paul Walsh

And just maybe building on that point if you look across our global business, the rate of improvement in our reserve brand portfolio is very encouraging. When I was starting to see the higher end marks really outperformed the average for the group which is what we wanted to do.

Ian Shackleton – Nomura

And just coming back on the first point there Paul I mean in some of your comments early on there was a big focus on investment within the business in emerging market. When you think about M&A opportunities do you also think about that as a key priority?

Paul Walsh

First of all we will invest in the business that we currently have to make sure that our infrastructure particularly in the emerging markets can deliver on the growth potential of that market. Secondly we are very mindful of M&A opportunities and you saw in the first half we moved in Tanzania, we moved in Vietnam and I would hope that we can continue to find such opportunities and deploy our cash flow accordingly. So those are the priorities.

Ian Shackleton – Nomura

Thanks very much.

Operator

We will take our next question from Trevor Stirling from Sanford Bernstein. Please go ahead.

Trevor Stirling – Sanford Bernstein

Good morning. Three question please. Deirdre you referred in the call that the percentage of operating costs in Europe as a percent of sales that rose despite sales costs, costing cut in Greece and Spain, could you – perhaps just give us a little bit color on where the problem area lies for you in Europe at the moment.

Second question Paul, you talked a lot about the new routes to market to middle class emerging market consumers and you talked about the brands that you’re developing, but you’ve talked specifically about the route to market aspect of that.

And then the final area of, talking about investment in infrastructure and marketing in emerging markets. Clearly, China has received a lot of investment in both infrastructure and marketing and it is therefore somewhat disappointing to see a 3% decline in organic net sales in the half in China?

Paul Walsh

Well, maybe let’s ask Gilbert in a moment to speak specifically to China and Deirdre can take the issue on operating cost, but I guess in operating cost terms, it’s simply the fact that sales fell at a rate whereby we could not remove cost quite the same rate. I think that in nutshell is what the issue is.

Regarding routes to market in the emerging middle class, I think there is no question that we’re seeing more consumers available to us at price points where we believe we can make good money. For many years in these emerging markets, there have been consumers there, but the ability to purchase a kind of brands that we will get appropriate margin from as been more limited. So that is now changing, it’s changing fast and we are basically trying to build our sales force that will be able to get into far more outlets than previously has been the case.

Gilbert, you wish to speak to China?

Gilbert Ghostine

Yes, Paul. Regarding China, when you look at China, scotch whisky category grew 3% in the first half, Johnnie Walker was up 9%, and our super deluxe brands in China were up 22% and the performance was not only strong on the scotch side but also on the beer side. Our beer business Guinness was up 26%. Now what we need to take into consideration in the first half that we expanded our distribution on Jonnie Walker Black Label at the same time the with the strength of the renminbi and the impact of the exchange rates, this opened opportunity for flow of goods from outside the market and this has driven the impact on our profitability in the first half.

Now, the good news on China is the momentum continues in the second half. The Jonnie Walker had a very strong Chinese New Year. Black Label performed very well and most importantly Jonnie Walker Blue Label has a very strong January performance and Chinese New Year performance in China.

Paul Walsh

Anything to add to the operating cost issue.

Deirdre Mahlan

The only thing I would add with respect to Europe, because Paul absolutely right about the timing of talking cost out, as I also referred to some one-time cost that will not repeat. There are some costs associated with the reclaim of VAT where we had reclaim VAT in a prior period as those claims came through the amounts that we are actually going to successfully receive were lower than what we’ve originally submitted. So there was a one-time adjustment of write-off of that receivable, which also impacted the total operating cost in the period.

Trevor Stirling – Sanford Bernstein

Thank you very much.

Operator

We will take our next question from Ann Gurkin from Davenport. Please go ahead.

Ann Gurkin – Davenport

Good morning.

Paul Walsh

Good morning, Ann.

Ann Gurkin – Davenport

Continuing with the discussion about Europe since the Q1 interim statement, really what changed with the consumer behavior we kind of rather than you expected or at least for marketing not come through as expected or was it some kind of inventory destocking. Can you just kind of help me understand that better?

Paul Walsh

I’ll ask Andrew to comment on it in more detail but basically we have to keep Europe in the right context. We’re basically talking about importation restrictions in Turkey. We believe that situation will be addressed. We then have very-very weak economies in Greece in Spain in Ireland. Nobody should be surprised by that. I would say though that the consumer confidence is weaker and therefore our sales are a little weaker than we expected them to be, however the flip side of the coin is Russia is doing extremely well, Eastern Europe is doing extremely well and Germany and France are just fine. We’ve got some issues that we have to address in the UK and we will do that. So I would say those markets are a little weaker but we shouldn’t be surprised by what we’re seeing out of Greece Spain and Ireland. Andrew.

Andrew Morgan

Yeah Paul I think that’s exactly Diageo has had significant positions for many years in Greece and in Spain and in Ireland, so we shouldn’t be surprised that we’ve been impacted by the economic situation in those countries. But I think it is fair to say that come November, December the declines were greater than we had originally and we had to react accordingly and that was kind of late in the half as Deirdre indicated early to get significant reaction on the cost base, but you will see the impact of that coming through in the second half and improved operating margins.

