With Growth Slowing, Is It Time for Diageo to Rejigger?

Spirits maker Diageo disappointed investors with a weak six-month report. It has problems in emerging markets that are key to its plan for growth. Is it time for Diageo to change its approach?

Jan 31, 2014 at 4:15PM

Diageo (NYSE:DEO) shares fell by about 5% Thursday after the company reported disappointing results from the last six months and hinted that some of its troubles are unlikely to work themselves out anytime soon. Six-month sales were up 1.8%, about half of what analysts polled by Bloomberg News were expecting. But the company says it's still on the right track, and it likes its position as the largest player in the spirits industry, with a wide portfolio that spans every price range.

At the heart of the company's lackluster performance is slow growth in the emerging markets, coupled with developed markets where high-end spirits are selling particularly well but cheaper brands are not. Diageo is trying to reposition itself to get the most from the products that are selling well, while it tries to stem share losses in those areas where things have slowed. Let's have a look at the past six months and where the company may be headed from here.

Growth at the top
Like fellow distillers Brown-Forman (NYSE:BF-A) and Beam (NYSE:BEAM), Diageo has seen its most expensive brands grow in popularity. This explains why volumes were down 2% in North America, but net sales were up 5%. This has been a trend across most, if not all, geographic markets. The company's "reserve brands" posted a 26% increase in sales. Diageo's ultra-premium Johnnie Walker Platinum and Johnnie Walker Blue have been among its best performers. Its Ciroc vodka more than doubled sales in Western Europe, where overall sales were down by 1%. Even in a slowing Chinese market, sales of Johnnie Walker Black and Red were down, but top-tier scotches were up by double digits.

Brown-Forman and Beam have reported a similar trend. Brown-Forman CFO Donald Berg said in December that the company continues to see "the return of premiumization," encouraging the company in its efforts to introduce an ultra-premium Jack Daniel's No. 27 Gold, among other high-end spirits.

"We're pretty close back to what we saw prior to 2008, where the higher the prices, the higher the growth rates," Berg said.

At the soon-to-be-purchased Beam, its fastest-growing spirits have also been on the high end. While sales of its flagship bourbon increased 3% over the first nine months of 2013, sales of high-end Maker's Mark and Knob Creek each grew by at least 15%. Basil Hayden's, which sells at a price point more than twice that of Jim Beam, posted a 34% increase in sales.

Sales slow in the developing world
Diageo's sales by volume were down 3% in emerging markets, the product, at least in part, of slowing economic growth, especially among those with less money to spend. The company blamed part of its problems in China on a slowdown in luxury-goods sales due to a crackdown on "gift-giving," which is essentially an anticorruption effort.

But there are other issues at play in these developing markets that may point to weakness on Diageo's part. In Nigeria, an area of growth for Diageo's Guinness brand, beer volume declined 17%. Management attributed this to the weak economy and high inflation pushing drinkers into cheaper labels. Diageo wasn't ready for that -- in fact, it hiked prices in October -- and it lost share to other companies. Beer was weak elsewhere, too, and overall beer volumes for Diageo decreased by 12%.

What's more, Brown-Forman's net sales in emerging markets grew by 7% last quarter, as compared to the prior-year period. This included double-digit growth in China. Brewer Anheuser-Busch InBev also reported 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 14.8% year-to-date. This could indicate there's more going on than the luxury-goods crackdown that's dragging down sales in the Middle Kingdom.

The Foolish bottom line
Despite the weak half, Diageo believes it's well-positioned in the industry. Its broad range of products and price points can serve as a moat during hard times, when some drinkers are trading down, while still capturing the trade-up to premium and higher-level spirits by those who can afford it.

The past six months exposed some weaknesses, however. Diageo will need to fight to regain share in beer, and macroeconomic conditions could continue to work against it. It also faces growing competition in Asia and at the high end in the U.S. from Brown-Forman and Beam, which continue to introduce and grow premium whiskeys.

Is it time for Diageo to change its approach? Not radically, by any measure. But there are areas, particularly in addressing beer and soft sales in China, that require some rethinking and repositioning.

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