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Wall Street Breakfast

Diageo plc (NYSE:DEO)

F4Q07 Earnings Call

August 30, 2007, 04:30 AM ET

Executives

Paul Walsh - CEO

Nick Rose - CFO

Ivan Menezes - President, Diageo North America

Stuart Fletcher - President, Diageo International

John Pollaers - President, Diageo Asia Pacific

Andrew Morgan - President, Diageo Europe

Analysts

Christopher Gower - MF Global

James Edwardes Jones - Execution Limited

Nico Lambrechts - Merrill Lynch

Michael Bleakley - Credit Suisse

Ian Shackleton - Lehman Brothers

Simon Hales - Dresdner Kleinwort

Matthew Webb - Cazenove

Trevor Stirling - Sanford C. Bernstein

Presentation

Paul Walsh - Chief Executive Officer

Well, good morning everyone, and thanks for joining us today. Diageo's focus is on building brands and building superior organizations in market, thereby creating an even stronger platform for sustained growth.

The results that we have announced today demonstrate the success of that focus. The acceleration in growth year-on-year on all the key financial measures shows the strength of our business. Top line growth was up year-on-year to 7%, driven by stronger performance in International and Asia-Pacific. It was ahead of the growth in the first half due to improvement in Europe from a decline of 2% to 4% net sales growth in the second half and in Asia-Pacific, net sales growth improved from 9% in the first half to 17% in the second half.

We continued to increase marketing investment ahead of sales growth, with spend on a like for like basis up £85 million this year, which is ahead of last year's growth. Much of this increase is behind our most successful campaigns such as Johnnie Walker Keep Walking where net sales grew 16%, and Clearly Smirnoff, which drove 9% net sales growth. Our focus on value continues to deliver consistent improvement in operating leverage and this year operating margin has improved a further 40 basis points.

Operating profit growth is therefore up from 7% last year to nearly 9% this year. This stronger growth, together with the buyback program has generated 13% underlying growth in EPS, which again is up from 10% last year.

Looking to the key measures of Diageo's financial strength, free cash flow generation continues to be a key measure of success. Again, this year we have generated almost £1.4 billion allowing us to return a further £2.3 billion to shareholders and reduce our capital base by a further 5%.

We have delivered our operating and financial objectives and strengthened our business across all four regions. I am going to talk later about what we have done in each region to build our brands and build our routes to market this year and how that's enabled us to increase our guidance for organic operating profit growth in 2008 to 9%. But before that Nick is now going to take you through the results in more detail. Nick.

Nick Rose - Chief Financial Officer

Thank you Paul. Good morning everyone. As on previous occasions, I am going to assume that you've seen this morning's announcement and therefore just take you through the key points.

Our full year performance again shows good volume growth, price and mix improvement, further investment in our brands and operating leverage. The biggest driver of our volume growth of 5% in the full year was International, led by our Scotch brands in Latin America and our beer brands in Africa.

While International's performance drove 50% of our net sales growth, focus on value not volume in North America made the biggest contribution to the price and mix improvement we achieved. Further increases in marketing in International and Asia led to an overall 8% increase in marketing investment in the year. Significant operating leverage in North America meant that this region contributed 50% of our operating profit growth.

As Paul said, these results reflect our stronger performance in the second half. While North America and International continued to deliver strong growth, Europe and Asia-Pacific both accelerated top line growth. In Europe, volume increased by 3% in the second half, compared to a 5% decline in the first half. This better performance was delivered across all business units with GB and Russia the key drivers.

In Asia-Pacific, our key brands, Johnnie Walker, Smirnoff, and Windsor each delivered faster growth as a result of increased marketing investment. And this, along with innovation in India, led to volume growth of 17% in the second half, up from 7% in the first half. The increase in net sales growth in H2 to 9% led to the higher operating profit growth of 10% in the second half despite the increase in marketing spend, which was driven by higher spend in Europe and in Asia-Pacific.

So, moving now to the regions, North America has again delivered broadly based top line growth. Spirits, beer and wine, all grew net sales by 8%, partially offset by ready to drink, where net sales declined by 1% in the year. And although volume growth slowed, our focus on higher value brands and the price increases we have successfully put through on just over 50% of our volume has led to better top line leverage this year and net sales growth was equal to last year at 7%.

Captain Morgan, Smirnoff, Baileys and Crown Royal all gained share in competitive categories as a result of great marketing campaigns. Baileys also benefited from the national launch of Baileys flavors following the successful regional test last year. Diageo has again outperformed the US spirits market, increasing value share by a further 60 basis points.

We delivered stronger performance in beer in the second half as a result again of increased marketing spend, more focused merchandising and increased pricing. Our value share in beer was up 10 basis points. In wine, innovation, price increases, and strong growth of the premium brands delivered mix improvement and we gained 60 basis points of share in the premium wine segment.

Price increases and innovation with the launch of Smirnoff Raw Tea and Parrot Bay Tropical Malt Beverages generated mix improvement in ready to drink. Excluding ready to drink, marketing spend grew 6%. And we are now achieving substantial efficiencies in marketing procurement and our share of voice in spirits increased by 2.2 percentage points to 28.1%.

As you have seen, Europe's performance was significantly better in the second half, and GB was a big part of this improvement. You will recall that net sales in GB declined in the first half by 9%, primarily driven by our strategy to improve the net sales per case of our brands, particularly on Baileys at Christmas. However, a favorable stock position after Christmas and a focus on driving growth in core spirits, supported by increased marketing spend drove net sales growth in the second half.

In Ireland, our business continues to be impacted by the decline of the on-trade. While Guinness is still in decline, increased marketing spend in the second half delivered an improvement. In lager, performance has improved with focus on the off trade, with new campaigns, increased promotional activity, and the introduction of Bud Light. In spirits and wine, we are driving growth in both the on and off trade, with net sales growth of 4% in spirits and 7% growth in wine in the year.