As Paul says Europe is rather like Diageo as a whole it’s a mix of high growth markets and some more challenged environments. So we’ve got 31% growth in sales in Russia reported in the half, 8% sales growth in Germany which is doing very well for us, growth on France, 6% growth in Benelux. We have been careful to make sure that we continue to fund those growth environments and the brands and the categories that are continuing to do well for us, while at the same time, resizing our sort of cost base in a more challenged territories.

But we did see a more difficult environment as we got towards the end of the half than we had expected.

Ann Gurkin – Davenport

Thank you. And then North America, if you could just comment on as you look out to the second half, how do you balance holding the pricing or producing level of promotions versus market share losses?

Unidentified Company Representative

Sure, I’d say, we’re sticking with our strategy which is around reducing discounting and promotions, keeping our marketing investments, though it will moderate in terms of growth rates, second half versus first half and focusing on the premium and reserve upper end of the profile. So we have a strategy here that’s working and we plan to hold it. And as and when consumer conditions improve we will benefit even more.

Paul Walsh

It’s interesting if we look six months ago, I think I described the U.S. as sort of being a market of some false dome (ph) we had a good data period, then we had a weak one and we sort of when along like that we’re now putting together trends that are definitely trends in the right direction. They may not be as robust as we would like, but they are in the right direction and I’m very pleased by the performance of our high end marks in that marketplace and the fact that we’ve been able to drive that performance at the same time withdrawing promotional support. So I’m encouraged and let’s not lose sight of the fact that we are putting 30% of the marketing increase behind the strategic brands in the states. You should see that as volt of our confidence in that market.

Ann Gurkin – Davenport

Right and then Paul if I could ask, is the company as Diageo in a position, a comfortable position where you could make a large scale acquisition in the spirit space if interested?

Paul Walsh

You can see our balance sheet; it is extremely robust. But you also know our track record. We invest wisely. We expect an economic return on those investments. And I have said it in the past, whatever we buy, if we buy anything, it has to be accretive to the growth rate that we can already deliver internally.

Ann Gurkin – Davenport

Right. Thank you very much.

Paul Walsh

Thank you.

Operator

We will take our next question from Mitch Collett from Goldman Sachs. Please go ahead.

Mitch Collett – Goldman Sachs

Hi. You mentioned that the decline in Europe was because applying essentially for clients faster than you could take out cost. I wondered if that had addressed for H2. Secondly you also mentioned that November and December had been weaker than expected. Does that imply that the shape of the half was such that it got weaker as the half went on and therefore we shouldn’t really expect the recovery in Europe in H2?

And then finally, I suppose liked to all that, you’ve mentioned that you have increased confidence that you can meet guidance for the year. Obviously the comp is a lot harder for H2 in terms of organic operating profit growth. Can you give us a bit more color on what gives you that confidence? Thanks.

Paul Walsh

Yeah, I think Andrew has already covered some of the points that you raised, but maybe you can repeat them Andrew. Regarding our outlook, I’ve said in our press that I have more confidence that we can build on the momentum that we’ve already seen. That confidence is predicated on the fact that we are not expecting any rebound in consumer confidence in Southern Europe anytime soon. We think we have to deal with the cards we have been dealt with in those markets. However look at the emerging markets those trends are robust and continuing. Look at North America we believe that – that will continue too. So that is what gives me the confidence to believe that we can absorb the issues of Southern Europe going forward. Andrew?

Andrew Morgan

Yeah I think to be more specific I mean on Greece, Spain and Ireland there is nothing at the moment to suggest that we will trade any better at the top line then we’ve been doing in the last six months. However you will see an improved bottom-line performance the readjustment of brand marketing and cost base kicks in for the whole of the six months. The other parts of the region, we expect to continue to get growth in France, Germany, Benelux and especially in Russia and Eastern Europe.

Mitch Collett – Goldman Sachs

Thanks.

Operator

We’ll take our next question from Jason DeRise from UBS. Please go ahead.

Jason DeRise – UBS

Hi two questions and I know there has been a number of questions already on it but does the difference between consensus expectations and the way guidance and is it possible to get to a mid-single digit growth, would that be a heroic assumption to have in for the rest of the year as it was already mentioned it’s a tough comp for parts of the business in H2? So I mean I guess what else can you offer to give us more confidence about the growth rate stepping up? And then the second question, is a bit longer term in nature than just a half, when we take about what you did over the past decade it was very steady consistent growth, had EBIT generally hitting 7% growth a few year you had 9%. I mean where do you see the business model taking you in the mid-term, can you get back to those types of growth rates assuming the economies recover?

Paul Walsh

The problem with offering guidance is that it is then used in isolation from the context of the GDP figures which is – has to be weighted against. If the global economy continues to improve there is no reason this business cannot get back to historic growth rates, none at all.

Regarding your question, can we get to mid-single digits in profit growth, we will, I’m not sure quite when that is. And I can’t be that specific to say it’s definitely going to be in the next four months. What I can say, is that momentum is building and we will definitely outperformance the results we turned in last year.

Deirdre Mahlan

Paul, I would just add to that, if you remember, I know there was been some discussion about the difficult comps. If you look at the first half, putting Europe aside which Andrew has addressed with respect to what we’re doing to deal with Europe. The margin are expanding in every region and we do have or we’ve spoken about the specific places where we feel strongly that momentum is building. So if you take in to account the margin expansion even after significant marketing investment in the first half which shows that that investment is returning with respect to our ability to price through the line. And that gives us confidence to say that yes we will continue to build on the momentum in the first half even though it’s true that last year’s second half was a stronger performance.

