20-F 1 d211646d20f.htm 20-F 20-F

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 20-F

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: 30 June 2016

Commission file number 1-10691

DIAGEO plc

(Exact name of Registrant as specified in its charter)

England and Wales

(Jurisdiction of incorporation or organisation)

Lakeside Drive, Park Royal, London NW10 7HQ, England

(Address of principal executive offices)

David Harlock, Company Secretary

Tel: +44 20 8978 6000

E-mail: the.cosec@diageo.com

Lakeside Drive, Park Royal, London NW10 7HQ, England

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

American Depositary Shares

Ordinary shares of 28101/108 pence each

 

New York Stock Exchange

New York Stock Exchange(i)

2.875% Guaranteed Notes due 2022

8.000% Guaranteed Notes due 2022

7.450% Guaranteed Notes due 2035

4.250% Guaranteed Notes due 2042

 

New York Stock Exchange

New York Stock Exchange

New York Stock Exchange

New York Stock Exchange

(i) Not for trading, but only in connection with the registration of American Depositary Shares representing such ordinary shares, pursuant to the requirements of the Securities and Exchange Commission.

Securities registered or to be registered pursuant to Section 12(g) of the Act: None

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the Annual Report: 2,754,380,836 ordinary shares of 28101/108 pence each.


Indicate by check mark if each registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes x No ¨

If this report is an annual or transition report, indicate by check mark if each registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes ¨ No x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether each registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer x                             Accelerated Filer ¨                         Non-Accelerated Filer ¨

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

U.S. GAAP ¨    International Financial Reporting Standards
as issued by the International Accounting Standards Board x
   Other ¨

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow. Item 17 ¨ Item 18 ¨

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

This document comprises the annual report on Form 20-F and the annual report to shareholders for the year ended 30 June 2016 of Diageo plc (the 2016 Form 20-F).

 

 

 


Contents

 

5    Introduction
7    Recent trends
8    Historical information
12    Strategic report
12    Business description
12    Our business
17    Our global reach
18    Our brands
19    Breadth and depth across price points
20    Our strategy
21    Our business model
23    How we measure performance: key performance indicators
28    Chairman’s statement
32    Chief Executive’s statement
35    Market dynamics
38    How we will deliver our Performance Ambition
39    Risk factors
46    Cautionary statement concerning forward-looking statements
48    Business review
48    Operating results 2016 compared with 2015
80    Operating results 2015 compared with 2014
110    Liquidity and capital resources
112    Contractual obligations and commitments
112    Off-balance sheet arrangements
113    Risk management
113    Critical accounting policies
113    New accounting standards
114    Our role in society
133    Definitions and reconciliation of non-GAAP measures to GAAP measures
147    Governance
147    Board of Directors and Company Secretary

150

   Executive Committee
152    Corporate governance report
161    Report of the Audit Committee
165    Directors’ remuneration report
194    Directors’ report

 

3


Contents (continued)

 

197

   Financial statements

197

   Reports of independent registered public accounting firms

199

   Consolidated income statement

200

   Consolidated statement of comprehensive income

201

   Consolidated balance sheet

202

   Consolidated statement of changes in equity

203

   Consolidated statement of cash flows

204

   Notes to the consolidated financial statements

204

  

Accounting information and policies

207

  

Results for the year

224

  

Operating assets and liabilities

245

  

Risk management and capital structure

261

  

Other financial information

271

   Unaudited computation of ratio of earnings to fixed charges

272

   Additional information for shareholders

272

   Legal proceedings

272

   Related party transactions

272

   Share capital

273

   American depositary shares

274

   Articles of association

278

   Exchange controls

278

   Documents on display

279

   Taxation

282

   Warning to shareholders - share fraud

283

   Signature

284

   Exhibits

286

   Cross reference to Form 20-F

288

   Glossary of terms and US equivalents

 

4


Introduction

Diageo is the world’s leading premium drinks business. Its geographic breadth and range of industry leading brands across categories and price points is unparalleled.

Diageo plc is incorporated as a public limited company in England and Wales. Diageo was incorporated as Arthur Guinness Son and Company Limited on 21 October 1886. The group was formed by the merger of Grand Metropolitan Public Limited Company (GrandMet) and Guinness plc (the Guinness Group) in December 1997. Diageo plc’s principal executive office is located at Lakeside Drive, Park Royal, London NW10 7HQ and its telephone number is +44 (0) 20 8978 6000. Diageo plc’s agent for service of process in the United States is General Counsel, Diageo North America, Inc., 801 Main Avenue (6078-06), Norwalk, CT 06851.

This is the Annual Report on Form 20-F of Diageo plc for the year ended 30 June 2016. The information set out in this Form 20-F does not constitute Diageo plc’s statutory accounts under the UK Companies Acts for the years ended 30 June 2016, 2015 or 2014. PricewaterhouseCoopers LLP has reported on the accounts for the year ended 30 June 2016 and the group’s former auditors, KPMG LLP has reported on the accounts for the year ended 30 June 2015 and 2014; their respective audit reports were (i) unqualified, (ii) did not include a reference to any matters to which the auditors drew attention by way of emphasis without qualifying their report and (iii) did not contain a statement under section 498 (2) or (3) of the Companies Act 2006 in respect of the accounts for the years ended 30 June 2016, 2015 or 2014. The accounts for 2015 and 2014 have been delivered to the registrar of companies for England and Wales and those for 2016 will be delivered in due course.

This document contains forward-looking statements that involve risk and uncertainty. There are a number of factors that could cause actual results and developments to differ materially from those expressed or implied by these forward-looking statements, including factors beyond Diageo’s control. For more details, please refer to the cautionary statement concerning forward-looking statements on pages 46-47.

The content of the company’s website (www.diageo.com) or any other documents referred to herein should not be considered to form a part of or be incorporated into this report. This report includes names of Diageo’s products, which constitute trademarks or trade names which Diageo owns or which others own and license to Diageo for use. In this report, the term ‘company’ refers to Diageo plc and terms ‘group’ and ‘Diageo’ refer to the company and its consolidated subsidiaries, except as the context otherwise requires. A glossary of terms used in this report is included at the end of the report.

Diageo’s consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS) as endorsed and adopted for use in the European Union (EU) and IFRS as issued by the International Accounting Standards Board (IASB). References to IFRS hereafter should be construed as references to both IFRS as adopted by the EU and IFRS as issued by the IASB. Unless otherwise indicated, all financial information contained in this document has been prepared in accordance with IFRS.

Information presented

Organic movements and organic operating margins are before exceptional items. Share, unless otherwise stated, refers to value share. For a definition of organic movement and reconciliations of non-GAAP measures to GAAP measures see on page 133.

The brand ranking information presented in this report, when comparing information with competitors, reflects data published by sources such as IWSR, Impact Databank, Nielsen, Beverage Information Group and Plato Logic. Market data information and competitive set classifications are taken from independent industry sources in the markets in which Diageo operates.

Disclosures not incorporated by reference

The following pages and sections of the Annual Report of Diageo plc for the year ended 30 June 2016, are not incorporated by reference into this report on Form 20-F and are furnished to the United States Securities and Exchange Commission (SEC) for information only:

 

    Disclosures under the headings ‘Doing business the right way’ and ‘Our role in society’ in the section ‘Strategic Report – Our business’ on page 12.

 

5


Introduction (continued)

 

    Disclosures included under the titles ‘Number of responsible drinking programs (%)’, ‘Water withdrawals’ and ‘Carbon emissions’ in the section ‘Strategic Report – Our Global Reach – Diageo reports as five regions’ on page 17.
    Disclosures on pages 21 and 22 in the section ‘Strategic Report – Our business model’ under the sub-headings ‘Values’, ‘Our role in society’ and ‘Sustainability and responsibility priorities’.
    Disclosures on pages 25 and 27 in the section ‘Strategic Report – How we measure performance: key performance indicators’ of non-financial key performance indicators.
    Disclosures under the heading ‘Our role in society’ in the Chairman’s Statement on page 30.
    Disclosures under the heading ’ Our role in society’ in the Chief Executive’s statement on pages 33 and 34.
    Disclosures on pages 36 and 37 under the heading ‘Strategic Report – Market Dynamics – Earning the trust and respect which support performance’.
    Disclosures included under the heading ‘Strategic Report – How we will deliver our Performance Ambition – our three Sustainability and responsibility priorities’ on page 38.
    Disclosures included under the titles ‘Sustainability and responsibility’ on pages 61, 64, 68, 71, and 74 in relation to each reporting segment in the Business Review.
    Disclosures in the section ‘Strategic report – Our role in society’ on pages 114 to 132.

 

6


Recent trends

The following comments were made by Ivan Menezes, Chief Executive of Diageo, in Diageo’s preliminary results announcement on 28 July 2016:

“This is a good set of results delivering what we set out to achieve this time last year and demonstrating our momentum.

This better performance reflects the work we have done to strengthen our big brands through marketing and innovation, as well as expanding our distribution reach. Our six global brands and our US spirits business are all back in growth and we have seen a significant improvement in the performance of our scotch and beer portfolios. The delivery of volume growth; organic margin expansion; increased free cash flow; and the disposal of £1bn in non-core assets, comes from an everyday focus on efficiency in each aspect of our business. We have also made significant progress this year in our aim to improve the role of alcohol in society, partner with our communities and reduce our environmental impact.

These results position us well to deliver a stronger performance in F17. We are confident of achieving our objective of mid-single digit top line growth, and in the three years ending F19 delivering 100bps of organic operating margin improvement.”

 

7


Historical information

The following tables present selected consolidated financial data for Diageo for the five years ended 30 June 2016 and as at the respective year ends. The data presented below for the five years ended 30 June 2016 and the respective year ends has been derived from Diageo’s consolidated financial statements, audited by Diageo’s independent auditor. The group’s former auditors, KPMG LLP and its affiliates (KPMG) reported on the financial statements for the four years ended 30 June 2015.

 

                                                                                                             
Income statement data    Year ended 30 June  
     2016
£ million
    2015
£ million
    2014
£ million
    2013
£ million
    2012
£ million
 

Sales

     15,641        15,966        13,980        15,276        14,392   

Excise duties

     (5,156     (5,153     (3,722     (3,973     (3,753
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net sales

     10,485        10,813        10,258        11,303        10,639   

Cost of sales

     (4,251     (4,610     (4,029     (4,416     (4,208
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     6,234        6,203        6,229        6,887        6,431   

Marketing

     (1,562     (1,629     (1,620     (1,769     (1,671

Other operating expenses

     (1,831     (1,777     (1,902     (1,738     (1,652
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating profit

     2,841        2,797        2,707        3,380        3,108   

Non-operating items

     123        373        140        (83     147   

Net interest and other financial charges

     (327     (412     (388     (457     (441

Share of other tax results of associates and joint ventures

     221        175        252        217        229   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Profit before taxation

     2,858        2,933        2,711        3,057        3,043   

Taxation

     (496     (466     (447     (507     (1,011
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Profit from continuing operations

     2,362        2,467        2,264        2,550        2,032   

Discontinued operations

                   (83            (11
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Profit for the year

     2,362        2,467        2,181        2,550        2,021   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of shares

   million     million     million     million     million  

Shares in issue excluding own shares

     2,508        2,505        2,506        2,502        2,495   

Dilutive potential ordinary shares

     10        12        11        15        14   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     2,518        2,517        2,517        2,517        2,509   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Per share data

   pence     pence     pence     pence     pence  

Dividend per share

     59.2        56.4        51.7        47.4        43.5   

Earnings per share

          

Basic

          

Continuing operations

     89.5        95.0        93.0        98.0        76.6   

Discontinued operations

                   (3.3            (0.4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Basic earnings per share

     89.5        95.0        89.7        98.0        76.2   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

          

Continuing operations

     89.1        94.6        92.6        97.4        76.2   

Discontinued operations

                   (3.3            (0.4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted earnings per share

     89.1        94.6        89.3        97.4        75.8   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

8


Historical information (continued)

 

Balance sheet data

 

                                                                                                             
     As at 30 June  
     2016
£ million
    2015
£ million
    2014
£ million
    2013
£ million
    2012
£ million
 

Non-current assets

     19,639        18,134        15,495        16,481        15,098   

Current assets

     8,852        7,670        7,469        8,510        7,171   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

     28,491        25,804        22,964        24,991        22,269   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Current liabilities

     (6,187     (5,290     (4,851     (5,519     (4,762

Non-current liabilities

     (12,124     (11,258     (10,523     (11,384     (10,715
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

     (18,311     (16,548     (15,374     (16,903     (15,477
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net assets

     10,180        9,256        7,590        8,088        6,792   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Share capital

     797        797        797        797        797   

Share premium

     1,347        1,346        1,345        1,344        1,344   

Other reserves

     2,625        1,994        2,243        3,154        3,213   

Retained earnings

     3,761        3,634        2,438        1,741        234   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Equity attributable to equity shareholders of the parent company

     8,530        7,771        6,823        7,036        5,588   

Non-controlling interests

     1,650        1,485        767        1,052        1,204   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total equity

     10,180        9,256        7,590        8,088        6,792   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net borrowings

     (8,635     (9,527     (8,850     (8,403     (7,573
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Notes to the historical information

1. Accounting policies The consolidated financial statements for the five years ended 30 June 2016 have been prepared in accordance with IFRS. The IFRS accounting policies applied by the group to prepare the financial information in this document are disclosed in the notes to the consolidated financial statements.

 

9


Historical information (continued)

 

2. Exceptional items Exceptional items are those that in management’s judgement need to be disclosed by virtue of their size or nature. Such items are included within the income statement caption to which they relate, and are separately disclosed in the notes to the consolidated financial statements. An analysis of exceptional items is as follows:

 

                                                                                                             
     Year ended 30 June  
     2016
£ million
    2015
£ million
    2014
£ million
    2013
£ million
    2012
£ million
 

Items included in operating profit

          

Brand, goodwill and tangible asset impairment

     (118            (264     (50     (59

Restructuring programmes

            (82     (163     (69     (96

Duty settlements

            (146                     

Associate impairment

            (41                     

Pension changes – past service credits

                          20        115   

Disengagement agreements relating to United Spirits Limited

     (49                            
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     (167     (269     (427     (99     (40
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-operating items

          

Gains/(losses) on sale of businesses

     215        247               (83     23   

Step up gains

            156        140               124   

Other non-operating items

     (92     (30                     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     123        373        140        (83     147   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Items included in taxation

          

Tax credit on exceptional operating items

     7        51        99        27        19   

Tax on sale of businesses

     49                      28          

Loss of future tax amortisation

                                 (524
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     56        51        99        55        (505
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Exceptional items in continuing operations

     12        155        (188     (127     (398

Discontinued operations net of taxation (note 3)

                   (83            (11
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Exceptional items

     12        155        (271     (127     (409
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

3. Discontinued operations in the year ended 30 June 2014 comprised a charge after taxation of £83 million (£91 million less tax of £8 million) (2012 - £16 million less deferred tax of £5 million) in respect of the settlement of thalidomide litigation in Australia and New Zealand and anticipated future payments to thalidomide organisations.

4. Dividends The Board expects that Diageo will pay an interim dividend in April and a final dividend in October of each year. Approximately 40% of the total dividend in respect of any financial year is expected to be paid as an interim dividend and approximately 60% as a final dividend. The payment of any future dividends, subject to shareholder approval, will depend upon Diageo’s earnings, financial condition and such other factors as the Board deems relevant. Proposed dividends are not considered to be a liability until they are approved by the Board for the interim dividend and by the shareholders at the annual general meeting for the final dividend.

The table below sets out the amounts of interim, final and total cash dividends paid by the company on each ordinary share. The dividends are translated into US dollars per ADS (each ADS representing four ordinary shares) at the actual rate on each of the respective dividend payment dates.

 

                                                                                                                                   
            Year ended 30 June  
            2016      2015      2014      2013      2012  
            pence      pence      pence      pence      pence  

Per ordinary share

     Interim         22.60         21.50         19.70         18.10         16.60   
     Final         36.60         34.90         32.00         29.30         26.90   
     

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     Total         59.20         56.40         51.70         47.40         43.50   
     

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
            $      $      $      $      $  

Per ADS

     Interim         1.27         1.28         1.31         1.10         1.05   
     Final         1.95         2.14         2.06         1.89         1.72   
     

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     Total         3.22         3.42         3.37         2.99         2.77   
     

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

10


Historical information (continued)

 

Note: Subject to shareholders’ approval the final dividend for the year ended 30 June 2016 will be paid on 6 October 2016, and payment to US ADR holders will be made on 12 October 2016. In the table above, an exchange rate of £1 = $1.33 has been assumed for this dividend, but the exact amount of the payment to US ADR holders will be determined by the rate of exchange on 6 October 2016.

5. Net borrowings Net borrowings are defined as gross borrowings (short term borrowings and long term borrowings plus finance lease liabilities plus interest rate hedging instruments, cross currency interest rate swaps and funding foreign currency forwards and swaps used to manage borrowings) less cash and cash equivalents.

6. Share capital There were 2,754 million ordinary share of 28 101108 pence each in issue with a nominal value of £797 million throughout the five year period ended 30 June 2016.

7. Exchange rates A substantial portion of the group’s assets, liabilities, revenues and expenses are denominated in currencies other than sterling. For a discussion of the impact of exchange rate fluctuations on the group’s financial position and results of operations, see note 15 to the consolidated financial statements.

The following table shows year end and average US dollar/pound sterling noon buying exchange rates, for the periods indicated, expressed in US dollars per £1.

 

                                                                                                             
     Year ended 30 June  
     2016
$
     2015
$
     2014
$
     2013
$
     2012
$
 

Year end

     1.32         1.57         1.71         1.52         1.57   

Average rate(i)

     1.47         1.57         1.64         1.57         1.59   

 

 

(i)  The average of the noon buying rates on the last business day of each month during the year ended 30 June.

The following table shows period end, high, low and average US dollar/pound sterling noon buying exchange rates by month, for the six month period to 31 July 2016, expressed in US dollars per £1.

 

                                                                                                                                   
    2016  
    July      June      May      April      March      February  
    $      $      $      $      $      $  

Month end

    1.33         1.32         1.45         1.46         1.44         1.39   

Month high

    1.33         1.48         1.47         1.46         1.45         1.46   

Month low

    1.29         1.32         1.44         1.41         1.39         1.39   

Average rate(i)

    1.31         1.42         1.45         1.43         1.42         1.43   

 

 

(i)  The average of the noon buying rates on each business day of the month.

 

     The noon buying exchange rate as at 29 July 2016 was £1 = $1.33.

These rates have been provided for information only. They are not necessarily the rates that have been used in this document for currency translations or in the preparation of the consolidated financial statements. See note 1 to the consolidated financial statements for the actual rates used in the preparation of the consolidated financial statements.

 

11


Strategic report

Business description

OUR BUSINESS

Diageo is a global leader in beverage alcohol with iconic brands across spirits and beer. We truly understand the consumer and have world-class marketing and innovation skills to build powerful brands that play a positive role in society.

Diageo has built a strong platform for growth. We have grown through investment in our brands, and by acquisition to broaden our geographical footprint and category depth and range.

Our 21 market model(i) has established strong local business units, well positioned to win in increasingly competitive and fast paced operating environments.

We want to make a positive contribution – to society, to communities, to individuals, and to the environment – while continuing to prosper as a business. We actively create the shared value that is part of our heritage, and essential to our future.

Strength through global reach and iconic brands

We build global brands alongside local stars. These brands have broad consumer appeal across geographies to meet demand now and in the future.

Doing business the right way

For us, standards are everything, from how we produce and market our brands, to how we innovate and sell, and in governance and ethics as codified in our Code of Business Conduct.

 

We produce

  

We innovate

  

We market

  

We sell

We produce our brands from more than 150 sites in around 30 countries. We are committed to efficient, sustainable production to the highest quality standards. Our export-led International Supply Centre (ISC) employs over 4,000 people across more than 55 sites in Scotland, England, Ireland, Italy and the Netherlands.    Innovation is a mindset driving everything we do and an important growth engine for our business. We combine our world-leading technical and research capability with investments in smaller start-ups. We partner with entrepreneurs to actively experiment in digital technology, new business models and partnerships to solve business issues and unlock new opportunities.    For decades our brands have been at the forefront of marketing innovation and the same remains true today. We invest in world-class marketing to build our brands, focused on programmes which recruit and re-recruit consumers. We take our obligations to market responsibly and help consumers make informed decisions seriously.    Everyone at Diageo sells or understands how they can help sell. This is just one expression of the sales-led organisation we are building. We work to extend our sales reach by ensuring our products are available where people want them and by delivering memorable consumer experiences.

Our role in society

Everywhere we operate, we set out to have a positive impact on the world around us. Doing so is good for our business, for our communities and for our consumers.

At the core of our approach is a commitment to create a positive role for alcohol in society. This is fundamental to our purpose – celebrating life, every day, everywhere. We are also committed to tackling alcohol misuse through effective programmes that prevent and reduce alcohol misuse, and work with others to raise awareness and change people’s attitudes and behaviour. We market our products responsibly and provide the information consumers need to make informed decisions.

Our distilleries and breweries are at the very heart of the communities in which we work, which gives us an opportunity to create shared value. To do this, we work hard to increase access to opportunity through: enabling entrepreneurship, employability and skills; improving access to clean water, sanitation and hygiene; and helping to empower women.

By reducing carbon packaging, water and waste now, we are reducing our environmental impact to support future opportunities.

 

(i) Throughout this Annual Report 2016, reference to Diageo’s 21 geographically based markets are stated as ‘21 markets’.

 

12


Business description (continued)

 

Production

Diageo owns manufacturing production facilities across the globe, including maltings, distilleries, breweries, packaging plants, maturation warehouses, cooperages and distribution warehouses. Diageo’s brands are also produced at plants owned and operated by third parties and joint ventures at a number of locations internationally.

Diageo has been investing over the last few years in a number of restructuring programmes to increase the efficiency of its supply operations. This has resulted in improvements and changes in the group’s supply operations principally in North America, Scotland and Ireland.

The locations, principal activities, products, packaging production capacity and packaging production volume of Diageo’s principal production centres in the year ended 30 June 2016 were as follows:

 

Location

  

Principal products

       Production
capacity in
millions of
equivalent
units (i)
     Production
    volume in 2016
in

millions of
equivalent units
 
United Kingdom (Spirits)    Scotch whisky, gin, vodka, rum, ready to drink      96         52   
UK, Ireland (Guinness)    Beer      8         7   
Ireland (Baileys)    Irish cream liqueur      12         7   
Italy (Santa Vittoria)    Vodka, wine, rum, ready to drink      11         4   
Turkey    Raki, vodka, gin, liqueur, wine      8         6   
United States, Canada, US Virgin Islands    Vodka, gin, tequila, rum, Canadian whisky, American whiskey, progressive adult beverages, ready to drink      43         34   
Brazil    Cachaça, vodka      11         8   
Mexico    Tequila      1         1   
Australia    Rum, vodka, ready to drink      4         2   
Singapore    Finishing centre      7         1   
India    Rum, vodka, whisky, scotch, brandy, gin, wine      160         111   
Nigeria    Beer      7         5   
South Africa    Beer, spirits and ready to drink      8         6   
East Africa (Uganda, Kenya, Tanzania)    Beer and spirits      13         11   
Africa Regional Markets (Ethiopia, Cameroon, Ghana, Seychelles)    Beer      7         4   

 

(i) Capacity represents ongoing production capacity. The production capacities quoted in the table are based on actual production levels for the year ended 30 June 2016 adjusted for the elimination of unplanned losses and inefficiencies. On 7 October 2015 the group disposed of its brewing operations in Jamaica and Singapore and Malysia. On 1 January 2016 Diageo disposed of its wine operations in the United States. The figures above exclude the production capacity and volume for these operations.

Spirits

Spirits are produced in distilleries located worldwide. The group owns 29 Scotch whisky distilleries in Scotland, two whisky distilleries in Canada and one whiskey distillery in the United States. Diageo produces Smirnoff internationally. Ketel One and Cîroc vodkas are purchased as finished product from The Nolet Group and Eurowinegate, respectively. Gin distilleries are located in both the United Kingdom and the United States. Baileys is produced in the Republic of Ireland and Northern Ireland. Rum is blended and bottled in the United States, Canada, Italy and the United Kingdom, and is distilled and blended in the US Virgin Islands and in Australia, Venezuela and Guatemala. Raki is produced in Turkey, Chinese spirits are produced in Chengdu, in the Sichuan province of China, cachaça is produced in Ceará State in Brazil and Don Julio tequila in Mexico.

 

13


Business description (continued)

 

Diageo’s maturing Scotch whisky is located in warehouses in Scotland (the largest at Blackgrange holding approximately 50% of the group’s maturing Scotch whisky), its maturing Canadian whisky in La Salle and Gimli in Canada and its maturing American whiskey in Kentucky and Tennessee in the United States. In May 2014 the company announced its intention to invest approximately $115 million (£86 million) over three years to build a distillery and six barrel storage warehouses in Shelby County, Kentucky. The new distillery is expected to be in operation by the end of calendar year 2016.

In June 2012, the company announced a multi-year investment plan in Scotch whisky production and inventory and has spent approximately £1 billion to date. The investment program was completed in the year ended 30 June 2016. Investments made during the year ended 30 June 2016 in Clynelish and increases in warehousing capacity to support distilling and maturing activities are intended to provide for long term Scotch sales growth.

