Diageo plc (NYSE:DEO) 2019 Interim Results, Half Year Ended 31 December 2018 Earnings Conference Call January 31, 2019 5:00 AM ET
Ivan Menezes – Chief Executive Officer
Kathryn Mikells – Chief Financial Officer
Conference Call Participants
Good morning, everyone. Diageo has delivered another strong set of results, demonstrating consistent progress and momentum towards our performance ambition: to be among the best-performing, most trusted and respected consumer goods companies. I would like to thank all Diageo employees for their contribution to these results.
In this first half of fiscal 2019, we have delivered particularly strong top line growth with organic net sales up 7.5%. This was driven by good volume performance and strong price/mix with growth broad based across categories and regions, including our three focus areas of scotch, U.S. Spirits and India. We still expect to deliver mid-single-digit top line growth for the full year as these results benefited from a number of gains that will unwind in the second half. Kathy will share more on this in a moment.
I am pleased to see the step-up in price/mix coming through. This reflects our ongoing work on net revenue management and the mitigation of more of the cost inflation we face. We’ve also delivered organic operating margin expansion ahead of expectations while continuing to up-weight marketing investment. Kathy will walk you through some of the factors that favored the first half margins. We continue to feel good about delivery of our margin guidance, which remains unchanged.
Our focus on consistently delivering strong cash flow performance continues with the £1.3 billion free cash flow in the first half. Preexceptional EPS was up 14%, driven predominantly by organic growth. We returned £1.3 billion to shareholders in the half through a share buyback. Today, we are announcing an increase to our fiscal 2019 share buyback program, which will now return up to £3 billion to shareholders an additional £660 million.
And we have again increased the interim dividend by 5%. Our strategy is to be a reliable compounder of growth, creating a virtuous circle of consistent top line performance, margin expansion and increased investment in our brands. Consistent execution of our strategy is delivering the results we intended: sustainable organic net sales growth, investment behind our brands to fuel long-term growth, expanding our operating margins and strong free cash flow.
We also maintained a disciplined approach to capital allocation to maximize value for shareholders. We have increased investment in the business as our top priority. We actively managed our portfolio. In this half, we increased our investment in Shui Jing Fang and completed the sale of a portfolio of 19 brands to Sazerac. Since fiscal 2017, we have returned just under £7 billion to shareholders in dividends and share repurchases. Today, we announced the additional £660 million to be returned to shareholders in fiscal 2019 through our share buyback program. Finally, our TSR at 4% remains towards the top of our peer group.
Now let me hand over to Kathy to talk you through these results in more detail.
Thank you, Ivan, and good morning, everyone. During the half, we delivered another strong set of results. Our underlying results are consistent with our medium-term guidance with this half year benefiting significantly from phasing of savings and costs as well as some positive one-off items.
Let me start with some highlights. Organic net sales grew 7.5% with 3.5% volume growth and 4% positive price/mix. Organic operating margin increased 152 basis points. At £1.3 billion, free cash flow continued to be strong, £317 million higher than last year. Preexceptional EPS grew 13.6% to 77p, mainly driven by organic operating profit growth. Return on invested capital improved 135 basis points to 17.8%. This was largely driven by operating profit growth. And we delivered total shareholder return that’s in the top quartile relative to our peer group. It was up 4% in the six months to December 2018.
Let’s dive into it. Reported net sales were up 5.8% as organic growth more than offset unfavorable foreign exchange and the impact of disposing of a portfolio of 19 brands to Sazerac. Organic net sales grew 7.5%. It was broad based across all the regions, with a step-up in both volume growth and positive price/mix. Growth in the half was ahead of our medium-term guidance as it benefited from lapping a weaker prior year performance in markets like India, Kenya, Cameroon and the Caribbean in Central America and earlier Chinese New Year in 2019; very successful innovations such as White Walker by Johnnie Walker and Ketel One Botanical; and the disposal of the portfolio of 19 brands.
