Diageo CEO Paul Walsh upbeat on trading

Diageo CEO Paul Walsh upbeat on trading

Diageo has come from behind to surprise investors in a fiscal year that looked more than a little rocky at half-time. Here, just-drinks deputy editor Chris Mercer talks to Diageo CEO Paul Walsh about the results and what happens next.

Torrential rain is rattling the windows as I meet Paul Walsh in Diageo's small-yet-plush office in downtown London. Inside, though, the sun is beaming. Only hours earlier, the Johnnie Walker distiller impressed those faceless markets with a 5% rise in full-year net sales and a 17% jump in profits; not to mention the highly unusual publication of three-year guidance.

Boxed into a corner after its half-year announcement, Diageo has come out with fists pumping. 

I only have 20 minutes with Walsh, so we get straight down to the nuts and bolts. While the numbers look solid, I suggest that, in Europe, the storm clouds outside those windows seem apt. "I think we have to disaggregate Europe," Walsh shoots back. 

In the likes of Ireland, Greece, Spain and Italy, he says, "clearly you have countries that are going through economic turmoil. Consumer confidence is low, taxation is increasing and the ability for consumers to spend as they have been doing in the last decade has changed. What I found encouraging is that [yes], we're seeing a contraction at top-line, but we've held our margin and we are still selling product." He counters that the UK "is ok", while Benelux and Germany are "just fine, thank you very much". Russia, he says, is doing extremely well and the addition of Mey Icki in Turkey is expected to make a sizeable impact

That said, Diageo has just completed a review of its operations, with a particular focus on Europe, and I'm keen to find out how the firm has been protecting those European margins. For one thing, advertising spend is down in Europe. But, what about cost cutting within the business? Walsh says that the group has "already cut costs" in the worst-hit markets. "Equally, in our head office, there's been some cost reduction, as we try to put our resources more into the markets where we're seeing growth," he says. Cuts have been made across a range of back-office functions, he adds, including administration, finance and human resources. The firm, though, won't disclose job cuts numbers and has no plan to do so. 

Europe's loss is Asia and Latin America's gain, with emerging markets set to swallow more of Diageo's resources. Oh yes, and don't forget Africa, a region that Walsh believes is "often unrecognised" in Diageo's business. "Africa is a jewel," he enthuses. "Even in the teeth of the last economic fall-off, Africa continued to perform very well - not quite [rising] in double-digits, but not far enough."

Looking at Diageo's figures, it doesn't look fanciful of the group to expect emerging markets to provide 50% of its net sales by 2015. Are profits, though, another matter? The US and Europe still account for two thirds of company profits. "Profits may lag that 50% sales a little bit, but it won't be a lot," Walsh says. "If you look at our gross margins, there is nothing structurally that suggests that these developing markets can't have the same overall profitability. The issue you've got is scale. We've got to get to scale and our results today demonstrate that we're starting to get that scale."   

Underpinning Diageo's thinking is pure demographics. "Simply look at the number of middle class consumers coming on-stream in these markets over next 10-15 years, and then contrast that to what's happening in Europe," Walsh says. He argues that an annual income of just $10,000 is enough to "dramatically change" consumer tastes in emerging markets; a term, by the way, that he believes is already outmoded given the low debt, high investment make-up of many such markets.

In Asia specifically, it's been said before that Diageo would consider a stock market listing. I ask Walsh about this and whether the group would consider basing more business functions in the region. "We'd be open-minded to that, I'm not saying that we're hot to go and do that, but you have to be alert to these opportunities," he says. "China, and Asia, as a capital source is increasingly looking like a good prospect and if the market is going to grow there, then clearly you need more people there, so you get into the headquarters debate." In the last few months, Diageo has based its Reserve brands business in Singapore.

In China, though, Pernod Ricard still heads the market. Does this bother Walsh? "Of course, I don't like it. I want to be number one everywhere." How close is Diageo in China? "It changes every year - every year we just notch up and get a bit closer [to them]," he says. He does, however, assume the moral high ground by declaring Pernod to be "at the end of the day, a great company". You heard it here first.

All this focus on new markets threatens to make events in the West look even worse. Walsh, though, says that he still sees the US as "very exciting", albeit with Europe "a little less so". It's clear that North America is going to be important for Diageo for some time to come, with 41% of profits and 34% of sales coming from the region in the 12 months to the end of June. "The US demographics remain attractive," says Walsh. "There are 1m more legal purchasing age adults coming into the market every year," he adds. 

"The US spirits market never actually contracted," he reminds me. "I also think what you're seeing in the US is a bit of a two-speed consumer. If you're earning over $80,000 a year and you're reasonably content with your job prospects, you've come to terms with the fact that your house maybe isn't worth what you thought it was, and you've come back into the categories. If, however, you're earning less than $30,000 per year and you are worried about your job prospects then you are under a lot of pressure, and you are not in the mainstream for our products." Spirits, he believes, "are in better shape" in the US this year and have continued taking share from beer.    

Acquisitions have arguably played an important role in restoring investor confidence in Diageo in calendar 2011. The group has bought Turkey's Mey Icki for $2.1bn, sorted a tie-up in Vietnam and secured a landmark deal to gain indirect control of Chinese drinks group Shui Jing Fang.

For all this, there is a sense that everyone who follows Diageo is waiting for 'the big one', whether it be Jim Beam, Moet Hennessy or another heavyweight player. Diageo had GBP1.7bn (US$2.76bn) cash in the bank at the end of June. I suggest that Cognac, Champagne and Bourbon remain gaps in the Diageo portfolio.

Walsh argues that Champagne, Cognac are not true gaps, by virtue of its 34% stake in Moet Hennessy. "If [Moet owner] Monsieur Arnault would like to sell, we'd like to buy, so it's up to him," he says. Likewise, he adopts a passive position on Jose Cuervo Tequila, which is controlled by the Beckmann family. "We have a distribution contact, it's up for renewal in 2013, we'll see where that takes us," says Walsh.    

He adds: "I'm  more sympathetic to your point around Bourbon, in that our presence, given the scale that we enjoy in other categories, in Bourbon we are light. That's just the way it is." With Diageo tipped as a buyer of Beam Global brands, following Beam's planned reinvention as a standalone company later this year, I ask Walsh whether the Bourbon situation is likely to change. "I don't see it changing in the near-term," he says.

With the three-year, organic guidance that Diageo has produced - average annual sales and profits rises of 6% and at least 10% respectively - is the firm making a statement about not needing acquisitions? Walsh expects Diageo will get involved in the next round of industry consolidation, whenever that happens. "We're still saying that we're interested in acquisitions, but it's got to be the right acquisition." 

For now, Walsh is content to indulge in a bit of 'we told you so' with anyone who doubted Diageo's ability earlier in the year. Time is up and, beyond the window pane, the sun is emerging.

For all just-drinks' coverage on Diageo's results, click here.