Diageo owns a controlling equity stake in United Spirits Limited (USL) which is the leading alcoholic beverage company in India selling over 90 million equivalent cases of Indian-Made Foreign Liquor (IMFL). USL has a significant market presence across India and operates 26 owned, 17 leased and 39 third party manufacturing facilities in India and Nepal. USL also operates spirit distillation plants for neutral alcohol, malt spirit, grape spirit and rum spirit with accompanying maturation facilities. USL has many leading Indian brands such as McDowell’s (Indian whisky, rum and brandy), Black Dog (scotch), Signature (Indian whisky), Antiquity (Indian whisky) and Bagpiper (Indian whisky).

Beer

Diageo’s principal brewing facility is at the St James’s Gate brewery in Dublin where the capacity was recently expanded to brew all beers sold in Europe and for global exports in particular to the United States. Diageo has breweries in a number of African countries: Nigeria, Kenya, Ghana, Cameroon, Ethiopia, Tanzania, Uganda and the Seychelles.

On 1 December 2015, Diageo disposed of its 25% equity stake in Sedibeng Brewery (Pty) Limited, which owned a brewery in South Africa. On 7 October 2015, Diageo also completed the disposal of its 57.87% shareholding in Desnoes & Geddes (Jamaican Red Stripe business) and its 49.99% stake in GAPL Pte Limited (Singapore and Malaysian beer business) to Heineken. GAPL owns 51% of Guinness Anchor Berhad, operating in Malaysia, which was also disposed of.

Guinness is brewed by over 50 third parties around the world under licence arrangements. Guinness flavour extract is shipped from Ireland to all overseas Guinness brewing operations which use the flavour extract to brew Guinness locally. Guinness Draught in cans and bottles is packaged at Runcorn and Belfast in the United Kingdom. The Runcorn facility performs the kegging of Guinness Draught which is transported to Great Britain in bulk.

Ready to drink

Diageo produces a range of ready to drink products mainly in the United Kingdom, Italy, South Africa, Australia, the United States and Canada.

Property, plant and equipment

Diageo owns approximately 95% of the manufacturing, distilling, brewing, bottling and administration facilities it uses across the group’s worldwide operations. It holds approximately 3% of properties on leases in excess of 50 years. The principal production facilities are described above. As at 30 June 2016, Diageo’s land and buildings are included in the group’s consolidated balance sheet at a net book value of £1,083 million. Diageo’s two largest individual facilities, in terms of book value, are the Leven bottling, blending and warehousing facility in Scotland and St James’s Gate brewery in Dublin. Approximately 38% of the net book value of Diageo’s land and buildings are properties located in Great Britain, 14% in India, and 12% both in the United States and Ireland.

 

14


Business description (continued)

 

Raw materials and supply agreements

The group has a number of long term contracts in place for the purchase of raw materials including glass, other packaging, spirit, cream, rum and grapes. Forward contracts are in place for the purchase of cereals to minimise the effects of short term price fluctuations.

Cream is the principal raw material used in the production of Irish cream liqueur and is sourced from Ireland. Grapes are used in the production of raki and are sourced from suppliers in Turkey. Other raw materials purchased in significant quantities for the production of spirits and beer are molasses, cereals, sugar and a number of flavours (such as juniper berries, agave, aniseed, chocolate and herbs). These are sourced from suppliers around the world.

The majority of products are supplied to customers in glass bottles. Glass is purchased from a variety of multinational and local suppliers; the largest suppliers are Ardagh Packaging in the United Kingdom and Owens Illinois in the United States.

Competition

Diageo’s brands compete on the basis of consumer loyalty, quality and price.

In spirits, Diageo’s major global competitors are Pernod Ricard, Beam Suntory, Bacardi and Brown Forman, each of which has several brands that compete directly with Diageo’s brands. In addition, Diageo faces competition from local and regional companies in the countries in which it operates.

In beer, Diageo competes globally as well as on a regional and local basis (with the profile varying between regions) with several competitors, including AB InBev, Heineken, SABMiller, Molson Coors and Carlsberg.

Research and development

Innovation forms an important part of Diageo’s growth strategy, playing a key role in positioning its brands for continued growth in both the developed and emerging markets. The strength and depth of Diageo’s brand range provides a solid platform from which to drive innovation. Diageo continuously invests to deepen its understanding of shopper trends and changing consumer habits to inform product and packaging development. Supporting this, the group has ongoing programmes to develop new products across beverage alcohol categories which are managed internally by the innovation and research and development function, which also takes advantage of a substantial open innovation network.

In the year ended 30 June 2016, the group’s research and development expenditure amounted to £28 million (2015 — £26 million; 2014 — £24 million), representing principally the cost of developing new products, from idea generation through to full product development. Research and development expenditure is generally written off in the year in which it is incurred.

Trademarks

Diageo produces, sells and distributes branded goods and is therefore substantially dependent on the maintenance and protection of its trademarks. All brand names mentioned in this document are trademarks. The group also holds numerous licences and trade secrets, as well as having substantial trade knowledge related to its products. The group believes that its significant trademarks are registered and/or otherwise protected (insofar as legal protection is available) in all material respects in its most important markets. Diageo also owns valuable patents and trade secrets for technology and takes all reasonable steps to protect these rights.

Regulations and taxes

Diageo’s worldwide operations are subject to extensive regulatory requirements regarding production, product liability, distribution, importation, marketing, promotion, sales, pricing, labelling, packaging, advertising, labour, pensions, compliance and control systems and environmental issues. In the United States, the beverage alcohol industry is subject to strict federal and state government regulations. At the federal level, the Alcohol and Tobacco Tax and Trade Bureau of the U.S. Treasury Department oversees the industry, and each state as well as some local authorities in jurisdictions in which Diageo sells or produces products, have regulations. Federal, state and local regulations cover virtually every aspect of its operations, including production, distribution, marketing, promotion, sales, pricing, labelling, packaging and advertising.

 

 

15


Business description (continued)

 

Spirits, beer and wine are subject to national import and excise duties in many markets around the world. Most countries impose excise duties on beverage alcohol products, although the form of such taxation varies significantly from a simple application to units of alcohol by volume, to advanced systems based on imported or wholesale value of the product. Several countries impose additional import duty on distilled spirits, often discriminating between categories (such as Scotch whisky or bourbon) in the rate of such tariffs. Within the European Union, such products are subject to different rates of excise duty in each country, but within an overall European Union framework, there are minimum rates of excise duties that can be applied.

Import and excise duties can have a significant impact on the final pricing of Diageo’s products to consumers. These duties have an impact on the competitive position as compared to other brands. The group devotes resources to encouraging the equitable taxation treatment of all beverage alcohol categories and to reducing government-imposed barriers to fair trading.

Advertising, marketing and sales of alcohol are subject to various restrictions in markets around the world. These range from a complete prohibition of alcohol in certain cultures and countries, such as in certain states in India, and through the prohibition of the import of spirits, wine and beer, to restrictions on the advertising style, media and messages used. In a number of countries, television is a prohibited medium for spirits brands and in other countries, television advertising, while permitted, is carefully regulated. Many countries also regulate the use of internet-based advertising and social media in connection with alcohol sales.

Spirits, beer and wine are also regulated in distribution. In many countries, alcohol may only be sold through licensed outlets, both on and off trade, varying from government or state operated monopoly outlets (for example, Canada, Norway and certain US states) to the common system of licensed on trade outlets (for example, licensed bars and restaurants) which prevails in much of the Western world (for example, most US states and the European Union). In about one-third of the states in the United States, price changes must be filed or published 30 days to three months, depending on the state, before they become effective.

Labelling of beverage alcohol products is also regulated in many markets, varying from health warning labels to importer identification, alcohol strength and other consumer information. As well as producer, importer or bottler identification, specific warning statements related to the risks of drinking beverage alcohol products are required to be included on all beverage alcohol products sold in the United States and in other countries where Diageo operates. Expressions of political concern signify the uncertain future of beverage alcohol products advertising on network television in the United States. Any prohibitions on advertising or marketing could have an adverse impact on sales of the group.

Regulatory decisions and changes in the legal and regulatory environment could increase Diageo’s costs and liabilities or impact on its business activities.

Acquisitions and disposals

Diageo has disposed of its wines and certain beer assets in the year ended 30 June 2016. For a description of principal acquisitions and disposals since 1 July 2013, see note 9 to the consolidated financial statements.

Seasonality

Approximately 40% of Diageo’s annual net sales occur in the last four months of each calendar year.

 

16


Business description (continued)

 

OUR GLOBAL REACH

Diageo is the leading spirits player in every region of the world. This regional profile provides us with exposure to the greatest consumer growth opportunities in our sector. We operate as 21 geographically based markets around the world and have a presence in over 180 countries. We employ more than 32,000 talented people across our global business.

 

LOGO

Diageo reports as five regions

 

                                                                                              
    North America     Europe, Russia
and Turkey
    Africa     Latin America
and Caribbean
    Asia
Pacific
 
% Share by region          
Volume (%)     19.1        17.8        12.7        8.4        42.0   
Net sales(i) (%)     34.1        24.3        13.4        8.3        19.9   
Operating profit before exceptional items(ii) (%)     49.1        25.4        6.7        6.3        12.5   
Operating profit(iii) (%)     51.8        26.8        7.1        2.7        11.6   
Number of responsible drinking programmes (%)     21.2        25.4        15.6        15.7        22.1   
Water withdrawals(iv) (%)     10.0        38.2        37.8        1.8        12.2   
Carbon emissions(iv) (%)     6.7        42.7        37.4        2.3        10.9   

Number of employees(v) (%)

    9.0        33.5        16.5        9.8        31.2   

 

(i) Does not include corporate net sales of £36 million. (ii) Excluding exceptional operating charges of £167 million (2015 – £269 million) and corporate and ISC costs before exceptional items of £150 million (2015 – £123 million). (iii) Excluding corporate and ISC costs of £150 million (2015 – £139 million). (iv) Excludes corporate offices which account for <2% of combined impacts. (v) Employees have been allocated to the region in which they reside. Most people who work on behalf of Diageo are employed by Diageo, although, we also employ fixed term or temporary employees. In 2016 we hired 1,386 fixed-term or temporary employees. We have a strong commitment to dialogue, and in 2016, 46% of our employees were covered by collective bargaining agreements. Diageo aims to maintain regular, open dialogue with unions over issues of common interest.

 

17


Business description (continued)

 

OUR BRANDS

Our global reach is matched by our broad portfolio of international and local brands. We own the top two largest spirits brands in the world, Johnnie Walker and Smirnoff, and 20 of the world’s top 100 spirits brands.

Our portfolio spans consumer drinking occasions. Using local market insights, our teams are able to select the most relevant brands from our global portfolio to meet the consumer opportunity in their market. All of our marketing activities adhere to the Diageo Marketing Code to ensure our brands are marketed responsibly. A selection of our brands are included in the table below.

 

Global giants(i)

Our business is anchored around our six biggest global brands.

Johnnie Walker    Smirnoff    Captain Morgan    Baileys    Tanqueray    Guinness

Local stars

  

Reserve

Can be individual to any one market, and provide a platform for our business to grow.

   Exceptional spirits brands at above-premium price points to capture the global luxury opportunity.
Crown Royal    Yenì Raki    JeB    Johnnie Walker Blue Label    Johnnie Walker Gold Label Reserve   

Johnnie Walker

King George V

Buchanan’s    Windsor    Grand Old Parr    Private Collection    Lagavulin    The Singleton of Glen Ord
Bundaberg    Bell’s    McDowell’s No. 1    Cîroc    Ketel One vodka    Tanqueray No. TEN
Ypióca    Cacique    Shui Jing Fang    Ron Zacapa Centenario XO    Tequila Reserva de Don Juilo    Bulleit Bourbon

Source: Impact Databank Value Ratings, May 2016. (i) Global giants represent 40% of Diageo net sales.

 

18


Business description (continued)

 

BREADTH AND DEPTH ACROSS PRICE POINTS

Our portfolio, well diversified across price tiers, enables us to participate where the consumer opportunity is greatest, and to capture shifts in consumer preference.

We hold strong positions across all key international spirits categories to serve consumer occasions and price points with our brands. Our most strategically important category is scotch. We have also established footholds in key emerging markets through participation in local spirits categories: raki in Turkey, cachaça in Brazil, local whisky in India, and a small position in the baiju category in China.

 

    

Ultra premium

  

Super premium

  

Premium

  

Standard

  

Value

Scotch whisky   

Johnnie Walker

Blue Label

  

The Singleton of

Glen Ord

  

Buchanan’s

  

Johnnie Walker

Red Label

   VAT 69
North American whisk(e)y    Crown Royal Extra Rare    Bulleit Bourbon    Crown Royal    Seagram’s 7 Crown   
Vodka    Cîroc    Ketel One vodka    Smirnoff Sourced    Smirnoff    Istanblue
Rum   

Ron Zacapa

Centenario XO

  

Pampero

Aniversario Ron Extra Añejo

  

Captain Morgan

Private Stock

   Captain Morgan   
Liqueur          Sheridan’s Original Layered Liqueur    Baileys    Emmets
Tequila    Tequila Reserva de Don Juilo    Peligroso Tequila         
Gin    Tanqueray No. TEN    Jinzu    Tanqueray    Gordon’s    Gilbey’s
Local spirits    Shui Jing Fang       Yenì Raki    Ypióca   

McDowell’s

No. 1

Beer       Kilkenny    Guinness    Tusker Finest Quality Lager    Dubic Extra Lager

 

19


Business description (continued)

 

OUR STRATEGY

We pursue the following strategy to deliver our Performance Ambition:

We aim to grow our participation in international premium spirits, driven by growth in both populations and incomes, and the increasing penetration of spirits in emerging markets. To support this, we participate in both beer and mainstream spirits selectively to deliver organisational scale and distribution reach, and to shape responsible drinking trends in markets where international premium spirits is an emerging category.

Our intent is to build breadth and depth across drinking occasions by shaping consumer demand for our international premium spirits brands. In developed markets our strategy is to drive premiumisation through spirits price tiers up to our reserve portfolio. In emerging markets our strategy is to develop from an import-based premium spirits model to become a local player where appropriate, participating in categories that give us the scale and access to the fast growing middle-class consumer. Everywhere we operate, we do so in a responsible and sustainable way.

 

Prioritised investment in:    Targeted investment in:
Premium core spirits(i)    Reserve    Mainstream spirits(i)    Beer
The brands at the core of our business that provide both scale and strong margin contribution.    Exceptional spirits brands at above-premium price points to capture the global luxury opportunity.    Spirits-based brands priced at a similar amount per serve to mainstream beer or local spirits that enable us to shape local spirits consumption.    Provides local scale and route to consumer, with focused participation in markets where we have leadership positions.

 

    Outcomes of our strategy     
  ① Efficient growth    ③ Credibility and trust   
  ② Consistent value creation    ④ Motivated people   

 

We measure progress against our strategy using the following financial and non-financial indicators:
Organic net sales growth ①    Return on average    Reach and impact of    Health and safety ③ ④
Organic operating margin    invested capital ②    responsible drinking    Employee
improvement ①    Total shareholder return ②    programmes ③ ④    engagement index ③ ④
Earnings per share before         Water efficiency ① ③     
exceptional items ①       Carbon emissions ① ③     
Free cash flow ①               

See our key performance indicators (KPIs) pages: 23–27.

 

(i) Spirits include ready to drinks (RTDs).

 

20


Business description (continued)

 

OUR BUSINESS MODEL

From our position as a global leader, we deliver returns for shareholders, while creating value for our customers and employees. In everything we do, we set out to make a positive contribution to society.

We have structured our organisation into a 21 market business model, applying country-specific strategies to meet local consumer and customer needs. This business model enables us to identify and execute against the most valuable growth opportunities, and also to supply our brands efficiently and effectively using our global expertise, while sourcing and producing locally where optimal to do so. This market-driven business model helps us to capture consumer trends early to deliver sustainable performance.

 

Global leader    Agile business model    Focused on:
Broad portfolio    21 markets    Performance drivers
Global reach   

Consumer insights

   Read more: page 38.
Financial strength   

Participation strategy

   Sustainability and responsibility
Efficient supply and procurement   

Supply resources

   priorities
Leading capabilities    Global functions    Read more: page 38
Values          
Our role in society          
Broad portfolio: we have world-leading brands across categories and price points.    Consumer insights: in-market consumer insight teams are able to identify trends more accurately and quickly, delivering more locally relevant solutions.   

Performance drivers: we have identified six performance drivers which are key to improving

execution and achieving our aims: premium core brands; reserve; innovation; route to consumer; cost and productivity; and talent. Each market focuses on the priorities that will drive performance in that market.

Global reach: we have global reach through

the breadth and depth of our global and local brands.

   Participation strategy: flexibility to select the best portfolio of brands that capture the unique consumer opportunity that exists in each specific market and then to invest directly against the largest identified growth opportunities. Each market is able to deploy a customised combination of global and local brands to provide brand price tier coverage that is best suited to its specific consumer needs.    Sustainability and responsibility priorities: every business decision, every operation, and every programme and initiative must work towards our three sustainability and responsibility priorities: creating a positive role for alcohol in society; building thriving communities; and reducing our environmental impacts.
Financial strength: our competitive advantage is reflected by our strong financial returns and consistent financial performance.   

Supply resources: our 21 markets are

designated as import markets, import and

third party production markets, or import

and local production markets. Where we have dedicated in-market supply resource it increases the speed with which we can respond to local consumer demand and helps to protect our supply chain from political and economic volatility.

   Our performance drivers and sustainability and responsibility priorities are underpinned by our commitment to the highest standards of governance and ethics.

Efficient supply and procurement: across

the world we have efficiency in supply and procurement, with high-quality manufacturing operations and environmental standards.

  

Global functions: our 21 markets are

supported by a global structure and shared services designed to leverage scale, drive efficiency, share best practice, impart knowledge and help build capability at a local level, as well as apply governance of controls, compliance and ethics.

    

 

21


Business description (continued)

 

Leading capabilities: our focus is on brilliant execution including cutting-edge consumer insights and marketing, scalable innovation, and winning relationships with our customers through distribution and sales.          
Values: at the heart of everything we do are our company values: passionate about customers and consumers; be the best; freedom to succeed; proud of what we do; valuing each other.          
Our role in society: we are passionate about ensuring alcohol continues to play a positive role in society, and are committed to playing our part in tackling alcohol misuse.          

 

22


Business description (continued)

 

HOW WE MEASURE PERFORMANCE: Key performance indicators

GAAP measures - Financial GAAP performance measures similar to the financial non-GAAP key performance indicators are presented below.

 

NET SALES GROWTH (%)    OPERATING MARGIN IMPROVEMENT (BPS)    BASIC EARNINGS PER SHARE (PENCE)
LOGO    LOGO    LOGO
Net sales growth (%) 2016 (3.0) 2015 5.4 2014 (9.2)    Operating margin improvement (BPS) 2016 123 2015 (52) 2014 (351)    Basic earnings per share 2016 89.5 2015 95.0 2014 89.7
Definition    Definition    Definition
Sales growth after deducting excise duties.    The percentage point movement in operating profit, divided by net sales.    Profit attributable to equity shareholders of the parent company, divided by the weighted average number of shares in issue.
Performance    Performance    Performance
Net sales declined by 3% due to disposals and adverse exchange, partially offset by organic growth and acquisitions.    Operating margin improved by 123bps mainly driven by lower exceptional operating charges.    Basic eps of 89.5 pence reduced by 5.5 pence principally due to the change in net exceptional charges from a charge of £44 millon in the year ended 30 June 2016 compared with a net gain of £104 million in the year ended 30 June 2015.

 

NET CASH FROM OPERATING
ACTIVITIES (£ MILLION)
   RETURN ON CLOSING INVESTED
CAPITAL (%)
    
   
LOGO    LOGO   
Net cash from operating activities (£ million) 2016 2,548 2015 2,551 2014 1,790    Return on closing invested capital 2016 23.2 2015 26.7 2014 28.7   
   

Definition

Net cash from operating activities comprises the net cash flow from operating activities as disclosed on the face of the cash flow statement.

  

Definition

Profit for the year divided by net assets at the end of the financial year.

  

Performance

Net cash from operating activities was flat. Adverse movements in working capital and translation exchange were offset by higher operating profit.

  

Performance

Return on closing invested capital decreased by 350bps due to the increase in net assets driven by the weakening of sterling, partially offset by an increase in post employment liabilities.

  

 

23


Business description (continued)

 

We use the following 11 key performance indicators (KPIs) to measure our financial and non-financial performance.

They measure progress against our strategy and our performance against our KPIs are explained below:

Relevance to strategy

#1  Efficient growth

#2  Consistent value creation

#3  Credibility and trust

#4  Motivated people

 

Financial ®               Financial ®               Financial ®           
Organic net sales growth (%) #1    Organic operating margin improvement (bps) #1    Earnings per share before exceptional items (pence)(i) #1
LOGO    LOGO    LOGO
Definition    Definition    Definition
Sales growth after deducting excise duties, excluding the impact of exchange rate movements, acquisitions and disposals.    The percentage point movement in operating profit before exceptional items, divided by net sales after excluding the impact of exchange rate movements and acquisitions and disposals.    Profit before exceptional items attributable to equity shareholders of the parent company, divided by the weighted average number of shares in issue.

Why we measure

This measure reflects our performance as the result of the choices made in terms of category and market participation, and Diageo’s ability to build brand equity, increase prices and grow market share.

  

Why we measure

The movement in operating margin measures the efficiency of the business. Consistent operating margin improvement is a business imperative, driven by investment choices, our focus on driving out costs across the business and improving mix.

  

Why we measure

Earnings per share reflects the profitability of the business and how effectively we finance our balance sheet. It is a key measure for our shareholders.

Performance

Volume growth of 1.3% driven by North America and Europe combined with positive price/mix, primarily mix effect resulted in an organic net sales growth of 2.8%.

  

Performance

Organic operating margin improvement was driven by favourable mix effect which helped gross margin increase combined with procurement efficiencies in marketing activity offset by higher overheads.

  

Performance

Earnings per share before exceptional items increased 0.6 pence largely driven by operating profit growth, higher associate income and lower finance charges partially offset by adverse exchange effects and the impact of disposals.

More detail: see pages 49    More detail: see pages 50-51    More detail: see pages 51

 

24


Business description (continued)

 

Non-Financial    Non-Financial    Non-Financial
Alcohol in society(ii) (reach and impact of responsible drinking programmes) #3, #4    Health and safety (lost-time accident frequency per 1,000 employees) #3, #4   

Water use efficiency(iv)

(l/l) #1

LOGO    LOGO   

LOGO

Definition    Definition    Definition
Number of programmes supported by Diageo that aim to reduce harmful drinking.    Number of accidents per 1,000 full-time employees and directly supervised contractors resulting in time lost from work of one calendar day or more.    Ratio of the amount of water required to produce one litre of packaged product.

Why we measure

We put our resources and skills into programmes that encourage a responsible attitude to alcohol and are effective in preventing and reducing alcohol misuse, working with others to maximise impact. These programmes address the risk of harm to consumers or communities and help us deliver our Performance Ambition.

  

Why we measure

Safety is a basic human right: everyone has the right to work in a safe environment, and our Zero Harm safety philosophy is that everyone should go home safe, every day, everywhere.

  

Why we measure

Water is the main ingredient in all of our brands. To sustain production growth and respond to the growing global demand for water, we aim to improve efficiency, minimising our water use, particularly in water-stressed areas.

Performance

We seek to broaden the reach of programmes, but we are prioritising the impact they have. This involves supporting projects that are effective in meeting their objectives. We share case studies showing impact evaluation on www.diageo.com.

  

Performance

In 2016, we improved our performance with a reduction in LTAs of 13% compared with 2015. This was driven by a strong focus on embedding standards into newer markets to reduce accident levels and leveraging best practice safety management tools. In some of our more established markets, this enabled us to get close to our target of zero accidents.

  

Performance

12.1% improvement on 2015, resulting from process optimisations and improvements across all sites and in particularly at our Tusker Brewery in Kenya and our Gimli Distillery in Canada.

More detail: see pages 115-117    More detail: see pages 120-121    More detail: see pages 125-128

 

25


Business description (continued)

 

Financial ®    Financial    Financial ®

Free cash flow

(£ million) #1

   Return on average invested capital (ROIC) (%) #2   

Total shareholder return

(%) #2

LOGO    LOGO    LOGO
Definition    Definition    Definition
Free cash flow comprises the net cash flow from operating activities aggregated with the net cash received/paid for loans receivable and other investments, and the net cash cost paid for property, plant and equipment, and computer software.    Profit before finance charges and exceptional items attributable to equity shareholders divided by average invested capital. Invested capital comprises net assets aggregated with exceptional restructuring costs and goodwill at the date of transition to IFRS, excluding post employment liabilities, net borrowings and non-controlling interests.    Percentage growth in the value of a Diageo share (assuming all dividends and capital distributions are re-invested).

Why we measure

Free cash flow is a key indicator of the financial management of the business and reflects the cash generated by the business to fund payments to our shareholders and acquisitions.

  

Why we measure

ROIC is used by management to assess the return obtained from the group’s asset base. Improving ROIC builds financial strength to enable Diageo to attain its financial objectives.

  

Why we measure

Diageo’s Directors have a fiduciary responsibility to maximise long-term value for shareholders. We also monitor our relative TSR performance against our peers.

Performance

Improvement was driven by lower capex, increased operating profit and lower interest payments partially offset by adverse working capital impact mainly driven by prior year improvement in debtor collection.

  

Performance

Adverse exchange led in a decline of ROIC partially offset by the increased return from growth in operating profit and income from associates.