The disposal, which completed in late December, favorably impacted organic growth in North America and Diageo by about 80 basis points and 30 basis points, respectively. I expect net sales growth in the second half to be slower. For the full year, I expect it to be towards the upper end of our mid-single-digit net sales growth guidance. Volume growth accelerated. This was largely driven by India, which accounted for nearly 60% of total volume growth as it lapped a weaker prior year period. There were also volume gains in gin and scotch.
Contribution from price/mix continued to be strong, with every region delivering positive price/mix. Improved growth in U.S. Spirits and scotch more than offset the adverse impact of the double-digit net sales growth of Diageo India, a business with lower average NSV per case compared to Diageo’s average.
Net sales growth continued to be broad based across our regions and across our categories with the exception of rum. Scotch, our largest category, delivered a strong performance with net sales up 7%. Growth was broad based across most regions and brands. Johnnie Walker growth accelerated with net sales up 10%. This was largely driven by Johnnie Walker Black Label and White Walker by Johnnie Walker, a successful limited edition inspired by the HBO series, Game of Thrones.
Johnnie Walker Blue Label also performed well with net sales up double digit. Growth across our primary scotch brands was also good, up 10%, with Latin America and Caribbean and India performing strongly. Both Old Parr and Buchanan’s improved as they benefited from lapping a weaker prior year in Colombia as a result of the tax changes in the market. Elsewhere, net sales declined in Windsor in South Korea amidst category decline, and in J&B in Europe.
Performance in vodka continued to improve with net sales up 3%. Performance improved in U.S. Spirits where net sales were flat as growth from the Ketel One Botanical innovation roughly offset declines in Smirnoff and Ciroc vodka. Outside the U.S., vodka net sales increased 6% with growth in every region. Canadian whiskey net sales were up 5%, driven by Crown Royal, which continued to gain share in the category. Crown Royal Regal Apple, now in the fifth year since its launch, delivered double-digit net sales growth. It continued to recruit new consumers into the brand and the seasonal limited time offer, salted caramel, also performed strongly.
In U.S. whiskey, growth was driven by Bulleit with net sales up 7% in the U.S. where it continued to gain share. Rum net sales declined 3%. This was largely driven by a 9% decline in Captain Morgan net sales in U.S. Spirits as a result of category weakness and a strong comparable in the previous year. Outside U.S. Spirits, net sales in Captain Morgan were up 4%. In liqueurs, net sales increased 3%. Growth in Baileys was broad-based across all regions with the exception of Europe, which was flat, as a result of shipment phasing in Great Britain where we continued to gain share in the category.
Net sales in IMFL whiskey were up 11%, driven by our Prestige and Above brands. Diageo India delivered a solid performance as a result of good execution and lapping soft results last year. In gin, net sales growth accelerated to 28%. Both Gordon’s and Tanqueray net sales were up strong double digit and continued to gain share in Europe, their biggest market. In tequila, net sales increased 29% with both Don Julio and Casamigos delivering strong growth and share gains in the U.S.
Beer net sales were up 4%. This was largely driven by Guinness with net sales up 4%, Senator Keg in Kenya and Serengeti Lite in Tanzania. In Kenya, our business benefited from a soft comparable period due to last year’s presidential elections. Beer net sales growth was partially offset by weakness in Nigeria where good performance in Guinness and Guinness Malta was not sufficient to offset net sales decline in Satzenbrau, which participates in the competitive value lager segment. Net sales growth was broad based across our portfolio of brands. Global Giants were up 6% with all brands in growth except Captain Morgan. Net sales of local stars also increased 6%. This was mainly driven by strong growth in Chinese white spirits, Crown Royal and McDowell’s in India and partially offset by declines of Windsor in South Korea and J&B in Europe.
In reserve, net sales were up 11%, largely driven by strong performance in SJF in China, Ketel One in the U.S. and tequila, both Don Julio and Casamigos. Reported operating profit and organic operating profit were both up 12%, largely driven by organic growth. Organic margin expanded 152 basis points in the half, ahead of our expectations largely as a result of phasing benefits. I’ll walk you through more detail on these in a minute.
You can see here that our gross margin expanded 50 basis points in the half. This resulted from positive price/mix and productivity efficiencies, which more than offset the adverse impact of cost of goods sold inflation in the half where we experienced upward inflationary pressure across our commodity costs, including Agave, cereals, utilities and glass as well as transportation costs in the U.S. I expect this inflation pressure to continue in the second half.