In Spain, the market trends are negative, but we have made changes to our route to market, focusing on our key customers and improving sales force efficiency. This has increased sales coverage, but did initially reduce customer stock levels which had a further negative impact on sales in the year. In the second half, we upweighted all of our marketing activity in Spain and drove net sales growth of 1% against a first half decline.

Our strongest performances in Europe were in Continental Europe and Russia. Premiumization in Continental Europe is delivering good results, particularly on Johnnie Walker, which is growing share in Germany, in Greece, in Spain, and in Poland. In Russia, volume increased by 25% and net sales grew by 63%. The move to an in market company has improved our net sales rate per case and our profitability. And therefore, together with the higher volume growth, Russia's year-on-year performance has improved very strongly.

International continued to deliver strong top line growth and share gains in what are some of the world's fastest growing markets. In Latin America, Diageo's Scotch strategy continues to drive growth ahead of the category, led by Johnnie Walker with net sales up 20% and by Buchanan's. Increased investment is also driving growth in other categories with Smirnoff and Baileys both up around 30%.

In Africa, our beer brands performed strongly, with Nigeria now the second biggest market for Guinness volume worldwide.

In East Africa, we are driving growth across all our beer brands. Guinness was up 30% and Tusker and Pilsner were both up 15%. In South Africa, mix improvement has been a key driver of growth with stronger growth from ready to drink and Scotch. South Africa is a great opportunity for us being the fifth largest market for Scotch in the world. Category growth is in double digits and Johnnie Walker is leading this, growing net sales by over 40% in the year.

Despite a number of challenging trading environments, we expanded our Global Travel and Middle East business, principally through the premiumization of Johnnie Walker in Asian duty-free channels, and by innovation, including the global rollout of Baileys flavors and by our continued focus on visibility and distribution. Following many years of spend increasing ahead of sales, this year in International marketing spend increased broadly in line with sales.

In Asia-Pacific, while net sales growth was delivered in all markets and across all key brands, as you can see on this chart, four markets and three brands are key. In the second half, net sales growth accelerated from 9% to 17%. Marketing was upweighted behind Johnnie Walker across the region, behind Windsor in Korea and behind our new brand launches in India.

In China, net sales were up 60% and Johnnie Walker continued to outperform the Scotch category, with additional volume of over 200,000 cases in the year.

In India, new brand introductions widened our offering and together with continued growth from Smirnoff and Johnnie Walker, drove a more than 30% increase in net sales in the year.

Diageo's focus on driving value in segments with favorable consumption trends, led to net sales growth even in tougher markets such as Japan, Taiwan and Thailand. In Korea, continued focus on Windsor delivered further share gains and double-digit top line growth. This performance was delivered despite investigations being undertaken by the Korean National Tax Service. And since the year-end, Diageo's Korean import license has been cancelled and we are currently operating through a third party distributor. It is not yet clear how long this situation will prevail, but it will have an impact on net sales growth and the profitability of our business in Korea.

Marketing spend grew by 8% and as a percentage of net sales increased by 10 basis points to 15.5%. The 10% growth behind our spirits brands accounted for most of the overall increase. Spend was leveraged across a number of brands supporting our focus on driving higher net sales volume through price and mix improvement rather than volume growth.

Increased spend on Guinness, especially in Europe, drove an 8% increase behind our beer brands. Marketing on ready to drink was reduced in Europe as we continued to focus on profitability. This was partially offset by higher spend in Asia-Pacific.

Operating margin has again expanded this year by a further 40 basis points on an underlying basis. Despite the pressure on input costs, gross margins have risen by 80 basis points. In North America, strong top line growth drove very strong margin improvement. In Europe and International, margins have been maintained in the full year. And in Europe, the benefit to H1 margins as marketing spend fell by 7% was reversed in the second half as marketing spend grew by 12%.

In International, strong growth from our premium sprits brands in Latin America, and Global Travel and Middle East delivered operating margin improvement. However, an increase in operating costs in Africa led to a fall in operating margin there. I would not expect a similar increase next year.

Second half margins were also lower as overhead costs incurred in the first half of 2006 were not incurred until the second half this year. As you know, we have continued to upweight our investment in marketing in Asia-Pacific. As these results show this spend is driving our top line and delivering share gains for our brands, but in the short term, this has impacted operating margins in this region.

Moving now to our reported income statement, as you will have seen in this morning's release, we have moved to a single column format for the income statement as a result of new accounting guidelines. And this does make the year-over-year comparison, particularly in exceptionals a little more difficult. There is a little impact from disposals and acquisitions in the year. Disposals relate to the termination of the Three Barrels distribution agreement in GB, and the disposal of the United Beverages wholesale business in Ireland.

Acquisitions include two months of Bushmills and the acquisition of the Smirnov brand in Russia. Costs relating to the re-launch of Smirnov brand during the year resulted in an overall operating loss for the brand.

The adverse exchange rate movement was due to the strength of sterling primarily against the US dollar; however, during the year, sterling strengthened against nearly all of our major trading currencies.

For the next financial year, at current exchange rates, we anticipate the adverse exchange rate impact on operating profit to be in the region of £65 million, partly offset by £5 million on interest.

Profit from associates increased by £18 million to £149 million, mainly driven by Moët Hennessy. Net finance charges increased by £26 million in the year. Let me break this out for you in more detail.

The net interest charge increased by £58 million to £251 million. Our average net debt increased from £4 billion to £4.6 billion in the year. And our effective interest rate after foreign exchange movements increased from 5% to 5.5%, mainly driven by increases in US dollar and Euro interest rates. For fiscal 2008, I would expect the net interest charge to rise further as our average net debt increases to fund the share buyback and as our effective interest rate increases as a result of the moves we have seen in global interest rates. We currently have about 60% of our debt in fixed rates.