  

Performance

Diageo delivered total shareholder return of 17% as dividends paid increased by 5% and share price increased driven by underlying business improvement and exchange.

More detail: see page 52    More detail: see page 53     

 

26


Business description (continued)

 

Non-Financial    Non-Financial   

Remuneration

Some KPIs are used as a measure in the incentives plans for the remuneration of executives. These are identified with the symbol®.

Carbon emissions(v)

(1,000 tonnes CO2e) #1, #3

  

Employee engagement index(vi)

% #3, #4

  
LOGO    LOGO   

Definition

Absolute volume of carbon emissions, in 1,000 tonnes.

  

Definition

Measured through our Values Survey; includes metrics for employee satisfaction, loyalty, advocacy and pride.

   See our Directors’ remuneration report from page 165 for more detail.

Why we measure

Carbon emissions are a key element of our environmental impact and the impact of the industry. We recognise the importance of reducing our carbon emissions to mitigate climate change and position us well for a low-carbon economy in the future, as well as creating efficiencies and savings now.

  

Why we measure

Employee engagement is a key enabler of our strategy and performance. The survey allows us to measure, quantitatively and qualitatively, how far employees believe we are living our values. The results inform our ways of working, engagement strategies and leadership development.

    

Performance

7.7% reduction in total carbon emissions resulting from cumulative impacts of multiple energy efficiency initiatives and switches to renewable fuels, predominately biogas recovery and reuse and displacement of fossil fuels.

  

Performance

This year, 97% of our people participated in our Values Survey (24,843 out of the 25,712 able to participate). 77% of our people were identified as engaged, with 80% feeling they were ‘enabled to perform’. Our survey scores have improved each year since 2014.

    
More detail: see pages 128-129    More detail: see pages 121-123     

 

 

(i) For reward purposes this measure is further adjusted for the impact of exchange rates and other factors not controlled by management, to ensure focus on our underlying performance drivers.
(ii) Alcohol in society KPI has been redesigned to measure reach and impact of programmes. See more details on page 116.
(iii) Non-financial KPIs for the year ended 30 June 2015 include United Spirits Limited, except health and safety (see pages 120-121).
(iv) In accordance with Diageo’s environmental reporting methodologies, data for each of the four years in the period ended 30 June 2015 has been restated and total water used excludes irrigation water for agricultural purposes on land under the operational control of the company.
(v) Data for each of the four years in the period ended 30 June 2015 has been restated in accordance with the WRI/WBCSD GHG Protocol and Diageo’s environmental reporting methodology.
(vi) In 2014, we reviewed our overall approach to measuring engagement, and adopted a revised index. The new index allows us to compare our results with other best-in-class organisations, and sets us a more stretching benchmark for employee engagement.

See reconciliation of non-GAAP measures to GAAP measures on page 133.

 

27


Business description (continued)

 

CHAIRMAN’S STATEMENT

Diageo is a global leader in an industry that is growing and financially attractive. As we deliver on our future opportunities with our brands and geographic reach, we will continue to promote responsible drinking as part of a balanced lifestyle. This is at the centre of Diageo’s purpose to celebrate life every day, everywhere.

 

Recommended final dividend per share

2016: 36.6p h5%
2015: 34.9p

Total dividend per share(i)

2016: 59.2p h5%

2015: 56.4p

Total shareholder return (%)

2016: h17%
2015: h2%

 

(i) Includes recommended final dividend.

A stronger, more competitive business

I am pleased with the performance Diageo has delivered this year, my last as Chairman. We are a stronger business and have returned to growth, and I would like to thank our Chief Executive, Ivan Menezes, and the Diageo Executive team for leading this progress. Diageo has positioned the consumer at the heart of the business, through marketing, innovation, local participation strategies and now has the consumer-facing culture required to succeed in today’s competitive marketplace.

Diageo’s opportunity for growth lies in positive global demographics and income growth, and the increasing penetration of spirits in emerging markets. Our footprint is made up of enviable positions in key geographies: in Africa and India, which together represent almost half of the global growth opportunity for our industry, and also a leading competitive position in North America, the biggest driver of developed market growth. In each of these markets we have a strong portfolio of brands, a proven capability in identifying and acting on consumer insights, leading skills in marketing and innovation, and a reputation for operating in a responsible and sustainable way.

 

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Business description (continued)

 

Business development

Responsiveness and agility are key drivers of performance and the Diageo Executive team have enhanced these capabilities in several areas during the year, including: a continued focus on building a world-class sales organisation, investment in local production, and building the capability of local talent. Alongside the continued focus on organic growth, Diageo released £1 billion from the sale of non-core assets through a more proactive approach to managing our portfolio. This included the sale of our wine interests – primarily the US-based Chateau and Estate Wines and the UK-based Percy Fox businesses to Treasury Wine Estates – and the sale of non-core beer assets in Jamaica and Malaysia. These transactions followed the restructuring of our business in Southern Africa, having achieved our goal of leadership in spirits and growth in the beer business through the successful brandhouse joint venture with Heineken and Namibia Breweries. Diageo now has the scale to move to the next stage of growth in South Africa with a focused, simplified ownership structure.

Our investment in United Spirits Limited (USL) in India offers Diageo a transformational growth opportunity in one of the most attractive spirits markets in the world. India is set to become the second country after China with a population of more than one billion consumers of legal purchase age, with the expected growth of 18–19 million legal purchase age consumers per year.

Since Diageo became the principal shareholder in USL in India in July 2013, we have been determined to capture the significant growth opportunity of one of the largest spirits markets in the world. On 25 February 2016, Diageo announced that it had entered into an agreement with Dr Vijay Mallya under which he resigned from his position as Chairman and Non-Executive Director of USL and from the boards of other USL group companies. The agreement brought to an end the uncertainty relating to the governance of USL and put in place a five-year global non-compete (excluding the United Kingdom), non-interference and standstill arrangement with Dr Mallya.

Value creation and dividend

We measure our progress towards achieving our Performance Ambition through four areas: efficient growth, value creation, credibility and trust, and motivated people. We improved against each of our efficient growth metrics, and Ivan will discuss these in his statement. Our value creation measures also improved. Return on average invested capital (ROIC) was broadly flat against a decline last year and our total shareholder return (TSR) performance has improved on last year, up 17%.

Diageo targets dividend cover (basic earnings per share before exceptional items/ dividend per share) within the range of 1.8 to 2.2 times. The recommended final dividend for the year ended 30 June 2016 is 36.6 pence per share, an increase of 5% over the prior year in line with our policy to rebuild dividend cover to our targeted range. This brings the full year dividend to 59.2 pence per share and dividend cover to 1.5 times. Subject to approval by shareholders, the final dividend will be paid to shareholders on 6 October 2016. Payment to US ADR holders will be made on 12 October 2016.

 

29


Business description (continued)

 

Our role in society

Ensuring we make a positive contribution to society has always been a priority for Diageo and is at the core of our Performance Ambition. Doing so is good for our business, good for our communities and good for our consumers, and it is also true to our values and our people. The Diageo Code of Business Conduct defines these values and helps our employees live by them every day.

We put our resources and skills into hundreds of programmes around the world that reduce alcohol misuse, working closely with other stakeholders to raise awareness and change people’s attitudes and behaviour. This forms part of our support of the industry’s Global Producers’ Commitments to Reduce the Harmful Use of Alcohol, now in their fourth year, which are making a tangible difference in areas such as reducing drink driving and tackling underage drinking. We are also proud that we are supporting skills and social enterprise in the community, through programmes like Learning for Life, bringing opportunities for training and careers in the hospitality industry, and Plan W, empowering women through learning. And we are working hard, including with our suppliers, to reduce our environmental impact, setting ourselves new, challenging targets around water, carbon and waste for 2020. These priorities represent an interlinked, holistic approach to understanding and managing our impact on society.

Partnerships are key to delivering positive outcomes, and we have recently announced a global strategic partnership with the NGO WaterAid, building on our efforts to improve access to safe water across Africa. Also this year, through a partnership with the United States Agency for International Development, we have extended our work on skills as part of their programme in Colombia, and have set up a new farming supply chain in South Sudan, supporting livelihoods for hundreds of people. These partnerships, with more to follow, increase the reach of our programmes and help us contribute to the UN Global Goals.

Managing geo-political risks and opportunities

Political and other volatility continues to be a growing feature of the global economy and many of the markets in which we operate. We are continually improving our ability to understand and interpret it; and to evaluate and act against the potential risks and the opportunities for the business. We have integrated the work of our strategy, risk and public affairs teams and also improved our in-depth analysis of, and scenario planning for, priority markets. I am confident this will further enhance our resilience and growth potential.

It is too early to assess the implications of the United Kingdom’s decision to leave the European Union for our business and operations over the longer term. We believe, however, that with our proven record of managing trade and operating globally, Diageo remains well placed to deliver its Performance Ambition.

Board changes

In November 2015, Deirdre Mahlan stepped down from the Board, as she moved from her role as Chief Financial Officer to take up the role of President, Diageo North America. I wish to thank Deirdre most sincerely for her excellent contribution to the Board and am pleased that she continues to play a pivotal role in leading this important business for Diageo. I am also delighted to have welcomed Kathryn Mikells to the Board as Chief Financial Officer, effective 9 November 2015. Kathryn joined us with a track record for capital discipline and for developing strong cost cultures to create efficient, agile organisations.

 

30


Business description (continued)

 

Diageo announced on 18 May 2016, that Javier Ferrán would be appointed to the Board as a Non-Executive Director from 22 July 2016. On my retirement from the Board on 31 December 2016, Javier will take over as Chairman from 1 January 2017. On behalf of the Board, I would like to welcome Javier to Diageo and say how delighted I am that he has agreed to be the next Chairman. Through his roles at Lion Capital and Bacardi, Javier has a wealth of experience across the consumer goods sector and brings a strong set of skills to the role of Chairman.

 

LOGO

Global volume share of premium spirits (%) Diageo 25% Beam Suntory 6% Pernod Ricard 16% Brown-Forman 7% Bacardi 9% Others 37% Source: Impact Databank, March 2016

A global leader

It has been an honour to serve as your Chairman. During the past eight years Diageo has become a truly global leader, with the assets and consumer-facing culture required to succeed. Diageo’s values are deeply rooted in the principle of always doing the right thing. I am therefore confident that Diageo will continue to prosper, and succeed in delivering its Performance Ambition for all stakeholders around the world.

Dr Franz B Humer

Chairman

 

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Business description (continued)

 

CHIEF EXECUTIVE’S STATEMENT

This has been a year of significant progress for Diageo. Our performance demonstrates our focus on disciplined execution in everything we do. It is this focus which has delivered volume growth, our fifth consecutive year of organic margin improvement and strong cash conversion. I am confident we now have the platform to deliver sustainable growth.

 

 

Reported volume movement    Organic volume movement

2016: h0.1%

2015: h58%

  

2016: h1.3%

2015: i1%

Reported net sales movement    Organic net sales movement

2016: i3.0%

2015: h5%

  

2016: h2.8%

2015: flat

Reported operating profit movement    Organic operating profit movement

2016: h1.6%

2015: h3%

  

2016: h3.5%

2015: h1%

 

Performance

We have a clear strategy, consistently applied which has returned Diageo to both organic volume and organic net sales growth, delivered margin improvement and a strong cash performance.

This year we delivered organic volume up 1.3%, and organic net sales up 2.8%, with a stronger performance across both in the second half. The improvement in organic net sales has been driven by a return to volume growth, and a significant turnaround in US Spirits.

We are a more focused company following the disposal of non-core businesses. These disposals, along with adverse exchange, did however impact reported net sales, which declined 3.0%.

We have sustained positive price/mix despite a weaker pricing environment globally, and we have strengthened our leadership position and brought our brands to an increasing number of consumers. Our beer business has grown for seven successive quarters and continues to provide a strong distribution platform for our spirits ambitions in Africa.

All six global giant brands reported improved organic performance this year. Smirnoff’s and Captain Morgan’s improvement was driven by their performance in the United States combined with continued good growth in Europe. Guinness’ momentum continues with the brand growing in Africa and in Great Britain and Ireland, supported by innovations from The Brewers Project.

North America delivered organic net sales growth of 3%. This performance is in line with our expectations, with the biggest contributor to organic net sales improvement being that our biggest brands are back in growth.

Organic operating margin was up, driven by favourable mix effect and marketing efficiency. Operating profit grew 3.5% on an organic basis. On a reported basis, operating profit was up 1.6%, negatively impacted by exchange and disposals. Earnings per share before exceptional items was up 1% as profit growth, higher associates income and lower finance charges more than offset the impact of exchange and disposals.

 

32


Business description (continued)

 

LOGO

2016 net sales by category (%) Scotch 24% IMFL Whisky 5% Beer 18% Liqueurs 5% Vodka 13% Gin 3% NAM Whisk(e)y 8% Tequila 1% Rum 7% Other 10% Ready to drink 6%

 

 

 

We continue to drive productivity and cash conversion, delivering over 100% cash conversion for a second year and free cash flow improved by £134 million.

Business transformation

Over the past three years, my goal has been to put the consumer at the heart of our business. Consumer trends are moving faster than ever before and companies that can interpret and deliver quickly against consumer insights will thrive. The renewed momentum we have in the business is because we have the consumer-facing culture required to succeed and the agility to move at pace.

We have shifted the focus of our marketing to be centred on the recruitment and re-recruitment of consumers and on what drives consumption occasions, and we are introducing more rigour around the evaluation of the effectiveness of our spend. We continue to uphold the highest standards of responsibility, ensuring that all our marketing activities adhere to our strict Diageo Marketing Code.

Our role in society

We know that the issues that are most material to our business and stakeholders are:

 

    To create a positive role for alcohol in society

 

    Build thriving communities

 

    Reduce our environmental impacts.

Our strategy recognises that these issues are connected to our opportunities as a business, as well as the UN Global Goals launched in 2015. Our strategy also reflects how the elements of our value chain are interdependent, and how contributing to society, to communities, and to the environment strengthens our business.

We are passionate about ensuring alcohol has a positive role in society as part of a balanced lifestyle and are committed to tackling misuse. We do this through our implementation of the Global Producers’ Commitments to Reduce the Harmful Use of Alcohol, an unprecedented partnership of the world’s largest alcohol companies coming together to tackle harmful drinking – and, as an industry, we are seeing good progress against the targets we set ourselves for 2017. We welcome the trends we are seeing, such as consumers, and particularly young adults, drinking better not more, and the significant fall in the number of alcohol-related road traffic fatalities in many countries. This suggests that initiatives such as the multi-stakeholder approach advocated by the Global Producers’ Commitments are having a positive impact.

 

33


Business description (continued)

 

We are not complacent and there is more to do. This year, we signed a strategic partnership agreement with the United Nations Institute for Training and Research (UNITAR) which, over the next two years, will work towards reducing traffic death and injuries, and improve road safety globally. I was proud to learn that we were approached to partner with UNITAR on the basis of our strong track record in supporting programmes and policies to address drink driving.

We are long-standing leaders in providing consumer information to help people make informed choices as part of a balanced lifestyle, and recently announced that Johnnie Walker Red Label will be the first global brand to provide per serving alcohol content and nutritional information on-pack. The new labels are designed to help consumers understand what’s in their glass, and conform to the new Diageo Consumer Information Standards which came into force on 1 July 2016 and applies to all Diageo brands.

During the year, I also had the opportunity to launch our new DRINKiQ exhibit at the Guinness Storehouse in Dublin, Ireland, which is one example of our work to help people make informed decisions. This exhibit supports our global responsible drinking website, DRINKiQ.com, which was relaunched in January this year in 12 languages.

United Kingdom (UK) and the European Union (EU)

Following the UK’s vote to leave the EU on 23 June 2016, we are working closely with government and our industry bodies to ensure our views are reflected in the transition process. We welcome the formation of a specialist international trade department, as it is

important for Diageo that the UK continues to benefit from open access to the EU as well as favourable international trade agreements. We believe that the outcome of this referendum will not have any material near-term impact on our business and we are well placed to continue our global business without significant disruption.

Our people

I would like to thank all our 32,000 people for their energy and dedication during the year. I am fortunate to lead a business with motivated, committed teams around the world. This was demonstrated by this year’s annual employee Values Survey, which showed another year of improving engagement scores. Our results compare very well with those of other multinational companies, which I see as a real competitive advantage for Diageo.

Franz, in his statement, highlighted that Javier Ferrán, who joined the Board as a Non-Executive Director on 22 July 2016, will succeed him as Chairman on 1 January 2017. I would like to extend my thanks to Franz for his role in making Diageo the strong business it is today, and for his stewardship of the Diageo Board during his eight years as Chairman. I look forward to working with Javier as we build on Diageo’s leadership position.

Outlook

Diageo has an enviable portfolio of brands, a truly global footprint and exposure to the fastest growing opportunities in our sector. The business is now able to respond faster to consumer insights, to shape trends and to deliver. We have been embedding a productivity culture, and are committed to sustainable efficiency in every area of our cost base to achieve £500 million in savings in the coming three years. Two-thirds of the efficiencies identified will be re-invested back into the business to drive growth. We are confident of achieving our objective of mid-single digit organic net sales growth, and in the three financial years ending 2019 delivering 100 basis points of organic operating margin improvement.

I am also confident that, with the consumer at the heart of our business, we will extend our leadership position and become one of the most trusted and respected consumer products companies in the world.

Ivan Menezes

Chief Executive

 

34


Business description (continued)

 

MARKET DYNAMICS

The global beverage alcohol market is large and diverse, with an estimated six billion(i) equivalent units of alcohol sold each year, generating £260 billion(i) of net sales. Like other consumer goods companies, beverage alcohol companies operate in a context of increasing stakeholder expectation – with the added element of high, and highly diverse, levels of regulation. This environment presents opportunities for Diageo, with our global reach, our range of iconic brands across price tiers, and our approach to responsibility, sustainability, governance and ethics.

A market that is profitable and expanding

The beverage alcohol market is profitable, growing and attractive. Over the medium term, the industry is expected to grow overall in both volume and value. This is driven by consumer fundamentals including a rise in global incomes and a growing legal purchase age population. At the same time, margins remain significantly higher than for the overall consumer goods market.

The market for beverage alcohol is also highly diverse, with significant variations in culture and conditions between, and within, individual countries and regions. It is broadly split between developed and emerging markets, but each individual market presents different consumer dynamics and a different outlook. This diversity presents opportunities to agile businesses that can act on consumer insight and deliver trusted, competitive products.

Developed market opportunities

Typically, developed market populations are ageing and growing more slowly than those in emerging markets. Overall, levels of disposable income are higher, and consumers are often prepared to pay a premium for high quality brands with heritage and provenance. We see consumption occasions as opportunities to promote our international spirits brands, and, within those brands, to encourage consumers to trade up to our reserve portfolio.

Emerging market opportunities

Opportunities in emerging markets are driven by growth in both populations and wealth. Each country is different, and growth occurs at different price points depending on wealth and local conditions. An understanding of local consumers and the categories, brands and price points they are seeking is vital to accessing this growth.

The emerging middle-class plays an important role. These relatively affluent consumers already drink beer or local spirits, and the opportunity is to further access this existing consumption pool with our brands and to offer an opportunity to trade up to our international spirits brands for certain occasions. Outside this group, an estimated 25% of global alcohol consumption is from non-commercial or illicit products. Capturing market share in this consumer segment by offering legitimate, safe, attractive brands that deliver quality at an affordable price is an important opportunity.

There is also a significant and growing number of globally affluent consumers in the emerging markets, who represent an opportunity for our reserve portfolio.

Geo-political volatility

While there are positive medium-term prospects for the beverage alcohol industry, all consumer goods businesses, including beverage alcohol businesses, continue to navigate a volatile global economy. Our Chief Executive discusses the United Kingdom’s referendum vote to leave the European Union on 23 June 2016 on page 34.

The slowdown in the Chinese economy, oil price shocks, persistent conflicts in many parts of the world, and terrorist attacks in Europe are just some of the events and trends that have contributed to an unpredictable environment. The resulting uncertainty, changes to economic variables such as exchange rates and commodity prices, and fluctuations in political security can all reduce consumer confidence and spending power.

Our broad participation across geographies, categories and price tiers acts as a natural hedge against individual market volatility, while we retain the flexibility in each market to respond quickly to local dynamics through our 21 market business model. Continued focus on local sourcing of ingredients, scenario planning and risk management, and management of foreign exchange exposure all work to protect the business against the challenges of volatility.

 

(i) Diageo estimates.

 

35


Business description (continued)

 

Earning the trust and respect which support performance

Our ambition is to be one of the best performing, most trusted and respected consumer products companies in the world – ensuring we play a positive role in society is at the heart of this. Operating in a responsible and sustainable way every day, everywhere, not only helps us be a trusted and respected business, it also helps drive our performance.

The launch of the UN Global Goals in September 2015 and the Paris Agreement on climate change in December 2015 represent an important milestones in what was arguably an unprecedented period of concerted action to address global issues. These initiatives both reflect and drive a wider trend in which stakeholders of all kinds, including consumers and in particular millennials, have increasing expectations that businesses must create value beyond their economic contribution.

Delivering measurable social benefits, tackling alcohol misuse, demonstrating good corporate governance and reducing environmental impacts in line with a clear sustainable development strategy are, more than ever, business imperatives which drive performance.

We have built on our long history of sustainability and responsibility programmes by developing a strategy that is aligned with the UN Global Goals and Paris Agreement and focuses on the three areas that are most material to us and our stakeholders: creating a positive role for alcohol in society; building thriving communities; and reducing our environmental impact. We have set ourselves targets to achieve in each of these areas by 2020.

Creating a positive role for alcohol in society

Alcohol has been enjoyed for centuries and is part of celebrations around the world. Whether people drink beer, wine or spirits, alcohol is alcohol, and the vast majority of people who choose to enjoy it, do so moderately and responsibly. We respect that some people choose not to drink, and recognise that the misuse of alcohol can be harmful to individuals and society. Putting our resources and skills into programmes that prevent and reduce alcohol misuse and working with others to raise awareness and change attitudes and behaviour is good for society and good for the long-term future of our business.

Support for effective alcohol policies

The beverage alcohol industry is one of the most highly regulated in the world, with regulation varying widely between countries and jurisdictions. Diageo complies with all laws and regulations, wherever we operate, as a minimum requirement. We advocate effective alcohol policies that are evidence-based, account for drinking patterns, target at-risk groups, treat all forms of alcohol equally, and involve all stakeholders. Such policies include mandating a minimum legal purchasing age of not less than 18; a maximum blood alcohol concentration (BAC) level for drivers of no more than 0.08mg; and lower BACs for novice and commercial drivers.

However, we advocate against measures that are not based on evidence or are likely to have unintended consequences in what are often complex markets. A particular concern is policies that inadvertently push consumers towards unregulated or illicit alcohol, which can be a risk to public health.

Industry collaboration

We are one of 12 global producers of beer, wine and spirits which, in 2013, launched a set of commitments designed to support Member States’ implementation of the World Health Organization’s (WHO) global strategy to Reduce the Harmful Use of Alcohol. These commitments focus on reducing underage drinking, strengthening and expanding marketing codes of practice, providing consumer information and responsible product innovation, reducing drink driving, and enlisting the support of retailers to reduce harmful drinking. Diageo goes beyond industry collaboration and works in partnership with governments, law enforcement, educators and civil society to support campaigns to reduce harmful drinking.

 

36


Business description (continued)

 

Building thriving communities

We can add significantly to the contribution we make to communities through direct and indirect employment, taxes, and community investment efforts by working to leverage the economic and social impact of our entire value chain. Helping communities thrive within the supply chain also builds resilience within our business. We build trust with government and other stakeholders by focusing on human rights throughout our value chain, and through local sourcing initiatives, particularly in Africa where we aim to source 80% of agricultural materials for use in local markets by 2020. This helps secure supply, and delivers wider benefits to the local community.

Climate change and water scarcity

All businesses, particularly those that rely on agricultural raw materials, are exposed to a variety of environmental issues associated with climate change, such as droughts, floods and biodiversity loss. These issues can affect a business’ operations directly, or indirectly as a result of their impact on the wider value chain and associated communities. Water scarcity is particularly important to us because water is our main ingredient. Our Water Blueprint, launched in April 2015, defines our strategic approach to water stewardship, and focuses specifically on stewardship in the water-stressed areas shown in the map below.

Trust and transparency

As part of the process of creating value, we are increasingly expected to be transparent about our most material social and environmental issues. This is delivered through reporting frameworks such as the International Integrated Reporting Framework, the Global Reporting Initiative Guidelines, and the United Nations Global Compact principles. We report against all three of these, and believe that this regulation and scrutiny can be an advantage to companies with good corporate governance and the right approach to sustainability and responsibility.

 

LOGO

 

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HOW WE WILL DELIVER OUR PERFORMANCE AMBITION

Diageo’s performance drivers and sustainability and responsibility priorities are key to achieving our aims. Each of our 21 markets focuses on the priorities that are most relevant to driving growth and creating shared value in that market.

Our six performance drivers

1 Strengthen and accelerate growth of our premium core brands

Our premium core brands are sold in more than 180 countries around the world. They are enjoyed by consumers in developed markets and have wide appeal in emerging markets. They include iconic brands Johnnie Walker, Smirnoff, Captain Morgan and Baileys.

2 Win in reserve in every market

Seven years ago we shifted our approach to luxury spirits and made reserve a strategic priority. The results demonstrate what building capability and having focus can do.

