Diageo: The only way is up?

If Ivan Menezes wanted a theme song to accompany his presentation of Diageo’s latest annual results, he might have chosen the 1980s hit The Only Way is Up, so eager was he to present a positive outlook after a further mediocre year.

Menezes has been in the hot seat for just more than two years, in both of which the world’s largest premium spirits group has underperformed rivals such as Pernod Ricard on the back of China’s anti-austerity drive, faltering emerging markets and changing consumer preferences in the US, where vodka and Scotch have come under volume and price pressure from tequila and American whiskey.

2014-15 was flat for Diageo: organic sales growth was effectively unchanged, underperforming analysts’ consensus hopes of a very modest 0.2% gain. Operating profit was 3% ahead but in the key North American market organic volumes fell by 3% and net sales by 1%.

Overall pre-tax profits rose by 8.2% and Menezes stressed that the 9% increase in the dividend underlined the board’s confidence that the group is about to enter a stronger phase.

Menezes said that the “challenges” of the past year “do not diminish my confidence” in 2015/16 “and even more beyond that.” However, Diageo is entering a year of “transition” (i.e. marginal growth) before organic profit growth returns to the mid single digits from 2017 onwards. That pattern, Menezes says, “will be sustained” and operating margins will expand by 100 basis points over three years.

Effectively he was acknowledging that Diageo is trying to match the pace set by Pernod Ricard, which is expected to show organic growth of about 2% when it reports annual figures at the end of August, and LVMH, which recently announced strong figures for its Moet Hennessy arm for the past three months.

But Menezes’ optimism in the medium term up to 2020 is not without foundation. The second half of the 2014/15 financial year was stronger than the first. In addition, he has cleared the decks of some peripheral interests such as the Gleneagles Hotel and minority beer stakes in India and confirms that he could look at other non-core disposals, although Guinness remains a plank of the Diageo growth plan.

With £2bn of free cash flow from the latest trading year, he will be able to look at further potential investments but not in wine.

“Without getting into specifics you can expect us to be active managers of our portfolio,” he said. “Wine is small. It plays a role in the US right now, but it is not going to get bigger for us.” That comment will do nothing to reduce speculation that the US vineyards could be for sale.

By introducing greater balance between depletions and shipments and making the organisation more streamlined, Menezes reckons he can save a further £500m in operating costs, much of which will go to into marketing and other sales support. This will come on top of £200m of savings achieved over the past two years. He wants the company be the best at creating top line growth and to become the most efficient in the industry. Surprisingly he claims that it “is in the best shape that it has ever been in.”

“The actions we’ve taken in the last couple of years really give me the confidence the company is strong,” he said. “We can see the momentum building across our markets and categories.” For instance, he says Scotch sales are “healthy”.

He says his confidence is based on favourable demographics (more people in the developing world entering spirits consumption) and the global economy picking up. The US market, Diageo’s largest, is beginning to accelerate, including sales of the key driver brands such as Smirnoff, Crown Royal and Captain Morgan and globally “everywhere in our business the consumer is trading up, drinking better.”

Menezes believes that Diageo will capitalise on those factors through its size, its portfolio strengths and its changing emphasis on greater flexibility and awareness of trends, including brand innovation.

Diageo’s European market has returned to growth and China is showing positive trends, notably on baijiu, where sales have stabilised and are turning up. There are no prospects, however, of reviving plans for a new production plant for the Chinese spirit.

Organic sales growth in Africa last year was 8% and accelerating and India, where Diageo controls United Spirits, “is a fantastic asset” and already a £1bn a year business. And although the previous antics of colourful non-executive chairman VJ Mallya are an obvious irritation (“there is a process were are going through and that is all I will say”), the company is beginning to deliver under Diageo’s management.

Similarly, Menezes refuses to comment on the US stock market regulator’s “request for information” about potential pipeline stuffing to improve trading figures. He emphasises that “no allegations have been made” and that Diageo is complying fully with the process. And as former head of the US operation he sought to imply confidence that the official probe will come to nothing by saying that he was “proud” of Diageo’s “very high values and standards and rigorous controls”.

But despite Menezes’ determined enthusiasm, Diageo’s shares fell by more than 1% on the results, which were below expectations.

Investors and analysts were also little enthused by the medium-term projections, which were based largely on industry trends rather than specifics that will benefit Diageo more than others; being biggest does not automatically mean being the most successful.

While Menezes rightly did not want to reveal his hand to rivals, many analysts viewed his vision as a broad brush picture of what Diageo ought to achieve over the next few years rather than bankable promises. Question marks remain about whether they will be fully realised in the face of increasing competition from rivals aiming to capitalise on the same trends and opportunities.

While Menezes undoubtedly believes that better times lie ahead for Diageo, for the time being at least, the jury remains out.