Net other finance income was £32 million higher than last year. Investment income was zero this year, reflecting the sale of our remaining General Mills shareholding in fiscal 2006. Post employment income increased by £29 million to £48 million. In 2008, post employment income will be at a similar level to 2007.

The weakening of the US dollar against both sterling and the Euro led to a £6 million credit, as we accounted for the impact of foreign exchange movements on short term intercompany loans. And finally, other finance charges are unchanged year-on-year.

In the last three years since the introduction of IFRS accounting standards, our effective tax rate has varied from over 30% to less than 10%. And as anticipated, the tax charge in 2007 was 32%, reflecting our underlying effective tax rate, which again for 2007 was around 25%, and the three major items which are shown on this chart. The increase in deferred tax assets in the balance sheet has given rise to a tax credit of £93 million in the income statement. At the same time, a reduction in the Dutch tax rate from 29.1% to 25.5% has reduced the current value of existing deferred tax assets. And this has given rise to a charge of £103 million.

And in addition, the settlement of the tax computation, which covered the GrandMet and Guinness merger, together with the utilization of capital losses in respect of the sale of Pillsbury and Burger King has resulted in a tax charge of £139 million in the income statement. However, there is a corresponding tax credit in discontinued operations.

Going forward, I continue to believe that the best way in which to view the tax charge is in terms of the underlying effective rate. At the interim presentation, I said that I anticipated that the growth of our business in the US and in other higher taxation territories outside of the UK and Ireland would increase Diageo's underlying effective tax rate. And in fiscal 2008, it is therefore likely to be around 26% and to stay at that level for the foreseeable future. My view of the underlying cash tax rate remains unchanged at 21%.

As Paul said, this year has seen another year of strong cash delivery. Interest payments have increased, mainly as a result of the increase in the interest charge. And in addition, last year we received a net £20 million relating to the one-off deferred payment on the Burger King Subordinated debt. Tax payments were down year-on-year as refunds relating to prior year settlements were higher this year.

Our cash tax paid is currently running below the 21% ongoing rate. And again, as I said at the interims, I do expect this to come into line. However, it's unlikely to be before 2009 and therefore in 2008 cash tax paid is expected to be around £400 million.

At the time of our interim announcement, I also said that I expected working capital to increase ahead of sales, as a result of our investment in Scotch inventory. While working capital has increased year-on-year, the increase was less than last year as a result of some better working capital management, giving a small favorable free cash flow movement. Lower net capital expenditure is due to proceeds from the sale of land and buildings, primarily the sale of the brewery site at Park Royal. And other outflows of £78 million include the £50 million payment made into escrow in respect of the UK pension scheme, which we announced in March.

Strong cash flow generation in the year means that despite the return of £2.3 billion to shareholders through our dividend and share buyback programs, net debt has only increased by £800 million. Diageo continues to manage its debt to a series of ratios that are broadly consistent with a single A credit rating. And as previously guided, this means that assuming similar levels of free cash flow and acquisition activity in 2008 to those that we saw in 2006 and 2007, we will have the financial capacity to fund a share buyback of around £1 billion this year.

Reported EPS was £0.672 per share last year and is £0.554 this year. As this slide shows, the change in our tax rate from 8% last year to 32% this year is the main driver of this movement in EPS. The underlying tax rate was 25% in both fiscal '06 and '07 and adjusted to this rate and excluding exceptional items, the movement in EPS is from £0.505 per share last year to £0.548 this year. And that's an increase of 9%.

Exchange adversely impacted earnings by £60 million which reduces EPS by £0.02, and therefore the underlying increase in EPS excluding that exchange movement is 13%.

So in summary, by consistently delivering improvement in our key financial measures, we believe that we do create shareholder value and create an even stronger platform for growth each year. As you have seen this year we have accelerated top line growth as our brands have performed strongly throughout the world. We have again expanded our operating margins as we focus on driving net sales value, not volume. Our free cash flow of £1.4 billion reflects the quality and the strength of our business, which is particularly important to me in these volatile markets. And the improvement we have delivered on return on invested capital, up 70 basis points to 14.4%, also reflects our determination to deliver shareholder value.

And now I will hand you back to Paul.

Paul Walsh - Chief Executive Officer

Thank you Nick. Diageo's strengths are the quality and diversity of our brands, our routes to market and of course our global reach. By investing each year to extend the leadership position of our brands, by improving our routes to market and by focusing on the growth opportunities in each of our four regions, we will drive consistent growth.

Let me take you through some examples of exactly how we've done that this year. This chart shows our performance in each major category. We have the widest range of leading premium brands across each beverage alcohol category and we have outperformed in each category again this year. At an individual brand level, we have gained share across many markets, which extends our leadership positions even further.

In Scotch, the performance of our brands within the category and across markets is a great example of this success. Scotch, as you know, accounts for around 30% of our sales and it is the category in which we are driving the highest growth. We manage the category for value and this year we delivered 4 percentage points of price mix as we increased prices and focused on our higher value brands. Many brands contributed to this strong overall growth, although the performance of two brands particularly stands out -- Johnnie Walker and Buchanan's.

The performance of Johnnie Walker over recent years demonstrates the power of bringing together great brands, a focused organization with global reach, and innovative marketing. Having achieved a stellar 11% growth last year, the brand grew a further 16% this year, extending its position as the world's leading Scotch. Asia-Pacific and International have led this success, but in the brand's biggest market, the US, it grew 7% and in Europe, it was up over 10%, demonstrating that growth can be achieved in what may be a difficult segment.

We are consolidating our leading positions in many markets, including the fastest growing Scotch markets of the world, Russia and India. In Thailand, we have continued to support the brand throughout the political uncertainty of the last year and we gained share on both Johnnie Walker Red Label and Johnnie Walker Black Label.