3 Innovate at scale to meet new consumer needs

We are a company built and sustained through innovation, which gives us the drive to create new products, new categories and new experiences for consumers. We are the leaders in our industry, inventing today for tomorrow, staying on the edge of, and anticipating, consumer behaviour.

4 Build and then constantly extend our advantage in route to consumer

We have put the consumer at the centre of our business. Our route to consumer transformation has driven a clear understanding of what success looks like in a store, in a bar and in the hands of our consumers. We now have the consumer-facing culture to succeed.

5 Drive out costs to invest in profitable growth

We want to continuously get more efficient and effective in everything we do to further enable us to invest in growth for our business, our people and our brands. We have set a goal to deliver productivity savings of £500 million over the next three years, with two-thirds of this re-invested for growth.

6 Ensure we have the talent to deliver our Performance Ambition

We employ bright, collaborative people at all levels in our business, and must continue to do so if we are to achieve our aims. Our people, culture and values are what will make the difference.

Our three sustainability and responsibility priorities

1 Create a positive role for alcohol in society

We are committed to maintaining our leadership position by ensuring we make a positive contribution to society and work to tackle alcohol misuse alongside the industry. We will continue to operate in a responsible way every day, everywhere, to remain a trusted and respected business and drive our performance. We remain focused on delivering the five Global Producers’ Commitments and our own stretching 2020 targets.

2 Building thriving communities

We create value for millions of people as a buyer of goods and services, as an employer, as corporate citizens, and as producers of some of the world’s best-loved brands. We want to continue to help those communities thrive, by making Diageo a great, safe, and diverse place to work, by building sustainable supply chains, and through programmes that empower communities and individuals.

3 Reducing our environmental impacts

We’re dependent on the natural resources we share with the communities around us, and with the wider world. We want to use those resources responsibly, and make a net positive contribution to the environment through our operations and supply chain. We are working to reduce our impacts in the areas of water, carbon, packaging, and waste.

 

 

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Risk factors

Diageo believes the following to be the principal risks and uncertainties facing the group. If any of these risks occur, Diageo’s business, financial condition and performance could suffer and the trading price and liquidity of securities could decline. Because any global business of the kind Diageo is engaged in is inherently exposed to risks that become apparent only with the benefit of hindsight, risks of which Diageo is not presently aware or which Diageo does not currently consider to be material could also impact Diageo’s ability to execute its strategy. In addition, these risks could affect Diageo’s business, financial condition and performance and the trading price and liquidity of securities. The order of presentation of the risk factors below does not indicate the likelihood of their occurrence or the potential magnitude of their consequences.

Risks related to the global economy

Diageo’s business may be adversely impacted by unfavourable economic, political, social or other developments and risks in the countries in which it operates

Diageo may be adversely affected by economic developments in any of the countries where it has distribution networks, production facilities or marketing companies. In particular, Diageo’s business is dependent on general economic conditions in its most important markets, including the United States and the countries that form the European Union. If there is a significant deterioration in the economic conditions in any of Diageo’s important markets, it may contribute to reduced demand for Diageo’s products, reduction in consumer confidence and spending levels generally, customer destocking, negative impacts on Diageo’s customer, supplier or financial counterparties or a reduction in the availability of, or an increase in the cost of financing to, Diageo. Diageo’s business is also affected by other economic developments such as the imposition of any import, investment or currency restrictions, including tariffs and import quotas or any restrictions on the repatriation of earnings and capital. Any of these developments may have a material adverse effect on Diageo’s business and financial results.

Diageo’s operations are also subject to a variety of other risks and uncertainties related to its global operations, including adverse political, social or other developments. Political and/or social unrest, potential health issues, natural disasters, politically-motivated violence and terrorist threats and/or acts, including those which are specifically directed at the alcohol industry, may also occur in countries where Diageo has operations. Any of the foregoing could have a material adverse effect on Diageo’s business and performance.

Many of these risks are heightened, or occur more frequently, in emerging markets. These disruptions can affect Diageo’s ability to import or export products and to repatriate funds, as well as affecting the levels of consumer demand (for example, in duty free outlets at airports or in on trade premises in affected regions) and therefore Diageo’s levels of sales or profitability. A substantial portion of Diageo’s operations are conducted in emerging markets, and emerging markets represented approximately 42% of Diageo’s net sales for the year ended 30 June 2016. Emerging markets are also generally exposed to relatively higher risk of liquidity constraints, inflation, devaluation, price volatility, currency convertibility, sovereign default, as well as additional legal and regulatory risks and uncertainties. Any of these factors may affect Diageo disproportionately or in a different manner as compared to its competitors, depending on Diageo’s specific exposure to any particular emerging markets, and could have a material adverse effect on Diageo’s business and financial results.

The results of the United Kingdom’s referendum to leave the European Union may result in economic and political uncertainty and complexity, have a negative effect on economic conditions in Europe and adversely affect Diageo’s business and financial performance

Diageo is headquartered in the United Kingdom and has significant production and investment in Scotland. In June 2016, the United Kingdom voted by referendum to leave the European Union. Although it remains too early to assess the potential impact of this vote for Diageo, may lead to a sustained period of economic and political uncertainty and complexity until the detailed terms of the United Kingdoms exit from the European Union are finalised and as the United Kingdom negotiates and concludes any successor trading arrangement with other countries. The decision in the referendum that the United Kingdom should leave the European Union could also negatively impact economic conditions in Europe more generally and may have adverse effects on Diageo’s business and financial performance. For instance, the referendum may contribute to volatility in exchange rates, risk to supply chains across the EU, restrictions on the mobility of employees, possible changes to customs duties and tariffs and/or industry specific requirement and regulations.

 

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The United Kingdom’s referendum vote to leave the European Union could also have further implications for the constitutional makeup of the United Kingdom and issues around independence and devolved government in Scotland and Northern Ireland, which could result in a further period of political uncertainty in the United Kingdom and may otherwise adversely affect Diageo’s business and financial results, particularly in light of Diageo’s substantial inventory and operations located in Scotland.

Risks related to the industry

Demand for Diageo’s products may be adversely affected by many factors, including changes in consumer preferences and tastes and adverse impacts of a declining economy

Diageo’s collection of brands includes some of the world’s leading beverage alcohol brands, as well as brands of local prominence. Maintaining Diageo’s competitive position depends on its continued ability to offer products that have a strong appeal to consumers. Consumer preferences may shift due to a variety of factors including changes in demographic and social trends, public health regulations, changes in travel, vacation or leisure activity patterns, weather effects and a downturn in economic conditions, which may reduce consumers’ willingness to purchase luxury or premium branded products. Continued economic pressures could also lead to consumers selecting products at lower price points, whether Diageo’s or those of its competitors, which may have an adverse effect on Diageo’s business and financial results. The competitive position of Diageo’s brands could also be affected adversely by any failure by Diageo to achieve consistent, reliable quality in its products or in its service levels to customers.

In addition, the social acceptability of Diageo’s products may decline due to public concerns about alcohol consumption. These concerns could also result in regulatory action, litigation or customer complaints against companies in the industry and may have an adverse effect on Diageo’s business and financial results.

Growth in Diageo’s business has benefited from both the launch of new products, and the creation of brand extensions and product innovation remains a significant element of Diageo’s growth plans. The launch and ongoing success of new products is inherently uncertain, especially as to their appeal to consumers. The failure to launch successfully a new product can give rise to inventory write-offs and other costs and can affect consumer perception and growth of an existing brand. There can be no assurance of Diageo’s continuing ability to develop and launch successful new products or variants of existing products or of the profitable lifespan of newly or recently developed products.

Diageo is subject to litigation directed at the beverage alcohol industry and other litigation

Companies in the beverage alcohol industry are, from time to time, exposed to class action or other litigation relating to alcohol advertising, product liability, alcohol abuse problems or health consequences from the misuse of alcohol. Diageo may also be subject to litigation arising from legacy and discontinued activities, as well as other litigation in the ordinary course of its operations. Diageo is further subject to the risk of litigation by tax, customs and other regulatory authorities, including with respect to the methodology for assessing importation value, transfer pricing or compliance matters.

Changes in the political and economic climate have resulted in an increased focus on tax collection in recent years, and tax authorities are showing an increased appetite to challenge the methodology used by multinational enterprises, even where a company complies with international best practice guidelines. Changes in tax law (including tax rates), tax treaties, accounting policies and accounting standards, including as a result of the Organisation for Economic Co-Operation and Development’s review of base erosion and profit shifting and the European Union’s anti-tax abuse measures, could also result in litigation or other actions by relevant tax authorities. Any such litigation or other actions may result in damages, penalties or fines as well as reputational damage to Diageo or its brands, and as a result, Diageo’s business and financial results could be materially adversely affected. For additional information with respect to legal proceedings, see ‘Additional information for shareholders — Legal proceedings’ and note 18 to the consolidated financial statements.

Climate change, or legal, regulatory or market measures to address climate change, may negatively affect Diageo’s business or operations, and water scarcity or poor water quality could negatively impact Diageo’s production costs and capacity

In the event that climate change has a negative effect on agricultural productivity, Diageo may be subject to decreased availability or increased pricing for certain raw materials that are necessary for Diageo’s products, such as sugar, cereals, hops, agave and grapes. Water is the main ingredient in substantially all of Diageo’s products and it is also a limited resource in many parts of the world.

 

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As demand for water continues to increase, and as water becomes scarcer and the quality of available water deteriorates, Diageo may be affected by increasing production costs or capacity constraints, which could adversely affect Diageo’s business and financial results.

An increase in the cost of production could affect Diageo’s profitability

The components that Diageo uses for the production of its beverage products are largely commodities that are subject to price volatility caused by changes in global supply and demand, weather conditions, agricultural uncertainty and/or governmental controls. Commodity price changes may result in unexpected increases in the cost of raw materials, glass bottles, flavours and other packaging materials and Diageo’s beverage products. Diageo may also be adversely affected by shortages of such materials, by increases in energy costs resulting in higher transportation, freight and other operating costs or by inflation. Diageo may not be able to increase its prices to offset these increased costs without suffering reduced volume, sales and operating profit.

Risks related to regulation

Regulatory decisions and changes in the legal, tax and regulatory environment could increase Diageo’s costs and liabilities or limit its business activities

Diageo’s operations are subject to extensive regulatory requirements relating to production, distribution, importation, marketing, advertising, promotion, sales, pricing, labelling, packaging, product liability, labour, pensions, antitrust, compliance and control systems, and environmental issues. Changes in laws, regulations or governmental or regulatory policies and/or practices could cause Diageo to incur material additional costs or liabilities that could adversely affect its business. In particular, governmental bodies in countries where Diageo operates may impose new labelling, product or production requirements, limitations on the marketing, advertising and/or promotion activities used to market beverage alcohol, restrictions on retail outlets, restrictions on importation and distribution or other restrictions on the locations or occasions where beverage alcohol is sold which directly or indirectly limit the sales of Diageo products. For example, in 2015 two of the major states (in terms of population and per capita alcohol consumption) of the Republic of India, the State of Kerala and the State of Bihar, announced the imposition of a total ban on alcohol consumption. These regulatory measures could impact the sale and distribution of Diageo’s products in India, which could adversely affect Diageo’s business and financial results.

Regulatory authorities under whose laws Diageo operates may also have enforcement power that can subject the group to actions such as product recall, seizure of products or other sanctions which could have an adverse effect on Diageo sales or damage its reputation. Any changes to the regulatory environment in which Diageo operates could cause Diageo to incur material additional costs or liabilities, which could adversely affect Diageo’s performance.

Beverage alcohol products are also subject to national excise, import duty and other duties in most countries around the world. An increase in any such duties could have a significant adverse effect on Diageo’s sales revenue or margin, both through reducing overall consumption and by encouraging consumers to switch to lower-taxed categories of beverage alcohol.

Diageo’s reported after tax income is calculated based on extensive tax and accounting requirements in each of its relevant jurisdictions of operation and this may be subject to change following the Organisation for Economic Co-Operation and Development’s review of base erosion and profit shifting and the European Union’s anti-tax abuse measures. Changes in tax law (including tax rates), tax treaties, accounting policies and accounting standards could increase the cost of doing business and lead to rise in Diageo’s effective tax rate.

Diageo is subject to data privacy regulations in many of the markets in which it operates, and laws and regulations in this area are developing and changing on a continual basis, including, for example, the new General Data Protection Regulation adopted in the European Union in April 2016. Breach of any of these laws or regulations can lead to significant fines and/or damage to Diageo’s reputation as well as significantly restricting its ability to deliver or digital productivity and growth plans.

Failure by Diageo to comply with anti-corruption laws or failure of Diageo’s related internal policies and procedures to comply with applicable law may have a material adverse effect on Diageo’s business and financial results

Diageo operates a global business, including in certain countries which are reported to have high levels of corruption risk (i.e., countries in which the Transparency International index of perceived levels of public sector corruption is less than or equal to fifty). There is increasing scrutiny and enforcement by regulators in many jurisdictions of anti-bribery laws, including pursuant to the US Foreign Corrupt Practices Act and the UK Bribery Act. Such enforcement has been enhanced by applicable regulations in the United States, which offer substantial financial rewards to whistleblowers for reporting information that leads to monetary fines.

 

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While Diageo has implemented and maintains internal practices, procedures and controls designed to ensure compliance with anti-bribery legislation and routinely conducts investigations, either at its own initiative or in response to requests from regulators in connection with compliance with such internal controls, there is no guarantee that such procedures will be effective in preventing compliance failures at Diageo.

Any investigations and lawsuits, regardless of the ultimate outcome of the proceeding, are time consuming and expensive and can divert the time and effort of Diageo’s personnel, including senior management, from its business. Adverse publicity, governmental scrutiny and legal and enforcement proceedings can also have a negative impact on Diageo’s reputation and on the morale and performance of its employees. To the extent that violations of anti-corruption laws and/or Diageo’s internal policies and procedures are found, or Diageo’s internal policies and procedures are found not to comply with applicable law, possible regulatory sanctions and fines and other consequences may also be material.

Risks related to Diageo’s business

The value of Diageo’s brands and its net sales may be negatively affected by its failure to maintain its brand image and corporate reputation or adapt to a changing media environment

The value of Diageo’s brands and its profitability depends heavily on its ability to maintain its brand image and corporate reputation. Adverse publicity, whether or not justified, may tarnish Diageo’s reputation and cause consumers to choose products offered by its competitors. Such adverse publicity could arise as a result of a perceived failure by Diageo to make adequate positive social contributions, including in relation to the level of taxes paid by Diageo, or by the failures of internal controls or compliance breaches leading to a breach of Diageo’s Code of Business Conduct, its other key policies or of the laws or regulations in the jurisdictions in which it operates.

In addition, Diageo’s ability to maintain, extend, and expand its brand image depends on its ability to adapt to a rapidly changing media environment. Diageo maintains an online presence as part of its business operations, and increasingly relies on social media and online dissemination of advertising campaigns. Diageo’s reputation may suffer if it is perceived to fail to appropriately restrict access to its online content or if it breaches any marketing regulation, code or policy. In addition, the growing use of social and digital media increases the speed and extent that information or misinformation and opinions can be shared. Negative posts or comments about Diageo, its brands or its products on social or digital media, whether or not valid, could seriously damage Diageo’s brands and reputation.

Any failure to maintain, extend, and expand Diageo’s brand image or adapt to a changing media environment may have an adverse effect on Diageo’s business and financial results.

Diageo faces competition that may reduce its market share and margins

Diageo faces substantial competition from several international companies as well as local and regional companies in the countries in which it operates and competes with drinks companies across a wide range of consumer drinking occasions. Within a number of categories, the beverage industry has been experiencing continuing consolidation among major global producers, as evidenced by several business combinations of substantial value carried out by significant competitors in 2015. Consolidation is also taking place among Diageo’s customers in many countries. These trends may lead to stronger competitors, increased competitive pressure from customers, negative impacts on Diageo’s distribution network, downward pressure on prices, predatory marketing tactics by Diageo’s competitors and/or a decline in Diageo’s market share in any of these categories. Adverse developments in economic conditions or declines in demand or consumer spending may also result in intensified competition for market share, with potentially adverse effects on sales volume and price. Any of these factors may adversely affecting Diageo’s results and growth potential.

Diageo may not be able to derive the expected benefits from its business strategies, including in relation to expansion in emerging markets, acquisitions, productivity initiatives or inventory forecasting

There can be no assurance that Diageo’s business strategies will result in opportunities for growth and improved margins. Part of Diageo’s growth strategy includes expanding its business in certain emerging market countries where consumer spending in general, and spending on Diageo’s products in particular, has not historically been as great but where Diageo believes there are strong prospects for growth. There is no guarantee that this strategy will be successful, and some of these markets may represent a higher risk in terms of their changing regulatory environments and a higher degree of uncertainty over levels of consumer spending.

 

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It is also possible that Diageo’s business strategies could give rise to further business combinations, acquisitions, disposals, joint ventures and/or partnerships (including any associated financing or the assumption of actual or potential liabilities, depending on the transaction contemplated). There can be no assurance that any transaction will be completed or that any such transaction would deliver the anticipated benefits, cost savings or synergies. The success of any transaction will depend in part on Diageo’s ability to successfully integrate new businesses with Diageo’s existing operations and realise the anticipated benefits. Acquisitions may also expose Diageo to liabilities it may not be aware of at the time of the acquisition, for example if acquired companies and business do not act, or have not acted, in compliance with applicable laws and regulations. The current and ongoing issues in USL detailed in note 18 to the consolidated financial statements provide an example of integration and legal challenges.

Similarly, there can be no assurance that the cost saving or productivity initiatives implemented by Diageo in order to improve efficiencies and deliver cost savings will deliver the expected benefits, and such programmes may result in significant costs to Diageo or may have other adverse impacts on the business and operations of the Group. Diageo continues to undertake programmes designed to improve the effectiveness and efficiency of end-to-end operations, including changes to organisational structures, business processes and business systems. Disruption caused to business processes as a result of such change could impact Diageo operations and lead to adverse customer or consumer reaction. There may also be a risk of impairment charges on goodwill or other intangible assets and failure to meet financial targets. Any of the foregoing may have an adverse effect on Diageo’s business and financial results.

Certain of Diageo’s aged product categories may mature over significant periods of up to 30 years, and forecasts of demand for such products in future periods are subject to significant uncertainty. There is an inherent risk of forecasting error in determining the quantity of maturing stock to lay down in a given year for future consumption as a result of changes in business strategy, market demand and preferences, macroeconomic conditions, introductions of competing products and other changes in market conditions. Any forecasting error could lead to Diageo being unable to meet the objectives of its business strategy, future demand or lead to a future surplus of inventory and consequent write down in value of maturing stocks. If Diageo is unable to accurately forecast demand for its products or efficiently manage its inventory, this may have a material adverse effect on Diageo’s business and financial results.

Contamination, counterfeiting or other events could harm the integrity of customer support for Diageo’s brands and adversely affect the sales of those brands

The success of Diageo’s brands depends upon the positive image that consumers have of those brands, and contamination, whether arising accidentally, or through deliberate third party action, or other events that harm the integrity of or consumer support for those brands, could adversely affect their sales. Diageo purchases most of the raw materials for the production and packaging of its products from third party producers or on the open market. Diageo may be subject to liability if contaminants in those raw materials or defects in the distillation, fermentation or bottling process lead to low beverage quality or illness among, or injury to, Diageo’s consumers. Diageo may recall products in the event of contamination or damage. A significant product liability judgement or a widespread product recall may negatively impact sales and profitability of the affected brand or all Diageo brands for a period of time depending on product availability, competitive reaction and consumer attitudes. Even if a product liability claim is unsuccessful or is not fully pursued, any resulting negative publicity could adversely affect Diageo’s reputation with existing and potential customers and its corporate and brand image.

Additionally, third parties may sell products which are either counterfeit versions of Diageo brands or inferior brands that look like Diageo brands, and consumers of Diageo brands could confuse Diageo products with them. A bad consumer experience with such a product could cause them to refrain from purchasing Diageo brands in the future and in turn could impair brand equity, adversely affecting Diageo’s business.

Diageo’s business may be adversely affected by increased costs or shortages of talent

Diageo’s business could be adversely affected by labour or skill shortages or increased labour costs due to increased competition for employees, higher employee turnover or increased employee benefit costs. Diageo’s success is dependent on the capability of its employees. There is no guarantee that Diageo will continue to be able to recruit, retain and develop the capabilities that it requires to deliver its strategy, for example in relation to sales, marketing and innovation capability within markets or in its senior management. The loss of senior management or other key personnel or the inability to identify, attract and retain qualified personnel in the future could make it difficult to manage Diageo’s operations and could adversely affect Diageo’s business and financial results.

 

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Diageo may be adversely affected by disruption to production facilities, business service centres or information systems (including cyber-attack)

Diageo would be affected if there was a catastrophic failure of its major production facilities or business service centres. Diageo operates production facilities around the world. If there was a technical failure in Diageo production facilities, or fire or explosion at one of Diageo’s production facilities, it could result in damage to the facilities, plant or equipment, their surroundings and/or the local environment and/or injury or loss of life. Such an event could lead to a loss in production capacity, or could result in regulatory action, legal liability or damage to Diageo’s reputation.

Diageo has a substantial inventory of aged product categories, principally Scotch whisky and Canadian whisky, which may mature over periods of up to 30 years or more. The maturing inventory is stored primarily in Scotland, and the loss through contamination, fire or other natural disaster of all or a portion of the stock of any one of those aged product categories could result in a significant reduction in supply of those products, and consequently, Diageo would not be able to meet consumer demand for those products as it arises. There can be no assurance that insurance proceeds would cover the replacement value of Diageo’s maturing inventory or other assets, were such assets to be lost due to contamination, fire or natural disasters, destruction resulting from negligence or the acts of third parties, or failure of information systems or data infrastructure.

As with all large systems, Diageo’s information systems could be subject to cyber-attack by outside parties’ intent on extracting information, corrupting information or disrupting business processes. Such unauthorised access could disrupt Diageo’s business and/or lead to loss of assets or to outside parties having access to confidential information, including privileged data or strategic information of Diageo and its employees, customers and consumers, or to making such information public in a manner that harms Diageo’s reputation. The concentration of processes in business service centres also means that any sustained disruption to the facility or issue impacting the reliability of the information systems used could impact a large portion of Diageo’s business operations and in some circumstances, could result in property damage, breaches of regulations, litigation, legal liabilities and reparation costs.

Diageo’s operations and financial results may be adversely affected by fluctuations in exchange rates and fluctuations in interest rates

Diageo is engaged in an international business that operates in, and makes sales into, countries with different currencies, while its financial results are presented in sterling. As a result, Diageo is subject to foreign currency risk due to exchange rate movements, which will affect the sterling value of its transactions, as well as the translation to sterling of the results and underlying net assets of its operations. In particular, approximately 31.9% of Diageo’s net sales in the year ended 30 June 2016 were in US dollars, approximately 11% were in euros and approximately 14.9% were in sterling. Movements in exchange rates used to translate foreign currencies into sterling may have a significant impact on Diageo’s reported results of operations from year to year. Exchange rate fluctuations may also expose Diageo to increased interest expense on borrowings denominated in currencies which appreciate against the sterling. As a result, Diageo’s business and financial results may be adversely affected by fluctuations in exchange rates. Diageo may also be adversely impacted by fluctuations in interest rates, mainly through increased interest expense.

Diageo’s operations and financial results may be adversely affected by movements in the value of assets and liabilities related to its pension plans

Diageo operates a number of pension plans throughout the world, which vary in accordance with local conditions and practices. The majority of these pension plans are defined benefit plans and are funded by payments to separately administered trusts or insurance companies. The ability of these pension plans to meet their pension obligations may be affected by, among other things, the performance of assets owned by these pension plans, the liabilities in connection with the pension plans, the underlying actuarial assumptions used to calculate the surplus or deficit in the plans, in particular the discount rate and long term inflation rates used to calculate the liabilities of the pension funds, and any changes in applicable laws and regulations. For example, Diageo’s deficit in respect of post-employment plans before taxation increased by £934 million from £259 million at 30 June 2015 to £1,193 million at 30 June 2016, primarily as a result of a decrease in returns from corporate bonds used to calculate the discount rates on plan liabilities. If there are significant declines in financial markets and/or deterioration in the value of fund assets or changes in discount rates or inflation rates, Diageo may need to make significant contributions to the pension funds in the future.

 

 

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Furthermore, if the market values of the assets held by Diageo’s pension funds decline, the valuations of assets by the pension trustees decline or the valuation of liabilities in connection with pension plans increase, then company cash contributions may increase which, as a result, could materially adversely affect Diageo’s financial position. There is no assurance that interest rates or inflation rates will remain constant, that pension fund assets can earn the assumed rate of return annually or that the value of liabilities will not fluctuate; Diageo’s actual experience may be significantly more negative than the assumptions used.

Diageo’s operations may be adversely affected by failure to maintain or renegotiate distribution, supply, manufacturing or licence agreements on favourable terms

Diageo’s business has a number of distribution, supply, manufacturing or licence agreements for brands owned by it or by other companies. These agreements vary depending on the particular brand, but tend to be for a fixed number of years. There can be no assurance that Diageo will be able to renegotiate its rights on favourable terms when these agreements expire or that they will not be terminated. Failure to renew these agreements on favourable terms could have an adverse impact on Diageo’s business and financial results. In addition, Diageo’s business and financial results may be adversely affected by any disputes with distributors of its products or with suppliers of raw materials.

