Diageo's (DGEAF) CEO Ivan Menezes on Q4 2016 Results - Earnings Call Transcript

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Diageo PLC (OTCPK:DGEAF) Q4 2016 Earnings Conference Call July 28, 2016 4:30 AM ET

Executives

Ivan Menezes - Chief Executive Officer

Kathryn Mikells - Chief Financial Officer

Analysts

Olivier Nicolai - Morgan Stanley

Sanjeet Aujla - Credit Suisse

Chris Pitcher - Redburn Partners

Trevor Stirling - Sanford Bernstein

Nik Oliver - UBS

Simon Hales - Barclays Capital

Andrea Pistacchi - Citigroup

Anthony Bucalo - HSBC

Stéphanie D’Ath - Bank of America Merrill Lynch

Laurence Whyatt - Société Générale

Alex Smith - Investec

Edward Mundy - Jefferies Group

Mitch Collett - Goldman Sachs

Tristan Van Strien - Deutsche Bank

Komal Dhillon - J.P. Morgan

Operator

Good morning, and welcome to the Diageo Preliminary Results Call with Ivan Menezes, Chief Executive; and Kathryn Mikells, Chief Financial Officer. [Operator Instructions] I will now hand over to Ivan to introduce today’s call.

Ivan Menezes

Hello, everyone. And welcome to the call. I’m sure by now, you’ve had a chance to look at our press release and the webcast, that Kathy and I did earlier this morning. We’re both in London and ready to take your questions. So with that, operator, let’s take the first one.

Question-and-Answer Session

Operator

Thank you, Ivan. And your first caller is Olivier Nicolai from Morgan Stanley.

Olivier Nicolai

Hi, good morning, Ivan, Kathy. I’ve got a couple of questions, please.

First of all, your margin in Africa was down, particularly in H2, affected by negative mix. How should we think about margins in 2017 in Africa and particularly what could be the impact from the sharp depreciation of the euro?

And just regarding your FX guidance of £370 million impact on EBIT for 2017, could you give us an idea of how much is coming from transactional versus translational? Thank you.

Ivan Menezes

Hi, Olivier, I’ll take the first one then ask Kathy to jump in on the second. On Africa margin, yes, we were impacted by Nigeria, in particular, on the margin and in this year’s organic. But going forward to your question, I do expect Africa to expand margins going forward and getting operating margin up again. So that’s very much in our plans.

Kathryn Mikells

And then, your question with regard to the impact on operating profit coming from FX benefit, about 70% is translation relative to transaction.

Olivier Nicolai

Okay. Thank you very much. Just to follow up on the FX, concerning your hedging profile on FX, should we expect further positive transactional again in full year 2018. Or in other words, if you are not hedged on your transactional, you will have expected more than £370 million for this year?

Kathryn Mikells

Yes, yeah, our hedging profile generally, we’re at any point in time out about 18 to 24 months. Right, and so that diminishes kind of the immediate impact either positive or negative with regard to transaction. And so we’ll still have that rolling off in fiscal 2018.

Olivier Nicolai

Very clear, thank you very much.

Operator

Our next caller is Sanjeet Aujla from Credit Suisse. Please ask your question.

Sanjeet Aujla

Hi, Ivan, Kathy; just few questions on the U.S., please, can you give us a little bit more color on the new agreements you have with your distributors there, what’s actually changing?

Also, can you try and help us quantify the price adjustment on Smirnoff? And are you adjusting price anywhere else in the portfolio?

And thirdly, you’re talking more positively about margins in the U.S. I think the message at the Investor Day was not to expect much margin expansion out of that business in the foreseeable future. So what’s really changed in there to give you more optimism on expanding margins in the U.S.? Thanks.

Ivan Menezes

Hi, Sanjeet. Sure. The distributor agreements are basically focused on strengthening our sales executional capabilities. So things like, we run the activation armies in the top 40 cities, how we support behind the activation army. Things like more focus on multicultural and a non-premise; more focus on reserve brands.

We’re at a point now where our distributor partnerships are strong. We are getting better real-time data on performance. We are aligning supply chains closer, so we can really get efficiency in working capital, both for our distributors and for ourselves. So I’d say it’s just raising the game to the next level of execution. And just to me the key is widening our advantage relative to competition.

On the price adjustments on Smirnoff, I would say we’ve had to make pack- and state-wise adjustments on the 175s and the 750s. We’ve done most of it. There’s a little more to do. As you know, Vodka is very competitive. But the way I would characterize pricing in the U.S. is, in Fiscal 2016, we virtually got no price. But under the surface, we took price on brands like Crown Royal and Bulleit and Don Julio, and we’ve had to make adjustments on brands like Smirnoff and Captain Morgan.

In fiscal 2017, I don’t expect us to get much price. Mix is very positive; mix is driving a couple of points of improvement. That should continue. And we will stay on the premium core brands, particularly on Smirnoff and Captain Morgan, just to ensure we are - price premiums are not too high. So I’m not expecting price in the next year as well.

On margins, we have a strong productivity program in North America. There’s still - as you know this is a scale business. It is very efficient. But we see room for more. Supply chains can be run more efficiently. We will be taking tramlining through our product lines, working with distributors more closely. And we’re looking at our back-office activities on driving more efficiency there.

The margin picture in North America, from fiscal 2012 to fiscal 2014 we grew 100 basis points of margin, a lot. Last year, we dropped because our volumes were down. In fiscal 2016, we grew 40 basis points. I would say the underlying business algorithm should drive some small margin expansion, not as big as it’s been in the past years. But at the same time, I would say we are - this is the market I’m looking to invest. And in our global productivity program we talk about two-thirds coming back into reinvestments.