In China, Johnnie Walker Black Label is also growing faster than the competition and share is up a further 6 percentage points. Even where category growth is weak, Johnnie Walker has performed strongly. In North America, it grew 2 points of value share in a declining category and in Spain, Johnnie Walker Black's growth has made it the number one deluxe Scotch.

Advertising and promotion has increased across all regions as we continue to leverage the Keep walking campaign and the Vodafone McLaren Mercedes sponsorship to great effect to build brand image and as a platform for our responsibility messages.

Buchanan's in Latin America is one of our great local priority brand success stories. Net sales grew nearly 40% this year. This performance demonstrates our approach to category leadership. LatAm was the first place where we implemented the category approach to managing our Scotch brands. We now use this approach around the world.

Our Scotch brands have grown strongly in Latin America for a number of years. This year we delivered a further 25% growth. Johnnie Walker and Old Parr grew strongly, but it was Buchanan's that was the star. Great sales execution, focusing on the key selling seasons, and through merchandising links with other Diageo brands such as Baileys at Mother's Day, has been a key driver of this growth. Lifestyle advertising through distinctive music event sponsorship and with the Buchanan's Forever campaign have been successful in driving brand awareness and then growth.

As with Johnnie Walker, we are also using innovation to drive the premium growth opportunity with the roll out of Buchanan's 18-year-old and the introduction of super deluxe Buchanan's Red Seal. Share gains in both the deluxe and super deluxe segments have extended the leadership position that Buchanan's already enjoys.

Vodka is our second biggest spirits category and the growth we have delivered in vodka is again higher than the category growth.

The largest premium spirits brand in the world, Smirnoff, grew volume by 6% to 23 million cases, while net sales grew 9%. As with Johnnie Walker, Smirnoff grew in all four regions. The US is the biggest market. There the Clearly Smirnoff campaign continues to build the brand image. Volume was up 5% and price increases led to 10% net sales growth. Smirnoff Flavors and the Smirnoff Black re-launch were the major contributors to the brand's growth in Latin America and great performance in the Middle East contributed to 17% net sales growth in International.

Growth in Asia-Pacific was driven by India, with Smirnoff Flavors a major contributor and by Australia, where we have increased advertising to support a price increase and there net sales grew by 22%. The key marketing activity for Smirnoff was the Clearly Smirnoff campaign, which ran in many markets driving the Smirnoff purity message. The Smirnoff Experience program was expanded through a collaboration with YouTube to search for 1- globe trotters to follow in the footsteps of Vladimir Smirnoff, building on the Signatures campaign.

Moving now to beer, growth of our beer business has improved in each of the last two years. Guinness remains the key driver of this growth. Strong growth of the brand in Africa means that the brand's footprint is shifting from its traditional markets of Ireland and Great Britain to the emerging markets.

The new Guinness Greatness campaign was a big part of the 17% growth the brand delivered across Africa as sales grew in Cameroon, Ghana, Nigeria and East Africa. The brand's expansion in recent year's into newer geographies such as Korea and India has also contributed to growth this year.

Guinness is our biggest single beer brand, but outside of Guinness our beer brands grew net sales by 9%. Double-digit growth from Malta Guinness, Pilsner and Tusker in Africa and from Red Stripe and Smithwicks in North America, improved overall performance.

Moving now to the way our brands reach our customers and consumers, again, a couple of examples. Mainland China has this year overtaken Thailand and Taiwan to become our third biggest market in Asia and our biggest Asian market for Johnnie Walker. During the year we have strengthened our business platform to support this growth. Within Moët Hennessy Diageo China, sales headcount increased by 40% and our dedicated marketing resource was almost doubled. We continued to increase our coverage and we are now present in over 80 cities.

We also made the decision to create a dedicated distribution platform, Diageo China. This will have full sales and distribution capabilities with about 200 employees in offices around China. With Moët Hennessy Diageo and Diageo China, we will have the right infrastructure to continue to deliver further growth in China.

In addition to these organizational changes, we have also widened our participation across the spirits categories. We've activated full scale consumer and trade activities behind Baileys, we've launched Smirnoff Flavors and Smirnoff Black to take the lead in the newly emerging vodka category.

We have also expanded our Scotch offering to the Asian expat community in China with the focus on Windsor, Dimple and Old Parr. And as you know, we have taken a minority stake in a Chinese company in order to enter the very profitable premium Chinese white spirits category.

The disruption caused in the Russian market by the introduction of strip stamps did impact our first half trading but it is now behind us. Volume for the full year was up 25%, as we now capture the distributor margin net sales were up over twice as much. Our in market company has now been established for a year and it has created a superior route to market for our brands. Johnnie Walker, Black Label, Johnnie Walker Red and Baileys already hold the leadership position in their segments. They now benefit from the direct representation we have in over 70 Russian cities and the relationships we have established with key accounts. We are driving growth with these priority customers as we up-weight in store activities to improve brand visibility.

I want to look now at how we focus on the key growth opportunities with some more examples. Firstly, our biggest market the United States. We have focused our business in the US behind the long-term consumer trends. Consumers are looking for sophistication and image and this is leading them to premium brands. Over 90% of our sales are in this premium category. In beer, our brands are solely premium. In wine, we have invested in the premium segment with the acquisition of Chalone and through innovation.

In spirits, execution is focused on the priority brands in each category. For example, we are driving stronger growth in Smirnoff, which is up 10% whereas our popular price point offering, Popov, was down 2%. We have realigned our marketing spend to reinforce the premium status of our priority brands.

The performance of the US beverage market in recent months shows these consumer trends are continuing. Popular and value spirits brands are declining between 2% and 4%, while premium brands are growing net sales around 5%, and the super and ultra premium brands are growing even more strongly.