Diageo may not be able to protect its intellectual property rights

Given the importance of brand recognition to its business, Diageo has invested considerable effort in protecting its intellectual property rights, including trademark registration and domain names. Diageo’s patents cover some of its process technology, including some aspects of its bottle marking technology. Diageo also uses security measures and agreements to protect its confidential information and trade secrets. However, Diageo cannot be certain that the steps it has taken will be sufficient or that third parties will not infringe on or misappropriate its intellectual property rights in its brands or products. Moreover, some of the countries in which Diageo operates offer less intellectual property protection than Europe or North America. Given the attractiveness of Diageo’s brands to consumers, it is not uncommon for counterfeit products to be manufactured and traded. Diageo cannot be certain that the steps it takes to assist the authorities to prevent, detect and eliminate counterfeit products will be effective in preventing material loss of profits or erosion of brand equity resulting from lower quality or even dangerous counterfeit product reaching the market. If Diageo is unable to protect its intellectual property rights against infringement or misappropriation, this could materially harm its future financial results and ability to develop its business.

Risks related to Diageo’s securities

It may be difficult to effect service of US process and enforce US legal process against the directors of Diageo

Diageo is a public limited company incorporated under the laws of England and Wales. The majority of Diageo’s directors and officers, and some of the experts named in this document, reside outside of the United States, principally in the United Kingdom. A substantial portion of Diageo’s assets, and the assets of such persons, are located outside of the United States. Therefore, it may not be possible to effect service of process within the United States upon Diageo or these persons in order to enforce judgements of US courts against Diageo or these persons based on the civil liability provisions of the US federal securities laws. There is doubt as to the enforceability in England and Wales, in original actions or in actions for enforcement of judgements of US courts, of civil liabilities solely based on the US federal securities laws. In addition, punitive damages in actions brought in the United States or elsewhere may be unenforceable in England and Wales.

 

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Cautionary statement concerning forward-looking statements

This document contains ‘forward-looking’ statements. These statements can be identified by the fact that they do not relate only to historical or current facts. In particular, forward-looking statements include all statements that express forecasts, expectations, plans, outlook and projections with respect to future matters. Examples of forward-looking statements include statements regarding exchange rates, interest rates, the availability or cost of financing to Diageo, social, political and environmental developments, consumer trends, preferences and purchasing power, overall market trends, the consequences of the referendum on the UK’s membership in the EU, and their impact on Diageo’s business operations and financial condition; statements made about Diageo’s strategy, trends in results of operations, margins, and growth rates and growth rate objectives; estimates of Diageo’s cash flows, effective interest rates, effective tax rates, cost savings, results of hedging instruments, cash contributions in post-employment plans, impacts of exchange rates, dividend policies and shareholders return objectives, executive compensation levels, outcomes of litigation, and the impact of new accounting policies on Diageo’s consolidated results and financial position. By their nature, forward-looking statements involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. There are a number of factors that could cause actual results and developments to differ materially from those expressed or implied by these forward-looking statements, including factors that are outside Diageo’s control.

These factors include, but are not limited to:

 

    economic, political, social or other developments in countries and markets in which Diageo operates, which may contribute to reduced demand for Diageo’s products, reduced consumer spending, negative impacts on Diageo’s customer, supplier and financial counterparties or the imposition of import, investment or currency restrictions;

 

    the results of the decision in the United Kingdom’s referendum on 23 June 2016 to leave the European Union, which may lead to a sustained period of economic and political uncertainty and complexity until the detailed terms of the United Kingdom’s exit from the European Union are finalised and as the United Kingdom negotiates and concludes any successor trading arrangements with other countries, and which may also negatively impact economic conditions in Europe more generally which could have an adverse impact on Diageo’s business operations and financial performance;

 

    changes in consumer preferences and tastes, including as a result of changes in demographic and social trends, public health regulations and travel, vacation or leisure activity patterns, or as a result of contamination, counterfeiting or other circumstances which could harm the integrity or sales of Diageo’s brands;

 

    any litigation or other similar proceedings (including with tax, customs and other regulatory authorities), including that directed at the drinks and spirits industry generally or at Diageo in particular, or the impact of a product recall or product liability claim on Diageo’s profitability or reputation;

 

    the effects of climate change and related regulations and other measures to address climate change, including any resulting impact on the cost and supply of water;

 

    changes in the cost of production, including as a result of increases in the cost of commodities, labour and/or energy or as a result of inflation;

 

    legal and regulatory developments, including changes in regulations regarding production, product liability, distribution, importation, labelling, packaging, consumption, advertising and data privacy; changes in tax law (including tax treaties), rates or requirements (including with respect to the impact of excise tax increases) or accounting standards; and changes in environmental laws, health regulations and the laws governing labour and pensions;

 

    the consequences of any failure by Diageo to comply with anti-corruption and other laws and regulations or any failure of Diageo’s related internal policies and procedures to comply with applicable law;

 

46


Business description (continued)

 

    ability to maintain Diageo’s brand image and corporate reputation or to adapt to a changing media environment, and exposure to adverse publicity, whether or not justified, and any resulting impacts on Diageo’s reputation and the likelihood that consumers choose products offered by Diageo’s competitors;

 

    increased competitive product and pricing pressures, including as a result of actions by increasingly consolidated competitors, that could negatively impact Diageo’s market share, distribution network, costs or pricing;

 

    the effects of Diageo’s business strategies, including in relation to expansion in emerging markets and growth of participation in international premium spirits markets, the effects of business combinations, partnerships, acquisitions or disposals, existing or future, and the ability to realise expected synergies and/or costs savings;

 

    Diageo’s ability to benefit from its strategy, including its ability to expand into new markets, to complete and benefit from existing or future business combinations or other transactions, to implement cost saving and productivity initiatives or to forecast inventory levels successfully;

 

    contamination, counterfeiting or other events that could adversely affect the perception of Diageo’s brands;

 

    increased costs or shortages of talent;

 

    disruption to production facilities or business service centres or information systems (including cyber-attack), existing or future;

 

    fluctuations in exchange rates and interest rates, which may impact the value of transactions and assets denominated in other currencies, increase the cost of financing or otherwise affect Diageo’s financial results;

 

    movements in the value of the assets and liabilities related to Diageo’s pension funds;

 

    renewal of supply, distribution, manufacturing or licence agreements (or related rights) and licences on favourable terms or at all when they expire; and

 

    failure of Diageo to protect its intellectual property rights.

All oral and written forward-looking statements made on or after the date of this document and attributable to Diageo are expressly qualified in their entirety by the above factors and by the principal risks set out in the ‘Risk factors’ section above. Any forward-looking statements made by or on behalf of Diageo speak only as of the date they are made. Diageo does not undertake to update forward-looking statements to reflect any changes in Diageo’s expectations with regard thereto or any changes in events, conditions or circumstances on which any such statement is based. The reader should, however, consult any additional disclosures that Diageo may make in any documents which it publishes and/or files with the US Securities and Exchange Commission (SEC). All readers, wherever located, should take note of these disclosures.

This document includes names of Diageo’s products, which constitute trademarks or trade names which Diageo owns, or which others own and licence to Diageo for use. All rights reserved. © Diageo plc 2016.

The information in this document does not constitute an offer to sell or an invitation to buy shares in Diageo plc or an invitation or inducement to engage in any other investment activities.

This document includes information about Diageo’s target debt rating. A security rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating organisation. Each rating should be evaluated independently of any other rating.

Past performance cannot be relied upon as a guide to future performance.

 

47


Business review

Operating results 2016 compared with 2015

GROUP FINANCIAL REVIEW

This is a good set of results and reflects better execution across the business. Our improved performance was driven by the return to growth of each of our six global brands and our US spirits business. The delivery of volume growth; 19bps of organic margin expansion; increased free cash flow; and the disposal of £1 billion in non-core assets, comes from driving efficiency in every aspect of the business and across every expense item to fuel future growth. I believe this consistent approach to growth, productivity and cash will drive better value creation.

Kathryn Mikells,

Chief Financial Officer

 

Net sales declined 3.0% as organic growth in each region and acquisitions were more than offset by adverse exchange and disposals

Organic results improved with volume growth of 1.3%

Organic net sales growth of 2.8%

Operating profit grew 1.6% with organic growth, lower exceptional operating charges and acquisitions partially offset by adverse exchange and disposals

Organic operating profit growth of 3.5%

Net cash from operating activities was flat, £2.5bn

Free cash flow continued to be strong at £2.1bn up £134 million on last year

Basic eps of 89.5 pence was down 6% as lower exceptional income reduced basic eps by 6.1 pence

Eps before exceptional items increased 1% to 89.4 pence

 

LOGO    Volume Net sales(i) Operating profit(ii) Operating profit before exceptionals(iii) North America Europe Africa Latin America and Caribbean Asia Pacific

 

 

(i) Excluding corporate net sales of £36 million (2015 - £80 million).
(ii) Excluding corporate and ISC costs of £150 million (2015 - £139 million).
(iii) Excluding exceptional operating charges of £167 million (2015 - £269 million) and corporate and ISC costs before exceptional items of £150 million (2015 - £123 million).

 

                                                                 

Summary financial information

          2016     2015  

Volume

     EUm           246.4        246.2   

Net sales

     £million           10,485        10,813   

Marketing

     £million           1,562        1,629   

Operating profit before exceptional items

     £million           3,008        3,066   

Exceptional operating items

     £million           (167     (269

Operating profit

     £million           2,841        2,797   

Share of associates and joint ventures profit after tax

     £million           221        175   

Non-operating items

     £million           123        373   

Net finance charges

     £million           327        412   

Tax rate

     %           17.4        15.9   

Tax rate before exceptional items

     %           19.0        18.3   

Profit attributable to parent company’s shareholders

     £million           2,244        2,381   

Basic earnings per share

     pence           89.5        95.0   

Earnings per share before exceptional items

     pence           89.4        88.8   

Recommended full year dividend

     pence           59.2        56.4   

 

48


Business review (continued)

 

Growth by region

   Volume     Net Sales     Marketing     Operating
profit
 
   %     %     %     %  

North America

     (1     3               9   

Europe, Russia and Turkey

            (3     4        2   

Africa

     19        (1     (3     (32

Latin America and Caribbean

     (5     (16     (14     (69

Asia Pacific

     (3     (6     (13     112   

Diageo(i)

            (3 )      (4 )      2   

 

                                                                                       

Organic growth by region

   Volume
%
    Net sales
%
     Marketing
%
    Operating
profit(ii)

%
 

North America

     1        3         (2     4   

Europe, Russia and Turkey

     2        4         5        6   

Africa

     9        3         1        (11

Latin America and Caribbean

     (2     1                (1

Asia Pacific

            2         (12     13   

Diageo(i)

     1        3         (2     3   

 

 

(i) Includes Corporate. Corporate net sales in the year ended 30 June 2016 were £36 million (2015 – £80 million) a decrease of 55% due to the sale of the Gleneagles Hotel in June 2015. Net operating charges before exceptional items were £150 million (2015 – £123 million), increased due to costs related to the productivity programme, the reinvestment of the savings delivered by the organisational review announcement in January 2014, and increase in the annual incentive plan costs. These increases were partially offset by increased profit on land sales.
(ii) Before exceptional items.

KEY PERFORMANCE INDICATORS

Net sales growth (£ million)

Net sales declined 3.0%. Organic net sales growth of 2.8% driven by volume and mix.

 

LOGO

10,813 145 90 131 10,485 (172) (122) (400) Organic movement 2015 2016 Exchange(i) Volume Disposals Price/mix Acquisitions Asia Pacific net sales adjustment(ii)

 

 

(i) Exchange rate movements reflect the translation of prior year reported results at current exchange rates.
(ii) Diageo has reflected the full year impact of an accounting change USL made in its most recent quarterly results to account for sales by third party manufacturers on a net sales basis. See page 54 for more details.

Net sales declined 3.0%. Adverse impact of exchange and disposals reduced net sales by 5.3%. These movements were partially offset by organic net sales growth of 2.8% with volume growth of 1.3% and positive price/mix, primarily mix.

Net sales and operating profit were impacted by adverse exchange movements driven by the weakness of a number of currencies against sterling, in particular the Nigerian naira, the South African rand, the Venezuelan bolivar, the Brazilian real and the Turkish lira, partially offset by the strengthening of the US dollar.

 

 

49


Business review (continued)

 

Operating profit growth (£ million)

Operating profit growth of 1.6%. Organic operating profit growth of 3.5%.

 

LOGO

 

102 99 2,841 2,797 22 (83) (96) 2015 2016 Exceptional operating items Acquisitions Exchange Organic movement Disposals

 

Operating profit growth of 1.6% was driven by organic growth, acquisitions and lower exceptional operating charges (£167 million in 2016; £269 million in 2015). These movements were partially offset by adverse exchange and the impact of disposals.

Acquisitions and disposals

Acquisitions made in 2015 increased net sales in the year ended 30 June 2016 by £90 million and operating profit by £22 million, largely due to the acquisition of the remaining 50% shareholdings in Don Julio and United National Breweries.

Businesses which were disposed of in the year ended 30 June 2015, primarily Bushmills and Gleneagles, and those disposed of in the year ended 30 June 2016, the sale of wines and certain beer assets, contributed net sales of £655 million and operating profit of £121 million in the period ended 30 June 2015, and contributed net sales of £255 million and operating profit of £25 million in the period ended 30 June 2016. The year on year movement on net sales was £400 million and £96 million on operating profit.

Operating margin (%)

Operating margin improved by 123bps. Organic margin improved by 19bps.

 

LOGO

78bps 55bps 33bps 27.10% 89bps 14bps 25.87% (114)bps (32)bps Organic movement 2015 2016 Exceptional operating items Marketing Exchange Overheads Acquisitions and disposals Asia Pacific net sales adjustment(i) Gross margin

 

 

 

(i) Diageo has reflected the full year impact of an accounting change USL made in its most recent quarterly results to account for sales by third party manufacturers on a net sales basis. It has no impact on gross profit or operating profit. See page 54 for more details.

 

50


Business review (continued)

 

Operating margin improved by 123bps mainly driven by lower exceptional operating charges, a 19bps improvement in organic margin and the net sales adjustment in Asia Pacific. These movements were partially offset by an adverse exchange impact. Organic operating margin improvement was driven by favourable mix, including the return to growth in North America which drove gross margin improvement, as well as net procurement efficiencies after reinvestment in increased marketing activity. These benefits were partially offset by higher overheads driven by a year on year increase in annual incentive plan costs and inflation.

Basic earnings per share (pence)

Eps decreased to 89.5 pence. Eps before exceptional items increased from 88.8 pence to 89.4 pence

 

LOGO

95.0 3.39 89.5 3.95 1.83 (6.14) (1.37) (0.82) (3.33) (2.97) 2015 2016 Exceptional items(i) Associates and joint ventures Exchange on operating profit Finance charges Acquisitions and disposals Tax Operating profit excluding Non-controlling interests exchange 950339895395183(614)(137)(082)(333)(297)20152016Exceptionalitems(i)AssociatesandjointventuresExchangeonoperatingprofitFinancechargesAcquisitionsanddisposalsTaxOperatingprofitexcludingNon-controllinginterestsexchange

 

 

 

 

(i) Exceptional items net of tax and non-controlling interests.

Lower exceptional income (net of tax and non-controlling interests) (£2 million in 2016; £156 million in 2015) reduced basic earnings per share by 6.1 pence. Pre-exceptionals eps was up 0.6 pence as adverse exchange, net impact of acquisitions and disposals, a higher tax rate and the increase in non-controlling interests from higher operating profit in USL, were more than offset by organic operating profit growth, higher associate income and lower finance charges. Finance charges were lower on the fall in both net interest charge and other financing charges. Net interest charges declined from debt reduction and lower interest rates. Other finance charges dropped due to lower hyperinflation charge for Venezuela as we moved to a consolidation rate which recognised the impact of the inflation rate as well as the impact of lapping a £13 million charge in 2015 in respect of an increase in value of Zacapa related financial liabilities.

 

Movement in net finance charges

    £ million  

2015

  

    412   

Net interest charge reduction

  

    (51

Reduction in other finance charges

  

    (34
    

 

 

 

2016

  

    327   
    

 

 

 
     2016     2015  

Average monthly net borrowings (£ million)

     9,245        10,459   

Effective interest rate(i)

     3.3     3.5

 

 

(i) For the calculation of the effective interest rate, the net interest charge excludes fair value adjustments to derivative financial instruments and borrowings. Average monthly net borrowings include the impact of interest rate swaps that are no longer in a hedge relationship but excludes the market value adjustment for cross currency interest rate swaps.

The fall in average monthly net borrowings arose from disposals proceeds and continued strong cash flow. The effective interest rate reduced in the year ended 30 June 2016 largely driven by changes in financing in USL together with the repayment of Diageo bonds with a higher interest rate.

 

51


Business review (continued)

 

Net cash from operating activities and free cash flow (£ million)

Net cash from operating activities(i) was £2,548 million in 2016 a decline of £3 million on £2,551 million in 2015.

 

 

LOGO

2,551 (83) 152 (170) 93 5 2,548 2015 2016 Exchange(ii) Operating profit(iii) Working capital Interest and tax Other(iv)

 

 

Free cash flow was £2,097 million in 2016 an increase of £134 million.

 

LOGO

1,963 137 152 93 5 2,097 (83) (170) 2015 2016 Capex Working capital movement Exchange (ii) Interest and tax Operating profit (iii) Other (iv)

 

 

(i) Net cash from operating activities excludes capex, loans and other investments (collectively £(451) million in 2016 – £(588) million in 2015).
(ii) Exchange – on operating profit before exceptional items.
(iii) Operating profit excluding exchange, depreciation and amortisation, post employment payments and non-cash items but including operating exceptional items.
(iv) Other items include post employment payments, dividends received from associates and joint ventures.

Net cash from operating activities declined by £3 million driven by negative working capital movement, partially offset by increased operating profit and lower interest payments.

The negative working capital movement was driven by the year on year comparison to a significant reduction in receivables in 2015. This was partially offset by a favourable movement on inventory and payables.

Free cash flow improved £134 million driven by lower capex, increased operating profit before exchange, and lower interest payments, partially offset by negative working capital movement.

 

52


Business review (continued)

 

Return on invested capital (%)

The return on closing invested capital of 23.2% for the year ended 30 June 2016, calculated as profit for the year divided by net assets as of 30 June 2016, decreased by 350bps principally due to the increase in net assets driven by the weakening of sterling against a number of currencies partially offset by an increase in post employment liabilities.

Return on average invested capital (ROIC)(i) decreased 22bps

 

LOGO

12.3% 14bps 12.1% 3bps 47bps (8)bps (62)bps (16)bps 2015 2016 Exchange Associates and joint ventures Acquisitions and disposals Non-controlling interests Operating profit excluding Other exchange

 

 

 

(i) ROIC calculation excludes exceptional items.

ROIC before exceptional items decreased 22bps driven mainly due to the adverse impact of exchange which was partially offset by the increased return from growth in operating profit and income from associates.

 

53


Business review (continued)

 

Income statement

 

                                                                                                                                   
     2015
£ million
    Exchange
(a)
£ million
    Acquisitions
and disposals

(b)
£ million
    Organic
movement(ii)
£ million
    Reclassifi-
cation(iii)
£ million
    2016
£ million
 

Sales

     15,966        (360     (362     397               15,641   

Excise duties

     (5,153     188        52        (121     (122     (5,156
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net sales

     10,813        (172     (310     276        (122     10,485   

Cost of sales(i)

     (4,585     68        200        (56     122        (4,251
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     6,228        (104     (110     220               6,234   

Marketing

     (1,629     13        17        37               (1,562

Other operating expenses(i)

     (1,533     8        19        (158            (1,664
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating profit before exceptional items

     3,066        (83     (74     99               3,008   

Exceptional operating items (c)

     (269             (167
  

 

 

           

 

 

 

Operating profit

     2,797                2,841   

Non-operating items (c)

     373                123   

Net finance charges

     (412             (327

Share of after tax results of associates and joint ventures

     175                221   
  

 

 

           

 

 

 

Profit before taxation

     2,933                2,858   

Taxation (d)

     (466             (496
  

 

 

           

 

 

 

Profit for the year

     2,467                2,362   
  

 

 

           

 

 

 

 

 

(i) Before exceptional operating items, see pages 55-56.
(ii) For the definition of organic movement see page 133.
(iii) Following a review of the third party production arrangements in India it was determined to be more appropriate to ensure consistent reporting by reclassifying the excise duties payable by the third party production companies as excise duties. This change was implemented by USL in its first three months of its financial year ended 30 June 2016, and resulted in net sales for the year ended 30 June 2016 reducing by £122 million with a corresponding decrease in cost of sales. There was no impact on gross or operating profit.

(a) Exchange

The impact of movements in exchange rates on reported figures is principally in respect of the Nigerian naira, the South African rand, the Venezuelan bolivar, the Brazilian real and the Turkish lira, partially offset by the US dollar.

Venezuela is a hyper-inflationary economy where the government maintains a regime of strict currency controls with multiple foreign currency rate systems. Access to US dollar on these exchange systems is very limited. The foreign currency denominated transactions and balances of the group’s Venezuelan operations are translated into the local functional currency (VEF) at the rate they are expected to be settled, applying the most appropriate official exchange rate. For consolidation purposes, the group converts its Venezuelan operations using management’s estimate of the exchange rate that capital and dividend repatriations are expected to be realised. The consolidation exchange rate and the accounting treatment are monitored and reviewed depending on the economic and regulatory developments in the country.

The effect of movements in exchange rates and other movements on profit before exceptional items and taxation for the year ended 30 June 2016 is set out in the table below.

 

54


Business review (continued)

 

                     
     Gains/
(losses)
£ million
 

Translation impact

     (13

Transaction impact

     (70
  

 

 

 

Operating profit before exceptional items

     (83
  

 

 

 

Net finance charges – translation impact

     (17

Mark to market impact of IAS 39 on interest expense

     (9

Impact of IAS 21 and IAS 39 on net other finance charges

     2   
  

 

 

 

Net finance charges

     (24

Associates – translation impact

     (4
  

 

 

 

Profit before exceptional items and taxation

     (111
  

 

 

 

 

                                           
     Year
ended
30 June
2016
     Year
ended
30 June
2015
 

Exchange rates

     

Translation   £1 =

     $1.48         $1.57   

Transaction  £1 =

     $1.55         $1.58   

Translation   £1 =

     €1.34         €1.31   

Transaction  £1 =

     €1.28         €1.23   

(b) Acquisitions and disposals

The impact of acquisitions and disposals on the reported figures was primarily attributable to the disposals of The Old Bushmills Distillery Company Limited on 27 February 2015, Gleneagles Hotels Limited on 30 June 2015, Desnoes & Geddes Limited (D&G) on 7 October 2015, the wine businesses in the United States and the UK Percy Fox wine business on 1 January 2016, which were partially offset by the acquisition of 50% equity interests, that the group did not own, in both Don Julio in Mexico on 27 February 2015 and a joint venture in South Africa on 29 May 2015.

(c) Exceptional items

Exceptional operating charges in the year ended 30 June 2016 totalled £167 million before tax, a decrease of £102 million against last year.

Exceptional operating charges in the year ended 30 June 2016 included an impairment charge in respect of the Ypióca brand and related tangible fixed assets and goodwill allocated to the Paraguay, Uruguay and Brazil (PUB) cash-generating unit of £62 million, £14 million and £42 million, respectively. Forecast cash flow assumptions have been reduced principally due to a challenging economic environment in Brazil and significant adverse changes in local tax regulation.

On 25 February 2016 the group incurred an exceptional operating charge of £49 million including a $75 million

(£53 million) payment to Dr Vijay Mallya over a five year period in consideration for (i) his resignation and the termination of his appointment and governance rights and his relinquishing of the rights and benefits attached to his position as Chairman and Non-Executive Director of United Spirits Limited (USL); (ii) his agreement to five-year global non-compete (excluding the United Kingdom), non-interference, non-solicitation and standstill undertakings; and (iii) his agreement that he and his affiliates will not pursue any claims against Diageo, USL and their affiliates. In addition to the amount Diageo agreed to pay Dr Vijay Mallya there was net gain of £4 million arising from the termination of certain related agreements, that were previously provided for less legal fees directly attributable to the settlement.

 

55


Business review (continued)

 

In the year ended 30 June 2015 exceptional operating charges were £269 million before tax which comprised £146 million in respect of a settlement agreement of disputes with the Korean customs authorities, £82 million in respect of restructuring programmes and an exceptional impairment charge of £41 million in respect of the group’s 45.56% equity investment in Hanoi Liquor Joint Stock Company.

Non-operating items in the year ended 30 June 2016 were a net gain of £123 million before tax compared to a gain of £373 million before tax last year, a decrease of £250 million against last year.

The year ended 30 June 2016 included an exceptional gain before taxation of £457 million in respect of the sale of Diageo’s 57.87% shareholding in D&G (Jamaican Red Stripe business) and a 49.99% stake in GAPL Pte Limited (Singapore and Malaysian beer businesses) to Heineken, which completed on 7 October 2015. The gain is net of a £13 million cumulative exchange loss, in respect of prior years, recycled from other comprehensive income and transaction costs of £7 million. As part of the transaction, Diageo purchased an additional 20% shareholding in Guinness Ghana Breweries Limited (GGBL) from Heineken which increased Diageo’s shareholding in GGBL to 72.42%.

