Diageo (NYSE: Deo, Lse: DGE)

Diageo (NYSE: DEO, LSE: DGE) was created in 1997 with the merger of brewer Guinness and spirits-maker Grand Metropolitan. The company's major brands include Guinness, Johnnie Walker, Lagavulin, Captain Morgan, Tanqueray, Bushmills, Crown Royal, Baileys, Smirnoff and a number of other beer, wine and spirit properties (Diageo.com, 2011). When Diageo was formed, it had inherited a number of food interests from Grand Met including Burger King and Pillsbury, but in the early 2000s it divested its food businesses to focus strictly on alcoholic beverages (Ibid). The history of many of the companies and brands within the Diageo family dates to the 18th and 19th centuries. Diageo has roughly a 29% share of the premium spirits market. It competes in beer as a differentiated provider and its share of the heavily-fragmented global beer market is considerably smaller as a result.

Diageo is structured on the basis of geographic units. The four main units are Asia Pacific, Europe, North America and International (2010 Annual Report). Within each geographic area, individual nations and brands have their own companies. Within each nation/product company (e.g. Guinness Anchor Berhad for beer in Malaysia) there are units for individual products, and there are divisions that separate the production and marketing functions. Diageo markets in far more locations than it produces. For example its scotch business has production in dozens of sites throughout Scotland, but the marketing of the product is conducted nationally around the world. Key production/marketing units are Diageo Ireland, Great Britain, Scotland, Diageo Brands NV in Europe and Diageo North America. In addition, there are several sub-units dedicated to financing, located in Europe, Britain and the United States (2010 Annual Report).

The board of Diageo is comprised of 11 individuals, seven of whom are non-executive (external) directors and the remainder coming from within the company. Strategic lead is taken by the Executive Committee, which is comprised of a mix of functional managers and regional managers, including executives for marketing, procurement, Asia Pacific, Africa, HR and finance. This team is responsible for steering global strategy for Diageo, with sub-units taking direction from this overall strategy.

There is no "Letter to the Stockholders" section of the 2010 Annual Report, but rather a "Chairman's Statement." In this, the chairman notes that the current operating environment is characterized by volatility. The company responded by making significantly changes to its business, including organizational restructuring and taking steps to reduce the cost base. The Chairman reports that the strategies outlined the previous year were implemented, resulting in "greater efficiencies and stronger performance." He concludes by mentioning that the company increased its dividend to the stockholders.

The audit of the financial statements was conducted by KPMG. It was "audited to the extent required by the regulations." The report was approved by the Board of Directors and complies with applicable UK regulations on governance. The auditor's report is clean -- there are no matters on which to report with respect to the Companies Act of 2006, the IASB and the director's report. The statements are deemed to "give a true and fair view of the state of the group's affairs as at 30 June 2010 and its profit for the year ended," that they have "been properly prepared in accordance with IFRS" and have been "prepared in accordance with the requirements of the Companies Act of 2006 and Article 4 of the IAS regulation" (p.105).

The section concerning management discussion and analysis outlines the performance of many of Diageo's star brands. The company saw the scotch category grow 5% with Johnnie Walker experiencing double digit growth spurred by improvements in the Middle East, Latin America, South-East Asia and the Global Travel segment. Smirnoff, the company's flagship vodka brand, saw declining performance in fiscal 2010, but ultra-premium vodkas improved significantly. Captain Morgan growth was mixed, with weak sales in North America and strong sales in Europe and International. The company distributes Jose Cuervo and saw decline in this brand in North America, a region that experienced weakness overall. Guinness was flat as strong growth in South-East Asia offset declines in Europe. The company struggled with sales declines in Africa as the recession caused consumers to "trade down" from the premium stout segment. Share for Guinness in the core UK and Ireland markets was up, but volumes for industrial beer were down in general.