North America is going to be high on our priorities to reinvest in marketing, once we are confident we can get the returns. So that’s how I would characterize margins going forward.

Sanjeet Aujla

Many thanks.

Operator

Our next caller is Chris Pitcher from Redburn. Please ask your questions.

Chris Pitcher

Hi, there. A couple of questions, you mentioned how much you increased your European sales force by. I was wondering if you could give us some similar statistics on your U.S. business. And then, you singled out in the presentation scotch. India and the United States as central to your medium-term guidance. Could you give us an idea of what you think the growth ranges are for those three different parts of the business? Thanks very much.

Ivan Menezes

Hi, Chris; on the distributor sales force in the U.S. we made adjustments. As you know, we got out of the wine business, and so we had to resize a bit on that. But I’d say, more than the sheer numbers it’s the redeployment. We’ve got a 3,000 plus sales force in the U.S., but we’re putting more focus on multicultural segments and more focus on the on-premise and on-reserve, and activating in the on-trade and in 3rdSpace and in the communities in the big cities. I’d say it’s more that and better data, more disciplined execution, where we’ve released a lot of capacity by getting out of wine, and we’re redirecting that against spirits execution.

The three priorities…

Chris Pitcher

Just a follow-up…

Ivan Menezes

Go ahead.

Chris Pitcher

…on that, sorry, if I understand how your sales force go to the market, how many of your sales people now would be going and selling the whole Diageo portfolio versus more specialist things going in and focusing on reserve or whisky and the like? Is that perhaps the way it’s going? It’s become much less of the portfolio approach?

Ivan Menezes

No, I would say the vast majority in the U.S. are selling the full portfolio. So we do have specialist resources that focus on, say, African-American and Asian accounts or the Korean clubs in California. I mean, we’ve got a very-tailored sales force against the opportunities. So it’s tailored by channel, by type of outlet, but the vast majority is selling the full portfolio.

Chris Pitcher

Okay, thank you.

Ivan Menezes

On the three priorities, scotch, as you know, we got it back to flat this year from the decline in the last couple of years. I would expect us to improve that this year. I’m not going to give you a scotch forecast, but you can expect momentum to continue and build.

India, we grew 5% this year. I would expect that to improve. You know our medium-term goal in India is to get to double-digit growth on USL. And the third was the U.S. - oh, the U.S., next year we’ll grow in line with the market. That’s the goal.

Chris Pitcher

When do you think the market will grow?

Ivan Menezes

Sorry?

Kathryn Mikells

When do you think the market will grow?

Ivan Menezes

Well, it grew this year at about 4% on spirits in fiscal 2016.

Chris Pitcher

Thank you very much.

Ivan Menezes

Yeah.

Operator

Our next question comes from Trevor Stirling from Bernstein. Please ask your question.

Trevor Stirling

Morning, Ivan and Kathy; three questions from my side, please, Ivan. The first one, concerning the top line aspiration of mid-single-digit fiscal 2017 to 2019, is that an average across the three years or such that by the end of fiscal 2019 you’ll be up at a mid-single-digit growth?

Second question maybe for Kathy, the overhead drag is simply - good performance on gross margin expansion on the market and savings but about 110 bps of drag from overhead. Is that something that we can expect to go forward, at least the inflationary element of that?

And the third question my side, Ivan, coming back to U.S. scotch strategy, you mentioned Buchanan’s and Johnnie Walker, but single malt seems to be the fastest growing bit of the U.S. scotch category. What are your plans in malts in the U.S.?

Ivan Menezes

Sure, why don’t I take the first? The growth rate is the average over the three years, mid-single-digit. On scotch malt, we absolutely see this as the vibrant end of the whisky market. We do have stepped-up plans on growing our malts business through - we’re up- weighting our reserve focus in the U.S. significantly. And it’s not just malts, it’s also super deluxe Johnnie Walker blends as well, where brands like Blue Label are doing very well in the U.S., and I want to really accelerate that momentum as well.

So going into fiscal 2017, the team has I think quite a robust plans against scotch in total, Johnnie Walker in particular, malt strong. And super deluxe scotch I expect to continue to accelerate because that’s the very vibrant end of the marketplace.

Kathryn Mikells

And then, I’ll take the question with respect to overhead. So as you look at the overhead impact to our margin, about 50 basis points of that was as a result of the bigger bonus accrual effectively this fiscal relative to last fiscal. Last fiscal, it would have been artificially, well, obviously off of what wasn’t a great year for Diageo overall.

When you think about the inflationary impact, I’d say, overall, we’ll continue to have an inflationary impact. But we will be looking to address that in part by getting more productive overall within our workforce. So that impact is going to continue to be there. We’d at least be looking to get partial offsets against that impact.

Trevor Stirling

Thank you very much, Ivan, Kathy.

Ivan Menezes

Thanks, Trevor.

Operator

Your next question comes from Nik Oliver from UBS. Please ask your question.

Nik Oliver

Hey, good morning. Thanks for the question. Two from my side; firstly, on the marketing spend, another year of good efficiencies there. How should we think about that line going forward? Is there more scope for efficiency or should we think about marketing spend gradually increasing as a percent of sales in fiscal 2017 and fiscal 2018?

And secondly, Ivan, just coming back on to your comment on the U.S. market growth, in terms of growing in line with the market, was that a commitment for the full-year on average or by the year end? And if it is the full-year on average, just a sense of what are the key building blocks, getting us from that 3% depletion rate this year up to circa 4% next year? Thank you.