We see consumers making deliberate trade-offs in order to treat themselves to affordable luxuries and spirits in particular will continue to benefit from this trend. With our focus at a distributor level, our Reserve Brand Group and our leading brands, we continue to be in a position to capitalize on the growth opportunities in the US market.

As Nick described, focus on growth opportunities has improved our performance throughout Europe in the second half. The improvement reflects a renewed focus in all regions on our core brands and the consumer trend to premium products. As a result, net sales improvement was not only across all regions during the second half, but also across many of our priority brands in Europe.

Great Britain had a significant turnaround in the second half. This reflected a more aggressive commercial focus on our core spirits brands in both the on and the off trade, with share gains in all categories. Historically Diageo's strength in Ireland is in the on trade, but as the trend from on to off continues, Diageo shifted its focus and grew volume in the off trade by 7%.

In Spain, we have focused on the premium segments in Scotch, driving almost 20% growth in Johnnie Walker. In Continental Europe, marketing spend was reallocated towards key brands and premiumization strategies with the re-launch of Smirnoff Black and a focus on innovation with Baileys flavors.

Our performance in Thailand is in marked contrast to the difficult consumer environment there. We were alert to the key consumer trends which emerged from the economic and political uncertainty there. We responded quickly to the changing consumer behavior. Given our range of brands in Scotch, we were able to focus on Johnnie Walker Red and Benmore and the growth we have generated in these brands has more than offset the decline in Spey Royal.

Through our brand building activities, we continue to differentiate Johnnie Walker from competitors. Grand Prix activations with a responsible drinking message and music-based on-premise events have helped us grow share. Our brand diversity gives us the perfect platform in Thailand to capitalize on the opportunities which are now emerging as consumers broaden their choices. In the next year, we will be investing behind new growing categories.

Before we move to questions, let me try and summarize what I hope you've heard today. You've seen a set of results which has delivered against all the key financial measures, 7% top line organic growth, 40 basis points of organic operating margin expansion, and 13% growth in underlying EPS. Increased investment behind proven growth drivers has led to share gains, which have expanded the leadership position of our brands around the world. We have continued to invest in building superior routes to market, which delivers better sales execution for our brands.

We have maintained our focus on strong cash generation with free cash flow of £1.4 billion again this year, and our capital discipline with a 70 basis points improvement in return on capital. Taken together, it shows Diageo's strength and it also shows that we finish the year with a stronger platform for growth. It is for these reasons that our guidance for operating profit growth in 2008 is 9%, although we will watch for any impact the current volatility in financial markets may have on our broader trading conditions.

So, thank you. I'd now like to invite Nick, Ivan, Andrew, Stuart and John will now join me to take your questions. But before they do join me, let me again share with you some examples of our advertising campaigns around the world. And the first is Smirnoff.mobi. Smirnoff.mobi is a recently launched mobile phone platform for Smirnoff, which is way ahead of the market. It provides a link to our Smirnoff Signatures campaign and delivers content which is specifically developed for consumers on the move. It will provide a 'pocket guide to vodka' offering products such as 'Nightlife Guide' where consumers can choose from a selection of UK bars; it will provide a 'Pocket Bartender' providing them with a menu of Smirnoff Signature cocktails, and it will also cover responsibility messaging.

Smirnoff stands for being clearly original, and the application of this new technology is a perfect demonstration of this. We are now going to take a look at Smirnoff.mobi and then show you three other marketing executions for Smirnoff, Crown Royal, and Captain Morgan. Okay.

And to join me, if you wish to ask a question please raise your hand and then press the red button that's before you. If you'd be kind enough to state your name, the company that you work for as this event is being webcast. So, if you want to start.

Question And Answer

Christopher Gower - MF Global

Hi, good morning. Christopher Gower, MF Global. I have three questions if I may. The first being, can you just describe to us the competitive environment that you are currently seeing in the US at the moment? Secondly, can we have an update on the Guinness review that I believe you are conducting at the moment? And finally, what are the gaps in the portfolio and how you're going to plug these gaps? Thank you.

Paul Walsh - Chief Executive Officer

Okay. Maybe we can take them in reverse order. We have very, very few gaps in our portfolio. I think people may point to lack of scaled presence in the ultra premium vodka category. We all know that there are certain vodka... super premium vodka brands likely to come to market. We will participate in that process. At the same time, we will continue to develop brands such as Ciroc and so on. I think to say more about the M&A environment beyond that is unwise at this point in time. The Guinness review that we cited was really looking at the cost effectiveness of our business in Ireland. That was linked in the press to the value that maybe ascribed to the site that we have. I think particularly as it pertains to the site and the value, nothing is going to happen there in the immediate term. And I think it is unfortunate that the review that we have on Guinness is getting such focus because the reality is that we constantly review the efficiency of our operations around the world. It just so happens that that one got so media attention, and I am sure that's what you'd expect us to in any event. Regarding the competitive environment in the United States, I'd ask Ivan maybe to comment on that.

Ivan Menezes - President, Diageo North America

Sure. Firstly on the marketplace, we still the marketplace as robust. And the underlying trend of premiumization is very strong. As Paul indicated, if you segment the marketplace, what's under pressure is value spirits under $10 a bottle. You go above $10 and that's 90% of our business, it's very strong, and even in the developments of the last few months, we see that robustness continue. So, our view on the outlook for spirits in the US remains still looking at an industry that will grow 2% to 3% in volume, and have a nice price mix kicker for another 2% to 3%. And that's routed in the underlying demographics, the shifts in tastes [ph], and ultimately spirits playing really as an affordable luxury. And your average household that buys three or four bottles of Johnnie Walker Black a year, it's not a lot of money, and the attachment to the brand is so strong. So the trade-down in spirits consumption we really don't see happening, the pressure is really at the low-end.

Paul Walsh - Chief Executive Officer

I'd just add to what Ivan said by saying let's not forget the distribution system also that we have in our marketplace, still capable of improvement, but it's really performing well for us. This will be the third year straight where we have gained share in that marketplace, and we intend to keep it that way.