Regionally, Europe saw a slight increase in volume (1%) but declines in sales as margins were squeezed. This hurt operating profit, despite declines in marketing spending. North America was the weakest market of the year, posting a 2% decline in volume and a 3% decline in sales despite increased marketing efforts. International posted strong gains, with an 8% increase in volume, a 13% increase in sales, all supported with a strong increase in marketing expenditure. Asia-Pacific saw a slight increase in volume (2%), profit (1%) and marketing expense. Overall, North America is the largest region with 34% of total sales; Europe had 28.4% of sales; International 27% and Asia Pacific was the smallest segment with 10.5% of global sales.

The company's strong geographic diversification saw is able to offset weakness in recession-hit countries like Spain and Ireland with strong growth from other regions. The company's product diversification has allowed it to enjoy steady growth even downturns in a number of key regions and products. Lager spurred 10% growth in Africa, for example, and Latin America and the Caribbean both experienced 15% sales growth. Whiskey spurred growth in Taiwan, offsetting rum declines in Australia. Overall, the company's diversified, global approach should be expected to stabilize the business and in 2010 it appears that this was the case.

Going forward, Diageo expects to continue with its broad strategy of providing a range of alcoholic beverages to consumers and continuing with a global focus. The company expects to continue to face challenges in North America and Europe, and has adjusted its marketing expenditures accordingly. Diageo expects to continue as the leading producer of premium spirits, a position it currently occupies with 29% global market share. Its focus will remain in scotch, beer and vodka, but it is expected that Diageo will continue to focus growth on other product lines. The company is focusing its growth strategy on continued marketing efforts, leveraging its distribution capabilities and on new product introductions. Specific markets targeted for their high growth potential are South Africa, China, Vietnam and India.

Part Two:

Diageo's income statement shows improvements in sales in each of the last two years. The company's turnover was £12.958 billion in 2010, up 5.5% from 2009 levels. The company earned £1.743 billion in profit, up 2.2% from the year previous. This translates to earnings per share of 66.3p, compared with 64.5p in 2009 and 58p in 2008. The common size income statement highlights some of the underlying causes of the decline in net profit margin, which fell from 13.89% in 2009 to 13.45% in 2010. The common size income statement can be found in Appendix a.

The common size analysis reveals little change in the company's operations year over year. Diageo saw its excise increase slightly year over year, which is not surprising given that many governments are turning to increased taxation on price inelastic products as a means of balancing their budgets. It is surprising that the increase in excise was not greater. Diageo saw a slight reduction in its cost of goods sold over the past year. There were slight increases in marketing expense, primarily in North America to help overcome slumping sales, but also in Asia Pacific and Africa to support rapidly growing markets. The company's moves in 2009 to reduce operating expenses paid off in fiscal 2010, with operating expenses declining from 13.62% of sales to 13.03% of sales. As a result of these changes, Diageo saw its operating profit as a percentage of sales improve in fiscal 2010. This implies that the reduction in net income was the result of non-operating factors. Tax as a percentage of sales rose from 2.33% to 3.68% in 2010, a jump of 73% in real sterling. As with excise, this increase in taxation was not unexpected as governments seek to increase taxes in order to make up for their budget shortfalls.

The income statement shows that Diageo has increased in size over the past couple of years by 21.7%. This growth has been matched by increases in profit over that same time period. The growth in most expense categories has been more or less in line with revenue growth. The income statement therefore tells the tale of a company in a relatively mature industry that is finding some growth in some markets, but has also maintained its strategic focus on its core businesses. With no major acquisitions or divestitures over this period, Diageo has been able to focus on the steady growth of its core business.

The common size balance sheet reveals a slight improvement in the company's financial situation. The common size balance sheet can be found in Appendix B. Diageo has seen its equity improve from 21.5% of assets to 24.6%, with a corresponding reduction in liabilities. This has been achieved with a slight reduction in the company's borrowings from 42.65% of assets to 42.03%. While deferred taxes have increased, the company has seen its post-retirement benefits liabilities reduced. With respect to the structure of Diageo's assets, non-current assets have been reduced slightly. Non-tangible assets (primarily intellectual property) did not change significantly in value. Diageo was able to reduce its inventories slightly in 2010, in addition to reducing its receivables. These moves allowed Diageo to improve its working capital management -- a greater percentage of its assets are held in cash and equivalents.

