Diageo : 2022 Interim Results Q&A transcript

Diageo F22 Interim Results Investor Q&A Call

Date: Thursday, 27 January 2022

Conference Time: 09:30 (UTC+00:00)

Ivan Menezes: Hello, everyone, and thank you for joining our interim results call for fiscal '22. I hope you've had a chance to read our press release and watch our presentation webcast on diageo.com.

I'm very pleased with our results for the first half of fiscal '22. It builds on our strong momentum in fiscal '21, and demonstrates our world-class brand building, supply chain excellence and agile culture. Organic net sales were up 20%, all 5 regions delivered double-digit growth and exceeded net sales in the first half of fiscal '19.

Growth was broad-based across categories, and I was particularly pleased with the strong growth in scotch, up 27%; the continued outperformance in tequila, up 56%; and the recovery in beer, up 22%. We also delivered a significant improvement in operating margin, up 131 basis points, while increasing our marketing spend ahead of net sales growth. We achieved this while managing higher cost inflation and ongoing disruption from global supply chain constraints.

Our advantaged portfolio, combined with effective marketing, excellent commercial execution, and successful innovation, enabled us to gain or hold off-trade share in the majority of our markets, and we also gained share in the on-trade as it continued to recover. We are investing in long-term growth, including production capacity, digital capabilities, and our Society 2030 goals. And we're delivering consistent returns for shareholders, increasing our interim dividend by 5%, and accelerating the timeline for completion of our return of capital program to 2023.

While we expect continued volatility in the near term, I'm optimistic about the growth prospects for our industry and for Diageo. We believe we are well positioned for resilience in the off-trade and further recovery in the on-trade. We expect to continue benefiting from the rapid premiumization of the spirits category, and its share gains within total beverage alcohol. Our premium differentiated brand, Guinness, is well positioned for key growth trends in beer. I am confident in our strategy, and our ability to execute strongly through the remainder of fiscal '22 and beyond.

Operator: We will now take our first question from Pinar Ergun from Morgan Stanley.

Pinar Ergun: I have 2 questions, please. The first one is to what extent have supply constraints impacted volumes, especially in North America? And do you see any signs of improvement in the supply chain situation? And the second one is, do you see any possibility that consumers might spend less on premium spirits as the cost of living goes up? And, I guess in that context, can Diageo continue to raise prices with a limited impact on volumes?

Ivan Menezes: Hi Pinar, I'll take the second on premiumization trends and ask Lavanya to address your first question on supply constraints. I would say the premiumization trends, as you know, have been very long dated and steady in the U.S. and in other parts of the world. People drinking better has been a trend that has really sustained through lots of cycles, economic cycles and disruptions.

The second point I'd make is, if you look at the U.S. market, the average American household that buy spirits, this is about half the households, they spend about $1 a day on spirits purchases to consume at home. So, when you're faced with an economic crunch, our product is an infrequent purchase, people typically buy spirits 6, 7 times a year, they buy a few bottles of a category. So, if you're drinking Ketel One vodka, you're buying a few bottles a year, and it's only a few dollars off a premium to a low-priced vodka. And so, we do believe, actually, that the sustainability is good.

The other thing I would say is, if you look at the demographics, young adults, in America, again, 21 to 35, over-indexed in buying premium spirits, the multicultural population over-indexes in buying premium spirits, and you see these demographic trends also very positive for premiumization in spirits. So, we're not immune from overall consumer confidence and spending power, but I would say within those shifts, we still see our higher-priced brands growing faster, and that tailwind should continue for Diageo.

Lavanya Chandrashekar: I'll take the first part of your question, Pinar. On supply constraints impacting volumes in North America, yes, we are seeing issues that are impacting our business in North America. But having said that, our U.S. beer business in North America grew 3% volume in half 1. If I look back at pre-COVID levels, volume growth from this business was somewhere between 1% and 2% at the top end. So yes, we are seeing issues, they're spotty. But having said that, I think the organization is doing a fantastic job of navigating them and being able to grow volume faster than we have historically grown on the business.

Let me talk a little bit about where we are seeing constraints. Two areas, one is on certain parts of our portfolio we're seeing constraints in terms of aged liquid. That's true on Crown Royal, and that's true on tequila, being liquid constrained. And then on Bulleit, we have a very specific issue around glass, and that really is impacting just the Bulleit bottle, which is a very bespoke bottle, and we are working with our strategic bottle supplier on that brand to resolve those issues.

Operator: We will now take our next question from Sanjeet Aujla from Credit Suisse.

Sanjeet Aujla: Ivan, Lavanya, a couple of questions from me, please. Just following up again on the supply chain dynamics in North America. Can you give us a bit of a time frame as to when you expect those constraints to be resolved or certainly moderating from what we've seen in H1?