On 1 January 2016, Diageo completed the sale of the majority of its wine interests in the United States and its UK based Percy Fox businesses to Treasury Wine Estates. Together with the sale of the group’s other wine interests in the United States the transactions resulted in a loss before taxation on disposal of £191 million including an estimated provision for the settlement of a guarantee given in respect of the lease payments due to Realty Income Corporation, the lessor of the vineyards. The loss is net of an exchange gain of £12 million, in respect of prior years, recycled from other comprehensive income and transaction costs of £8 million.

On 29 January 2016, Diageo disposed of its interests in Argentina to Grupo Peñaflor. The transaction resulted in a loss before taxation of £38 million including a cumulative exchange loss of £20 million, in respect of prior years, recycled from other comprehensive income and other directly attributable costs of £7 million.

On 1 December 2015, Diageo disposed of its 42.25% equity interests in DHN Drinks, its 25% equity stake in Sedibeng Breweries Limited and its 15.01% equity stake in Namibia Breweries Limited (South African associate interests) to Heineken. The net cash consideration received was £120 million, which included the repayment of £31 million in respect of loans previously made to DHN Drinks and Sedibeng Breweries Limited. A loss before taxation of £27 million, including a £30 million cumulative exchange loss, in respect of prior years, recycled from other comprehensive income, was accounted for in the income statement.

On 30 September 2015, the group completed the disposal of its shareholding in Central Glass Industries Limited (CGI), a Kenyan glass bottle manufacturer, resulting in a gain before taxation of £14 million, net of £1 million transaction costs. £7 million of the gain is attributable to non-controlling interests.

A guarantee provided by Diageo for a loan of $135 million (£92 million) given by Standard Chartered Bank (SCB) to Watson Limited was called and $135 million paid to SCB during the year. The underlying security package for the loan remains in place. A provision of $135 million has been made. Further details are set out in note 18.

In the year ended 30 June 2015 non-operating items included a gain of £63 million as a result of Don Julio becoming a subsidiary of the group and as part of the transaction, Diageo sold its wholly owned subsidiary, The Old Bushmills Distillery Company Limited to the Cuervo group, resulting in a gain of £174 million. A gain of £103 million arose on the increase of the group’s investment in United Spirits Limited (USL) from 25.02% to 54.78% (excluding the 2.38% interest owned by USL Benefit Trust). On 30 June 2015, Diageo completed the disposal of Gleneagles Hotel Limited to the Ennismore group resulting in an exceptional gain of £73 million. In addition a provision of £30 million was charged to the income statement in respect of a guarantee provided to a third party financial institution.

Cash payments in the year ended 30 June 2016 for exceptional restructuring, for the payment in respect of the Watson guarantee (reported in ’movements in loans and other investments’ in the consolidated statement of cash flows), for disengagement agreements relating to United Spirits Limited and for thalidomide were £52 million, £92 million, £28 million and £12 million, respectively. In the comparable period the cash expenditure for exceptional restructuring, for the legal settlement in Korea, for the guarantee and for thalidomide were £117 million, £74 million, £30 million and £19 million, respectively.

 

56


Business review (continued)

 

(d) Taxation

The reported tax rate for the year ended 30 June 2016 was 17.4% compared with 15.9% for the year ended 30 June 2015. The tax rate before exceptional items for the year ended 30 June 2016 was 19.0% compared with 18.3% in the prior year. It is expected that the tax rate before exceptional items for the year ending 30 June 2017 will be 21%.

(e) Dividend

The group aims to increase the dividend at each half-year and the decision as to the rate of the dividend increase is made with reference to dividend cover as well as the current performance trends including top and bottom line together with cash generation. Diageo targets dividend cover (the ratio of basic earnings per share before exceptional items to dividend per share) within the range of 1.8-2.2 times. For the year ended 30 June 2015 dividend cover was 1.6 times. Beginning with the interim dividend for the year ended 30 June 2016 we slowed growth to 5% consistent with our focus on stabilising and rebuilding dividend cover. The recommended final dividend for the year ended 30 June 2016 is 36.6 pence, an increase of 5% consistent with our interim dividend. This brings the full year dividend to 59.2 pence per share and dividend cover to 1.5 times. We would expect to maintain dividend increases at roughly a mid-single digit rate until cover is back in range.

Subject to approval by shareholders, the final dividend will be paid to holders of ordinary shares and ADRs on the register as of 12 August 2016. The ex-dividend date for the holders of the ordinary shares is 11 August 2016, and 10 August 2016 for US ADR holders. The final dividend will be paid to shareholders on 6 October 2016. Payment to US ADR holders will be made on 12 October 2016. A dividend reinvestment plan is available to holders of ordinary shares in respect of the final dividend and the plan notice date is 15 September 2016.

 

57


Business review (continued)

 

Movements in net borrowings and equity

 

                                           

Movement in net borrowings

   2016
£ million
    2015
£ million
 

Net borrowings at the beginning of the year

     (9,527     (8,850

Free cash flow (a)

     2,097        1,963   

Acquisition and sale of businesses (b)

     1,047        (306

Proceeds from issue of share capital

     1        1   

Net purchase of own shares for share schemes (c)

     (1     (8

Dividends paid to non-controlling interests

     (101     (72

Purchase of shares of non-controlling interests (d)

     (21       

Disposal of non- controlling interests

            1   

Net movements in bonds (e)

     (1,003     (701

Net movements in other borrowings (f)

     (233     386   

Equity dividends paid

     (1,443     (1,341
  

 

 

   

 

 

 

Net increase/(decrease) in cash and cash equivalents

     343        (77

Net decrease in bonds and other borrowings

     1,236        315   

Exchange differences (g)

     (725     (7

Borrowings on acquisition of businesses

            (869

Borrowings disposed through sale of businesses

     14          

Other non-cash items

     24        (39
  

 

 

   

 

 

 

Net borrowings at the end of the year

     (8,635     (9,527
  

 

 

   

 

 

 
 

 

(a) See page 138 for the analysis of free cash flow.

(b) Acquisitions and sale of businesses include the disposal of the group’s shareholdings in D&G and GAPL on 7 October 2015 for a net cash consideration, including disposal costs, of $783 million (£510 million); the disposal of the group’s equity stake in its South African associate interests on 1 December 2015 for a cash consideration of ZAR 2,517 million (£119 million), net of disposal costs; the disposal of the group’s wine interests in the United States and its UK based Percy Fox for a cash consideration of $551 million (£375 million), net of disposal costs; and the proceeds from the sale of CGI, a Kenyan glass manufacturer, for KES 3,931 million (£25 million), net of disposal costs.

In the year ended 30 June 2015 cash payments primarily comprised £1,118 million in respect of the acquisition of additional 26% investment in USL and £192 million for the 50% equity interest in Don Julio BV that it did not already own, partially offset by cash received of £391 million in respect of sale of the Whyte and Mackay Group and £456 million on the sale of equity share capital in The Old Bushmills Distillery Company Limited.

(c) Net purchase of own shares comprised purchase of treasury shares for the future settlement of obligations under the employee share option schemes of £47 million (2015 – £75 million) less receipts from employees on the exercise of share options of £46 million (2015 – £67 million).

(d) In the year ended 30 June 2016 Diageo purchased an additional 20% shareholding in Guinness Ghana Breweries Limited for £21 million.

(e) In the year ended 30 June 2016, the group repaid bonds of $1,500 million (£1,003 million). In the comparable period, the group repaid bonds of €1,000 million (£792 million) and $500 million (£330 million), issued bonds of €1,000 million (£791 million), and a bond of £370 million acquired on the purchase of USL was repaid using the proceeds from the sale of the Whyte and Mackay Group.

(f) Net movements in other borrowings are driven by the net repayment of short term commercial paper.

(g) Net borrowings increased because of unfavourable exchange differences primarily on the US dollar and euro denominated borrowings partially offset by a favourable movement on foreign exchange swaps and forwards.

 

58


Business review (continued)

 

                                           

Movement in equity

   2016
£ million
    2015
£ million
 

Equity at the beginning of the year

     9,256        7,590   

Profit for the year

     2,362        2,467   

Exchange adjustments (a)

     875        (225

Net remeasurement of post employment plans

     (856     113   

Tax on post employment plans

     166        (11

Exchange recycled to the income statement (b)

     51        88   

Fair value movements on available-for-sale investments

     (20     20   

Non-controlling interests acquired (b)

            641   

Purchase of shares of non-controlling interests

     (21       

Disposal of non- controlling interest

     (24       

Dividends to non- controlling interests

     (101     (72

Dividends paid

     (1,443     (1,341

Other reserve movements

     (65     (14
  

 

 

   

 

 

 

Equity at the end of the year

     10,180        9,256   
  

 

 

   

 

 

 

 

 

(a) Movement in the year ended 30 June 2016 primarily arose from exchange gains in respect of the Indian rupee, Turkish lira, US dollar and euro.

(b) In the year ended 30 June 2016 exchange losses of £51 million were recycled to the income statement in respect of disposals.

In the year ended 30 June 2015 following the acquisition of majority equity stakes in USL, 50% equity interest in Don Julio and one of the group’s joint ventures in South Africa that it did not already own exchange losses of £88 million were recycled to the income statement and on the acquisition of USL a 43.91% non-controlling interest of £641 million was recognised.

Post employment plans

The deficit in respect of post employment plans before taxation increased by £934 million from £259 million at 30 June 2015 to £1,193 million at 30 June 2016. The increase primarily arose due to a decrease in returns from ‘AA’ rated corporate bonds used to calculate the discount rates on the liabilities of the post employment plans (United Kingdom reduced from 3.8% to 2.9% and Ireland from 2.6% to 1.4%) partially offset by a reduction in long term inflation rates (UK RPI from 3.2% to 2.8%, UK CPI from 2.2% to 1.8% and Ireland CPI from 1.6% to 1.4%). Total cash contributions by the group to all post employment plans in the year ending

30 June 2017 are estimated to be approximately £200 million.

 

59


Business review (continued)

 

NORTH AMERICA

North America, the largest market for premium drinks in the world, accounts for about a third of our net sales and around half of operating profit. North America continues to be a very vibrant market and we are focused on setting the business up for long-term growth. In the year, we disposed of our wine assets in the United States, and our new management team have made a number of changes to refocus marketing activity, upweight on premise activity, and enhance distributor relationships.

 

LOGO    Net sales by markets Net sales by categories Net sales by price points (%) (%) (%) US Spirits Canada Spirits(i) RTDs Value Super premium and Wines Other Beer Other Standard Ultra premium DGUSA Wine Premium (i) excluding RTDs

 

(i) excluding RTDs

 

                                                                                                                             

Key financials

  2015
£ million
    Exchange
£ million
    Acquisitions
and
disposals
£ million
    Organic
movement
£ million
    2016
£ million
    Reported
movement

%
 

Net sales

    3,455        172        (159     97        3,565        3   

Marketing

    542        23        (14     (10     541          

Operating profit before exceptional items

    1,448        77        (30     56        1,551        7   

Exceptional operating items

    (28               
 

 

 

         

 

 

   

Operating profit

    1,420              1,551        9   
 

 

 

         

 

 

   

Our markets

North America business is headquartered in Norwalk, Connecticut, and comprises US Spirits, Diageo Guinness USA (DGUSA) and Diageo Canada.

Supply operations

We have nine bottling, distilling, blending and maturation sites including operations in Plainfield, Illinois; Amherstburg, Ontario; Valleyfield, Quebec; Relay, Maryland; Gimli, Manitoba; Tullahoma, Tennessee and Louisville, Kentucky. Over the last five years, we have made significant changes to our supply footprint in North America as we focus on continuously improving efficiency across our supply chain. Since 2010 we have invested more than $250 million (£160 million) in our network and people to deliver world-class manufacturing and packaging operations.

Route to consumer

Route to consumer in the United States is through the three-tier system and we distribute our products through approximately 40 spirits distributors and brokers, and more than 400 beer distributors. We have a unique route to consumer for our spirits business in the United States, with approximately 3,000 dedicated distributor sales people focused only on Diageo and Moët Hennessy spirits brands. We consolidate our US Spirits business into a single distributor or broker in 41 states and the District of Columbia, representing more than 80% of our US Spirits volume.

The US Spirits business operates through three divisions in open states where we sell to distributors who then sell to retailers, and through two division in control states where we sell to the state, which in turn sells to state or agency stores and on premise retailers. DGUSA sells and markets brands including Guinness and Smirnoff Ice. Beer distribution generally follows the three-tier open state regulations across the United States. Diageo Canada distributes our collection of spirits and beer brands across all Canadian provinces, which generally operate through a provincial control system. Diageo Canada operates through a single broker with a dedicated sales force handling our brands in the country. National brand strategy, strategic accounts marketing and corporate functions are managed at the North America level.

 

60


Business review (continued)

 

Sustainability and responsibility

Through our focus on responsible drinking we have built a reputation as a leading voice in the industry in North America, our largest market. 2015 saw the successful culmination of our 12-year campaign for alcohol companies to be allowed to include alcohol content and nutritional information per serve on packaging. In October we followed this by putting macro nutritional labels on our Crown Royal packaging – a first for any alcohol company.

Operational sustainability is another key issue for us. We have introduced rigorous water management procedures across our North America sites. For example, at our George Dickel distillery in Tullahoma, Tennessee, all water is either reused or returned to the local water source without impact, resulting in zero wastewater leaving the site. Our focus on improving energy efficiency and reducing carbon emissions has made North America Diageo’s best-performing region for this metric.

Performance

Net sales

Net sales were £3,565 million in the year ended 30 June 2016 an increase of £110 million compared to net sales of £3,455 million in the year ended 30 June 2015. Net sales were favourably impacted by exchange rate movements of £172 million primarily due to the strength of the US dollar against sterling and organic growth of £97 million (see further performance analysis below) partially offset by the loss of £159 million of net sales due to disposal of the wine businesses in the United States in January 2016 and Bushmills in February 2015.

Operating profit

Operating profit was £1,551 million in the year ended 30 June 2016 an increase of £131 million compared to operating profit of £1,420 million in the year ended 30 June 2015. Operating profit benefited £77 million from exchange rate movements due to the strength of the US dollar and organic growth of £56 million, partially offset by the loss of £30 million operating profit on the disposal of the wine businesses in the United States in January 2016 and Bushmills in February 2015. No exceptional operating charges were recorded in the year ended 30 June 2016 compared to £28 million restructuring cost in the year ended 30 June 2015.

Further performance analysis

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

North America delivered net sales growth of 3%, following the expected strong performance in the second half in US Spirits. Full year depletion and net sales growth in US Spirits was 3%. Growth in North American whisk(e)y, scotch and tequila drove positive mix. North American whisk(e)y, with net sales up 6%, was the main driver of net sales growth as Crown Royal and Bulleit continued to gain share in the category. Performance of Smirnoff and Captain Morgan improved, with net sales up 2% for both brands. In scotch, Johnnie Walker and Buchanan’s both performed well, with net sales up 7% and 9%, respectively. Reserve brands performance also improved, with net sales up 5%, driven by Johnnie Walker reserve variants, Bulleit, Don Julio and Ketel One vodka. Elsewhere in the region DGUSA net sales grew 1%, with growth in ready to drink offsetting a decline in beer, and in Canada net sales were up 4%. Marketing in North America was down 2% as a result of procurement efficiencies and more focused spend on innovation. Operating margin increased 39bps for the year, as improvement in gross margin and lower marketing more than offset higher overheads.

 

                                                                                       

Markets and categories:

   Organic
volume
movement

%
    Reported
volume
movement
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

North America

     1        (1     3        3   
        

US Spirits

     1        (1     3        4   

DGUSA

            (3     1        5   

Canada

     2        2        4        (5
        

Spirits(i)

     1        1        3        8   

Beer

     (3     (7     (2     (2

Ready to drink

     4        1        5        7   

 

61


Business review (continued)

 

                                                                                       

Global giants and local stars(i):

     Reported
volume
movement(ii)

%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Crown Royal

        6        6        12   

Smirnoff

        1        2        6   

Captain Morgan

        3        2        6   

Johnnie Walker

               5        10   

Ketel One vodka

        2        4        10   

Cîroc

        (6     (7     (1

Baileys

        (2            4   

Guinness

                      5   

Tanqueray

        5        7        13   

Don Julio

        30        34        42   

Bulleit

        25        28        36   

Buchanan’s

        3        9        16   

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement.

 

  Net sales in US Spirits were up 3%, with a 10% net sales increase in the second half following a transition to a replenishment model for innovation launches. Diageo’s North American whisk(e)y brands accounted for half of the overall net sales growth as Crown Royal and Bulleit continued to gain share. Crown Royal net sales increased 5%, with net sales of Crown Royal Deluxe up 5% as it benefited from the new “The One Made For A King” campaign which focused on the quality and heritage of the brand. Crown Royal Regal Apple continued to benefit from the popularity of the shot occasion and delivered a solid performance, with net sales up 15%, as it entered its second year after launch. Cîroc performance improved in the second half, as the brand benefited from the launch of its Apple flavour. Smirnoff net sales were up 2% but it underperformed the vodka category. Growth from a more focused flavours portfolio and the newly launched Smirnoff Sourced, a blend of real fruit juice and spirit, offset a decline in Smirnoff Red which lapped last year’s brand renovation and promotional activity and continued to be impacted by a competitive price environment. Performance in scotch improved as Johnnie Walker’s net sales increased 7%, largely driven by reserve variants, up 23%. Buchanan’s net sales were up 9% and share increased, as the ‘A lo Grande’ campaign enhanced the connection with hispanic consumers. Increased investment in the on-trade and focus on recruiting new consumers amongst millenials had a positive impact on Captain Morgan, which gained share despite weakness in the rum category. Net sales for the brand were up 2%, largely driven by the Original Spiced variant and Cannon Blast, which proved to be popular in the shot occasion. Don Julio, with net sales up 34%, was the fastest growing brand in the portfolio and gained share.
  DGUSA net sales increased 1%, as growth in ready to drink offset a decline in beer. In ready to drink the launch of Smirnoff Electric and a solid performance of Smirnoff Ice, which benefited from new flavours and packaging, drove net sales growth of 7%. Beer net sales were down 3% largely driven by a decline in Smithwick and Harp. Guinness net sales were broadly flat as the launch of Guinness Nitro IPA offset the net sales decline of Guinness American Blonde Lager, which lapped the previous year launch, and Guinness draught which continued to be impacted by a crowded craft beer segment.
  Net sales in Canada increased 4%, largely driven by Crown Royal, which benefited from the launch of Crown Royal Northern Harvest Rye, rated ‘2016 world whiskey of the year’ by Jim Murray’s Whiskey Bible, distribution gains, and the ‘We Make Whisky The Canadian Way’ campaign, which highlights the brand’s quality and craftmanship. Performance in vodka and ready to drink was also good, with net sales up 2% and 6%, respectively.
  Marketing reduced 2% driven by procurement efficiencies and more focused spend on innovations. Spend was also focused against the largest brands in US Spirits, with investment in Smirnoff, Crown Royal and Captain Morgan up 6%, and fast growing brands such as Don Julio, Bulleit and Buchanan’s where investment was up 16%.

 

62


Business review (continued)

 

EUROPE, RUSSIA AND TURKEY

Diageo is the largest premium drinks business in Europe. Within the geography of Europe there are three markets: Europe, Russia and Turkey. In Europe consumer marketing programmes are developed at a market level to drive consistency, efficiency and scale across all countries. In Russia we are driving our premium core, standard and value brands and reserve portfolio, whilst in Turkey, we use our local businesses’ strong route to consumer to drive accelerated growth in international premium spirits. In Europe our reputation as a trusted and respected company and for groundbreaking innovation, is key to our ability to attract and retain the people we need to deliver our Performance Ambition.

 

LOGO    Net sales by markets Net sales by categories Net sales by price points (%) (%) (%) Europe Turkey Spirits(i) RTDs Value Super premium Russia Other Beer Other Standard Ultra premium Wine Premium (i) excluding RTDs

 

(i)  excluding RTDs

 

                                                                                                                             

Key financials

   2015
£ million
    Exchange
£ million
    Acquisitions
and
disposals
£ million
    Organic
movement
£ million
     2016
£ million
     Reported
movement
%
 

Net sales

     2,617        (87     (88     102         2,544         (3

Marketing

     388        1        (5     20         404         4   

Operating profit before exceptional items

     804        (24     (24     45         801           

Exceptional operating items

     (20                 
  

 

 

          

 

 

    

Operating profit

     784               801         2   
  

 

 

          

 

 

    

Our markets

Europe comprises Great Britain, Ireland and Continental Europe (including Iberia, France, Germany and the Europe Partner markets distribution businesses), while Russia and Turkey are standalone markets. Europe is managed as a single market with country teams focusing on sales and customer marketing execution.

Supply operations

The International Supply Centre (ISC) comprises the supply operations in the United Kingdom, Ireland and Italy. The group owns 29 whisky distilleries in Scotland, a Dublin based brewery, maturation and packaging facilities in Scotland, England, Ireland and Italy. The ISC ships whisky, vodka, gin, rum, beer, wine, cream liqueurs, and other spirit-based drinks to over 180 countries. Through our £1 billion investment in Scotch whisky production and inventory, announced in 2012, distilling capacity has increased by over 25%. Raki, vodka and wine are produced at a number of sites in Turkey and Smirnov vodka and other local brands are produced in Russia.

Route to consumer

In Great Britain we sell and market our products through Diageo GB (spirits, beer and ready to drink) and Justerini & Brooks Retail (wines private clients). Products are distributed through independent wholesalers and directly to retailers. In the on-trade, products are sold through major brewers, multiple retail groups and smaller regional independent brewers and wholesalers. On 1 January 2016 we sold our Percy Fox wines distribution business.

In the Republic of Ireland and Northern Ireland, Diageo sells and distributes directly to the on-trade and the off-trade as well as wholesalers.

 

63


Business review (continued)

 

In Continental Europe, we distribute our spirits brands primarily through our own distribution companies, apart from France where products are sold through a joint venture arrangement with Moët Hennessy and Europe Partner markets where we use third party distributors.

Europe Partner Markets distributes our beer brands in mainland Europe, focusing on Germany, Russia and France, our largest mainland European beer markets.

In Russia we operate through wholly owned subsidiaries.

In Turkey, we sell our products via the distribution network of Mey İçki, our wholly owned subsidiary. Mey İçki distributes both local brands (raki, other spirits and wine) and Diageo’s global spirits brands.

Sustainability and responsibility

Promoting responsible drinking is both a key issue and a key strength for us, in a region where concern over harmful drinking is high on the public agenda. The work we are doing in support of the Global Producers’ Commitments includes partnering with industry colleagues on a responsible marketing pact, as well as our own responsible drinking programmes. This work makes an important contribution to the promotion of alcohol as part of a balanced lifestyle, while also enhancing our reputation.

This reputational aspect is essential in a region where people increasingly want to work for companies that they believe make a positive social and environmental, as well as economic, contribution. Our manufacturing operations, notably our distilleries in Scotland and our Guinness brewery in Ireland, aim for leadership in safety standards and environmental sustainability.

Performance

Net sales

Net sales were £2,544 million for the year ended 30 June 2016 a decrease of £73 million compared to net sales of £2,617 million in the year ended 30 June 2015. Net sales were adversely impacted by £87 million exchange rate movements driven mainly by the Turkish lira, euro and Russian rouble, and £88 million following the disposal of the Percy Fox wine business in January 2016 and Bushmills in February 2015, partially offset by organic growth of £102 million (see further performance analysis below).

Operating profit

Operating profit was £801 million in the year ended 30 June 2016 an increase of £17 million compared to operating profit of £784 million in the year ended 30 June 2015. Operating profit was negatively impacted by £24 million exchange rate movements principally due to the weakening of the Turkish lira, euro and Russian rouble against sterling and £24 million loss due to the disposal of the Percy Fox wine business in January 2016 and Bushmills in February 2015 offset by organic growth of £45 million. No exceptional operating charges were recorded in the year ended 30 June 2016 compared to £20 million restructuring costs in the year ended 30 June 2015.

Further performance analysis

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

The region’s performance reflects momentum in Europe, strong net sales growth in Russia driven by price increases in a tough economic and exchange environment and good growth in Turkey. In Europe, net sales were up 3% with Great Britain and Continental Europe the main contributors and with share gains across the market. Baileys performed strongly driven by execution against core growth drivers, especially sampling. Guinness net sales were up 2% supported by innovations from ‘The Brewers Project’ and Tanqueray grew net sales double digit in most countries across Europe. Reserve brands continued to perform well also growing

 

64


Business review (continued)

 

double digit. In Russia, price increases led to net sales increase of 27% while volume was down 9%, with share gains in rum but share losses in scotch in the face of increased competition. In Turkey net sales were up 6% driven by Johnnie Walker underpinned by steady growth in raki at 3%. Gross margins were up in both Europe and Russia. Overall region operating margins improved by 51bps. In Europe procurement savings offset increased marketing and overheads leaving margin improvement in Russia to drive the region’s increase.

 

                                                                                       

Markets and categories:

   Organic
volume
movement

%
    Reported
volume
movement
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Europe, Russia and Turkey

     2               4        (3
        

Europe

     4               3        (2

Russia

     (9     (12     27        (12

Turkey

     (2     (2     6        (7
        

Spirits(i)

     2        1        6          

Beer

     2                      (2

Ready to drink

     2        2        (3     (2

Global giants and local stars(i):

    Reported
volume
movement(ii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Guinness

       4        2        1   

Johnnie Walker

       3        7        3   

Smirnoff

              1          

Baileys

       5        9        6   

Yenì Raki

       1        4        (9

Captain Morgan

       8        9        5   

JeB

       (3     (4     (6

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement.