Ivan Menezes

On the second one, I’m not going to give you decimal point forecast on the U.S. spirit business. We grew 3% this year, it will improve. Let’s face it; we are underperforming the market right now, because of the drag of Smirnoff and Captain Morgan. Both of them grew 2% this year. We expect improvement, but it will be gradual, it will be through the course of the year. The thing I would point to is I have confidence in the momentum in the U.S., which is really coming through stronger execution.

Our marketing has significantly stepped up. I spent a week in the U.S. a few weeks back and just went through all the brands and our marketing programs, very, very strong. The commercial execution, I talked about it earlier. It’s also stronger. And the distributor alignment against what we want to get done in the on and off trade, in the multicultural segments, et cetera is good. So that’s why I feel confident we’ll get improvement. But it will be gradual. This is a supertanker and we will steadily get it better.

Nik Oliver

Okay, thanks. I think in the past, you talked about stabilizing some of the low-end brands as being part of that driver of the sequential improvement. Is that still a part of the strategy as well?

Ivan Menezes

That is part of the strategy. So we are - there’s still a drag, the low-end brands. And so, Deirdre and the team have plans underway to improve our competitiveness at that end of the market as well.

Kathryn Mikells

And then your last question with regard to marketing spend I thought I’d go ahead and address. If you look at how we’ve basically lowered our overall marketing spend most recently, it’s come from really getting efficiency out of our marketing spend, so consolidating our vendors, benchmarking our contracts, negotiating better deals using our agencies more smart way. That has given us a lot of benefit in the U.S. as well as Europe.

We’re concentrating that program on rest of the world, but obviously we have a disproportionate amount of our marketing spend in Europe, in the U.S. And so, I’d expect we’ll continue to get more from that but not to the same degree that we've seen over the last couple of years. But the place that we’re really looking to step up then across the board is I’d say marketing effectiveness, right. And that’s really a set of better tools and data. So that we can really use that spend in a more effective manner and therefore get more pounds of revenue for our money.

But overall, I think it is fair to say that given we want to really invest in growth and two-thirds of our overall productivity savings we’re looking to target to invest in growth, that we’re not looking to get a lot of incremental benefit on marketing as a percent of sales.

Nik Oliver

Okay, thanks a lot.

Ivan Menezes

Thanks, Oliver.

Operator

Your next question comes from Simon Hales from Barclays. Please ask your question.

Simon Hales

Thank you. Good morning, all. Two or three questions, please. Ivan, you mentioned earlier, you expected African margins to increase in 2017. Does that sort of also apply specifically to the Nigerian market? And I’d just be grateful if you could give us a little bit more detail on perhaps how you’re thinking of dealing with the naira devaluation there. Is the cost savings you can take out of that business is there? Are you aiming to pass on some of those FX moves in terms of pricing?

And then secondly, not want to get bedded down in quarterly trends. But I was just struck by some of the change in trends in Q4 versus Q3 in terms of your sales growth rates getting much better in Africa and much worse in Latin America. Is there anything specific or changes happening in those markets we should be aware of or is it just comp-issues on that?

And then, just finally on the U.S. good to see Captain Morgan back in growth, 2% growth for the full-year; how much of a contribution was Cannon Blast to that?

Ivan Menezes

Hi, Simon, Africa margins, yes, Nigeria is a big piece of the improvement. We are taking a very aggressive approach in terms of how we manage in the volatility and the challenges in Nigeria, managing our cost base very tightly. We’ve gone through quite a significant change in that business and organization to get our cost base down. We’re managing mix, pricing, local sourcing of materials. So Nigeria will be a contributor and I am expecting margin expansion out of them for next year.

On the Q4-Q3 trends, I wouldn’t read too much. I mean, there are some specific things in the phasing of Brazil, et cetera. Underlying trends in Latin America are good in terms of market share performance, very broad based. Our scotch business is doing well. And in Africa, you’ve seen our overall beer business is doing well.

Captain Morgan, we had OSR, was up nicely. Cannon Blast did contribute, but overall we had I’d say a broad based recovery in Captain Morgan. We were cycling some stuff in Captain Morgan White, et cetera. But overall, the Captain momentum has improved. I would not declare victory yet, because this is a slight improvement, but our marketing program, both on the - we’ve up-weighted on-premise activities a lot. And we’re seeing in - the activation army is in the 40 cities, where we’re back in the on-premise. You can see the uplift coming through on brands like Captain Morgan from the activation army.

So we will continue to work at that. We still need some pricing adjustments relative to the key rum competitor. And most of them were made this year in fiscal 2016. We have some more to make as we go into fiscal 2017. So that’s how I would characterize Captain Morgan; encouraging, but not yet where we want it.

Simon Hales

Perfect. Thank you.

Operator

Your next question is coming from Andrea Pistacchi with Citigroup. Please ask your question.

Andrea Pistacchi

Yes, good morning. I have three questions, please. The first one on Ciroc in the U.S., which had a more difficult year, I think part of the problem were the technical issues related to the timing of the launches in H1. But more broadly, if you could give us more color on what you think the problem is for Ciroc and what you’re planning to do to address it? You referred to some - more seasonal flavors.

Second question, where, please, is the main focus for your innovation this fiscal 2017 in terms of brands or categories?

And thirdly on emerging markets, 3% organic growth about in fiscal 2016. There were some technical factors there, some destocking still holding you back in H1. So do you think the underlying performance is a little better than that? And given the macro outlook with some countries probably, some macro bottoming out in Brazil, Russia, what do you expect for EMs in fiscal 2017? Thank you.