Overall, the balance sheet shows that the company is growing steadily. Diageo's total assets have increased 21.6% over the past two years, with increases coming in many key categories. Of note is one category that has not grown, receivables, illustrating that Diageo has been able to tightly control its receivable levels over the past two years. The company's equity declined in 2009, but grew again in 2010. Diageo has effectively doubled its cash holdings in the past two years as well, showing a commitment to improving its financial strength and showing restraint with respect to increases in spending.

The statement of cash flows does not typically receive "common-size" treatment. Diageo was able to increase its cash flow from operations by 41.9% in 2010, a dramatic improvement over prior years. This performance belies that relative stability in evidence on the income statement. Cash generated from operations increased 19.5% and the company received substantially more interest in 2010. Diageo saw its cash outflow from investing activities reduced by 7.2% on the year, although the amount was not significant in terms of its entire cash flow situation. A 24.3% increase in cash outflow from financing activities was noted. Diageo increased its dividend, as noted in the Chairman's Statement, sending an additional £44 million to shareholders in 2010 over 2009 levels. The company increased its loans, so while borrowing as a function of capital structure was reduced, total borrowings increased. In addition, Diageo halted its share repurchase scheme that saw the company repurchase £1.088 billion in shares in 2008 and a further £354 million in shares in 2009.

The statement of changes in owner's equity also does not typically receive the "common-size" treatment for analysis. Diageo's equity improved significantly in 2010, following a decline in 2009. The company has generally held the book value of its equity steady through share repurchases, but this program halted in 2010 and that was the most significant factor in the sharp increase in book value of the firm's equity (23.5%). The other factors contributing to changes in the value of owner's equity have remained relatively stable over the course of the past four years, including comprehensive income and dividends paid. While these have changed, those changes have not significantly impacted on the book value of the owner's equity to the degree that the share repurchase program did.

The financial statements at Diageo do not reveal any significant shifts in strategy over the past three years, nor do they reveal any weaknesses in the company. A large company with a high level of geographic diversification would be expected to weather the economic storm that hit Diageo's large markets in the UK, the U.S. And Ireland, and that is precisely what has happened. In essence, there are no surprises in the Diageo financial reports. The company is performing as a mature company with a high degree of diversification would be expected to perform.

Part 3:

A financial ratio analysis can be conducted with respect to the firm's key ratios -- liquidity/solvency, profitability and efficiency being the most important. These ratios are best analyzed in the context of the company's own historic performance, to highlight areas of improvement and areas of weakness. It is also important to understand where these levels are with respect to the industry -- even an improving ratio may be at an unhealthy ratio or vice versa. Diageo's industry in alcohol beverages is a difficult one to benchmark. A substantial percentage of Diageo's sales comes from beer, a highly fragmented industry in which none of Diageo's spirits competitors operate. Among spirits operators, only Pernod Ricard has the type of diversification that Diageo has. It is the most similar competitor, although its wine business (Jacob's Creek) is more significant than any of Diageo's wine businesses. Other competitors such as Bacardi and Brown Forman (Jack Daniel's) are oriented towards one or two star products. On MSN Moneycentral, Diageo's industry is characterized as "Wineries and Distilleries," and some of the differences between Diageo's business and the wine business in particular should be taken into consideration. The year-over-year company analysis probably has more weight than the industry comparison analysis.