Paul Walsh

Thanks, Deirdre, good point.

Jason DeRise – UBS

Just on the point on the AMP, it increased substantially above sales and I know you’ve already said it would increase about sales in the second half. Does that need to increase by that rate? Do you think that that’s the way to think about it or will it slower that?

Paul Walsh

It will be in the zone of high single-digit to 10% that we’ve already shown. And that is very much around backing the momentum that we are seeing taking the ideas that we are seeing emerging markets and in U.S. and investing behind them and gaining share as a consequence.

Jason DeRise – UBS

And just one more one H2 performance, to get a better performance overall as most of that about to stabilizing Europe and – or do you need to see the – I mean acceleration in parts of the business.

Paul Walsh

We need the trends to continue in emerging markets and North America and we need some stabilization around the margin and cost in Europe. As I said in Southern Europe we are not expecting the fundamentals around the consumer to improve.

Jason DeRise – UBS

Okay. Thank you.

Paul Walsh

Thank you.

Operator

We will now move to Jamie Isenwater from Deutsche Bank. Please go ahead.

Jamie Isenwater – Deutsche Bank

Good morning. Three unrelated questions from me please; the first one in terms of media inflation can you talk about what you’ve seen maybe deflation in the last six months and what you are expecting for the second half of the year? Second question is about (inaudible) China whether you can give us an update on what’s happening there. I think the shares are now below the minimum offer price. So any sort of light you can shed would be useful. And then the third question is how much of the 4% price mix that you’ve delivered in international is actually coming from Venezuelan price increases? Thanks.

Paul Walsh

Okay first of all on China. I can’t comment on the stock price movement, it is what it is. We are going through the process of approval. It is longer than we thought it would be, but we remain confident that we’ll prevail in this regard. And we have to be respectful of the Chinese process that they are putting around, around their assets. So nothing really new to report there and the stock price as you’ve seen sort of – inflows. So I don’t think that’s an indicator of what’s likely to happen in the process of approval. Around Media I’ll ask Andy to comment on rates but my sense is that the notion of simply looking at media inflation is an old concept. We need to very much look at our media mix going forward particularly as we move more and more into the digital space. And by the way to (inaudible) earlier point on Johnnie Walker in China, just look at some of the films that are being shown in China and the loyalty that – that is building with Chinese consumers for the Johnnie Walker brand it is very-very impressive. And that is a very different approach to marketing but Andy...

Andrew Morgan

Yeah you’ve made the key points I think Paul which is we need to think about the effectiveness of our marketing and it’s our job to make sure that it gets more effective every single year. And indeed that has been the case in this half. The campaigns running particularly in emerging markets are driving the returns and you can see in the top line in those markets. So the answer to your question is that there is inflation now at media level, it varies massively from market to market in aggregate it would be low single digits. We’ve combated that completed with our mix and effectiveness programs which are ongoing year-in year out.

Paul Walsh

Some of the example now coming out of Africa, on how we’re actually using digital media is very, very impressive. I’m very pleased with the work that the teams being doing in that regard.

Stuart, on the price mix in international?

Stuart Fletcher

Yeah, price mix across international I think was pretty broad based and of course, Venezuela was a component across the whole of Latin America we got seven point price mix and we have positive price mix in Africa and five points of price mix in GTME.

And then when you look across the brands, again it’s a very consistent story. Six points of price mix on Baileys, four points on Johnnie Walker, seven points on Smirnoff. So this is pretty broad based price mix performance and Venezuela was a component, but that’s what it was, a component.

Jamie Isenwater – Deutsche Bank

Great. Thank you very much.

Operator

We will take our next question from Jonathan Cook from RBS. Please go ahead.

Jonathan Cook – RBS

Thank you. I just had two questions on the use of capital. You talked about strategic partnerships in emerging markets. I think these are referring mainly to distribution agreements and sales force investments. But just wanted to check, do you actually expect to make further equity or financials investment and buy up local spirits companies as I think you had done in Vietnam?

And then the second question is on Ketel One, I think – I see the option period for that, the option window opens in June this year. So I wondered if you had an update on any use on that one, please.

Paul Walsh

Well, let’s take the Ketel One question, upfront, in fact Ivan and had dinner with the Nolet family only a few days ago. They are delighted with the investment. They are delighted with the partnership. The fact that Ketel One has grown its non-North American sales by 55% since it came under our ownership delights them. And therefore I think it’s highly unlikely that there will be any change in the equity arrangements of that brand in the near term. And I am kind of very pleased that that’s the way it is.

Regarding this issue of use of capital, let me first say that our job as managers is to generate the cash first. We are doing that. It is then to make sure that we are maximizing the opportunities for our existing business wherever it operates and we’ve done that progressively through infrastructure investments, strategic partnerships, et cetera, et cetera. That’s the first call. We will then look at M&A opportunities and I have many times that I am very compelled where it makes sense to deploy more capital into the emerging markets. And we then have the opportunistic M&A opportunities that often get cited around more at Tennessee, or Cuervo or whatever that by and large are outside of our control. Here today we are very much focused on growing our organic business and making acquisitions where it makes sense in the emerging markets. If the other situation is changed so be it.

Jonathan Cook – RBS

Okay. That’s good. Thank you very much.

