The party has wound down at Diageo in the past year. Enthused about the spirits maker’s acquisition of Seagram Co.'s brands, its focus on core businesses and its powerful market position, investors giddily pushed the company’s shares more than 50 percent higher during chief executive Paul Walsh’s first two years on the job. But a less hospitable economic environment, slower growth prospects for several hot products and a profit warning early in 2003 have wiped out much of that gain. Any celebration of Walsh’s third anniversary as CEO, which occurs this month, will likely be somewhat somber.
The December 2001 Seagram deal sparked much of the initial euphoria. For $5 billion -- its share of an $8.15 billion joint purchase with French rival Pernod Ricard -- London-based Diageo got 60 percent of the Seagram liquor brands and boosted its U.S. market share from 16 percent to about 25 percent. Among the well-known names Diageo snagged: Captain Morgan rum and Crown Royal Canadian whiskey, which together with existing franchises Guinness stout, Johnnie Walker scotch and Smirnoff vodka gave the world’s biggest spirits maker ten of the world’s 20 top-selling alcoholic beverages. The Seagram additions have helped fatten profit margins to an estimated 21.9 percent from 18.1 percent in 2000.
While bulking up the liquor business, Walsh, 48, unloaded less lucrative food companies, selling Pillsbury Co. (which he formerly ran) to General Mills for $10.4 billion in 2000 and Burger King Corp. to private equity firm Texas Pacific Group for $1.5 billion in 2002.
However, Walsh’s more focused approach hasn’t insulated Diageo, which sells its products in 180 countries, from the effects of a sluggish global economy, severe acute respiratory syndrome and the falling dollar. Tumbling securities markets have forced Diageo to write down £120 million ($192 million) to start filling a £1.4 billion pension gap.
In the midst of these setbacks, Diageo had to acknowledge that growth rates and margins were flagging in “ready-to-drink” malt cocktails such as Smirnoff Ice, which contributed nearly 40 percent to its sales increase in 2002 but are now operating in a more mature marketplace.
Walsh, a pipefitter’s son raised in the working-class town of Royston, England, near Manchester, says the recent trials have “proved that Diageo, with its wide array of brands and clear global leadership, is a very resilient company.”
That said, Diageo hasn’t met his expectations. Walsh estimated that sales would grow 8 to 10 percent and profits more than 10 percent in the 2003 fiscal year ended June 30. But in February, Diageo said double-digit sales and profit growth would be unattainable. Excluding acquisitions and currency effects, analysts are now forecasting a 4 percent sales increase, to £9.2 billion, and a 6.2 percent rise in operating profit, to £2 billion, for the 2003 fiscal year. (Actual numbers were slated to be released September 4.)
“In the wake of the profit warning, investors are worried that Diageo might not be able to translate its size advantage into performance that’s better than smaller and currently faster-growing rivals like Pernod Ricard,” says Deutsche Bank analyst Graeme Eadie.
The amiable Walsh, a 21-year veteran of Diageo and its predecessors, possesses a strong financial and operating background. After graduating from Manchester Polytechnic in 1977 with a degree in accounting and economics (as a child he did quadratic equations for fun), he went to work as an accountant at Co-op Group, a local soft-drinks maker. In 1982 he joined the finance department at Watney, Mann and Truman Brewers, a division of Grand Metropolitan, which merged with Guinness in 1997 to form Diageo.
In 1987 Walsh, then Watney’s finance director, was appointed CFO of Grand Met’s Inter-Continental Hotels division, and he arranged its sale to Japan’s Seibu Saison Group in 1989. He also helped orchestrate the $5.7 billion hostile takeover of Pillsbury that same year, becoming CEO there in 1992. Concentrating on prominent, high-margin brands like Green Giant vegetables, Walsh helped boost Pillsbury’s sales by more than 80 percent and profits by more than 150 percent during his eight-year tenure.
Walsh recently spoke about the challenges ahead with Institutional Investor Staff Writer David Lanchner.
Institutional Investor: Do you expect this fiscal year to be any easier than the last one?
Walsh: There are reasons to think that sales and profit growth could improve, although I’m not willing to make a forecast, given the level of uncertainty in the world. Most importantly, there are signs that conditions are set for global economic recovery, perhaps in late 2003 or early 2004. We’ve seen interest rate cuts in the U.S. and the U.K., and there is pressure on the European Central Bank to reduce rates as well. We’ve also had a tax package in the U.S. Moreover, the world is operating on some of the lowest inventory levels that we’ve ever seen, so in my opinion, once a recovery starts, the impact will be more immediate and deeply felt than in the past. But we’ve clearly demonstrated that we can do well in very difficult economic situations. Despite what the world threw at us last year, we still grew our sales and our profit organically.
What continuing benefits do you expect to see from the Seagram deal?
We believe that the larger distribution network those brands benefit from now will continue to enhance their performance. So overall you can expect even better top-line performance from these brands. What’s more, we didn’t just get brands with Seagram, we also got some great people. There were certain skills Seagram had in areas where we were not as developed. While we were good at marketing, they were very good at sales and distribution management. Their contributions should help us improve our profit margins over the medium to long term.
Is it possible that your unfunded pension liabilities could increase?
That will happen if markets deteriorate further. But put our disclosures on the deficit into context: First of all, a lot of companies are in a similar situation but have not yet been as transparent as we have. That’s because we’ve adopted a new British accounting rule, FRS 17, even though it won’t officially come into effect until 2005. Under FRS 17, because bond yields are low, the discount rate we use is low, raising the net present value of our pension liability. That is matched against very low asset values, which are a consequence of the depressed stock market. If bond yields drift upward over the next three years and the stock market has a reasonable, even modest run, we’ll be wondering what the hullabaloo was all about. It’s also worth noting that given Diageo’s cash flow, we could fix the pension deficit in a year if we had to. We aren’t doing that, though, because if bond yields rise and equity markets improve, we’ll be left with a massive pension surplus, which the government will then tax.
Are you looking for further acquisitions in spirits?
Diageo and other [beverage] companies like Pernod Ricard and Allied Domecq are so big that their choices are very restricted in terms of what antitrust laws would permit. Equally, when you’ve got the quality of brands that we have, why would you want to go out and buy second-tier ones? I’d much rather put my management focus on growing the brands that we own than into acquiring brands that are not as good. Apart from relatively small, bolt-on acquisitions, I don’t see much we could realistically acquire in the spirits category.
What about other acquisitions?
We’ve always looked at wine because it’s a good long-term-growth category. But we haven’t done anything because we find it hard to make the numbers work. To put it simply, you buy the dirt, you plant the vine, you wait five years, you pick the grape, you put it in a bottle, and you store it for three years. That’s a long cash flow cycle, which means it’s hard to get a decent return on assets, given the prices vineyards currently sell at. There is a surplus situation developing in wine, however, which may bring prices down to more reasonable levels.
Should investors be braced for further weakness in the ready-to-drink sector?
On a global basis we are still seeing RTD products growing about 10 percent per year, and we are certainly not going back to the heady levels of two years ago, when growth was in the 30 to 40 percent range. In time the growth may drop to single digits, and the operating profit margin may come down from about 20 percent today to something closer to 16 or 17 percent, which is a beer-type margin.
If beer growth is flat, why not sell that off and focus on faster-growing spirits?
For both financial and commercial reasons, it makes sense to keep beer. It still has great cash flow and remains highly profitable. Also, when you think about our route to market, if we can offer bar and supermarket owners both beer and spirits, it’s a more attractive package for them, and so it ultimately gives us greater distribution for all our products.