Ivan Menezes

Sure, hi, Andrea. In Ciroc, you’re right. There are - it was a tale of two halves in the U.S., where in the first-half with the shift in the innovation replenishment model we had a big decline. The second-half actually had a big increase. Overall for the year we were down 7% in the U.S. But the key issue for Ciroc in the U.S. and it is U.S. specific, is to really stabilize the core and get less dependent on big flavors needing to continuously recruit back the same consumers.

So we’re out to build - broaden the franchise beyond the urban market, get the core variant more stable. We got good plans on the marketing front. We will be taking a differentiated approach from what we’ve done before on how we broaden and strengthen the franchise. I expect in fiscal 2017, we will do better overall on Ciroc in the U.S.

Outside the U.S. Ciroc is in an amazing place. You will have seen in our presentation, in the UK, for example, we’ve overtaken the other French vodka competitor who long dominated this market. I mean, we are building it in reserve very nicely around the world. So I see Ciroc growing really nicely there. In the U.S., we’ve got to get more resilience and less dependence on big flavors every year. And that’s the direction we’re taking in our marketing.

On innovation, I’d say the core direction on innovation is less straight line extension, more innovation that recruits new consumers to a franchise and is more disruptive. So we are redirecting our resources to build more sustainable innovation and less from what we would just call recruiting existing consumers with line extensions. And it’s hard to give you market by market. We’ve got a pipeline. I’m very confident we will have a strong year in innovation. And the quality of sustainability will also improve, because we are putting our resources behind things that will really drive incremental growth and bring new consumers to our brands and less on straight line extensions.

Emerging markets, underlying business is better. And as we point out, we did have parts of the world where we had, like in South East Asia, where we have taken stock levels down. So the underlying momentum is slightly better than what you see.

Andrea Pistacchi

And for next year - sorry, fiscal 2017, what broadly would you expect?

Ivan Menezes

Yes, I would say, in total I would expect to see better; But again, I come back to the strength of Diageo right now is - you saw 70% of our growth came from North America and Europe in last year. So I think the world is volatile. I mean, it’s hard to predict the pace at which Brazil changes or comes back, or what happens in Russia, the pace of recovery in China and international spirits. So we’ve got some degree of volatility still out there.

But overall, I feel a good ability to drive some degree of improvement. I mean, India will be a big factor. India only grew 5% this year. We certainly expect it to do better going into next year. And that will be a big piece of it as well.

Andrea Pistacchi

Thank you.

Operator

Your next question comes from Anthony Bucalo from HSBC. Please ask your question.

Anthony Bucalo

Thank you. Ivan, just two questions; one, in Africa, are you having the same hard currency shortage problems as everyone else, and what kind of mitigating strategies in the market if you do?

And the second question is a bit more I guess existential. In that, the U.S. election cycle is usually a rather stressful time. This election cycle seems to be more stressful than any in recent memory. Do you see anything in your U.S. consumer feedback or chatter that indicates that maybe U.S. consumers are feeling a little bit anxious into the election in November? And are you seeing any impact maybe in the on-trade or possibly at the sort of local off-trade level?

Kathryn Mikells

I’m happy to take the first question. We would see the same kind of currency constraints as other companies would see in Africa. But we have, I’d say, gotten much better at getting out in front of these issues. And some of the big actions that we take is to get maximum local sourcing for products. We actually have introduced a number of new products that are made in-country, getting more into mainstream spirits and basically distilling and bottling in-country.

And so the more of our cost footprint that we can put into those countries, the less issue that we have associated with some of the hard currency constraints that we see. And I’d say that’s one of the places that we’ve gotten much better at getting out in front of and so it hasn’t been that big of an issue for us overall.

Anthony Bucalo

And is that why you’re confident that Africa margins can pick up again next year? Is that part of the positive story there?

Kathryn Mikells

So a big part of that positive story is what’s gone on underneath Nigeria. I mean, within Nigeria, beer actually grew 8% this year, right. What’s going on in Nigeria has a lot to do with just Orijin. And if you look at what went on in Orijin, I mean, we basically did something very disruptive; we created a new category. A lot of people kind of came into the category initially. We lapped peak Orijin sales in Nigeria in June.

And the decline that we saw year over year in Orijin is really what stressed our margins. We’ve seen a little bit of a move towards value brands throughout Africa as well. And so we have a little bit of negative mix, I would say, across the board generally. But it’s really the story of Orijin and the fact that Orijin has now stabilized in Nigeria. That gives us very good confidence in terms of the improved margins in Africa next year.

Anthony Bucalo

Great, thank you.

Ivan Menezes

Great, and on the U.S., Anthony, I’d say, the trends we’re seeing right now, we don’t see much change. The spirits category continues to be very healthy. I think one of the factors to your point, the on-trade is not as robust as we would like. At-home consumption is still stronger than the on-trade. You’ve seen it in some of the recent restaurant data coming out of U.S.

And that’s a good indicator of people’s levels of, let’s say, confidence. But as it relates to the spirits category overall and including the trends we have seen in July, we feel confident that what’s driving the growth there is much more demographics than taste changes, than response to consumer confidence. And that’s quite a secular trend, which will underpin solid growth for spirits. And so we feel confident about the spirits side continuing good growth.

Anthony Bucalo

Okay. Thank you.

Operator

Your next question comes from Stéphanie D’Ath from Bank of America. Please ask your question.

Stéphanie D’Ath

Hi, good morning. My first question concerns organic sales growth and your goal to grow mid-single-digit. Could you maybe speak or develop the trajectory? We have gone from flat to 2%. Consensus next year is at 4%. How and maybe comment on that?