 

  In Europe net sales were up 3%:
    In Great Britain net sales were up 4%. Baileys performance accelerated with net sales up 11% driven by increased off-trade visibility and on-trade activation. Smirnoff net sales were up 1% supported by a full year of the ‘We’re Open’ platform. Guinness net sales were up 1% benefitting from the Rugby World Cup activation, improved distribution and innovation successes from ‘The Brewers Project’. Tanqueray net sales grew double digit and the brand gained 2pps of share in the gin category, driven by expanding distribution with improved visibility and increased bartender advocacy. Reserve brands continued to drive profitable growth with net sales up 26% driven by Cîroc and scotch malts.
    In Ireland net sales were broadly flat. Guinness net sales were up 4%, driven by the continued successful innovations launched through ‘The Brewers Project’. Of these, Hop House 13 Lager has proven to be a stand out success gaining almost 3% share of lager beer in the Republic of Ireland. Other beer brands net sales declined 4% and net sales in spirits were down 1%.
    In France net sales increased 3% driven by Captain Morgan which almost doubled sales and reserve brands up 8%, driven mainly by scotch malts, partially offset by weakness in Smirnoff ready to drink.
    In Continental Europe net sales were up 4%:
    Net sales in Iberia were up 2%. Johnnie Walker net sales grew 6% in the year and Baileys performed strongly supported by increased investment. Gordon’s net sales were also up in the growing gin category. These positive net sales performances more than offset net sales decline in JeB.
    Net sales in Germany, Austria and Switzerland grew 12% driven by double digit growth in Johnnie Walker, Smirnoff, Tanqueray and Baileys. Reserve brand net sales were up 11% driven by scotch malts, Johnnie Walker and Tanqueray No. TEN.

 

65


Business review (continued)

 

    Benelux net sales were down 1% overall in this group of countries. Performance was impacted by a significant tax increase implemented towards the end of the first half in Belgium. As a result, the spirits market in Belgium has seen a significant decline through the second half which led to a 26% net sales decline over the same period.
    In Italy net sales were up 8% driven by double digit growth in scotch and gin. Johnnie Walker and scotch malts performed well with both Tanqueray and Gordon’s delivering strong growth albeit not as fast as the gin category.
    In Greece, net sales were up 5% driven by route to consumer investment and focus on consistent activation.
    Net Sales in Poland and the Europe Partner Markets were broadly flat.
  Performance in Russia continued to be impacted by the challenged economic dynamics. Price increases were implemented to offset currency devaluation, which impacted volume, down 9% but with net sales up 27%. Diageo scotch share has declined as a result of the level of these price increases on scotch relative to the competition. Captain Morgan however continued to achieve strong share gains and net sales growth, supported by consistent execution of growth drivers and the launch of Captain Morgan white.
  In Turkey net sales grew 6% and in raki, with net sales up 3%, the premiumisation trend continued with Yenì Raki and the super premium variant Tekirdağ Raki driving growth. Johnnie Walker net sales continued to be up double digit.
  Marketing increased by 5% and benefitted from procurement savings resulting in an underlying investment increase of 10%. The region continues to be focused on the key growth opportunities, reserve brands, gin, beer and innovation.

 

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Business review (continued)

 

AFRICA

In Africa our strategy is to grow Diageo’s leadership across beer and spirits by providing brand choice across a broad range of consumer motivations, profiles, and occasions. We are focused on growing beer faster than the market and accelerating the growth of spirits through continued investment in infrastructure and brands with mainstream spirits being critical to realising the potential of the region. Local sourcing is a key element of our strategy in Africa: it directly supports our commercial operations, while indirectly supporting our position by bringing wider benefits to society as a whole.

 

LOGO

   Net sales by markets Net sales by categories Net sales by price points (%) (%) (%) Nigeria South Africa Spirits(i) RTDs Value Super premium East Africa Other Beer Other Standard Ultra premium Africa Regional Premium Markets (i) excluding RTDs

 

(i) excluding RTDs

 

                                                                                                                             

Key financials

  2015
£ million
    Exchange
£ million
    Acquisitions
and
disposals
£ million
    Organic
movement
£ million
    2016
£ million
    Reported
movement
%
 

Net sales

    1,415        (102     54        34        1,401        (1

Marketing

    147        (11     6        1        143        (3

Operating profit before exceptional items

    318        (67     (12     (27     212        (33

Exceptional operating items

    (7               
 

 

 

         

 

 

   

Operating profit

    311              212        (32
 

 

 

         

 

 

   

Our markets

The region comprises Nigeria, East Africa (Kenya, Tanzania, Uganda, Burundi, Rwanda and South Sudan), Africa Regional Markets (including Ghana, Cameroon, Ethiopia, Angola and a sorghum beer business in South Africa) and South Africa (including Republic of South Africa and Mozambique).

Supply operations

We operate 12 breweries in Africa, four sites that produce sorghum beer in South Africa, cider plants and five facilities which provide blending and malting services. In addition, our beer and spirits brands are produced under licence by third-parties in 19 African countries. In the year ended 30 June 2016 we sold our 25% interest in a brewery in South Africa.

Route to consumer

In Africa our largest businesses are in Nigeria, where we own 54.3% of a listed company whose principal brands are Guinness, Orijin, Harp and Malta, and in East Africa, where we own 50.03% of East African Breweries Limited (EABL). EABL produces and distributes beer and spirits brands to a range of consumers in Kenya and Uganda, and owns a 51% equity in Serengeti Breweries Limited located in Tanzania. Within Africa Regional Markets, we have wholly owned subsidiaries in Cameroon, Ethiopia and Reunion and majority-owned subsidiaries in Ghana and the Seychelles. Angola is supplied via a third party distributor. In South Africa and Mozambique we sell spirits, beer, cider and ready to drink products through wholly owned subsidiaries, following the termination of the agreement with Heineken and Namibia Breweries Limited in December 2015. Diageo has agreements with the Castel Group who license, brew and distribute Guinness in the Democratic Republic of Congo, Gambia, Gabon, Ivory Coast, Togo, Benin, Burkina Faso, Chad, Mali and Guinea. Diageo sells spirits through distributors in the majority of other sub-Saharan countries.

 

67


Business review (continued)

 

Sustainability and responsibility

The issues we address differ between markets but a key issue in many is illicit alcohol. We work closely with governments and regulators on this significant public health issue and specific local issues, such as drink driving in South Africa or bringing in a minimum legal drinking age in Ghana. Our aim everywhere is to promote responsible drinking as part of a balanced lifestyle.

Our overall approach is to consider the broader context of our contribution as a local taxpayer, employer and member of the community. Our recent work to assess human rights impacts throughout the value chain was piloted in Kenya. We source 73% of agricultural materials locally and we work with more than 50,000 local farmers for our agricultural inputs. Fifteen of our production sites in Africa are in water-stressed areas, so we focus closely on managing water efficiently and enhancing access to clean water to surrounding communities through our pan-African Water of Life programme. This year we launched the Water Blueprint in East Africa, to address water stewardship in this water-stressed area. Our new Sustainable Agriculture Strategy will play an important part in strengthening our longstanding and mutually beneficial relationships with farmers and communities.

Performance

Net sales

Net sales were £1,401 million in the year ended 30 June 2016 a decrease of £14 million compared to net sales of £1,415 million in the year ended 30 June 2015. Net sales were adversely impacted by £102 million exchange rate movements primarily due to the weakness of the South African rand, Nigerian naira, South Sudanese pound and Kenyan schilling against sterling, partially offset by £54 million arising from the acquisition of the 50% of United National Breweries that the group did not own in South Africa and the restructuring of the South African operations and organic growth of £34 million (see further performance analysis below).

Operating profit

Operating profit was £212 million in the year ended 30 June 2016 a decrease of £99 million compared to operating profit of £311 million in the year ended 30 June 2015. Operating profit was reduced because of exchange rate movements of £67 million driven by the weak South African rand, Nigerian naira, South Sudanese pound and Kenyan schilling. In addition operating profit declined by £12 million due to the acquisition of United National Breweries and the restructuring of the South African operations and an organic reduction of £27 million. No exceptional operating charges were recorded in the year ended 30 June 2016 compared to £7 million restructuring costs in the year ended 30 June 2015.

Further performance analysis

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

Net sales increased 3% with growth in all markets except Nigeria where net sales declined 15%. In East Africa, the recovery of Senator in Kenya following the duty change and double digit growth in rum and vodka led to strong net sales growth. Net sales in Africa Regional Markets grew 9%, led by beer which was underpinned by the ‘Made of Black’ Guinness campaign, innovation with Guinness Africa Special, sustained growth of Malta Guinness and the roll out of Orijin in Ghana. Vodka, particularly Smirnoff 1818, continued to be the engine of growth in South Africa. Across the region, spirits net sales grew 4%, with reserve brands up 35% on the back of Cîroc and Johnnie Walker reserve brands which benefited from the enhanced route to consumer and the launch of Johnnie Walker Green Label. Operating margin decreased 252bps due primarily to the impact of adverse mix and volume decline in Nigeria as well as weaker mix in East Africa. This was partially offset by procurement savings delivered across the region.

 

                                                                                       

Markets and categories:

   Organic
volume
movement
%
    Reported
volume
movement
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Africa

     9        19        3        (1
        

Nigeria

     (11     (11     (15     (19

East Africa

     25        25        16        3   

Africa Regional Markets

     11        57        9        23   

South Africa

     1        5        5        (6
        

Spirits(i)

     2        2        4        (7

Beer

     20        39        11        9   

Ready to drink

     (37     (23     (43     (35

 

68


Business review (continued)

 

                                                                                       

Global giants and local stars(i):

     Reported
volume
movement(ii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Guinness

        6        6        1   

Malta Guinness

        14        13        10   

Tusker

        (15     (11     (27

Senator

        151        157        134   

Harp

        (23     (26     (28

Johnnie Walker

        (10     1        (7

Smirnoff

        6        12        (4

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement.

 

  In Nigeria, net sales declined 15% due primarily to Orijin lapping the successful launch last year and now competing with ‘me too’ brands. The introduction of new formats at compelling price points, brand equity building through the ‘Live Orijinal’ campaign and the recruitment of new consumers with Orijin Zero have stabilised the brand. In beer, distribution expansion, higher brand equity driven by the ‘Made of Black’ campaign, robust activation during the broadcast sponsorship of Barclay’s Premier League and innovation with Guinness Africa Special led to the growth of Guinness. Malta Guinness also grew, with net sales up 15%, on the back of ‘You vs’ brand campaign and increased distribution particularly into the off-trade. The business continued to broaden its portfolio in the value lager segment with brands such as Satzenbrau offsetting the decline in Harp. Beer net sales grew 8%.
  In East Africa, net sales increased 16% driven by double digit growth in beer, spirits and ready to drink. Senator grew in Kenya following the roll back of the duty increase early in the year and momentum was sustained throughout the year. This more than offset the decline in Tusker, which was impacted by the duty increase in Kenya and currency volatility in the markets, resulting in 17% net sales growth in beer. Mainstream spirits grew 26% led by Kenya Cane and Kane Extra, together with innovation such as Kenya Cane Coconut and Chrome vodka. The improved route to consumer, with deepening mainstream outlet coverage, continued to drive growth in this segment. Reserve brands grew 24% following enhanced distribution and activation supported by brand ambassadors. Ready to drink was up 14% as Smirnoff Ice Double Black and Guarana grew with positive gearing driven by price increase.
  In Africa Regional Markets, net sales grew 9% reflecting the strong growth in Cameroon, Ghana and Ethiopia. Ghana net sales growth accelerated to 30% due to the launch of Orijin Bitters and ready to drink variants. Beer, driven by Guinness, was up 9% as activation and promotion was stepped up behind the ‘Made of Black’ campaign and Guinness Africa Special was rolled out. In Cameroon, net sales growth of 12% was driven largely by good performance in beer coupled with double digit growth in spirits and ready to drink categories. In Ethiopia, net sales grew 8% with Malta Guinness up 71%. This more than offset the slight decline in Meta as competition intensified. A number of interventions were made, including relaunching Meta in November and introducing Azmera in April 2016 to recruit value oriented consumers. Markets continued to benefit from the enhanced route to consumer and capability builds, including the adoption of a sales force automation tool. Angola net sales declined 65% due to the macroeconomic headwinds and inventory reduction in view of weakening consumer demand and weaker currency.
  South Africa grew 5% driven by 13% growth in vodka led by Smirnoff 1818. Overall, scotch sales were flat reflecting the weaker performance of Bell’s, White Horse, J&B and Black and White due to increased competition in this price sensitive consumer segment. This was offset by 9% growth in Johnnie Walker across key variants such as Johnnie Walker Red Label, Johnnie Walker Black Label, Johnnie Walker Gold Label Reserve and Johnnie Walker Green Label which was launched in the second half of the year.
  Marketing was up 1% in the region with investment prioritised behind the biggest growth opportunities with proven sales drivers. In Nigeria, marketing declined in line with net sales, with spend focused on the Guinness and Orijin brands. East Africa up-weighted investment on mainstream spirits and value beer, notably in Kenya Cane and Senator. In Africa Regional Markets, the innovation, marketing campaigns and activation programmes behind Guinness and Malta Guinness contributed to the increase in marketing. South Africa maintained spend in Smirnoff to build scale and increased investment behind Johnnie Walker.

 

69


Business review (continued)

 

LATIN AMERICA AND CARIBBEAN

In Latin America and Caribbean the strategic priority is continued leadership in scotch, while broadening our category range through vodka, rum, liqueurs and local spirits. We continue to invest in routes to market and in the breadth and depth of our portfolio of leading brands. We are also enhancing our supply structure to enable the business to provide both the emerging middle class and an increasing number of wealthy consumers with the premium brands they aspire to. In this region’s changing regulatory landscape, our presence is supported by our reputation as a trusted and respected business, based on our stance on responsible drinking, and community development programmes like Learning for Life.

 

LOGO    Net sales by markets Net sales by categories Net sales by price points (%) (%) (%) PUB Mexico Spirits RTDs Value Super premium Venezuela West LAC Beer Other Standard Ultra premium Colombia Other Wine Premium

 

                                                                                                                             

Key financials

  2015
£ million
    Exchange
£ million
    Acquisitions
and
disposals
£ million
    Organic
movement
£ million
    2016
£ million
    Reported
movement
%
 

Net sales

    1,033        (134     (41     5        863        (16

Marketing

    194        (26     (1            167        (14

Operating profit before exceptional items

    263        (57     (5     (2     199        (24

Exceptional operating items(i)

    (5           (118  
 

 

 

         

 

 

   

Operating profit

    258              81        (69
 

 

 

         

 

 

   

 

(i) In the year ended 30 June 2016 exceptional operating item of £118 million was in respect of the impairment of Ypióca.

Our markets

Our Latin America and Caribbean (LAC) business comprises five markets: PUB (Paraguay, Uruguay and Brazil), Venezuela, Colombia, Mexico and West LAC (Central America and Caribbean, Argentina, Chile, Peru, Ecuador and Bolivia).

Supply operations

The majority of brands sold in the region are manufactured by our International Supply Centre in Europe. In recent years, we have acquired a number of supply operations and expanded our co-packer network across the region. In 2015 we acquired the remaining 50% equity interest in Tequila Don Julio in Mexico, which resulted in full ownership of the brand and its production facilities. In 2012 we acquired Ypióca in Brazil, including its cachaça production site, and in 2011 we acquired a controlling interest in Anejos de Altura (Guatemala) which produces Zacapa. We also have partnerships with over 12 brewers and over 20 co-packing partners.

Route to consumer

We sell our products through a combination of subsidiary companies and third party distributors. In Brazil, our in-market company sells directly to key accounts and distributors.

All products in Venezuela are sold through dedicated distributors. In Colombia we sell directly to key accounts, and serve all other retailers and channels through distributors.

In Mexico, Diageo sells directly to large retailers and wholesalers.

In selected markets in West LAC, we sell to wholesalers or distributors, while in key markets, such as Costa Rica, Dominican Republic, Jamaica and Argentina we use exclusive distributors.

 

70


Business review (continued)

 

Sustainability and responsibility

Diageo is known throughout Latin America for our commitment to developing an industry that can bring economic and social value to society. Our work includes programmes to combat key issues such as underage drinking and drink driving – two of the five Global Producers’ Commitments – and illicit alcohol. Programmes such as Actuando Mejor in Mexico and Today I don’t drive in Brazil are making a tangible difference in reducing alcohol-related harm. In the Dominican Republic, we are also working closely with the industry and government to tackle drink driving. This social commitment is echoed in our focus throughout the region on employability, skills and empowerment. Our flagship community re-investment programme, Learning for Life, is providing skills and training – including responsible service – to more than 100,000 people across the region.

Performance

Net sales

Net sales were £863 million in the year ended 30 June 2016 a decrease of £170 million compared to net sales of £1,033 million in the year ended 30 June 2015. Adverse exchange rate movements due to the weakening of the Brazilian real, Venezuelan bolivar, Mexican peso and Colombian peso negatively impacted net sales by £134 million and the disposals of the Jamaican operation and wines in Argentina, partially offset by the tequila Don Julio acquisition, reduced net sales by £41 million. Organic growth was £5 million (see further performance analysis below).

Operating profit

Operating profit was £81 million in the year ended 30 June 2016 a decrease of £177 million compared to operating profit of £258 million in the year ended 30 June 2015. Operating profit was adversely impacted by exchange rate movements of £57 million mainly driven by the Brazilian real, Venezuelan bolivar, Mexican peso and Colombian peso. In addition, operating profit was impacted by exceptional operating charges of £118 million in the year ended 30 June 2016 compared to operating charges of £5 million in the year ended 30 June 2015. In the year ended 30 June 2016 the group impaired the Ypióca brand and related tangible fixed assets and goodwill allocated to the Paraguay, Uruguay and Brazil (PUB) cash-generating unit. Organic decline was £2 million.

Further performance analysis

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

Net sales grew 1% in LAC. Growth in Mexico, Colombia and the domestic markets of West LAC was partially offset by the decline in Brazil, travel retail and the export channels. In Brazil, performance was impacted by subdued consumer confidence, a tax increase and significant slowdown in the travel retail channel, which resulted in a 7% decline in net sales. Performance in Mexico and Colombia was strong with net sales up 10% and 28% respectively, led by scotch and vodka. Currency weakness and lower underlying demand continued to impact the West LAC export channels. Diageo’s strategy in LAC is to expand our leadership position in scotch and broaden our portfolio. Scotch net sales grew 2%, led by Buchanan’s and Black and White, with share gains in most markets. Net sales of Johnnie Walker declined with weakness in PUB and West LAC partially offset by strong growth in Mexico and Colombia. Vodka net sales grew 8% driven primarily by growth in Mexico, Colombia and the domestic markets in West LAC. Don Julio gained share supported by increased activity to build brand awareness and drive recruitment in Mexico. Gross margin improved, benefitting from mix as well as procurement savings across logistics and production. This was offset by higher overheads resulting in operating margin decline of 39bps.

 

                                                                                       

Markets and categories:

   Organic
volume
movement
%
    Reported
volume
movement
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Latin America and Caribbean

     (2     (5     1        (16
        

PUB

     (5     (5     (9     (27

Colombia

     9        9        28          

Mexico

     10        19        10        7   

West LAC

     (2     (17     (3     (20

Venezuela

     4        3        173        (69
        

Spirits(i)

     (2     (2     1        (12

Beer

     23        (41     14        (60

Ready to drink

     (11     (12            (20

 

71


Business review (continued)

 

                                                                                       

Global giants and local stars(i):

     Reported
volume
movement(ii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Johnnie Walker

        (8     (4     (15

Buchanan’s

        (5     9        (7

Smirnoff

               6        (19

Old Parr

        (15     (1     (17

Baileys

        (3     (1     (14

Ypióca

        (6     (6     (28

Black and White

        48        63        34   

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement except for Smirnoff 4%.

 

  In Paraguay, Uruguay and Brazil (PUB), net sales declined 9%. In Brazil, net sales were down with declines in scotch, vodka and cachaça, driven primarily by the slowing economy, a tax increase in December 2015, currency volatility and a slowdown in the duty free channel. Despite the challenging operating environment, the business gained share in scotch, delivered through Johnnie Walker and Black and White marketing campaigns. The business continued to invest behind the Smirnoff trademark in music festivals and trade activations, as well as the rejuvenation of Ypióca. Net sales in Paraguay and Uruguay declined due to reduced demand in the export and travel retail channels given currency volatility.
  Colombia delivered 9% volume growth and 28% net sales increase, on the back of favourable mix and successive price increases following the currency devaluation. Scotch was the key growth driver, with double digit growth and share gains. The portfolio in Colombia continues to broaden with gin, vodka and tequila net sales growing double digit.
  Mexico net sales increased 10%. Scotch was a key growth driver with net sales up 17%, reflecting strong volume growth and price increase. Buchanan’s was up 20% following the relaunch of the brand with the ‘Good versus Great’ campaign, the introduction of new packaging and strong activations around Father’s Day with ‘A Great Father A Great Day’ campaign. Similarly, Johnnie Walker net sales grew double digit on the back of 8% volume growth across core variants such as Johnnie Walker Red Label, Johnnie Walker Black Label and Johnnie Walker reserve brands including the newly launched Johnnie Walker Green Label. In mainstream scotch, Black and White net sales grew supported by expanded distribution and activation across the on and off-trade. Following the execution of the new Smirnoff strategy to build the brand’s credentials through participation in music festivals and increasing activation across the on-trade, Smirnoff net sales doubled and share increased in the last six months. Don Julio also gained share in the year reflecting the successful marketing campaign, activation and higher brand awareness.
  West LAC net sales declined 3% primarily due to weakness in the export channels. Domestic markets’ net sales were stable with growth in Peru, Chile and Jamaica offset by a decline in Central America and Caribbean. In Peru, net sales grew 16%, led by increases in Johnnie Walker Red Label, Johnnie Walker Black Label and Old Parr, underpinned by the marketing campaigns and activations around gifting for Christmas and Father’s Day. Scotch was also a key engine behind Chile’s net sales growth of 9%. Johnnie Walker Red Label and mainstream scotch such as VAT 69, Old Parr and White Horse grew following distribution expansion as well as improved trade visibility. Central America and Caribbean net sales contracted 4% given currency volatility across the market.
  In Venezuela, volume increased 4% driven primarily by strong growth in rum as the business resumed production of local spirits following the stabilisation of glass supply. This was offset by the decline in scotch as access to foreign currency remains constrained. Net sales grew significantly faster as the business increased prices in a high inflation environment and transacted some scotch sales in sterling.
  Marketing increased broadly in line with net sales. Spend in Brazil was reduced in view of the weaker economic outlook. Mexico increased spend by 9%, investing behind Smirnoff and scotch to build brand equity and enhance activations. In Colombia, incremental spend was invested behind Johnnie Walker, Buchanan’s and Smirnoff ready to drink to support the Smirnoff Ice Green Apple flavour launch.

 

72


Business review (continued)

 

ASIA PACIFIC

Our strategy in Asia Pacific, which encompasses both developed and emerging markets, is to operate across categories in international spirits, local spirits, ready to drink formats and beer. We focus on the highest growth categories and consumer opportunities, driving continued development of super and ultra premium scotch, and leveraging the emerging middle class opportunity through a combination of organic growth and selective acquisitions.

 

LOGO    Net sales by markets Net sales by categories Net sales by price points (%) (%) (%) South East Asia Global Travel, Spirits(i) RTDs Value Super premium Greater China Asia East and Middle Beer Other Standard Ultra premium India Wine Premium Australia North Asia (i) excluding RTDs

 

(i)  excluding RTDs

 

                                                                                                                                    

Key financials

  2015
£ million
    Exchange
£ million
    Acquisitions
and
disposals
£ million
    Organic
movement
£ million
    Net sales
adjustment(ii)
    2016
£ million
    Reported
movement
%
 

Net sales

    2,213        (21     (28     34        (122     2,076        (6

Marketing

    344               (1     (42            301        (13

Operating profit before exceptional items

    356        (5            44               395        11   

Exceptional operating items(i)

    (193             (49  
 

 

 

           

 

 

   

Operating profit

    163                346        112   
 

 

 

           

 

 

   

 

(i) In the year ended 30 June 2016 exceptional operating items of £49 million was in respect of the disengagement agreement relating to USL (2015 - £146 million was in respect of settlement of several disputes with the Korean tax authorities and £41 million in respect of the group’s 45.56% equity investment in Hanoi Liquor Joint Stock Company).
(ii) For further detail see page 54.

Our markets

Asia Pacific comprises South East Asia (Vietnam, Thailand, Philippines, Indonesia, Malaysia, Singapore, Cambodia, Laos, Myanmar, Nepal and Sri Lanka), Greater China (China, Taiwan, Hong Kong and Macau), India, Global Travel Asia and Middle East, Australia (including New Zealand), and North Asia (Korea and Japan).

Supply operations

We have distilleries at Chengdu, in China that produce Chinese white spirit and in Bundaberg, Australia that produce rum. United Spirits Limited (USL) operates 27 owned manufacturing facilities in India including one in Nepal, leases 13 facilities in India and further 34 are licensed to produce USL and Diageo brands. In addition, we have bottling plants in Korea, Thailand, Indonesia and Australia with ready to drink manufacturing capabilities.