And then secondly, as you think about the pricing outlook particularly in Europe, can you give us a sense of what sort of magnitude of pricing you feel you're in a position to take in the region? I think we've seen a lot come through in emerging markets already, but I'm particularly interested in how you're thinking about Europe.

And then my final question, just on China, if there's any colour you can give us on the current sell out trends into Chinese New Year particularly against the heightened lockdowns that we've seen in recent weeks?

Ivan Menezes: Yes. Why don't I take China and pricing and ask Lavanya to cover supply chain. On China, we see the environment is solid. I mean you see in our numbers both baijiu and scotch whisky continued good momentum. You do have the impact of COVID lockdowns in various parts of the country that does impact business. I'd say going into Chinese New Year, it's solid but not exuberant, and in particular, I'd say for our baijiu business, the large-scale banqueting occasions are going to be less, and large-scale gifting is going to be a bit less. But we remain confident on continued strong growth in China on both scotch whisky and baijiu. And we're gaining share, and

we're feeling very good about the momentum there, and certainly for the longer term, we feel very positive about the growth prospects of China.

On pricing in Europe, I'd say if you look at what we've been doing in Europe, we've been investing behind the brands strongly. We're gaining market share. Actually, we've gained in 5 out of 6 markets, we're gaining significant share. And our spirits business is performing very well. As we've talked before, we've got multiple levers to manage the inflationary impacts. Volume growth helps us, and there's very good volume growth in Europe. Mix is positive, and we will be taking some price, so the combination of productivity and pricing will offset inflation, but we're very surgical in how we apply our price increases, but you will see more pricing coming into Europe because of the inflationary pressures.

Lavanya Chandrashekar: Sanjeet, I'll take your question on supply constraints in North America. As I've mentioned to Pinar, we've got to look at this in the context of the overall performance of the business, which has been absolutely fantastic in delivering volume growth in North America as well. And really, our organization has been able to achieve very strong results because of the proactive approach that we have taken to this area, and because of the strategic relationships that we have with key suppliers. In North America, as an example, the procurement organization has been able to bring in new suppliers to the market, and this has allowed us to increase our glass capacity by almost 25%.

Now on Bulleit specifically, the teams are actively working on it, and we think it's going to be a matter of months to be able to resolve it. It's not going to be a long-term issue by any means.

On the aged liquid constraints that we have, we have a number of tools in our arsenal that help us to work around that. The first thing is demand shaping; we are able to move our A&P spend to parts of the portfolio where we do not have similar constraints. Look at our results on scotch in North America as an example, and Johnnie Walker in North America, with strong double-digit growth in the scotch category. So we are able, through a combination of revenue growth management and pricing on the constrained areas, as well as the demand shaping, to tackle constraints in these situations.

Operator: We will now take our next question from Simon Hales from Citi.

Simon Hales: Three from me as well, please. Can I just follow up on those pricing comments? Are you seeing competitors really following or matching the price move that you've been making in the U.S. and Europe? That's my first question.

Secondly and more specific to your business in the U.S., there was some mixed brand performances in the first half from the volume and sales momentum point of view. Clearly, your premium brands have done very well; tequila, scotch, et cetera, showing strong growth. But some of the more mainstream ends of the portfolio, Smirnoff and Captain Morgan, look like they're struggling a little bit, while Baileys and Bulleit admittedly, given some of the supply constraints on Bulleit, are under a bit of pressure. Can you give us a little bit more colour of the drivers there and, perhaps more importantly, how we should think about how those trends will evolve in the second half?

And then just finally, a quick final one on CapEx. Clearly, you're upweighting CapEx this year. I appreciate there's some catch-up in that sort of CapEx expectation. But how should we think about CapEx really beyond 2022?

Ivan Menezes: So I can do the first two and Lavanya can cover CapEx. I'd say pricing, Simon, the revenue growth management capabilities we now have are really embedded. The analytics and data is very good. As I talked about earlier, we're investing behind the brands; brand equity is going up, and we feel reasonably confident about our ability to take measured price increases and sustain the market share momentum we're looking at. You have different competitive dynamics in different parts of the world, but it's clear, the inflationary pressures are high for everyone right now, and I'd say our customers are also understanding, because everything they're buying right across the spectrum is facing more inflationary pressures. So, I do believe we will be able to sustain, kind of, discipline and pricing and as I said, surgically applied. And we really want to keep the momentum of growth, and make sure we're recruiting more consumers to our brands. And our investment levels in the brands and equity is very high.

On the U.S. brands, I would just say, as we come through the bounce-back of COVID and some of the supply chain issues there are, you're seeing some little differences in the portfolio on shipments versus depletion, so I'll just answer your question directly on the three brands you mentioned.