James Edwardes Jones - Execution Limited

James Edwardes Jones from Execution. Just looking at your guidance for 2008, assuming the £40 million disposal profit is in the base, it looks like you need to do something close to 11% underlying, if I can describe it as underlying, which of the moving parts of the P&L you rely on to step up the gear in order to achieve that?

Paul Walsh - Chief Executive Officer

I'll invite Nick in a moment to give some of the specifics, but let me say generally what you have with Diageo is a broad base of geographies. You have a broad base of brands. On a geographic basis and indeed on a brand basis, we have good momentum. We have very good momentum. Not only are we seeing good volume performance, but we do see our brand equities capable of taking price and as we continue to focus on value, not volume, we will get the premiumization, a mix kicker. So I would say good volume momentum, price and mix improvement will be the core of any underlying profit improvement. We are also seeing on a regional basis improvements in Europe. We certainly have to wait and see how we perform in the first half through the Christmas period, but we are encouraged. We took our pain last year in that regard by taking some very aggressive pricing. So I would say underpinning any improvement is continued commercial success by market, by brand, but is there anything on top of that Nick that you would cite?

Nick Rose - Chief Financial Officer

My answer is slightly more technical than Paul's, so therefore not anywhere near as interesting. I think the single column sort of demon maybe at work here because I think we need to point out that when we quote organic growth, we strip out that exceptional gain. So when you look at our organic growth for this year, it does not include that £40 million as you rightly say on the disposal and obviously, it strips out exchange rate movements. And we would intend going forward that when we give you the organic or if you like underlying growth of the business, which in our mind is what organic really is, we'd be stripping out exceptionals and we'd be stripping out exchange, etc., etc. So it really is meant to be like for like and that 40 is out of what we call organic growth.

Nico Lambrechts - Merrill Lynch

It's Nico Lambrechts from Merrill Lynch. I have two questions. Do you raise guidance of 9%, could we assume that is a new target for the medium term as well or is that just raised guidance for financial '08 and we revert back to 8% thereafter? Second question is there was some de-stocking of Johnnie Walker in the US over the last 12 months. I believe that the sell-in was something like 2%, sell-out 10%. Could you give us some outlook for Johnnie Walker sales for the next 12 months in the US? Thank you.

Paul Walsh - Chief Executive Officer

Maybe the second part, Ivan in a moment, you can comment on. Regarding guidance, I think you're right. We are moving to 9% for the fiscal year that we've just started and I think it's reasonable to assume that we'd have that target going forward. Clearly situations can change and we would update the market if we felt either on the positive or the negative it warranted a change, but I think your assumption is reasonable. But I think at this point it's worth just reflecting on the consistency of Diageo performance. And it's interesting that this time last year, we started the fiscal year with a coup d'état in Thailand, bombings in Beirut. We had a worldwide ban on liquid through duty-free. We managed all of those pressures. It happens to be this year that we are looking at some fragility in the financial markets. We will manage those too. And if stand here this time next year, there will be other issues that we have to contend with and it goes back to the broad base of our operations, whether you look at geography or brand. We will always have a geography or a brand that is not up to expectation, but because of our breadth and the strength of our brands and the strength of our markets, we will weather that. Ivan?

Ivan Menezes - President, Diageo North America

Yes, Nico, on Johnnie Walker, you are right. Our reported results show a 4% volume growth, 7% sales growth. Through that we have achieved de-stocking, so the actual consumer uptake, and you see it in IRI and Nielsen is very strong. This brand is truly in a category, Scotch is down in the US, I mean, Johnnie Walker has absolutely transcended Scotch. Black Label not only commands a huge price premium, but has strong on-premise call, is doing very well in old channels across the country. So we expect Johnnie Walker momentum to continue strongly. The de-stocking in the wholesale system has happened, we'll do a little more, but I think you could expect the current trends to continue in terms of reported results and the health and equity of the brand has never been stronger, not just in Black Label. I mean, Red Label, it's unbelievable. Even Standard Scotch is demonstrating great growth and together, this trademark is really in a very strong place in the US and we are very optimistic about continuing to premiumize and grow the Johnnie Walker trademark.

Paul Walsh - Chief Executive Officer

Yes, just building on that, Johnnie Walker is clearly a star performer, but that said, it's only about half of our total Scotch business and I referenced in my earlier remarks, the category approach that we take with the variety of brands; but if you look at our total Scotch performance, sales net up 12%, 13%; clearly, within that Johnnie Walker was the major performer. But our other brands of Scotch are equally performing very, very well.

Michael Bleakley - Credit Suisse

Hi. Michael Bleakley here from Credit Suisse. A couple of questions, first of all on the international ex-Asia margin, you were commenting obviously that there were additional costs in Africa over the last year. Just wondering what is your outlook look like for international margin given the fact that obviously you are getting a lot of growth out of Scotch, which is presumably higher margin than the beer business, maybe you can confirm that? And where do you see the sort of the end game being on that international margin going forward? And the second one was really on the US. NGG, obviously, you are coming up to a period now where you will be reassigning some other contracts that you've first signed in 2002, one presumes. Can you give us some indication of that how that is going?

Paul Walsh - Chief Executive Officer

I will invite Ivan to offer any additional words. I think it' is pretty well from my perspective on the basis that our distributors are hitting the goals that we've set for them. In any contract renewals they will have new performance standards, which build on the success that we've already achieved. But even so, I still think there are huge opportunities in the US distribution system, and maybe, Ivan, you want to talk specifically to those opportunities.