With respect to liquidity, Diageo has a current ratio of 1.76, compared with 1.52 in 2009 and 1.17 in 2008. The quick ratio is 0.93, compared to 0.75 in 2009 and 0.60 in 2008. The cash ratio has also improved, to 0.36 in 2010 from 0.23 in 2009 and 0.15 in 2008. The debt to equity ratio is 3.06 in 2010, compared to 3.65 in 2009 and 2.86 in 2008. In general, these figures point to a significant improvement in liquidity over the past three years for Diageo. This improvement has been registered in each year. When analyzed against the common size balance sheet, it is evident that the majority of the liquidity improvement has come from the improvement in the cash position. Inventory and receivable levels have not changed significantly. Cash is 7.47% of the balance sheet in 2010, compared with 5.07% in 2009 and 4.46% in 2008. The statement of changes in cash flow highlights that the cessation of the share buyback program has been the major contributor to the improved cash position. Thus, Diageo has specifically halted a strategy in order to improve its liquidity position over the past couple of years, by retaining more of its cash flow rather than diverting it towards propping up the value of the company's stock.

With respect to the profitability ratios, Diageo has an extra such ratio that incorporates excise. Net sales margin (Gross sales -- excise) declined slightly to 75.47% in 2010 from 75.80% in 2009. This was at 76% in 2008, highlighting a steady three-year declining trend in the net sales margin. The gross margin, best taken as gross profit / net sales rather than the usual gross profit/gross sales, was 58% in 2010, down slightly from 58.1% in 2009 and 58.8% in 2008. The company has therefore seen a slight decline in its pricing power, which is reflected both in the price it pays to suppliers and the price it charges consumers. The company has not noted in the annual report any decline in bargaining power over suppliers, but has noted that it needed to reduce prices in some markets to spur sales. Operating profits increased in 2010 to 19.86% from 19.69% but this figure was 20.7% for 2008. The slight improvement last year reflected some expense reductions, in particular operating expense. The net margin before tax was 17.38% in 2010, up from 16.20% in 2009. Thus, while the net margin after tax declined, this was only due to increased tax expense. On a pre-tax basis, Diageo's net profitability improved. This is almost entirely attributable to the reduction in operating expense.

Diageo's operating efficiency ratios generally showed mix performance in 2010. The receivables turn improved to 6.5 times from 6.15 times. Asset turnover fell slightly to 0.7 times from 0.72 times. The inventory turnover ratio was 1.29 times, down from 1.35 times. It was noted previously that Diageo moved to improve its collections, resulting in a decline in accounts receivable, but this was not matched by improvements in asset or inventory efficiency. In general, however, Diageo's performance against its own benchmarks was good. Diageo outperformed most of its benchmarks in 2010. Among those it did not outperform, there were not dramatic shortfalls in performance nor were there any major points of concern. No ratios are at danger levels that require immediate attention.

Despite the limitations of ratio analysis vs. The industry, there is some benefit to performing these comparisons. The company's current ratio is better than the industry average of 1.6. Yet according to the metrics provided by MSN Moneycentral (2011), Diageo has a higher debt-to-equity ratio than most of its peers in the industry. The company's interest coverage is also weaker and both of these factors, if unqualified could be considered cause for concern. However, given Diageo's strong and consistent operating cash flows and the company's recent balance sheet improvements, there is no reason to believe that Diageo is going to be faced with a liquidity crisis any time soon. The company's solvency is also a non-issue for investors.

In general, the company earns superior margins compared with its industry peers. Diageo outperforms the industry in gross margin, pre-tax margin and net profit margin and outperforms the S&P as well. The company's premium spirits and premium pricing on its beer help it to earn superior margins on its products compared with many of its industry peers. According to MSN Moneycentral, Diageo's margin outperformance against the industry is a long-term trend as its five-year average margins are universally superior to those of its industry peers.

Diageo has lower turnover rates than its industry peers. The inventory turnover being lower is expected, given the nature of Diageo's business. Twenty-seven percent of sales -- the largest segment -- comes from scotch. The maturation process for scotch is measured in years, so Diageo inherently must carry high levels of inventory in order continue to have a steady supply of product. Many industry peers would be unlucky to carry inventory six months. The receivables turnover underperformance is more concerning. However, this is the one operating efficiency ratio to which Diageo has paid specific attention. So even though it underperforms the industry, it has made improvements, and the present ratio is not a cause for alarm.