Paul Walsh

Thank you.

Operator

We will take our next question from Chris Pitcher from Redburn Partners. Please go ahead.

Chris Pitcher – Redburn Partners

Good morning. A quick follow-up question on some of your Asia businesses. You mentioned that Jonnie Walker saw a good volume in China, but made a comment alluding some price competition increasing, I mean overall China saw minus 1% price mix, could you give us what the net sales growth for Johnnie Walker was on the falling growth of 9% and maybe flash out a bit about your competition comment on the (inaudible) and then secondly obviously India is heavily distorted by your change in route to market there, I was wondering if you could give us a more of underlying growth is there for Johnnie Walker, volumes and value and some updates on how some of your initiatives in local spirits are developing in India? Thanks very much.

Paul Walsh

Okay I think now that is coming your way Gilbert.

Gilbert Ghostine

Ready for it Paul. Thank you for this question. Let me start with India first. India we have new route to market and we are delighted with the impact that this is having on our business. I will start with the regular brands because Johnnie Walker has an iconic status in this market, has a leading position in whisky and we expanding Johnnie Walker Red Black and super-deluxe. But let me just make a point on VAT 69 and Smirnoff just to highlight the impact of our new route to market in India. These are brands that we user to market over the last few years in India. The impact of our route to market on these brands in H1 was VAT 69 was up 68% versus the same period last year and Smirnoff was up 40%. This is the impact of our new sales force that is going into more cities and enhancing the capabilities of the team we have on the marketplace.

Moving now to Johnnie Walker the biggest news on Johnnie Walker in India is now Johnnie Walker is marketed directly by our dedicated sales force in India which was not the case last year. Last year we used to go through a third party distributor, now Johnnie Walker is with the core team in India and we see big upside potential for Johnnie Walker in India. So this is with regarding India.

And now moving to China, China when we look at Johnnie Walker, volume was up at 9%, NSV was up 1%, most importantly on Johnnie Walker in China is we are gaining share in the deluxe and mostly in super deluxe. And this is the momentum that is continuing in the second half. And we could see the NSV going faster than the volume in the second half, based on us having addressed the situation that has affected our volume to NSV mix in the first half.

Chris Pitcher – Redburn Partners

Could you just give a bit more color on – you mentioned price increase has been rolled back, is the pricing environment in China for scotch becoming weaker or did you just go in at too higher price point and that’s had to be rolled back? I’m just trying to get a feel whether this is a beginnings of a weak pricing environment for China scotch now?

Unidentified Company Representative

It is not a weak environment for pricing in China. The situation is very easy. Johnnie Walker is becoming more popular in China, more successful. We launched a big mega campaign driven by clear Chinese insight Johnnie Walker brands is expanding its footprint and Johnnie Walker is a global brand, because of the strength of the renminbi, we had a flow of goods from outside the market and this did put pressure on our pricing in China. It is not impacted by our competitive position in China. It’s impacted by the strength of renminbi and the success of Johnnie Walker franchise in this market.

Chris Pitcher – Redburn Partners

Thanks very much and one final question just for Paul, please. You mentioned in response to an earlier question on acquisitions, that acquisitions have to be accretive to internal growth, that’s – I haven’t heard that coming before, could you give it more clarity is that internal growth in terms of operating profit earnings, returns just try to get a gauge of what your M&A hurdle rates are now?

Paul Walsh

Well, first of all I meant that they have to accretive to the NSV growth rate that the company is currently enjoying. In other words simply buying something as a cost reduction opportunity isn’t that appealing to us. We want brands that can come into our stabile (ph) that we can drive further, such Ketel One, the example I just cited around its international development. And that’s the way that we look at acquisitions and I think on the whole question of the deployment of cash I’ll probably answer that as comprehensively as I possibly can.

Chris Pitcher – Redburn Partners

Thank you. No, I just wanted to clarify what you meant by growth and that was clear. Thank you.

Paul Walsh

Thanks.

Operator

We will take our next question from James Edwardes-Jones from Espirito Santo.

James Edwardes-Jones – Espirito Santo

Yeah. Good morning, team. Two quick questions if I may. The – you had I think 40 basis points decline in your depreciation charge in the first half. Can you explain that a bit further given the amount of investment that’s going in to the business? And secondly, working capital outflow around £0.5 billion in the first half of the year, working capital is obviously a contributor of cash generation to business last year. Can we expect net working capital for the year as a whole or will you be able to repeat the cash inflow you did last year?

Paul Walsh

We have said that as a consequence of our performance last year we see that has been the first year in step changing our cash flow generation capability. Now there are certain things that we did last year around vendor terms that won’t be repeated but we will hold on to it. So I expect another strong year of cash flow not quite as strong as last year. On the...

Gilbert Ghostine

Yeah on the depreciation, the decrease is due to the exceptional accelerated deprecation associated with the supply restructuring that we announced last year or in 2009, which was a lower impact this year. So it doesn’t have to do with our underlying CapEx investment rates.

James Edwardes-Jones – Espirito Santo

Got it. And then what are the writing (inaudible) on that basis that the 40 basis points low depreciation charge would have benefited your operating margins?

Gilbert Ghostine

Yes.

James Edwardes-Jones – Espirito Santo

Sorry.

Gilbert Ghostine

Yes.

James Edwardes-Jones – Espirito Santo

Yes it is. Thank you.