Ivan Menezes - President, Diageo North America

Sure. I'd say, overall the contract renewals are going very well. Our focus really is how we take our collective gain to the next level in the distribution system. And I think as we've shown you in the past, we are putting very measurable focus on key capabilities in each distributor and we've set specific goals for raising those over time to world-class standards. There is a lot of room for improvement there. We are putting much more dedicated focus against our reserve and luxury portfolio, strengthening the on-premise. If you look at our arrangements in New York right now, I mean, they are significantly stepped up. And I think together with our distributor partners where our relationships are very strong, I mean, it really is about how do we take this good platform and keep taking it to a great place and recognizing the competitive environment, putting more distance between us and our competitors. So we are pleased with how it's going and it's very much on track with our expectations.

Paul Walsh - Chief Executive Officer

Stuart, do you want to address the margin question?

Stuart Fletcher - President, Diageo International

When you talked about the Africa comment on one-off costs, we did a number of restructurings of our distribution systems in Africa during the year to improve the stability of our business in a couple of markets, but also to increase the penetration through the distribution network. We incurred some one-off costs from that alongside some organizational restructuring, which includes the implementation of SAP in a couple of our very significant markets, which the SAP rollout will continue during the next 12 to 18 months. So, the nature of the SAP one-off costs would continue through. The restructuring and organizational nature, we wouldn't expect to come through. We also re-launched Guinness in new packaging in a few markets and had some one-off bottle write-off costs associated with that as well. To your point about the margin outlook for International, you are right. Scotch margins are somewhat higher than beer, although beer margins are very, very healthy in the international business, driven in part by the returnable bottle system that we operate with across Africa. And like everywhere else in Diageo, we are absolutely focusing on value. So pricing, premiumization, they are strong drivers of our business going forward and I would expect that through time, we will be increasing the TP [ph] margin of our business.

Michael Bleakley - Credit Suisse

All right. Thanks very much.

Paul Walsh - Chief Executive Officer

Ian.

Ian Shackleton - Lehman Brothers

Ian Shackleton, Lehman Brothers. Two questions, going back to the 9% guidance for '08, could you just tell me what the assumptions around input costs, the marketing spend now that are behind that? And second question is around India, you talked quite a lot about the opportunity in China and Russia. Could you just comment on how you see the Indian opportunity with this prospect of import tariffs coming down?

Paul Walsh - Chief Executive Officer

Maybe Nick can handle the input cost question. Regarding India, we know that at present because of the sheer volume of locally produced alcohol that in many ways tries to emulate Scotch. We know that that volume, a lot of it would migrate to Scotch if tariff levels were lower. The Indian government had made certain statements about reducing tariff levels. I am optimistic that that will take place. I think it's unwise to be specific at this stage on which regions will or provinces will also reduce their taxes and which will not actually just offset the federal reduction with increases of their own. But overall, I think the environment is improving for general tariff reductions. That being the case, we know that the Indian consumer wants the real thing and we have the brands to make sure that they get the real thing. Johnnie Walker would be the leading brand in that category and therefore we remain very, very bullish about the long-term potential of that market. Nick, input --?

Nick Rose - Chief Financial Officer

Ian, I think it's fair to say like a lot of consumer goods companies, we expect the next year to be tougher on input cost than the one that's just gone, not so much in the area of energy costs, which we've talked about a lot, but some of our very fundamental input costs; barley for instance, malt, glass, even corrugate is rising at a faster rate than we've seen for quite some time. And I think it's fair to say that factored into our guidance is an assumption that this year the supply part of our organization will certainly struggle to offset all of the inflationary pressure across our total input cost base. So, we see broadly inflation somewhere averaged across our whole input base between 3% and 4%. That's on average. Obviously, there is some big spikes within that. And historically, supply... the supply organizations managed through projects or procurement efficiency to offset most of the input cost inflation. I don't think we are going to achieve that in the current year and that impact is factored into our guidance. So a tougher year on the input side of the equation, which is moderating, if you like, always factored into the guidance that we are giving you.

Paul Walsh - Chief Executive Officer

Just going back to the Indian opportunity, whilst I focused on Scotch, we clearly have a much broader representation there and John, maybe you want to talk about some of the successes we've had this year because there have been a number.

John Pollaers - President, Diageo Asia Pacific

Yes, correct. We are very pleased with our performance this year in India. We have grown top line by about 36%. We've principally done that by firstly focusing on our core brands, so Johnnie Walker. Johnnie Walker has expanded its distribution in India and it's increased its market share, both Black and Red. At the same time, we've introduced a number of brands in the super deluxe territory. So we are cognizant of the need to take advantage of the trend we are seeing and the higher income elements of the Indian market.

We also see a very positive consumer trend in the emerging middleclass and through the year, we launched a joint venture with Radico Khaitan, the number two domestic player in India, and launched a product called Master Stroke. Within Diageo India, we have launched Haig, each to take advantage of the trading up from the Indian IMFL market, Indian Made Foreign Liquor, into high price segments. So while we'd expect to be operating at a different affordability tiers, in each instance we are operating at the higher end of those affordability tiers.

In our other global priority brands, we've had a fantastic year on Smirnoff, further expanding its distribution with manufacturing in more states, and we've launched very successfully Flavors. To post point on tax, just to add to that point, while we are very positive about the change that the Indian government has made, we will need to be lobbying across each of the states to ensure that it is given a full effect at a state level, because in a number of states right now it looks like the impact maybe to in fact increase price on Johnnie Walker, and... but we remain very positive, the doors are open to those conversations and we remain very, very confident about the progress that we are making.

Ian Shackleton - Lehman Brothers

Sorry, Nick, just on the marketing cost assumption in '08?

Nick Rose - Chief Financial Officer

Sorry. Our marketing cost assumption is very similar to where we are, if you like, in the year just ended, i.e., we will be increasing marketing ahead of sales. I think that's been fairly consistent over the last two or three years. I don't mean by huge leaps and bangs, but I certainly think in the sort of 1% to 2% territory ahead of sales growth is our assumption.

