3 Things to Watch for When Diageo Reports

Diageo (NYSE: DEO  ) was named Whisky Advocate's distiller of the year in 2013, beating out big American rivals Beam (NYSE: BEAM  ) and Brown-Forman (NYSE: BF-B  ) , and many other smaller spirits makers. But that's offered little consolation to Diageo investors, who have seen the company's shares trail the S&P 500 over the past 12 months, and by no small margin.

Here's a snapshot:

DEO Chart

DEO data by YCharts

Investors can take some solace in the high honor. But they'll also want to see more from the company when it reports Jan. 30, either in the way of better results or more optimistic guidance. Let's take a quick look at some areas that may be of particular interest Thursday.

Emerging markets have been a drag
This is the elephant in the room. Emerging market sales make up 42% of Diageo's business,
and the company had already been crediting weak top-line growth to a slowdown in Latin America and China six months ago. One particular concern here is that brewer Anheuser-Busch InBev (NYSE: BUD  ) reported strong growth in China in October. It saw overall shipments there rise by 8.8% and shipments of its "focus brands" -- Budweiser, Harbin, and Sedrin -- grow by 13.5% in the quarter and by 14.8% year-to-date.

That raises the question as to whether Diageo's slowdown was due to a macroeconomic factor, or a shift of consumer preferences. In either case, there are now even larger concerns about a slowdown in China's economy, enough to send U.S. stocks down sharply late last week.

Diageo has a two-pronged approach to growth: It executes around its key brands in the U.S., such as Johnnie Walker scotch and Crown Royal whiskey, and it looks to expand into emerging markets, where it introduces less expensive brands and gradually tries to get customers to trade up to more premium spirits.  

In order for that second, key part of its plan to succeed, it needs emerging economies growing stronger. The more people who improve their financial situation, the more who are willing to step up from a bottom-shelf scotch like Vat 69 to a premium scotch like Johnnie Walker Black Label.

In the six-month period reported in July 2013, Diageo was able to grow its volume of strategic-brand shipments to emerging markets by 6%. Investors should keep an eye on what management has to say about that growth over the past six months. A slowdown could spell trouble for one of the two key growth drivers.

It's new. Is it good, or just different?
Trying to win over drinkers is a competitive market. Variety seems to be forever increasing. Spirits makers need to be innovative, and they are at a real disadvantage there compared to brewers. While A-B InBev and other brewers can turn around a new beer and put it on the market in months, a new whiskey or scotch could take years. Still, distillers like Diageo, Beam, and Brown-Forman must innovate, coming up with new labels and new flavors.

Beam has been expanding its line of spirits to include flavored varieties like Knob Creek Maple and Jim Beam Maple, Red Stag flavored whiskeys, and Skinny Girl spirits and wines. Brown-Forman has had success with its Jack Daniel's Tennessee Honey whiskey -- which posted sales growth of 30% in the first half of fiscal 2014 -- and now introduced a ready-to-pour, lower-alcohol libation called Winter Jack.

Diageo said its success in the previously reported six months was driven in part by the success of new ventures, namely Crown Royal Maple, Bulleit bourbon, and Smirnoff vodka confectionery flavors. If these spirits continue to sell well, it's good news for Diageo. If not, it could be a setback.

Cracking "the beer code"
Beer may not make up a big percentage of Diageo's business overall -- around 10%, give or take, based on the company's earnings slides. But it makes up a much larger chunk of sales in emerging markets -- nearing a quarter of net sales there. Diageo owns the world-famous Guinness brand, but apparently hasn't been faring all that well in beer.

The trouble there is that some of the emerging economies it hopes to conquer love beer. In Africa, which Diageo sees as a key area of growth, beer makes up nearly 70% of sales.

"We need to crack the code in beer," CEO Ivan Menezes said. With A-B InBev pushing harder into emerging markets, and the U.S. still being taken by storm by craft beer, Diageo and its brand must find their place. 

The Foolish bottom line
Diageo is putting out good products, but it faces real challenges, especially if the feared slowdown in emerging markets takes hold. Thursday's report should give investors a better feel for how things are playing out.

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