Operator

We will take our next question from Nico Lambrechts from Bank of America/Merrill Lynch. Please go ahead.

Nico Lambrechts – Bank of America/Merrill Lynch

Thank you for taking the question, hello Paul and team.

Paul Walsh

Hi Nico.

Nico Lambrechts – Bank of America/Merrill Lynch

I would just like to come back to the comment on guidance as you are aware the market is currently at 5% organic EBIT growth for the full year, you haven’t changed your guidance, are you therefore comfortable with the market expectations for the full year and therefore second half growth rate of around 8% and related to that should Diageo gives us positive operating leverage this year i.e. operating EBIT growth be greater than organic sales for the full year?

Paul Walsh

Try to be a bit more direct Nico. I am confident that our second half performance will accelerate of what we’ve already delivered. Whether that gets us to 5 I don’t know it’s certainly in that territory but I know that the second half performance will be very robust and will build on the performance on the first half. We are going to continue to investment in marketing ahead of sales in the second half. The reason for that is that we do see opportunities now emerging, but investment this year is going to position us very, very well in the outgoing years.

And to round it all off, I come back to a point I made earlier, there is nothing fundamental in this business that has changed. I do see our ability to progressively move this business back into the high single digit operating profit growth levels that we saw before and what I believe as a consequence of what we’re seeing in North America, outstanding performance in emerging markets, we are on the roll to that delivery.

Nico Lambrechts – Bank of America/Merrill Lynch

And in terms the operating leverage, should we expect fiscal ‘11 and possibly also fiscal ‘012 as years were you invest with A&P in order to capture these opportunities, i.e., operating leverage we might only see in fiscal ‘13. Is that the sort of –

Paul Walsh

I think that’s too far out. I think that’s too far out. We’d have to look at it next year. Certainly, this year that’s what we’re signaling. But rather look at operating profit leverage, look to gross margin and that’s where you’re definitely going to see positive mix coming through.

Nico Lambrechts – Bank of America/Merrill Lynch

The 50 basis points which we saw on the first half for the full year.

Paul Walsh

Yeah.

Nico Lambrechts – Bank of America/Merrill Lynch

And follow-on question on the U.S. you are saying in the outlook statement that you have increased your investment in the U.S. to bold brand equity and move away from promotional support, could you may be comment on the brand equity strength of your major brands like Captain Morgan and Smirnoff. I remember during 2009 you were talking of positioning Captain Morgan and Coke in the beer isle and Captain Morgan gives you 40 drinks versus beer gives you 24. Has that not changed the status of Captain Morgan in consumers mind and are you getting that back to premium (ph) because these are your big brands in the U.S?

Paul Walsh

Ivan.

Ivan Menezes

Sure. Nico if you look at our priority portfolio, the big brands like Captain and Smirnoff and Crown Royal and Jonnie Walker in the U.S. what I am very pleased with is our brand health and equity measures are strong and improving. Now part of what you are seeing in, why our volume performance is subdued in some of these brands is we are reducing discounting and promotion and our price premium relative to competition is widening. So we are improving equity. We are improving our price premium. And I think that positions us very well. We have a lot of confidence in our campaigns on these brands, and that positions us very well as I said as the recovery comes for these brands to come back.

On some these brands, Captain Morgan is a good example. We’ve got a lot of new entrants coming into spiced rum at lower prices and at better value and I actually feel pretty good in that environment where a brand like Captain Morgan is holding its own, retaining its premium credentials and is widening its price gap at a time when there is still a fair amount of discounting and lower value brands coming into the category.

So overall for the most part on our premium portfolio in North America I feel very good about health of the equity and that indeed is why we feel confident in stepping up the marketing investment.

Nico Lambrechts – Bank of America/Merrill Lynch

So despite that you’ve (inaudible) it is very competitive because of the new entrants?

Paul Walsh

Yes but it’s quite amazing when you look at our ability to hold on to the price premium and the strength and that’s where the when you look at the leverage coming through the P&L we’re growing gross margins and growing operating margins, I think we’ve got the mix right for this environment which is focus on price mix improvement, drive strong gross margin improvement which we’re doing across the portfolio, investment ahead which we are doing in marketing, but through all of that we are expanding operating margins through very tight cost control both on the cost operating goods and the overhead line. So I like the mix of how the P&L is shaping and I like the way the brands are positioned and you are going to see some pretty new and exciting work as well developing on Captain Morgan as we go into the third and fourth quarter we have some terrific campaigns which we are going to backing strongly into the second half and into next year as well.

Nico Lambrechts – Bank of America/Merrill Lynch

Excellent, excellent. And then just finally a clarification you mentioned on China that a part of the price pressure was due to the Renminbi strength but on ticks in China it says that part of the sales decline was driven by higher trade investment behind Johnnie Walker, was there some discounting or promotional activity going on in that market as well or was this all related to the currency issue?

Gilbert Ghostine

I will say it is expanding our footprint on Black Label in on-premise. You are going into more accounts and also the strength of the Renminbi and the exchange rate that opened the door for more goods coming from outside the market.

Nico Lambrechts – Bank of America/Merrill Lynch

But have you actually reduced the price premium or reduced below the price points of your competitive brands?

Gilbert Ghostine

We were alone increasing our pricing on Johnnie Walker last year, so we had roll back our price to the same price of last year, because of the flow of goods from outside the market.