Simon Hales - Dresdner Kleinwort

Simon Hales from Dresdner Kleinwort. Just following on from that last question, Nick, on marketing spend, could you maybe just flush out a bit how we should be thinking about spend by region, and then particularly in relation to International and Asia-Pacific for FY '08? Secondly, you talked about Korea and obviously the problems you've had post the year-end, is there any chance you could maybe give some form of quantification to the sort of level of hit we might see in EBIT terms in that market and the loss of the import license? And then finally on the root to market changes you've implemented in Spain in '07, can you just clarify that all of the issues relating to wholesale stock levels being refused were fully through in '07, there's no more to come in 2008?

Paul Walsh - Chief Executive Officer

Okay. Let me take the question of Korea and then maybe Nick, you can handle the other ones. The issues of Korea we have factored into the guidance. I think for us to be anymore specific than that at this stage is unwise. So I just want to leave that at that point. The Korea issue is factored into our guidance. Nick?

Nick Rose - Chief Financial Officer

On marketing and obviously I'll let my colleagues modify if they want. I think broadly what you'll see in our marketing spend is quite a similar pattern to this year or perhaps more specifically to the second half of this year. So, what does that mean in my mind and I think in the way we are modeling the business, it certainly means that in Asia-Pacific, we expect John to be investing substantially in taking advantage of the opportunities in his business and some of those we have already talked about this morning. So you should expect to see good level of spend in marketing in Asia-Pacific. I think in international, as you've seen, we've got marketing spend pretty much in line with sales at the moment, and I would say that's a pretty good model, I think, for where Stuart will be in the next phase of international development. It's about maintaining the fantastic momentum we've got there rather than having to seed again a whole load of markets, which is more, if you like, what John is doing.

I think in Africa, oh sorry, in Europe, you have seen Andrew in the second half really begin to invest some... behind some of the growth drivers that I think again Andrew and the team identified when we had the last investor conference. And we have got a lot more confidence about some other ways of driving growth, and Andrew invested behind those in the second half of the year, and we would expect him to do that in this coming financial year. And therefore, I think you will see marketing spend in Europe running a little ahead of sales reflecting that. And Ivan, I think, has had a very consistent kind of investment policy in North America, which has been broadly in line with sales, particularly if you strip our RTD, you are seeing broadly in line with sales in North America as the trend. So now that's how I would see the overall breakdown and when you roll all that up, as I say, I'd expect this to be one or two points ahead of overall revenue growth for Diageo. I'll just pause in case my colleagues would like to... maybe on Spain, Andrew, do you want to just pick up on kind of route to market change we've seen?

Andrew Morgan - President, Diageo Europe

Yes, I think we are in a lot healthier place in Spain. Our trade terms changes resulted in a move away from a kind of market norm where a lot of stock was brought in by wholesalers two or three times a year, and largely on promoted deep discounted prices, particularly in Scotch. We've kind of taken that on really over the last eight months and now got a much more level kind of less polarized set of buying patterns with the trade. The side benefit of that is our pricing has stuck. So if you look at our gearing from volume to net sales, we are up 7 point swing from volume to net sales in the second half business in Spain. Is that all out? Pretty much, I would say. I would say next year, as sales out of the business should be pretty much in line with our Nielsen performance in terms of the off-take, so Scotch is running at about minus 5 at the moment. We are just beating the market. As a result, we are doing very well with Johnnie Walker and pretty much holding share with J&B. So you should see sales much more in line with consumer off-take as reflected in Nielsen.

Simon Hales - Dresdner Kleinwort

Good.

Paul Walsh - Chief Executive Officer

Okay. Let me... oops, one more.

Matthew Webb - Cazenove

Yes, Matthew Webb from Cazenove. Just wondering whether Nick could offer some guidance on the average interest rate for '08 assuming global rates stay broadly as they are. And also perhaps into '09, if that's possible because I am aware that there a couple of fairly large low coupon bonds that are coming up for maturity over the next 12 months. I was just wondering whether that would have much of an effect going into '09. Thanks.

Nick Rose - Chief Financial Officer

As far as we can see right now, and obviously it's a bit of a moving feast in the market at the moment, I would expect our average debt rate in the next financial year to be up somewhere around 30 to 40 basis points. I don't think more than that. And then going forward, I'm actually expecting things to be leveling out a little bit because we do have now a fairly regular maturity profile of our debt. It's fairly well spaced out. And when you look up everything that's maturing versus the current market rates, I'm actually expecting the profile that's been rising over the last couple of years to begin to flatten out a little bit. I'm not saying there might be another 10 basis points or so, but I don't think you are going to see anything like the 50 that we've seen this year. It's that kind of profile that we're looking for.

Paul Walsh - Chief Executive Officer

There was one more hand that went up very energetically, so we will take that as the last one.

Trevor Stirling - Sanford C. Bernstein

Thank you, Paul. Trevor Stirling from Sanford Bernstein. You commented on input costs and also rightly pointed out that that's something that most FMCG companies are facing at the moment. And that could well lead to a distinct rise in food and beverage inflation across many categories. Is that something that's also factored into your guidance or if that does evolve that way and there are opportunities for further price increases, would that represent upside to the 9%?

Paul Walsh - Chief Executive Officer

I think if there were further opportunities for price increases, there maybe some upside. I think the way that I would look at it is that we felt that our brands could take the level of price increase that we plan for. We've also had to accept that there is some upward pressure on input costs and therefore cost of goods sold. I think where we are is right... I do not want to go for more price increases at this point in time beyond what are currently in our plans and which basically replicate what we have been successful in putting through this year. So, whilst any further price increases would represent upside, I think it would be very unwise to bank on that at this point in time.

Okay. Thank you everyone for your attention and we'll see you around.

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Source: Diageo plc F4Q07 (Qtr End 6/30/07) Earnings Call Transcript
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