My second question is regarding developed markets versus emerging markets. So you were mentioning that EM underlying was actually slightly ahead. Do you expect that to continue to be the case or not, and more particularly maybe on Brazil, Nigeria and Middle East which were driving the performance down?

And then finally, can you maybe develop a little bit on reserve? It has been taking a lot - and driving a lot of growth in your portfolio. How accretive is it on the margin, and where do you see it going forward? Thank you.

Kathryn Mikells

Okay, maybe I’ll take the first couple and throw the third one to Ivan.

With regard to the trajectory in terms of how we see our sales, this year we had 2.8% organic sales growth. And earlier in the call Ivan said, over the next three years we’d expect to average mid-single-digits, right. We consider that to be at the low-end in kind of 4%, at the high-end 6%. You look at where consensus is for fiscal 2017 for us and I think it takes that appropriately into consideration.

When we look at emerging markets, a couple of things; so Ivan mentioned earlier that depletions are actually a little bit ahead of where our sales growth was in emerging markets. We did have some destocking in places like South East Asia, also in free trade zones. Specifically within West LAC we would have had some destocking.

And so the strength underlying the business in emerging markets is a little bit better than the net sales organic growth that we had this year. I talked a little bit about Nigeria already. It was down 15 NSV this year, and that’s really attributable to Orijin. Orijin has really settled out. In the last couple of months, we’ve introduced new products there, Orijin Zero more recently, and we’ve lapped the most difficult high peaking sales period. And so that will help Nigeria in terms of having an easier comp year-over-year and an easier comp kind of as the year progresses.

In Brazil, we did see the impact of a big tax increase there, effectively in the middle of this last fiscal year. Ahead of that tax increase, there was quite a lot of advance buying, right. So Brazil was actually up 9% NSV in the first half obviously down significantly in the second half. So Brazil’s pattern as we look next year will be weaker first half relative to second half as a result of some of the changes that have occurred there in terms of tax.

And, obviously, the economy has been weak there as well, but we would expect to see positive progression over the course of the year in 2017. So that underpins some of our confidence in terms of emerging market overall improvement next year, and India, obviously, is a big market for us, and we’d expect India growth to move up next year relative to the 5% it had this year.

Ivan Menezes

Great. On reserve, Stephanie, the gross margins in reserve are higher, the marketing investment is higher, but the overall contribution is also higher. So this, the reserve business is accretive from a margin standpoint and, clearly, growing faster is very good for Diageo’s margin development.

As you know, in the last four, five years we’ve doubled this business. It’s now about 14%, 15% of Diageo. I do see it remaining the fastest growing part of our business. We are investing heavily behind it. Just in the course of the last few years, if you take the top 100 cities in the world, we’ve doubled the number of outlets in which we’re activating reserve. We put a huge number of reserve brand ambassadors around the globe on our portfolio.

We - you would have seen in my presentation on the webcast we are segmenting the reserve business into three distinct segments and taking more tailored approaches here. I expect reserve to be very fast-growing business for Diageo and very helpful in the mix impacts on our margins. It’s really a consumer trend that is strong and sustained, not just in the developed world but as much in the emerging world.

In Africa, a small base, but we were up 30% on our reserve business. And so you’re seeing it really take hold everywhere and I’m really pleased with Diageo’s approach and we are at advantage in building this business.

Stéphanie D’Ath

Thank you. And maybe following up on that, could you specify maybe you are taking share in reserve and how you are doing at group level? I think you were more flat year-on-year and so it’s really offsetting.

Ivan Menezes

This year, we didn’t, and some of it was driven by Ciroc in the U.S., because of what we talked about earlier. But if you look at us over a sustained period, we have grown share steadily and I certainly expect us to grow share going forward. So I’d say this year reserve only grew at 7% and it was held back a bit by the U.S. performance and some of the corrections we took on super deluxe scotch in parts of Asia and Latin America. But underlying, I expect us to absolutely grow share.

Stéphanie D’Ath

And on scotch, you mentioned about a year-ago your inventory, or your production being slowed down a bit. Can you maybe comment on where production inventories and levels are, please?

Kathryn Mikells

So we continue to grow maturing whiskies overall and scotch. We had some adjustments, I would say, within some of our distilleries this year. We had a project with regard to environmental recycling at one of our distilleries that caused the distillery to be kind of taken out of production for a period of time. But overall, our expectation is we’re going to continue to grow our maturing whisky stocks against a long-term average, so kind of roughly in a 2% to 3% range, pretty steadily.

Ivan Menezes

Thank you.

Operator

Your next question comes from Laurence Whyatt from Société Générale. Please ask your question.

Laurence Whyatt

Good morning, Ivan and Kathy. A couple on your U.S. spirits division. Can you just explain to us the numbers on Smirnoff? You’ve taken the prices down as I understand, yet your price mix has increased. Could you just run through how that works on the - presumably on the mix side?

And secondly, could you give us a bit more detail on Crown Royal and where the growth is coming from? How much is growing in the core and how much is it from the flavor and line extensions? And how many line extensions do you expect that product to be able to do?

Ivan Menezes

Sure, Laurence. Overall, on Smirnoff itself, yes, we have had to sharpen pricing to be more competitive. But the advantage of our portfolio in North America is the overall portfolio has a very strong mix in its favor. So when Bulleit grows 33% and Don Julio grows high-single-digits and super deluxe scotch is growing fast, and Crown Royal growing fast. All of that is mix benefit, while we sharpen our competitiveness on Smirnoff and Captain Morgan.