Nico Lambrechts – Bank of America/Merrill Lynch

Got it. So you brought your price points closer to the competitor Chivas.

Gilbert Ghostine

The same price that we were last year, yes.

Nico Lambrechts – Bank of America/Merrill Lynch

Got it. Thank you very much.

Gilbert Ghostine

Thank you, Nichol.

Operator

We will take our next question from Simon Hales from Evolution Securities. Please go ahead.

Simon Hales – Evolution Securities

Good morning, everybody. Just a couple of follow-up really. I just wondered going back to the European business and the movement in the cost base for the second half, whether you could just quantify that a little bit more. Perhaps sort of help us understand in the first half how much of the decline in profits reduced some of the one-off that Deirdre talked about? How we should think about A&P spend moving H2 in Europe? And where perhaps some of the fixed cost base saving are going to come from in that region?

And then just secondly, just on the corporate cost line, I wonder if Deirdre could run through the movements again in the first half, just so I have a clear perhaps how we should think about forecasting that line for the full year?

Paul Walsh

I think the one-off cost in Europe were about £7, 8 million, that won’t be repeated and I think it’s not appropriate at this juncture to be specific on the cost reduction targets that we have in place in Europe, but they are in place and we will moving forward to prosecute that agenda with alacrity.

Regarding corporate charges?

Deirdre Mahlan

I mean the corporate cost side, I think what I said was that was largely driven by the budget to achieve rate, that for the regions are recording at budget rate and the budget to achieve difference goes through corporate. Again the impact of that in the second half will of course depend on what happens to the difference in the rates. The underlying corporate costs are moved by about £4 million and as I think that the point has been made several times, we are actively looking to control our costs in line with the operating environment and would expect that that would continue in the second half.

Simon Hales – Evolution Securities

Okay. Perfect. Thank you very much.

Operator

We will take our next question from Jamie Norman from Evolution Securities. Please go ahead.

Jamie Norman – Evolution Securities

Yes. Good morning, everybody. Just one question, really the only front in devotement (ph) in Asia-Pacific seems to be Australia which historically was a good source of growth for you. Just a perspective would be welcome on the retail environment. We know that two major retailers are slaking it out and your quote on Cross-5 do you see that continuing. And secondly any update on when the Aussie government might we are seeing the increase in the ready-to-drink packs that hit you last year. Thank you.

Paul Walsh

Gilbert?

Gilbert Ghostine

Yeah. Talking about Australia, Australia is an important piece of business for us, you are right. This is a market where we are leading the category and we are leaders in spirits and ready-to-drink. Despite the market being competitive, we have improved our market position and we gained share in spirits and in ready-to-drink. Christmas was very strong for us in Australia where we even improved furthermore our leadership in this market and we see this momentum continuing in the second half. On the ready-to-drink taxation I cannot comment on this one.

Jamie Norman – Evolution Securities

Okay. Thank you.

Paul Walsh

Thanks Jamie.

Operator

We will take our next question from Matthew Gordon from Matthew (ph). Please go ahead.

Unidentified Analyst

Yes, good morning everyone. I have two quick questions please. Firstly on Venezuela, could you talk about your pricing strategy there given the exchange rate movement and also what impact the pricing is having on volume and the second question is on Johnnie Walker global price mix which was down a touch despite from the tax there is a clear mix improvements coming through on that brand around the world, is that entirely down to this pricing issue in China or is there something else going on or there is a drag on Johnnie Walker’s price mix equation, good to have a bit of a clarity on that please?

Paul Walsh

Stuart can you speak Venezuela.

Stuart Fletcher

Yeah Matthew, hi. Look the pricing strategy in Venezuela is very consistent with where we’ve been in the past and that is essentially to be pegging our prices in dollar equivalents and we don’t move in every week or every month but within a relatively short time we look to basically hard currency price. That has meant through a combination of price increases and also as you know the restriction on availability of foreign exchange, that has led to volume reduction in Venezuela and we dropped volume 27% in the first six months, but our net sales were up 13. So we got 40 points of price mix in Venezuela. And I think that just appropriately reflects our strategy on maintaining hard currency pricing and maximizing our ability to generate earnings with the foreign currency that we can obtain.

Paul Walsh

On Johnnie Walker mix, Deirdre?

Deirdre Mahlan

I think there is an impact but of course in Asia, to the points that we have spoken about, but I think you have to go and look at it market by market as we’re looking. So of course in some markets we are seeing a trade up, in other places depending on what’s happening in the differences and the competitive activity between the on and the off trade there would be movements among that. So it is a combination of both pricing activity based on market conditions, and a combination of the trading up, the mix within the brand.

Unidentified Analyst

Okay. Thanks very much.

Paul Walsh

Thank you.

Operator

We will take our next question from Gerard Rijk from ING Bank. Please go ahead.

Gerard Rijk – ING Bank

Yes. Good morning. Three questions, if I may. First is about the cost of goods sold. Can you give a guidance on that for the second half, how it will dissolve I understand that your gross margin is doing quite well, but specifically this element.

Second one is your remark on the appreciating Yuan you have of course a relatively small exposure still China, but can you talk about the mechanics? Is that using this additional room for additional marketing spend in this area?

And thirdly, it’s about your successful U.K. story, up to now, and about cycling the successful category management initiatives. Is U.K. heading up to decline in the second half?

