Is Heineken's move for Punch a shout to the past?

Former analyst Ian Shackleton returns this month with a consideration of the 'Buy' position among analysts for Diageo, some further thoughts on the attractions of vertical integration in UK beer and pubs, and a warning that financial regulatory change will dramatically change corporate communications – and increase the value of just-drinks.

Assessing the Buy case on Diageo

Last month, I made the comment that, with its final results, Diageo delivered everything the analyst with a 'Buy' rating could have wanted – an earnings beat, a buyback announcement and some upbeat commentary. This has certainly led to a strong over-performance in the share price, which is now at nearly GBP26 compared with GBP22 before results, and GBP18 in mid-2016. Over the last 15 months, the average EPS estimate for this year has risen by over 10%, partly helped by the ongoing weakness of the UK Pound, and the company has added to the bullish sentiment by pushing the trigger on its planned GBP1.5bn buyback earlier this month.

What is surprising is that, when I look at analysts' recommendations, there has been little change over the last few years. As of today, 50% of the 30 analysts listed by Bloomberg have a Buy rating, which is slightly lower than a year ago (53%) but pretty consistent with the last few years.

This raises the question of how many of these analysts are really adding value to their clients, a theme which I shall return to later. Having said that, there are exceptions, and I was particularly attracted to the latest Buy research notes (not just one, but two of them) from some of my old colleagues who are now at Jefferies. The company has a GBP30 price target and has set out in some detail in its notes the two prongs to the story: a margin enhancement story, with a deeper focus on cost cutting as the company follows the model of RB (the old Reckitt Benckiser), and a growth story, with a particular focus on faster potential for growth in the US, which now accounts for over half of the company's profitability.

There is no doubt that Diageo has become more professional in its cost management in recent years, as it has copied best practice in other FMCG company. I can certainly see more potential here.

The difficult task, certainly in today's world, is to balance cutting costs with investing for the future. As organic sales growth has slowed in the FMCG world (we used to expect companies to target +4%-to-+6%; now, +2%-to-+3% appears to be the new norm), most large companies have focused more attention on margin, which, in turn, can then put a further brake on growth. This is why, in some ways, the zero-based budgeting approach, adopted by companies like Anheuser-Busch Inbev and Kraft Heinz, can be compelling as it has a simpler focus. That said, investors have started to question the end-game with this model. After all, you can't keep cutting costs forever.

If Diageo can deliver on both the growth and margin stories outlined by Jefferies, the group should remain a strong Buy proposition. What concerns me is that RB has been used as the best in class yardstick, at a time when the RB growth model appears to have slowed and the company is seen as buying growth with its recent Mead Johnson acquisition. Certainly, a recent article in The Times suggested that the RB model is under pressure. Unless it renews, the company could be under threat of being bid for.

Perhaps RB needs to be benchmarking itself more against Diageo?

Revisiting vertical integration in UK beer and pubs

At the start of this year, I wrote about the return of the vertically-integrated beer and pub model in the UK, following Heineken's bid to buy part of the Punch Taverns estate. The deal has now completed after a few regulatory tweaks, making Heineken not just the largest brewer in the UK, but also the country's number three pub owner - its now-3,000+ estate accounts for around 6% of the market.

Then, at the start of this month, C&C Group followed suit, taking a large stake in the Admiral Taverns business.

All this appears to be returning us to the days before the UK Beer Orders (1990), which obliged the larger brewers in the UK to sell down their pub estates and which, ironically, led to the formation of pub companies like Punch Taverns and Enterprise Inns.

The stand-alone pub company model worked very well for a few years, as profits were boosted by increasing discounts on beer and earnings accretion from debt-driven acquisitions of further pubs. Of course, when the music stopped, the outlook for trading in lower quality, traditionally-tenanted pubs, was pretty bleak, as investors have found out in recent years.

I was rather critical of Heineken's move on Punch. It strikes me that this model did not work well in creating global beer brands - note that none of the UK brewers survived the Beer Orders as independent entities. Most investors, I imagine, would have preferred Heineken to have invested its GBP1.2bn in international expansion in beer.

Having said that, the integrated model has continued to work well for the regional brewers/pub owners, such as Greene King and Marstons, where admittedly pub profitability tends to dwarf beer's P&L account. I assume that most of the regional brewers don't aspire to create global beer brands; they're happy to sell niche products, usually in real ale, which form a relatively small part of the sales in the pubs. Perhaps, then, we should describe them as pub companies that just happen to have a side interest in brewing.

So, where does that leave C&C? This is a company that promised super-growth back in the 2000's when its Magners cider brand grew like topsy. When the bubble burst, new management took over, re-engineered the business and then bought into overseas growth in cider with the (disastrous) Vermont Hard Cider Co purchase in the US in 2012, which has now been substantially written off.

What is the right strategy going forward, then, for a company with little opportunity for top-line growth? C&C has started buybacks, which is certainly a better use of capital than buying Vermont. Also, putting capital into a relatively defensive business like pubs, together with some vertically-integrated synergies, is also a sensible way forward. Indeed, the move shouldn't be a total surprise, considering the group tried to buy the Spirit pub estate in 2014 before being trumped by Greene King.

As a consumer, mind you, I mightn't get too excited to find C&C's Tennents lager on the bar of my local Admiral Tavern.

Update on MiFID ll – it hasn't gone away

Cast your mind back to January, when I told you about the pending 'Markets in Financial Instruments Directive' (MiFID II) here in the UK. The legislation, which takes effect from 3 January, will radically change the traditional relationship between brokers/analysts (sell-side) and investors (buy-side) by unbundling the charges that have traditionally been made by the former to the latter.

Certainly, we have seen an almost daily news-flow in the Financial Times in recent months, as negotiations between brokers and investors have begun in earnest. To me, this is only the starting point for what MiFID ll might mean for quoted companies and their communications.

What is certain is that this unbundling will result in less research and fewer analysts. This has all sorts of potential knock-on impact for companies: Will there be enough analysts to form a reasonable consensus view? Will investors increasingly go directly to corporate IR functions, thereby increasing their workloads? Will other stakeholders, such as the media, no longer have access to research?

As far as the companies are concerned, nothing has changed yet - if anything, the number of research analysts might have increased, as several research boutiques have started up, sensing a new opportunity in the post-MiFID ll world. The impact here will be enormous, perhaps not immediately, as broker commissions tend to work on a historic quarterly basis.

I leave you, then, with the thought that opinion-holding websites, such as just-drinks, will likely become more important once MiFID ll is here.