Our marketing spend was up 9% in the half, driving a 26 basis point higher investment rate. Although this was ahead of net sales growth, it was a bit less than expected as some of the investment has been shifted to the second half. We have continued to increase investment in our three focus areas, U.S. Spirits, scotch and India, and in attractive growth categories such as gin and Chinese white spirits.
Other operating items delivered 128 basis points of margin improvements, largely as a result of overhead productivity initiatives. In the half, we also benefited from phasing of productivity-related costs, which delivered about 20 basis points of margin improvement. I’m pleased with the progress that we’ve made across all of our productivity work streams and how our program continued to contribute to our organic margin expansion and to building a simpler, more efficient business.
As we look to the second half, I expect margin expansion to be muted. Our marketing investment rate and productivity related costs are expected to be higher, just due to phasing, as we continue to support future productivity initiatives.
As such, we remain on track to deliver our medium- term guidance of 175 basis points of margin expansion for the three years ending the 30th of June 2019. Let’s now move on to cash. Cash delivery continues to be strong with free cash flow at about £1.3 billion. This is £317 million higher than last year as operating profit growth and lower tax payments more than offset increased investment in maturing stock, higher year-on-year working capital outflow and higher CapEx.
Looking to the balance sheet. The operating working capital position improved in the half compared to this time last year. And our everyday focus on working capital management continued to deliver good results with average working capital as a percentage of net sales reduced by 67 basis points. Net CapEx increased £57 million versus last year. And looking ahead, for the full year, I still expect net CapEx to be in the range of £650 million to £700 million.
This is in line with our guidance as we increase investment in Scotland to transform our scotch whiskey visitor experience and continue to expand capacity in some of our emerging markets. Tax payments were £179 million lower year-over-year, largely driven by the benefit of lapping the one-off payment made to the UK tax authorities in August 2017.
Average net debt increased by about £1.4 billion. The two main drivers of the increase were the execution of our share buyback program and the closing of the partial tender offer to increase our holding in SJF to 60%. Our effective interest rate was 2.4%, 60 basis points lower than last year. This resulted largely from efficient debt funding and higher-than-anticipated gains on our swap portfolio. During the second half, we expect lower gains on our swap portfolio.
So for the full year, I expect our effective interest rate to be in a range between 2.5% and 2.8%. Other finance charges was £60 million lower than last year, largely driven by the decreased charge in respect of Zacapa put option and lower pension charges. While we expect higher charges year-on- year in the second half related to the Zacapa put option, overall, I now expect other finance charges for the full year to be broadly in line with fiscal 2018 due to the lower pension charges.
We have a disciplined approach to our capital structure through a leverage policy that targets an adjusted net debt-to-EBITDA ratio of 2.5 to 3.0x. Our priority remains to invest in the business to deliver sustainable and efficient organic growth and generate value through acquisitions that further strengthen our exposure to fast-growing categories.
Last year, we completed the acquisition of Casamigos, a brand that increased our participation in the fast- growing high-end tequila segment. We also acquired Belsazar, a premium vermouth from Germany’s black forest and Pierde Almas, an ultra-premium mezcal. This year, we increased our shareholding in Shui Jing Fang, our fast- growing Chinese white spirits business from approximately 40% to 60%. We also regularly review our portfolio to ensure that we allocate resources behind the opportunities that can maximize shareholder value in the long term. In the first half, we disposed of a portfolio of 19 brands, principally in the value segment in U.S. Spirits.
This segment has been in structural decline in the U.S. and this disposal enables us to focus our resources on the Premium and Above brands where there are stronger growth and profit opportunities. Our adjusted net debt-to-EBITDA at the end of the first half increased to 2.3x. This planned increase resulted from the higher adjusted net debt, which was up about £1.4 billion, partially offset by increased EBITDA.
At the end of this fiscal year, we expect to be back within our targeted leverage range. We have a clear dividend policy to target dividend cover of 1.8 to 2.2x. We finished fiscal 2018 at 1.8x , and today, we have announced an interim dividend of 26.1 p per share. This is an increase of 5% from last year and is in line with our guidance to maintain mid-single-digit increases until we’re comfortably back in our policy range.