Paul Walsh

First of all on COGS, we are pleased with the work that has gone behind orchestrating structural cost reduction and also the fact that on a constant mix we are at least holding on COGS flat. There is a lot of talk about escalating commodities. Two things I would say is that first of all, the next six months we are covered. That’s not an issue.

Also going beyond that, agricultural input is quite limited regarding the overall cost of good for our products. And indeed on a product category such as scotch the cost today actually doesn’t feature in cost of goods until that product has been matured and relieved from inventory which could be eight years plus. So cost of goods overall flat and we are not seeing immediate threat from commodity increases.

The other point on...

Unidentified Company Representative

GB.

Paul Walsh

GB.

Gilbert Ghostine

Yeah, GB, I think it’s fair to say is a healthier business than these current numbers suggest. You’ve seen the one-off impact on margins that we alluded to earlier that was in the GB numbers. We also had a buy-in in June of last year because of against the rumors of excise tax increases in the emergency budgets. So actually our sales numbers have been diluted by that impact. So the underlying sort of sales trend in the business, I would say, is more healthy than you are seeing in these numbers.

You know we’ve got share gain in bails. We’ve got 3 points of share gain in Baileys. We lost the share point in Smirnoff, so that’s from 49% to 48% of the market and it was a result of specific decisions not to participate in sort of binary listing opportunities in some of the on-trade because of the margin implications of that.

Our innovation is up 56% year-on-year. In U.K. we are really raising again on innovation and our reserve portfolio, the top end of the business was 27% in the half as well. So there is a lot of good news around the U.K. The other point that’s been mentioned before I think is our wine business was up 18% on sales, actually on decline in volume of 6%. So we are actually turning our wine business into a much more profitable piece of the business. So I’d expect an improving picture certainly at the bottom line in the second half for GB.

Gerard Rijk – ING Bank

Okay. And on China?

Gilbert Ghostine

China sorry. China we see premiumization back in China, super-premium brands are growing faster than deluxe brands and this is where we have invested behind Johnnie Walker. We have a big campaign behind Johnnie Walker that we launched two months ago that is yielding very good results and engaging emotionally Chinese consumers with the Johnnie Walker franchise and we are also testing higher investment behind Blue Label that is yielding great results and this is reflected by our performance on Johnnie Walker Black Label and most important behind Johnnie Walker Blue Label in January and during Chinese New Year where we saw very solid performance on Walker and mainly on Johnnie Walker Blue Label.

Gerard Rijk – ING Bank

That the appreciation of the Yuan you are taking advantage of that margin increase by investing more AMP or is it that you take more profit/

Gilbert Ghostine

Exactly. We are investing more in AMP and again profitability in China is very clear. We have three businesses in China. We have two joint ventures, one with Moet Hennessy and one with (inaudible) and these two businesses are profitable and we have one other company that is Diageo China Limited where we have Winter Smirnoff and Baileys and we are investing behind these brands for the future and this is the business unit where we lose money in China. And this is our own decision we believe that we’re investing behind these brands for the future and we see big potential behind Baileys, Smirnoff and winter in China.

Gerard Rijk – ING Bank

Okay thank you so much.

Operator

We will take our next question from Ervin Rampaul (ph) from HSBC. Please go ahead.

Unidentified Analyst

Yes hi good morning everyone, I am (inaudible) from HSBC. I have three follow-up questions on the U.S. so sorry Ivan, firstly, you have increased advertising to sales and your committed to continue to do that in H2, You’ve commented on the fact that there is less promotion going on, I was just wondering, when do you think the market will actually see some price increases? And you as the leader of the market, when do you think you’ll be able to actually increase prices?

Secondly, looking at Johnnie Walker volume down 9% in the U.S., you explained that it’s a technical basically convergence between sale in figures and depletion. Is this just a one-off element and do you think we’ll see other adjustments in terms of inventories in the future in the U.S?

And then thirdly, on the vodka category, we see trends on Cîroc absolutely slowing, but then quite a crowded space in vodka and more launches, actually more launches from Diageo as well and we see limited growth for the first half on Smirnoff and Ketel One. So I’m just wondering, if you think that the launches that the market has made, but also that you’ve made have may be jeopardize a bit the growth that you may have had on Smirnoff and Ketel One. How do you think about basically the overcrowded nature of the vodka space right now in the U.S.?

Ivan Menezes

Sure, let me take them one at a time. On the pricing outlook for the business, I mean the way we’re thinking about it is, we have reduced discounting and promotional support very consistently over the last 12 months, so our price realization are going up. We look at pricing decision by market, by brand, by pack size and in the U.S. by market is by state. And we’re following conditions very closely and as conditions improve both equity and consumer conditions, we will be in a position to take price and I’d say that’s the philosophy we are adopting on pricing going forward.

On your question on Jonnie Walker, there wasn’t adjustment in that brand, because if you recall last year, we got a somewhat surprised by a weak Christmas and November. And on our imported brands we tend to ship ahead out of the Scotland. So we were committed to the volumes. So it’s nothing unusual we are just adjusting the inventory level down there. The brand actually is really healthy.

We had depletions on Jonnie Walker were plus four in the first half and the top end of Jonnie Walker is doing amazingly well, super deluxe, we add a phenomenal Jonnie Walker Blue season in November and December. And Black Label is very healthy increasing its price premium growing share. I actually feel very good about Jonnie Walker.