Laurence Whyatt

Sorry. I probably wasn’t specific enough on the question. On the - you’ve got 1% volume movement for Smirnoff but you’ve got 2% net sales movement on Smirnoff in North America? Just wondering on that precise price mix and how that works on Smirnoff on its own, not including the other brands.

Ivan Menezes

Yes. We also have - we’ve - it’s the mix within Smirnoff. So some of the flavors, which we had kind of grown over the last few years those have - we’ve lost some of the cheaper flavors. We’ve introduced some higher price mixed innovation like Smirnoff Sourced, et cetera. So it’s the mix within Smirnoff that is helping that. You also have pack size mix that’s changing. The 750s in general in the U.S. are much more appealing to millennials than the 175s of old where the growth used to happen a lot more on the 175s. So you’ve got some of that dynamic.

On Crown Royal, total Crown Royal, I’m pleased to say the base is also strong growing mid-single-digit, and Crown Royal Apple grew about 15% in the year. To your point on flavors, we are going to be very careful about how we look at flavor extension on Crown Royal. I certainly don’t see this as one where we will keep introducing flavors.

We did a limited time offer in the summer for Honey with a limited quantity, but that’s to keep news in the category. We will probably do one more flavor. But what we measure when we introduce a new flavor in Crown is, is it bringing new consumers to the franchise, and our innovation approach is really targeted at recruiting more into the franchise and not cannibalizing existing consumers. But it’s an area of high watch out and whisky flavor proliferation is not something we believe in.

Kathryn Mikells

And Regal Apple, I think, is such a great example of bringing new consumers to the brand, because it’s brought more women to the brand, and it’s brought the shot occasion to the brand where it wasn’t necessarily participating as richly in that occasion. So it’s a great example of bringing new consumers to a brand through an innovation.

Laurence Whyatt

And just to follow up on that then, could you give us any more detail on the sort of percentage of women consumers using - drinking Crown Royal or Apple in particular?

Kathryn Mikells

I don’t have the percentage off the top of my head but it’s a significant movement relative to the baseline [ph].

Laurence Whyatt

Okay. Thank you very much.

Operator

Your next question comes from the line of Alex Smith from Investec. Please ask your question.

Alex Smith

Morning. I had a follow-up question on FX transaction from earlier; the benefits you expect to see coming through this year and into full year 2018. How, I guess, should we think about these benefits playing out? Do we expect them or should we expect them to all fall through to the bottom line, or are there other means that you can benefit from this? I guess I’m thinking about your competitor positioning in scotch in emerging markets where, I guess, over the last few years you’ve been hurt by quite significant local currency devaluations.

And then I had a second question, which is, I guess, a follow-up on Simon’s question. And without wishing to be overly obsessed in terms of quarterly sales trends, but I was struck in the U.S. that sales in Q3 were significantly stronger than Q4, whereas last year, it was Q4 that was particularly weak. So I’m just wondering if there’s anything we need to be aware of in terms of shipments as we look to H1 this year in North America. Thanks.

Kathryn Mikells

So I’ll take the first question on FX. Because we hedge our major currencies, when currencies move, either positively or negatively, the transaction effect, it dampens. Right? So it kind of rolls into our P&L over a period of time, and I said we’re typically hedging over an 18 to 24 month period, right.

So if spot rates stayed right where they are today and stayed in that place for the next 24 months, eventually, we would end up at the spot rate. But what happens is we end up moving towards the spot rate more slowly through the transaction impact on FX. And that’s why we would expect to see some benefit continue into fiscal 2018, but at this point we would not be at all close to fully hedged for fiscal 2018. You then came back to talk a little bit about the scotch portfolio.

One of the things I would just mention is overall, whilst Diageo has had the impact of FX over the last couple of years, other competitors have as well with regard to their imported products into emerging markets. So we always look first and foremost at making sure that our products are priced competitively, right. While FX moves and that puts pressure on us to raise price, we’ve got to be competitive in the markets.

And so those decisions are really made on a market-by-market level, and we’re obviously looking at things like demand elasticity relative to price as we make those decisions as well. So we’ll continue to monitor that situation. If we feel like there is a good trade for us to make with regard to price and volume and how that will impact our profit, we’ll make those trades. But we do that in a very detailed basis market-by-market.

Ivan Menezes

Alex, on the phasing in the U.S., I wouldn’t read - there’s not - Q3, Q4 is not the issue, there were some comps in Q3. I think what I would look at, and actually all I look at is depletions and what’s happening every month, every week, every quarter. The depletion momentum is improving. We had H2 depletions ahead of H1. And as we finish fiscal 2017, we had a tale of two halves, right, in terms of our shipment performance but we’re now on a more sustained shipments in line with depletions profile. So underlying business momentum, I expect to hold and improve slightly from where we are.

Alex Smith

And H2 depletions ahead of H1, would you say your market share trends within that was also better in H2 versus H1?

Ivan Menezes

Market share trends get a little messy, because if you look at NABCA and Nielsen, that’s not quite the case. If you look overall, NABCA and Nielsen is about one-third, or a little more than one-third of the market. If you look at independents and on-trade, we’re doing better. So H2 depletions were about 3% - were running about 3%, 3.1%. And as I said, we estimate a market at 4% and we were under 3% in H1.

So I am encouraged by the momentum, but we still lost share in Nielsen and NABCA in H2, more in Nielsen, than in NABCA. And some of that relates back to getting our Smirnoff and Captain Morgan momentum improving. Smirnoff in particular in the Nielsen markets.

Alex Smith

Thanks.

Operator

Your next question comes from Edward Mundy from Jefferies. Please ask your question.