Should we have any excess capital, we seek to return it to shareholders. In July last year, the board approved a share buyback program to return up to £2 billion of capital to shareholders. Later in the first half, we announced an increase in the program, utilizing the £300 million of net proceeds from the recent disposal. And as you’ve heard from Ivan, we’ve announced a further increase of up to £660 million in share buybacks. We are on track to execute the first tranche of the share buyback program with £1.3 billion utilized to repurchase 46.5 million shares in the first half.
Moving now to foreign exchange. Exchange negatively impacted net sales by £91 million in the half. There was no impact on operating profit in part due to our hedging program, which delays some of the impact of exchange, and in part due to devaluation of some emerging market currencies, which have a higher impact on net sales relative to operating profit. Adverse exchange impact on net sales in the first half was driven by the weakening of emerging market currencies, mainly the Turkish lira, Indian rupee and Brazilian real, only partially offset by the strengthening of the U.S. dollar.
As I look forward to the full year, using the rates presented here, exchange is expected to have an adverse impact of £80 million on net sales and £10 million on operating profit before exceptional items , increased 13.6%. Organic operating profit growth, lower finance charges, the positive impact of the share buyback program and higher income from associates more than offset the negative impact of higher tax expense and noncontrolling interest.
Our tax rate before exceptional items was 21.2%, in line with our guidance. Our current expectation for the full year is that our tax rate, before exceptional items, will continue to be between 21% and 22%. As I mentioned earlier, finance charges were lower than last year and had a positive impact on EPS. Noncontrolling interest had a negative impact on EPS as a result of the higher profit in our listed subsidiaries.
The execution of our share buyback program reduced the weighted average number of shares and had a positive impact on EPS. Basic EPS decreased 16% as the gain from the disposal of the portfolio of 19 brands was lower than last year’s exceptional tax credit due to the balance sheet remeasurement of our deferred tax liabilities in the U.S. These are another set of strong results with good performance against all the metrics that we use to measure efficient growth and value creation. Both organic net sales and operating profit growth were ahead of expectations. This was largely a result of phasing benefits with good continued underlying momentum. Cash delivery, at £1.3 billion, also continued to be strong. And as such, we’ve announced a further increase in our share buyback program, bringing the total program for fiscal 2019 up to £3 billion. Looking at the second half, I expect net sales growth to be lower as we will lap a stronger prior year comparable in many markets, as I explained earlier.
Overall, I expect net sales growth for the full year to be towards the upper range of our mid- single-digit organic net sales growth guidance. I also see limited opportunity for organic margin operating expansion in the second half, largely as a result of phasing of productivity costs and marketing expenses. Continued inflationary pressure across our commodity costs will also impact margin expansion for the remainder of the year. We’re on track to deliver another year of organic mid-single-digit net sales growth and the margin expansion required to deliver our guidance of 175 basis points of organic margin expansion we set as a target for the three years ending in June 2019. And now, back to you, Ivan.
Thank you, Kathy. We’re also making good progress on our ambition to be most trusted and respected. At the full year, we will also share details of our annual employee engagement survey. We’re driving a step change in industry efforts to promote responsible drinking, focusing on reducing underage drinking, drink driving and binge drinking. We have committed to industry-leading targets to educate 5 million young people about not engaging in underage drinking, generate 50 million pledges to never drink and drive and reach 200 million people with messages of moderation through our marketing.
We’re making rapid progress. Our Drink Positive campaign is running across our markets with over 17,000 employees participating in the first half. We’ve just launched a new campaign to promote DRINKiQ, our alcohol education platform for consumers in the UK, which has already reached over 1.5 million people. Smashed, our youth theater program, is now live in 20 countries and performed in 13 languages.
We’ve collected over 15 million pledges to Join The Pact against drink driving. And I’m particularly excited about the work of our brands creatively engaging with consumers with moderation messages including Crown Royal’s Hydrate Generously campaign around the NFL in North America; Haig Club’s Leave as You Arrived campaign with David Beckham; and Captain Morgan’s Live Like a Captain moderation campaign with grime artist, Lady Leshurr.