On your vodka question, vodka is indeed a very competitive and crowded category, but I have to say I feel very good about our category approach to vodka. You’ve seen the numbers on Ciroc which are very good. Ketel One, our reported numbers are flat to 1% but our depletions in the first half were running over 3% and most importantly our un-premise business Ketel One is running plus 7%, plus 8%. So that brand is very healthy. We feel, as Paul alluded to it, we feel very good about where it is. The campaigns are working strongly. There is a lot of price competition in that super premium segment. People repositioning down but Ketel has held its position and I feel will really come out of this and is coming out of this much more distinctively positioned holding its price premium and will well position to grow share. On Smirnoff which is the market leader 20% of the vodka market in the U.S. what you’ve seen in the first half is we have backed off promotional support, particularly in the chain markets on Smirnoffs to improve again price realization.

The brand is healthy. We’ve got some exciting campaigns on Smirnoff with the ‘I choose’ campaign and reality show called Master of the Mix, both of which are trending very well. So Smirnoff as we ease off pricing and discounting and improve price realization is coming under a bit of share pressure but the brand is healthy.

And then the new entries are there to really ensure that we keep category strength strong overall. So vodkas as you know is the fastest growing part of the U.S. spirits markets till today. We intend to lead the category and I actually overall feel very good about the portfolio including the new innovations and our ability to manage the total category here and kind of extend Diageo’s kind of competitive position. And I would take you back two or three years when we really did not have a position in vodka to play at super premium and in ultra-premium. We are in a very different place today and actually it’s one of the categories I am most excited about in terms of how well we’re positioned going forward.

Unidentified Analyst

Okay thanks. Just wanted to come back to the first question, I understand about pricing increase, I understand your comment about, it depends on brand equity, it depends on the state, it depends on the consumer confidence as Deirdre point, are you in a position on certain brands on in certain states today to put through price increases or what’s the – basically what’s the time horizon you have?

Ivan Menezes

As you look at what we have done, if you just look at the history in the first half, I mean within those numbers we have taken price increases on certain brands and pack sizes. So on vodka and rum certain states, if you – we will continue to do that and again I can’t give you specific plans on pricing here. But our focus is very much to improve price and mix in the business and we will be – we’re geared and positioned to it and you can see it from our posture on advertising and brand building investment. It’s very much to support that ability to improve pricing as market conditions allow.

Unidentified Analyst

Okay. Thank you very much.

Paul Walsh

And may be just to build on the vodka point, few years ago, people quite rightly criticized us because we did not have an ultra-premium offering, we’ve now got two brands that are setting the trends in that category, that the power of our marketing and it’s the power of our route to market.

Unidentified Analyst

Thank you very much.

Operator

We will now take our final question from (inaudible) from Exane BNP Paribas. Please go ahead.

Unidentified Analyst

Yeah, good morning, gentlemen. Two quick questions, you mentioned in the statement this morning that there have been some liquidity issues with distributors in Spain, which has led to the stocking. Could you expand a bit on the situation here and explain whether you have gone as far as recalling products from distributors on concerns that you may not get paid.

And secondly, second question is one scotch and inventories there. You carried out quite a big investment in 2008 on this part of the business, I wonder whether you could update us on your investment plans here given that demand at least for – to premium scotch has improved.

Paul Walsh

Let me talk about the scotch’s issue and maybe Andrew you can talk in a moment about Spain. We will continue to invest in scotch. One, we are very confident about the future of scotch in our existing markets and we remain optimistic that other markets that currently have got very high tariff levels will progressively – those tariff levels will progressively come down. So it behooves us to invest wisely in bulk liquid. We brought Roseisle on stream, which is a fantastic new distillery in Scotland. Clearly we have to wait till that liquid matures before we can start to sell it. So there is an inevitable lag here, but equally where we have the opportunity to buy bulk liquid that comes to market, we seize that opportunity. So we are very, very well-positioned for the long-term to capture the long-term prospects of scotch. Distributors in Spain.

Gilbert Ghostine

Yeah, I mean when you get a decline in consumption, you get two or three things that play in terms of trade stocks. The first thing is the same forward cover of stock in terms of sales, obviously is a lower absolute amount of stocks are automatically the lower consumption drives lower stocks in the market.

We are also hit in Spain though particularly as you got there very negative news flow from about November onwards, but just psychological factor in the Spanish trade where they decided to hold lower stocks and in some cases we decided not to ship as much as we might otherwise do to certain customers for obvious reasons.

So you are getting all of those three factors at play. I would say actually the more severe impact that we’ve seen from destocking has been in Greece, where we’ve had a number of customers on credit hold and in terms of taking a more conservative view on risk. But yeah there has been more destocking in Spain mostly driven by just lower consumption lower sales right to the way the down the channels through to the consumer.

Paul Walsh

Thanks Andrew. And thank you for your questions maybe as we warp up just to reinforce a couple of points. First of all we understand where our issues i.e. lie in Europe and we are resolute to tackle those issues. However the business overall has got fantastic momentum. We’re seeing premiumization return, we are seeing operating margin, sorry gross margins improve and whilst as we can’t comment specifically on pricing, the environment is somewhat better as we see inflation coming into play here. So we’ve got great momentum and we are investing behind that momentum and we are very confident of our improved performance in the second half. Thank you.

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