Edward Mundy

Good morning, everyone. Three questions, please. The first is on Slide 66 of the presentation pack where you show your ZBB processes by cost line and benchmarking versus other CPG. Once you’ve put through your £500 million of cost savings, which quartile would you be in for each of these sub-categories? Would you expect to be in the top quartile, or is getting into the top quartile more than £500 million of cost savings?

Secondly, in terms of stock levels, you’ve taken a lot of pain in the last couple of years from destocking in emerging markets. As you see some growth from new and emerging markets, is there potential for shipments to run ahead of depletions?

And the third question is on Seedlip, clearly very attractive margins given the high price and no excise. I mean, how do you think about the prospects of zero alcohol as a subcategory? How big could it be?

Kathryn Mikells

Okay. So I’ll take the ZBB question. I’d say two things. So first, clearly, as we target savings kind of over this next three-year period of time, our desire is to kind of move towards the top quartile. That said, ZBB and some of the other things that we’re doing are really just about creating a culture of everyday efficiency and effectiveness across every aspect of the business and every line item of expense in the business.

And it’s really getting that embedded in the culture that will continue to give Diageo benefits, I would say, far beyond fiscal 2019. Benchmarking is a pretty helpful tool in trying to think about costs or an approach in a different way. And I’d also expect three years from now the benchmark will have moved, right. So this is really about continuous improvement and continuing to look across every aspect of our business to get more efficient and more effective.

Ivan Menezes

Yes. Ed, on the stock question, I mean, there are some technical factors, which you’ll see a bounce-back, where we had reduced stock levels. But on an ongoing basis to your question about as the emerging markets come back or scotch gets stronger, we are very focused on really having everyone’s eye and measurement and incentives and data around what’s selling out and depleting, and really managing the stock levels and distributors very tightly as a result.

So I don’t expect us to get back into a position of having stock levels out of line in distributors. We’ve got rigor, we’ve data now. And the measurement systems in the organization are very focused on sell out and depletions, and that’s how we incent our people.

On Seedlip, as you know Seedlip is one of our 10 investments in Distill Ventures where we’re backing entrepreneurs who have new interesting ideas. Most of these we don’t disclose. So we’ve got a pipeline of exciting stuff there. I mean, we are interested in this space, and clearly, that is part of why we have made this investment. But to your question on non-alcohol in general, I mean Diageo, we do have plays, right. We have Guinness Malta in Africa is a big play. We’ve done Guinness Zero into Indonesia. And in non-alcoholic adjust beverages, we will continue to test and expand our opportunities as we see them.

And the Seedlip opportunity attracted us, because we do keep a track of what’s trending, what’s interesting. I mean, today in London’s hot restaurant, I mean Seedlip is on the cocktail menu. It’s doing pretty well. It’s selling for £30 in Selfridges, selling very well there. And we intend to be at the forefront of new consumer trends. And that’s all I’d say is what we are doing, right now. We are experimenting, we’re learning and we’re backing new developments in the space, as we are with our other investments in Distill Ventures.

Edward Mundy

Great. Thank you.

Operator

Your next question comes from Mitch Collett from Goldman Sachs. Please ask your question.

Mitch Collett

Hello. I wanted to come back to FX, and I wondered if the current spot rate remains, by the time your hedges are fully rolled off, how much would the cumulative benefit be. And then secondly, I wondered, going back to scotch, you’ve obviously had a difficult couple of years of having to take up pricing in certain markets because of FX. How do you expect that to play out now that isn’t a drag?

And then finally, a question I think I asked at the first-half stage. You’ve obviously had some good savings on marketing. At the first-half stage, I thought the message was that you would step it up in the second half, and it looks like that hasn’t really happened. Was there a temptation, perhaps, to reinvest some of the benefit of your savings to try and get your share in the U.S. in particular back to stable? Thank you.

Kathryn Mikells

Okay. I’ll start with the FX question. So I mentioned that transaction FX within the £370 million was about - call it 38%, so a little over - call it £110 million of transaction benefit. We would get some incremental benefit in fiscal 2018, because we have some hedges on right now for fiscal 2018 that would roll off, but that is relatively small compared to what we would have on hedges on right now for fiscal 2017.

So I’m not going to give very specific FX guidance out a year plus into the future, but that’s how I would think about it. So we get some incremental benefit in fiscal 2018, but it will be a fraction of what we would have in fiscal 2017.

Ivan Menezes

Mitch, on scotch pricing, we’re going to manage this very, very closely, and it’s very market specific. But the broad principles I would say generally in deluxe scotch and above, I don’t see us rolling back price. In standard and primary scotches in certain markets where, if we’ve got currency benefits and we’re uncompetitive, we will make adjustments. But then on the other hand, in so-called hard currency markets, like the U.S., I expect our scotch margins to really improve. So we manage it on a global basis. We manage global pricing very tightly.

Our goal is to improve equity and improve share country by country, and clearly, with the lens on improving margins over time. So we don’t knee-jerk pricing on scotch. We take it very - we take a sustained view of - even when these currencies like in Brazil and Russia devalued, I mean we didn’t recover the devaluations right away. You move slowly. You want to make sure you don’t drive consumers away from your category.

So we have a global team that looks at scotch pricing in excruciating detail, and we are making some adjustments clearly where we are uncompetitive. Then, we could benefit from and see the return we would get from adjusting pricing because of FX.

Your last one was marketing savings in the U.S. Yes. I think if you look at the U.S., actually, U.S. is a good example. Yes, within - we got good savings in procurement and efficiencies. However, if you look at our premium core brands in the U.S., so Captain, Smirnoff, Crown Royal, we increased investment 6% on those brands. If you look at our momentum brands like Bulleit and Don Julio and Buchanan’s, we increased investment 16%.