Our work to promote inclusion and diversity, essential for any business truly to thrive, continues to drive engagement among our employees, and I am proud that we’ve been recognized externally for this, including ranking fourth in the Thomson Reuters Global Diversity & Inclusion Index of the top 100 publicly listed companies. I’m also delighted that in December, Diageo was named Britain’s Most Admired Company 2018 in Management Today’s long- running awards, voted for by business peers from across all industry sectors.
We have strong foundations in place, but there is always more to do. Earning trust and respect for the way we treat our people, the way we conduct our business and our overall contribution to society remains central to everything we do at Diageo. Consistent execution of our strategy is yielding results. Let me take you through some of the examples of great execution in three of the six priorities: keeping premium core vibrant, winning in reserve and driving innovation at scale.
Beer grew by 4% in the half, largely driven by continued momentum from Guinness; improved performance of Senator Keg beer in Kenya; and growth of Serengeti in Tanzania, now the number one brand in volume and value share. In Europe, Guinness performance was led by GB through Guinness Draught and Hop House 13 Lager. We continued to gain share in GB over the last six months. Guinness is a committed supporter of rugby, and we’re very excited to announce recently our title sponsorship of the Six Nations rugby tournament.
We note that this association works. In the home nations autumn internationals match day, we saw a double-digit uplift on Guinness sales compared to a year ago in some of our key accounts. In Africa, Guinness was up 5% with broad growth across all key markets. Across Africa, we’ve continued to activate around football with our Guinness ambassador, Rio Ferdinand, visiting both Nigeria and Kenya in December with a very positive response. Guinness in Africa is leveraging our category-leading partnership with Facebook. We are now able to deliver highly targeted content, increasing our reach to 38 million consumers, almost eight times higher than two years ago.
In evaluation studies in Nigeria, we have found this targeted approach drives a double-digit uplift in sales and gives access to data to help us improve our effectiveness in the future. In the U.S., our core variants are in healthy growth. The new Open Gate Brewery & Barrel House in Maryland is generating a lot of interest, welcoming nearly 200,000 visitors since it opened in August. Our reserve portfolio is second to none and plays right into consumer aspiration for special moments and experiences with our brands.
Our reserve teams have been raising the bar to create the best experiences for consumers through our world-class programs for some 10 years now. The program goes from strength to strength, enabling highly targeted PR, stronger bartender capabilities and engagement with key influencers globally. Each year culminates in the annual Bartender of the Year competition and 2018’s final, held in Berlin, was the biggest ever. Our online viewership of the competition peaked to the highest level in world-class history with over two million cocktail lovers joining.
And we more than doubled the average number of media articles and broadcast pieces this year. We invited some of the biggest influencers to the finals and worked with them to create hundreds of pieces of brand content. We found that this content delivered a significant uplift in consumer engagement on social media. I’m delighted that later this year, we will be bringing the world-class final to Glasgow, in the home country of scotch, a key category for reserve.
Driving sustainable growth led by consumer trends is at the heart of our innovation strategy. The role for each innovation falls into one of three categories: recruit, rerecruit or disrupt. Our innovation model demands that we have a clear consumer insight, which serves as the core purpose of each launch. Our focus over the past few years has been on recruiting new consumers to our brands or recruiting into new occasions.
I’m pleased with the results of the strategy with successes like Ketel One Botanicals, Gordon’s Pink Gin, Hop House 13 Lager and Crown Royal Regal Apple, to name just a few. This year, we expect more than 50% of innovation projects to be within this recruit category compared to around 30% four years ago. Now let’s move on to our three focus areas, scotch, U.S. Spirits and India, where we saw a strong step-up in performance in all three areas.
Scotch had a strong first half with 7% top line growth. I’m delighted with the performance of Johnnie Walker over the past six months with net sales up 10%, including the launch of a limited edition White Walker by Johnnie Walker, a collaboration with HBO on their TV series, Game of Thrones. I’ll talk more about this in a moment. Buchanan’s net sales were up 7% with both the U.S. and LAC delivering high single-digit growth. Scotch malts improved with strong performance across Asia Pacific where malts are a core element of the region’s focus on prestige scotch.