On Captain Morgan, actually, our depletion momentum is positive. So, it's low single digits, but it's in growth. And if you look at market share momentum where we've been losing share, as you look at 12 months, 6 months, 3 months, it's improving. So, Captain should stabilize and be better. We've got a big program with the NFL, which we're excited about and we're in season right now, so you should see some improvement there.

Smirnoff depletions is about flat. I'm talking the U.S., and again, we've got good marketing and innovation coming behind Smirnoff. So, these two big brands will be below the North American growth rates, but we just need them to be stable to slight growth, and we do see that happening.

Baileys actually is positive, and what you're just seeing there is the lapping effect of some of the shipments and coming off tariffs and all the things that happened on Baileys. But we're very positive on Baileys in the U.S, and again, it's in high single-digit type depletion growth as we looked at the last 6 months.

Lavanya Chandrashekar: Simon, I'll take the second part of your question on the upweighting of CapEx in fiscal '22. We have guided to -- we will -- we expect to spend between GBP 950 million and GBP 1 billion of CapEx in fiscal '22. This is higher than our previous guidance and really comes from the catch-up of projects that were paused or put on hold due to COVID and now coming back online and actually the need to continue to invest in the business.

From a capital allocation strategy perspective, our strategy remains unchanged. Now our #1 focus will be to continue to invest in the business, and this includes capital investment as well as A&P spend. From a CapEx perspective, ensuring that we have sufficient capacity to meet the growth ambition of the business and the growth trajectory that we're seeing on the business today is critically important.

We also continue to invest behind strong consumer experiences. This is a large part of how we support our brands. We opened Johnnie Walker Princes Street back in September, and that has been a real boost to what consumers -- when consumers visit Princes Street, they come away with the love for the brand that's remarkable and unmatchable.

And in terms of digital capabilities, that's been a key focus area as well. We continue to invest behind digital capabilities to support our commercial growth of our business, our marketing

effectiveness, understanding as well as improving our marketing effectiveness as well as in building capabilities, even in terms of the supply chain. So that will remain our key focus area to continue to invest behind -- in our business.

Operator: We will now take our next question from Mitch Collett from Deutsche Bank.

Mitchell Collett: I've got 2 questions. First, can you comment on inventory levels at the end of the half, ideally by region, particularly given the gap between depletions and shipments that you may have on a few brands that you've just mentioned?

And then secondly, I think COGS per litre in the first half was up 1.6% year-on-year. I appreciate you say in the statement that COGS have benefited from some of your productivity efforts, but can you perhaps comment on how you've kept COGS per litre at that level given the premiumization you're seeing and then what you would expect is a reasonable level of COGS inflation for the second half?

Lavanya Chandrashekar: Sure. I can take both of the questions, Mitch. So on stock in trade inventory levels, I assume you're talking about trade stock. With essentially what we have seen across the business at a group level and within North America, what we're seeing is our stock in trade is relatively flat year-on-year with shipments in line with depletions. There have been some differences across different parts of different brands within North America, and that comes from we were -- we had increased stock levels to support the opening up of the on-trade in certain brands and in other places because of just managing the timing by when product gets to the market due to various supply chain issues. We've just seen some differences between shipment and depletion at a brand level. But at the total North America level as well as at the total group level, our shipments have been in line with depletions.

On your second question on COGS and how are we able to manage COGS inflation and what do we see happening on inflation, back in -- at the end of our year-end, last fiscal '21 year-end result, I had said with you that we are seeing a higher level of inflation. And we're seeing that come through in terms of both commodity costs as well as energy costs. We're also seeing the impact of higher logistics costs due to just shortages of drivers and containers, et cetera, that's impacting everybody, not just Diageo.

Where we are seeing the leverage that we have to offset inflation, first of all, I'll remind you that because of the nature of our business and the percentage of our business that have aged product, we have a natural buffer against inflation just because the whole -- a large percentage of what we are selling today we actually laid down the liquids several years ago, more than a decade ago in many cases. Other than that, we're seeing the benefits of volume growth. We grew volume 9% in the half, and that contributed significantly to margin benefit. Premiumization clearly contributes to our gross margin.

From a COGS perspective, we are -- productivity has been a big part of what has enabled us to keep growth muted despite inflation. And that's really embedded into our every day. And we're seeing COGS productivity come through on -- from a procurement perspective, from a manufacturing perspective, also from a logistics perspective. So we're seeing it really play out across the board.

And then from a margin -- going back to looking at margin, I mean revenue growth management has enabled us to take smart pricing, manage trade spend, manage mix -- a few mix in a way that allows us to grow our margins.