So the real weight against our brands is going up. We’re really driving out the inefficiency. We’re reallocating effectively. And in the U.S., we really put our money behind the brands that really need to move the needle, and there’s a real shift in weight against those brands.

Mitch Collett

If I can just come back to the FX side of things, if you do hedge 18 to 24 months forward, I guess, I’m struggling to understand why the transactional benefit wouldn’t be more material in 18 to 24 months’ time. So why wouldn’t you have a bigger impact than the £110 million you’ve guided to for fiscal 2017? And I guess is the underlying assumption flat scotch pricing behind the transactional benefit you expect?

Kathryn Mikells

Again, it’s a year-on-year impact. Right? FX is always a year-on-year impact. And so we’re going to get a pretty significant transactional benefit this year, right. And in fiscal 2018, at current spot rates, we’ll get another impact, but then ultimately, that impact is going to get weighted against what we’ve already achieved in fiscal 2017.

And finally, I’m not going to give specific guidance for fiscal 2018. You can ask me about it again in a year’s time. But that - it’s a year-over-year, and that’s what I’m giving you color against.

Mitch Collett

Okay. Thank you.

Operator

Your next question comes from Tristan Van Strien from Deutsche Bank. Please ask your question.

Tristan Van Strien

Hi, good morning, guys. Thank you very much for the question. I just want to ask a little bit more about India, in particular you - just three things on that. One, your margin increase was 700 bps. How much of that - if you strip out the UB share buyback, what is the margin there and how should we think about the margin progression in India the next three years as you’re emphasizing growth in that business?

The second one is on working capital. Kathy, you mentioned it in the webcast about the local regulations really preventing some of the working capital improvements. I was hoping you’d give a little bit more insight into that and what the opportunity really is around working capital in India.

And then the third bit. You’ve benefited a bit from excise reductions in Uttar Pradesh. I was wondering, if there are any other regulatory risks or opportunities that you’re seeing in the horizon over the next 18 months in India, please. Thank you.

Kathryn Mikells

Okay. And so on the first question, the benefit from the UBL share sale was a gain of £28 million, so you can think about it in those terms. On working capital in India, two things, what I mentioned in the presentation was India runs at a heavier working capital NSD rate relative to the rest of the company, right. That doesn’t at all take away from the fact that there are areas, where we can and are improving overall in our working capital efficiency in India as well.

Like the rest of Diageo, as the company grows, right, we get a natural headwind in terms of building inventory and building receivables supporting that growth that we then look to offset. Like, we get a little bit of benefit on trade credit, but we then have to offset that by getting more efficient, by effectively reducing our working capital days on average. But the growth naturally causes a use for us.

Ivan Menezes

On your bit about Uttar Pradesh, I mean, the nature of India is you’ve got ups and downs all the time across the state. And, yes, we do get some gains and benefits, and we are - our business in UB is strong, coming back strong. I would say that in the overall context, there’s no real change up or down when I look across all the state, but it’s something we obviously stay very close to and manage very tightly against.

Okay, I think we have time for one last question.

Operator

And that question comes from Komal Dhillon from J.P. Morgan. Please ask your question.

Komal Dhillon

Hi, morning, Ivan, morning, Kathy. Just another follow-up on India, particularly on GST, so it seems to be gaining traction, but could you comment on how much pressure would put on USL margins, if the bill does become law and what mitigating steps USL can take?

And then the second one on Nigeria, I know it’s a relatively small market for Diageo, and you have obviously an easy comp, as you mentioned in fiscal 2017, but just wanted to get an idea of the underlying demand impact as long as the naira doesn’t devalue further, and given the discrepancy between the official and black market rate. Thank you.

Ivan Menezes

Hi, Komal. On India GST, it’s as you point out, yes, it’s gaining steam, but it’s still in parliament and going through the political process, so really hard to predict as and when it will happen. Also, the timing of implementation is also unclear, because, I mean, this is a massive change and getting all the systems and information in place also will take time.

What are we in the industry doing about it if alcohol was being excluded from GST? We have very detailed work underway on - I mean, the two issues we’ve got to look it is how do we recover, trap taxes on input costs; and B, how do we get pricing flexibility in states, which have price control. And both the industry forum and us as a company have got a lot of activity in both of those.

So let’s see what happens. We’re very closely on top of it and we will manage through the margin impacts of it by working very hard with the regulators and the government to ensure that the industry doesn’t suffer.

Komal Dhillon

Okay.

Ivan Menezes

On Nigeria, the underlying demand is about - trending at about 5%. You’ve clearly got stronger growth on the value brands than on the premium segments in beer. And spirits continues to do well at the high end, and we’re going into mainstream spirits in a bigger way next year.

Komal Dhillon

Thank you.

Ivan Menezes

Good. Thank you. So let me just close the call here. Thanks, everyone, for joining. Appreciate you calling in early in the morning, or evening, wherever you are. Just to summarize, we’re pleased, this was a good set of results. We’ve delivered on the goals, we’ve set for ourselves. We do have momentum as we go into the new fiscal, and are positioned well to improve our performance again in fiscal 2017 and on delivering our guidance.

Kathy and I look forward to meeting many of you on our road shows, and if you’ve got any more questions, do contact Kathryn and the IR team. They’re all on standby and ready to help. Thanks again. Bye-bye.

Operator

Ladies and gentlemen, that does conclude today’s call. Thank you for participating. You may now disconnect.

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