Allied Domecq produced respectable interim results recently but still received a rather mixed response from the investment community. Ben Cooper asks what the world's second largest spirits company has to do to get a fair shake from the City.

Everyone knows that bad news travels fast but the other problem is that its effects linger for a long time. Over the years, Allied Domecq has had its share of bad news to give out to investors and it is fair to say that the company has something of a reputation in the investment community. And in spite of far better news of late, its reputation precedes it.

No more clearly can this be seen than following the publication of its interim results a couple of weeks ago. Allied reported a 6% rise in pre-tax profits before exceptionals to £266m, representing an increase of 12% at constant currency, in the half year to February 29, on turnover down 2% at £1.7 billion. At constant currency levels, sales would have been flat.

Philip Bowman, Allied's chief executive, described the interims as "an exceptional set of results, delivering growth at the top end of expectations". However, the response from investors and analysts has once again been mixed.

In spite of the rise in pre-tax profits, Allied's shares fell by 2.31% to 455.25p, with analysts highlighting disappointing drinks volumes and the currency hit as negative factors. The investment bank, Merrill Lynch, cut its rating on Allied from "buy" to "neutral", while Lehman Brothers reduced its rating to "equal-weight" from "over-weight".

The principal drivers of first-half growth were brands such as Malibu rum and Beefeater, while the company's wine business has also continued to make strong progress, notably in the US. With spirits brands such as Sauza and Maker's Mark performing well, North America was in general a strong performing area for the company, with trading profit up by 10% excluding adverse currency movements. However, adverse economic conditions in South Korea are likely to continue to impact on business for the rest of the year. Also, the company has experienced problems in its key Mexican market resulting from the illegal liquor production.

The company has also had problems with its new liqueur brand, Tia Lusso, launched in the summer of 2002. Bowman said that as a result of the intense competition, the target-date for the brand moving into profit in the fourth year after its launch, had now been pushed back by at least one year. However, Bowman said the brand would not be withdrawn from distribution as had been suggested in some quarters. "We're not making any money out of it, but I think it's something we'll persevere with," he said.

Earnings per share before exceptionals for the period rose to 18p from 16.9p and the interim dividend was 5.83p, up from 5.3p. Allied also reported that a 5% increase in marketing spend has resulted in a 1% per cent rise in spirits and wine volumes. Moreover, volumes for its nine core brands were up 6%.

While there were undoubtedly plenty of positives in the Allied interim results, there is concern about South Korea, Mexico and the slow progress in some European markets. Analysts pointed out that Allied is not the only major spirits company to be showing an improvement in the US and this progress is already built into the current share valuation. On the other hand, Mexico and South Korea are both areas of concern because of the company's high EBIT exposure in these markets.

Furthermore, even though it might be viewed as somewhat irrational, the equivocal view of Allied taken by the investment community may in part be due to the company's difficult history. "Industry specialists who look at the company in detail aren't so affected by the legacy but if I was going around to see experienced fund managers who might look back over 20 years it takes a long time to turn around such perceptions," one analyst said.

Stephen Whitehead, group corporate affairs director at Allied Domecq plc, attributed the fall in shares to profit-taking, pointing out that the Allied share price had risen from around £2.60 a year ago to its value on Tuesday 4 May of around £4.52. But he did concede that while the company had found the view of most analysts to be upbeat, there was some residual feeling of scepticism towards the company, stemming from its past, which was difficult to shake off.

"The glass is still always half empty rather than half full which Pernod doesn't get, even though their results are comparable." Whitehead told Just-drinks. "We recognise that and we fight against it, but I think people are beginning to see this a very different company."

Whitehead feels that Allied is now prevailing in its battle against a negative image, not least through demonstrable success. "My view is that we're getting there," he said. "We have had nine successive halves of growth in EPS and have absorbed over £100m of foreign exchange and pension costs, and the business has still delivered growth. The history of this company has taken a long time to shake off but I think we have just about shaken it off."

Even if some of the negative image of the past has been eradicated, some analysts believe that Allied suffers from a lack of scale in comparison with Diageo, whilst not providing the degree of growth which Pernod Ricard has managed of late.

"If you look at the valuation of Allied Domecq against Diageo and Pernod Ricard and try to understand why Allied Domecq does trade at a discount, a lot of it is down to scale," one analyst told Just-drinks. "Larger companies are seen to have stronger positions. Diageo have pretty much all the number one brands. If you compare it with Pernod Ricard, Pernod Ricard is seen as having grown faster than the other two, so its status as a special growth stock is what gives it its rating and Allied can't compete on either criteria."

To a degree, this perceived weakness could also be viewed as the mistakes of the past being visited on the Allied of the present. Put simply, there is a prevailing view that Allied's lack of scale counts against it and that it has failed to address this in spite of apparently repeated opportunities for big deals. While there may have been perfectly sound business reasons for eschewing merger or takeover opportunities in the past, some observers see Allied as the company which missed out on merging with Martini and later with IDV in the 90s, and then missed out in the Seagram sell-off too. The latter omission, as many would see it, allowed Pernod Ricard to steal a march on it, when it was already struggling to keep pace with its giant competitor Diageo.

This may be a harsh analysis but it is not without some foundation. But as Stephen Whitehead points out, the company now has different management and the current chiefs at Allied have forged a far more solid reputation for running a tight ship and providing growth.

It appears though that given the inexorable trend towards consolidation in the drinks industry and the plethora of merger opportunities currently around, the investment community may be waiting for the current Allied management to grasp the nettle and progress from solid organic growth to acquisitive expansion.

Analysts have been speculating for some time that the much-discussed flotation of Bacardi could provide an acquisition opportunity for Allied. On the other hand, Allied's scale issues could be addressed if Pernod Ricard were to make a move for the company as has been suggested in some quarters. The US-based wine and spirits producer, Brown-Forman, has also been suggested as a possible takeover target for Allied though its 40% family ownership currently militates against this.

Without a major deal, one might expect Allied's gentle rehabilitation to continue steadily for a few more years. However, a big merger could accelerate the process significantly. As one analyst put it: "There is the possibility that Allied Domecq in its current form won't be around forever, with the consolidation being seen in the industry, and that would create a completely new era. Then the past would be behind it."

So arguably what Allied's current management has to do finally to lay the ghosts of the past to rest is to do the deal which people have been waiting for it to do for more than 10 years.

Expert Analysis

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