Within Asia Pacific, Greater China made the strongest contribution with strong double-digit growth of malts in Mainland China, coupled with stabilization of our business in Taiwan. We also delivered in the U.S., supported by growth in the core malts range and a further limited edition collaboration with HBO and Game of Thrones. Primary scotch continued to perform well in LAC and in India led by Black & White and the local brand, Black Dog.
In other scotch, performance improved as Old Parr recovered following the impact from the tax changes in Colombia last year. However, we continued to see decline on Windsor due to the contraction of the scotch category in Korea and J&B continues to be under pressure in Europe. However, our total share of scotch in Spain was broadly flat year-on-year. White Walker by Johnnie Walker is the biggest cultural collaboration within the history of this 200-year-old brand. With this innovation, we’re opening up scotch to a whole new audience, thanks to the global cultural phenomenon that is Game of Thrones.
This is a limited edition, brand-new blend, drawing cues from the TV series storyline and executed in a stunning pack. We have seen great consumer appetite, which has translated into strong sales over the half. White Walker became the number one most-watched video ever on Johnnie Walker Instagram and became the most talked about whiskey on social media. In GB, the product was the number one bestseller in Amazon grocery for over a week.
And in the U.S., White Walker became the second most searched-for product in the history of online platform, Drizly. We’ve also launched a unique limited edition range of eight malt whiskeys, each paired with one of the iconic houses of Westeros as well as the Night’s Watch, all inspired by Game of Thrones. White Walker by Johnnie Walker and the Game of Thrones malt whiskeys have been rolled out in many of our markets across the globe and have made a real contribution to our first half results.
But more importantly, we have connected new consumers to Johnnie Walker and scotch. Turning to U.S. Spirits. I’m pleased to see a step-up in net sales growth. We’re now growing broadly in line with the market. Growth was underpinned by continued strong performance from Canadian whiskey, American whiskey, tequila and scotch; improved performance in vodka; and the impact of the sale of the portfolio of 19 brands, which closed in December 2018. The underlying performance in U.S. Spirits continues to improve.
Crown Royal continues to benefit from consistent execution against the brand’s Generosity platform and has, again, gained share in the Canadian whiskey category. We see continued strong performance in scotch, tequila, American whiskey and Baileys. Smirnoff has improved and we see the superb performance of Ketel One, driven by Ketel One Botanicals and supported by continued improvement from the base variant.
Ciroc continues to show weakness and remains a focus for us. Captain Morgan has come under increasing pressure recently after successfully delivering share growth in the declining rum category over the past couple of years. We continue to invest in the proven Live Like a Captain campaign through TV and digital media. And we are focusing on expanding consumption beyond the Captain and cola serve, educating consumers on new ways to drink Original Spiced Rum such as Captain and ginger ale or Captain and iced tea.
We are confident that the increased marketing investment and improved effectiveness of our brand plans is supporting sustainable growth in the U.S. India saw a strong start to the year with net sales up 12% benefiting from a weaker prior year and strong performance of our Prestige and Above brands, which were up 17%. Scotch delivered a strong half with Johnnie Walker growing double digit following the successful Keep Walking India campaign and our continued strategy to make the brand more accessible to younger, more affluent consumers through activities like sampling Johnnie and ginger across key on-trade outlets.
Locally bottled scotch brands also performed well, with Black Dog, Black & White and Vat 69 all in double-digit growth. I am pleased with the progress the Indian business continues to make on operating margin, now firmly in mid-teens operating margin territory. This is driven by positive price/mix and productivity improvements while we continue to invest in our brands with growth in marketing investment ahead of net sales.
Before we close, let me sum up. We have made a particularly strong start to this first half of fiscal 2019 and remain on track to deliver our guidance. These results have been delivered through our consistent focus on all six of our execution priorities with a standout performance from innovation. We are a stronger, more agile and disciplined business. As we deploy our strategy, we remain focused on building the long-term health of our brands to grow our business in a consistent and sustained way. Thank you.