Route to consumer

In South East Asia, spirits and beer are sold through a combination of Diageo companies, joint venture arrangements, and third party distributors. In Thailand, Malaysia and Singapore, we have joint venture arrangements with Moët Hennessy, sharing administrative and distribution costs. Diageo operates wholly owned subsidiaries in the Philippines and Vietnam. In Vietnam we own a 45.56% equity stake in Hanoi Liquor Joint Stock Company. In Indonesia, Guinness is brewed by, and distributed through, third party arrangements.

In Greater China the majority of our brands are now sold through our wholly owned subsidiary. Some brands are distributed through a joint venture arrangement with Moët Hennessy. In addition, we are the sole distributor of Shui Jing Fang, a super premium Chinese white spirit, through our controlling 39.71% equity stake in a listed company. Diageo operates a wholly owned subsidiary in Taiwan.

 

73


Business review (continued)

 

In India, we manufacture, market and sell Indian whisky, rum, brandy and other spirits through our 54.78% shareholding in USL. Diageo also sells its own brands through USL.

In Australia, we manufacture, market and sell the Diageo products and in New Zealand we operate through third party distributors.

In North Asia, we have our own distribution company in South Korea, whilst in Japan, the majority of sales are through joint venture agreements with Moët Hennessy and Kirin.

Airport shops and airline operators are serviced through a dedicated Diageo sales and marketing organisation. In the Middle East, we sell our products through third party distributors.

Sustainability and responsibility

Asia Pacific is a region of many and varied markets, and our 21-market business model enables us to address key issues and opportunities by market. Within the context of the Global Producers’ Commitments, our responsible drinking programmes focus on the issues highest on the agenda in each country. For example, in Indonesia and Vietnam we focus particularly on illicit alcohol; in India on drink driving; in Australia on consumer information and preventing underage and binge drinking. Our new DRINKiQ site, launched in January 2016, was particularly well received in Australia.

Likewise we tailor our sustainability programmes to each market. Our operations in India have the highest concentration of sites in water-stressed areas, so water, and the wider ‘WASH’ agenda is a key focus there. In Thailand and China, female empowerment is a significant issue, which we address directly through our ‘Plan W’ programme.

Performance

Net sales

Net sales were £2,076 million in the year ended 30 June 2016 a decrease of £137 million compared to net sales of £2,213 million in the year ended 30 June 2015. Net sales were adversely impacted by exchange rate movements of £21 million due to weak Australian dollar and Indian rupee against sterling and a £28 million loss due to disposal of the Bouvet wine business and transition of a number of operations in India to a franchise or royalty model, partially offset by organic growth of £34 million (see further performance analysis below). The full year impact of an accounting change for USL to account for the excise duties paid by third party manufacturers reduced net sales by £122 million.

Operating profit

Operating profit was £346 million in the year ended 30 June 2016 an increase of by £183 million compared to operating profit of £163 million in the year ended 30 June 2015. Organic growth improved operating profit by £44 million, partially offset by adverse exchange rate movements of £5 million mainly driven by the Australian dollar. Operating profit for the year ended 30 June 2016 was impacted by an exceptional operating charge of £49 million in respect of disengagement agreements relating to United Spirits Limited. Exceptional operating charges of £193 million in the year ended 30 June 2015 included a charge in respect of settlement of several disputes with the Korean tax authorities regarding the transfer pricing methodology applicable for imported products and an impairment charge in respect of the group’s 45.56% equity investment in Hanoi Liquor Joint Stock Company in Vietnam.

Further performance analysis

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

Net sales in Asia Pacific grew 2% as a result of growth in India, South East Asia and Australia. In China, Chinese white spirits grew while scotch declined and the shift towards lower ABV products in Korea led to a decline in net sales. Global Travel Asia and Middle East business declined primarily due to the geopolitical developments in the Middle East. The changes made to improve performance in USL led to net sales growth of 5% in India, largely driven by growth in IMFL whisky and scotch. Net sales in South East Asia grew 16% as the inventory reduction experienced last year ended. Australia net sales grew 2% driven by scotch and Guinness. Reserve brands net sales grew 4% largely driven by the strong performance of Shui Jing Fang in China and Johnnie Walker in South East Asia. Margin improved 176bps as a result of reducing marketing in India with the termination of USL related party agreements, and for Johnnie Walker Black Label and Johnnie Walker Blue Label in China. The sale by USL of United Breweries Limited shares also contributed to operating margin expansion.

 

74


Business review (continued)

 

Markets and categories:

   Organic
volume
movement
%
    Reported
volume
movement
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Asia Pacific

            (3     2        (6
        

India

            (4     5        (11

South East Asia

     3        3        16        15   

Greater China

     (5     (5     (2       

Global Travel Asia and Middle East

     (9     (9     (15     (14

Australia

     2        2        2        (5

North Asia

     6        6        (5     (6
        

Spirits(i)

            (3     1        (7

Beer

     8        8        7        4   

Ready to drink

     (3     (3     (3     (8

Global giants and local stars(i):

    Reported
volume
movement(ii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Johnnie Walker

       (4     (2     (2

McDowell’s

       (2            (16

Windsor

       (4     (10     (12

Smirnoff

       (4     (7     (9

Guinness

       8        7        4   

Bundaberg

       (5     (3     (10

Shui Jing Fang

       55        20        22   

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement except for McDowell’s 0%.

 

  South East Asia net sales were up 16% as it lapped the inventory reduction last year. In Thailand performance improved after a weak first half with net sales growing in the second half as the launch of Smirnoff Midnight 100 ready to drink offset the decline in scotch, which gained share in a declining category. In Indonesia net sales increased 1% as Guinness grew due to the focus on the on-trade post regulations restricting sale of alcohol in the off-trade were introduced last year. Vietnam was impacted by the special consumption tax on imported products introduced in January 2016 resulting in a net sales decline of 35%. Reserve brands performance was strong with net sales up 27% led by Johnnie Walker Gold Label Reserve and Johnnie Walker Blue Label.
  Greater China net sales were down 2%. In mainland China, scotch declined 42% as the continued weakness in premium scotch in the traditional on-trade channel resulted in distributors reducing inventory, although Diageo gained share in the super deluxe scotch segment. Chinese white spirits net sales grew 19% as growth in the second half was lower due to a tougher prior year comparison. In Taiwan net sales grew 8% driven by growth in Johnnie Walker.
  India net sales were up 5%, driven by the premiumisation strategy with good growth in prestige and above brands and popular brands net sales flat. Royal Challenge and McDowell’s No. 1 were relaunched during the year performed and contributed to growth with Royal Challenge net sales up 54%. Scotch grew 17% as Black Dog grew 23% and Johnnie Walker grew 22% with strong performance in Johnnie Walker Black Label, Johnnie Walker Red Label and Johnnie Walker Blue Label. The integration of Diageo’s brands into USL has created an exceptionally strong brand portfolio in India that participates across all price tiers in the IMFL and imported spirits segments. As a result of the focus on route to consumer, 20% of outlets are now meeting ‘perfect outlet’ standards driving recruitment and brand building. Gross margin improved 99bps with the growth of prestige and above brands driving positive mix and productivity initiatives that reduced the cost of goods sold. Operating margin improved 702bps as a result of gross margin improvement, lower marketing and the sale by USL of United Breweries Limited shares.
  Global Travel Asia and Middle East net sales declined 15% largely driven by the Middle East where net sales declined 20% as geopolitical developments led to weak performance in the domestic and travel retail business. Global Travel Asia net sales declined 7% as a result of lower spend by travellers and currency volatility.

 

75


Business review (continued)

 

  Australia net sales increased 2% with growth in scotch, vodka, liqueurs and gin offsetting the decline in the ready to drink business. In rum, strong growth of Captain Morgan both in ready to drink and spirits categories, offset the decline in Bundaberg. Reserve brands were up 7% largely driven by Johnnie Walker, as consumers continue to premiumise within the spirits category.
  North Asia net sales were down 5%. In Korea, net sales declined 10%, as Windsor suffered from increased competition in the traditional on-trade with net sales down 20% which offset growth from W-Ice, an innovation in the growing lower ABV premium whisky segment. In Japan, net sales were up 8% largely driven by scotch net sales growing 21% capitalising on the growth of the brown spirits segment.
  Marketing was 12% lower driven by reductions on Johnnie Walker Black Label and Johnnie Walker Blue Label in China and India where marketing reduced as a result of termination of USL related party agreements.

 

76


Business review (continued)

 

CATEGORY REVIEW

 

LOGO    Volume Net sales Marketing spend Scotch American North Rum Liqueurs Tequila to Ready drink Other Vodka Indian Made Gin Beer whisk(e)y Foreign Liquor (IMFL)

 

                                                                 

Key categories

   Reported
volume
movement(iii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Spirits(i)

     (1     3        (1

Scotch

     (3            (4

Vodka(ii)

            1        2   

North American whisk(e)y

     4        6        12   

Rum(ii)

     2        3        (3

Indian-Made Foreign Liquor (IMFL) whisky

     (5     3        (11

Liqueurs

     1        3        2   

Gin(ii)

     3        8        6   

Tequila

     15        8        28   

Beer

     21        6        1   

Ready to drink

     (9     (11     (11

 

(i) Spirits brands excluding ready to drink.
(ii) Vodka, rum, gin including IMFL brands.
(iii) Reported equals organic volume movement except for IMFL whisky (1)%, tequila (17)%, beer 13% and ready to drink (13)%.

 

77


Business review (continued)

 

                                                                 

Global giants, local stars and reserve(i):

   Reported
volume
movement(ii)
%
    Organic
net sales
movement
%
    Reported
net sales
movement
%
 

Global giants

      

Johnnie Walker

     (4     1        (3

Smirnoff

     1        2          

Baileys

     2        4        3   

Captain Morgan

     4        3        5   

Tanqueray

     11        12        15   

Guinness

     4        4        2   

Local stars

      

Crown Royal

     5        6        11   

Yenì Raki

     1        4        (9

Buchanan’s

     (2     10        1   

JeB

     (6     (9     (12

Windsor

     (4     (10     (12

Old Parr

     (13     1        (14

Bundaberg

     (6     (3     (10

Bell’s

            (1     (10

White Horse

     (11     6        (15

Ypióca

     (6     (6     (28

Cacique

     25        9        (24

McDowell’s

     (2            (16

Shui Jing Fang

     55        20        22   

Reserve

      

Scotch malts

     8        7        6   

Cîroc

     (2     (3     2   

Ketel One vodka

     4        4        10   

Don Julio

     25        18        40   

Bulleit

     27        29        36   

 

(i) Spirits brands excluding ready to drink.
(ii) Reported equals organic volume movement except for White Horse (9)%, Don Julio (13)% and McDowell’s 0%.

Unless otherwise stated percentage movements refer to organic movements in the following analysis.

 

  Scotch represents 24% of Diageo net sales and was flat in the year. Net sales grew in North America, Europe and Latin America and Caribbean driven by Johnnie Walker and Buchanan’s supported by new campaigns. Net sales declined in Africa; primarily in Angola, and in Asia Pacific driven by declines in China and Korea. The performance of Black and White was strong with net sales up 31%. Windsor net sales declined double digit in Korea due to the decline of the whisky category. Scotch reserve brands net sales grew 7% driven by strong growth in Johnnie Walker Gold Label Reserve, Johnnie Walker Blue Label and Johnnie Walker Green Label.
  Vodka represents 13% of Diageo’s net sales and grew 1%. Performance of Smirnoff, the largest brand in the category, improved growing 2%. Ketel One vodka returned to growth in the United States and Canada supported by a new campaign and pricing strategy. In addition, Cîroc performance improved from the first half driven by the success of Cîroc Apple in the United States.
  North American whisk(e)y represents 8% of Diageo’s net sales and grew 6%. Performance continued to be driven by strong growth in Crown Royal Regal Apple and Bulleit which continue to gain share in the United States.
  Rum represents 7% of Diageo’s net sales and grew 3%. Captain Morgan grew 3% driven by the base variant Original Spiced rum growing 3% and the Cannon Blast launch going well in the United States. Kenya Cane, a mainstream rum in Kenya, and Zacapa also contributed to the growth.

 

78


Business review (continued)

 

  IMFL whisky represents 5% of Diageo’s net sales and grew 3%. The relaunches of two of the biggest brands Royal Challenge and McDowell’s No.1 drove this growth with Royal Challenge net sales up 55% due to the relaunch.
  Liqueurs represents 5% of Diageo’s net sales and grew 3%. Baileys, the leading brand in this category, grew 4% due to 9% growth in its biggest market, Europe. The key growth drivers were on premise visibility, focused media content and sampling.
  Gin represents 3% of Diageo’s net sales and grew 8%. Tanqueray was the largest contributor growing double digit, followed by Gordon’s.
  Tequila represents 1% of Diageo’s net sales and grew 8%. The performance was driven by continued double digit growth of Don Julio in its biggest market, the United States.
  Beer represents 18% of Diageo’s net sales and grew 6% driven by strong performance in Africa where net sales grew 11%. Key contributors were East Africa and Nigeria. Strong growth of Senator following the excise duty remission grew sales in East Africa. In Nigeria, Malta Guinness, Pilsner and value brand Satzenbrau delivered a strong performance. Europe grew 2% on Guinness driven by the effectiveness of the ‘Made of More’ advertising campaign, innovations like Hop House 13 lager from ‘The Brewers Project’ and strong activation around the Rugby World Cup.
  Ready to drink represents 6% of Diageo’s net sales and declined 11%. This was largely driven by the decline in Orijin in Nigeria. The decline was partially offset by a good performance in Smirnoff Ice flavours in the United States driven by new marketing programmes and the launch of Orijin in Ghana and Cameroon. In Thailand, the Smirnoff Midnight 100 launch continued to progress well.
  Global giants represent 40% of Diageo net sales and grew at 3%.
    Johnnie Walker net sales grew 1% due to reserve brands growing 10% driven by Johnnie Walker Gold Label Reserve, Johnnie Walker Blue Label and Johnnie Walker Green Label. Europe and North America were the largest contributors with 7% and 5% growth, respectively. In Latin America and Caribbean, double digit growth in Mexico and Colombia was more than offset by decline in Brazil. In Asia Pacific, double digit growth in India and South East Asia was offset by declines in the Middle East, Global Travel and China.
    Smirnoff net sales grew 2%, as it returned to growth in the United States, the biggest market, where net sales were up 2%. In Europe, performance improved versus the first half and net sales grew 1%. South Africa and Mexico also delivered strong growth on Smirnoff growing double digit.
    Baileys net sales grew 4%, driven by 9% growth in Europe with the brand growing double digit in Great Britain, Iberia, Germany and Austria.
    Captain Morgan net sales grew 3% due to a strong performance in Europe and Russia. In the United States net sales grew 2% and it gained share in the category driven by increased on premise activity and the launch of Captain Morgan Cannon Blast.
    Tanqueray net sales grew 12% with Europe and North America accounting for more than two thirds of the growth. All other regions also delivered strong growth.
    Guinness net sales grew 4%. In Nigeria net sales grew 3% driven by the success of the ‘Made of Black’ campaign and activation against the football viewing occasion. In Cameroon and Ghana net sales increased double digit. Guinness also gained share and increased net sales in Great Britain and Ireland supported by the ‘Brewers Project’ innovations.
  Local stars represent 19% of net sales and grew 3%, due to Crown Royal in North America growing 6% and Buchanan’s up 10%, largely in North America and Mexico. Growth in Yenì Raki in Turkey and Shui Jing Fang in China largely offset the declines in Windsor in Korea and JeB.
  Reserve brands represent 15% of net sales and grew 7%. The return to growth in the second half was a result of the improved performance of Cîroc driven by the success of Cîroc Apple in the United States. Scotch reserve brands grew 7% with Johnnie Walker driving the growth particularly in the United States where it grew 23% and scotch malts growing 7%. Bulleit continued its strong growth with net sales 29%. Net sales of Shui Jing Fang were up 20% and Tanqueray No. TEN grew 26%.
  In Africa there are four local beer brands Senator, Malta Guinness, Tusker and Harp. Their performance is covered in the Africa section.

 

79


Business review (continued)

 

Operating results 2015 compared with 2014

GROUP FINANCIAL REVIEW

The following comments were made by Deirdre Mahlan, Chief Financial Officer, in Diageo’s Annual Report for the year ended 30 June 2015:

“Our performance this year reflected both the volatile global consumer and economic environment and the actions we took to strengthen the business. Reported net sales were up with the integration of USL and organic net sales flat driven by currency related challenges in specific emerging markets and embedding our sell out discipline. Our focus on cost delivered savings and drove margin expansion, prioritising cash resulted in a marked cash flow improvement and we continued to invest for the future.”

 

Net sales up 5% with full consolidation of United Spirits
Organic net sales flat
Net cash from operating activities of £2.6 billion up £0.8 billion
Free cash flow of £2 billion up £0.7 billion
9% final dividend increase, full year dividend was 56.4 pence
Operating margin down 52bps
Organic operating margin up 24bps
Shipment volume down 1%
Depletion volume was estimated to be up 1%
Basic eps 95.0 pence up 6%
Eps before exceptional items 88.8 pence due to adverse exchange and associates, offset by underlying improvements

 

LOGO    Volume Net sales(i) Operating before exceptional items(ii) Operating profit(iii) North America Europe Africa Latin America and Caribbean Asia Pacific

  

 

(i) Excluding corporate net sales of £80 million (2014 – £79 million).
(ii) Excluding exceptional operating charges of £269 (2014 – £427 million) and corporate and ISC costs before exceptional items of £123 million (2014 – £189 million).
(iii) Excluding corporate and ISC costs of £139 million (2014 – £130 million).

 

80


Business review (continued)

 

                                                                 

Summary financial information

        2015     2014  

Volume

   EUm      246.2        156.1   

Net sales

   £ million      10,813        10,258   

Marketing

   £ million      1,629        1,620   

Operating profit before exceptional items

   £ million      3,066        3,134   

Exceptional operating items

   £ million      (269     (427

Operating profit

   £ million      2,797        2,707   

Share of associates and joint ventures profit after tax

   £ million      175        252   

Exceptional non-operating items

   £ million      373        140   

Net finance charges

   £ million      412        388   

Tax rate

   %      15.9        16.5   

Tax rate before exceptional items

   %      18.3        18.2   

Profit attributable to parent company’s shareholders

   £ million      2,381        2,248   

Basic earnings per share

   pence      95.0        89.7   

Earnings per share before exceptional items

   pence      88.8        95.5   

Full year dividend

   pence      56.4        51.7   

 

                                                                                       
     Volume     Net sales     Marketing     Operating
profit
 

Growth by region

   %     %     %     %  

North America

     (4                     

Europe, Russia and Turkey

            (7     (6     (6

Africa

     7        (1     (3     (2

Latin America and Caribbean

     (6     (10     (4     (18

Asia Pacific

     622        64        13        2,229   

Diageo(i)

     58        5        1        3   
     Volume     Net sales     Marketing     Operating
profit(ii)
 

Organic growth by region

   %     %     %     %  

North America

     (3     (1     (4     (2

Europe, Russia and Turkey

                   2        3   

Africa

     7        6        4        10   

Latin America and Caribbean

     (7     (1     6        (3

Asia Pacific

     (3     (2     (8     7   

Diageo(i)

     (1            (1     1   

 

(i) Includes Corporate. In the year ended 30 June 2015 Corporate reported net sales, net operating charges before exceptional items and net operating charges were £90 million (2014 — £79 million), £123 million (2014 — £130 million) and £133 million (2014 — £142 million), respectively.
(ii) Before exceptional items

 

81


Business review (continued)

 

KEY PERFORMANCE INDICATORS

Net sales (£ million)

The full consolidation of USL, partly offset by adverse exchange delivered reported net sales growth of 5%. Organic net sales flat.

 

LOGO

10,258 896 (337) Organic movement (127) 123 10,813 2014 2015 Acquisitions and disposals(i) Exchange Price/mix Volume

 

 

(i) Impact of acquisitions and disposals on 2014 and 2015. See page 89 for further details.

Reported net sales were up 5%, largely driven by the full consolidation of USL, which contributed £921 million of net sales. Currency weakness, other than the US dollar, had an adverse impact on net sales. Organic volume decline was largely driven by lower shipments in the United States, reduction in inventory levels in South East Asia and West LAC, and the impact of pricing in Venezuela and Brazil. While these price increases contributed to positive price, the main driver of organic price/mix was positive mix, led by growth of reserve and Crown Royal.

Operating profit (£ million)

 

LOGO

2,707 158 (161) 4 67 22 2,797 2014 2015 Exceptional operating items Acquisitions Exchange Organic movement Disposals

 

Reported operating profit increased by £90 million primarily due to lower impairment charges of £223 million, lower exceptional restructuring costs of £81 million and the benefit from acquisitions of £67 million partly offset by the exceptional charge of £146 million in respect of settlement of several disputes with the Korean tax authorities in the year ended 30 June 2015 and adverse exchange rate movements of £161 million. Organic operating profit growth was £22 million (0.7%).

 

82


Business review (continued)

 

Operating margin (%)

Full consolidation of USL rebased operating margin by c200bps. Organic operating margin improved 24bps.

 

LOGO

26.39% 168bps (61)bps (183)bps Organic movement (64)bps 36bps 52bps 25.87% 2014 2015 Exceptional operating items Gross margin Exchange Marketing Acquisitions and disposals Other operating expenses

 

 

(i) Exchange impacts in respect of profit on intergroup sales of products and the intergroup recharges have been re-allocated to the respective income statement categories for the purposes of calculating margin impacts only.

Operating margin was 25.87% in the year ended 30 June 2015 (2014 – 26.39%). Excluding the impact of lower exceptional charges which benefited operating margin by 168bps, operating margin decreased 220bps from 30.55% to 28.35%).

The full consolidation of USL lowered reported operating margin for the group. The organic improvement in margin was largely as a result of cost savings and efficiencies, which more than offset the impact of cost inflation and negative market mix.

Basic earnings per share (pence)

Eps increased to 95.0 pence from 89.7 pence. Eps before exceptional items fell 6.7 pence.

 

LOGO

89.7 12 1.6 (6.4) (3.1) 1.4 1.5 (1.3) (0.4) 95.0 2014 2015 Exceptional items(i) Operating profit excluding FX Exchange on operating profit Associates and joint ventures Finance charges Tax Non-controlling interests Other including USL(ii)

 

 

(i) Exceptional items net of tax and non-controlling interests.
(ii) The organic impact of fully consolidating USL results is included in other. The movements for operating profit, finance charges, tax and non-controlling interests, all exclude USL.

Earnings per share was 95.0 pence in the year ended 30 June 2015 (2014 – 89.7 pence), with an exceptional gain after tax of £155 million, compared to an exceptional loss after tax of £271 million in the prior year, benefiting eps by 12 pence. Eps before exceptional items of 88.8 for the year ended 30 June 2015 fell 6.7 pence as compared to 95.5 pence for the year ended 30 June 2014 largely as a result of adverse exchange movements and lower income from associates and joint ventures. Organic growth in operating profit had a positive impact on eps. Net finance charges excluding acquired debt in USL reduced due to lower interest rates which benefited eps.

 

                     

Movement in net finance charges

   £ million  

2014

     388   

Net interest charge decrease

     (48

Consolidation of net borrowings acquired in USL

     60   

Movement in other finance charges

     12   
  

 

 

 

2015

     412   
  

 

 

 

 

83


Business review (continued)

 

                                           
                 2015               2014  

Average monthly net borrowings (£ million)

     10,459        9,174   

Effective interest rate(i)

     3.5     3.8

 

(i) For the calculation of the effective interest rate, the net interest charge excludes fair value adjustments to derivative financial instruments and borrowings. Average monthly net borrowings include the impact of interest rate swaps that are no longer in a hedge relationship but excludes the market value adjustment for cross currency interest rate swaps.

The increase in average net borrowings was principally the result of the acquisition of the controlling interest in USL, completed on 2 July 2014, and the consolidation of USL’s net borrowings. The effective interest rate decreased in the year ended 30 June 2015 as the negative impact of consolidating USL’s net borrowings was more than offset by lower interest rates on new debt issued and an increase in the proportion of floating rate debt through the use of swaps.

 

84


Business review (continued)

 

Net cash from operating activities and free cash flow (£ million)

Net cash from operating activities increased from £1,790 million to £2,551 million.

 

LOGO

1,790 (40) 76 (156) 734 79 68 2,551 2014 2015 USL OCF(i) Operating profit(ii) Exchange(iii) Working capital movement Interest tax Other operating items(iv)

 

(i) USL net cash from operating activities is shown separately and is excluded from the other line items shown above.
(ii) Operating profit after operating exceptional items adjusted for non-cash items including depreciation and amortisation, excluding exchange.
(iii) Includes £5 million relating to translation exchange impact of exceptional operating items.
(iv) Other operating items includes pension related payments, dividends received from associates and joint ventures, and payments in respect of the settlement of Thalidomide

Free cash flow was £1,963 million in 2015 an increase of £728 million.

 

LOGO

1,235 (7) (57) Operating profit 76 (156) 734 (7) 79 59 1,963 2014 2015 USL free cash flow(i) Operating profit excluding exchange(ii) Exchange Working capital movement Net capex movement Interest and tax Other operating items(iii)

 

 

(i) USL free cash flow is shown separately and is excluded from the other line items shown above.
(ii) Operating profit adjusted for non-cash items including depreciation and amortisation.
(iii) Other operating items includes pension related payments, dividends received from associates and joint ventures, and payments in respect of the settlement of Thalidomide.

The increase in net cash from operating activities was primarily driven by the positive working capital movement. This was largely due to lower debtors as a result of phasing of shipments, with days sales outstanding 6 days lower than last year. This compares with an increase in debtors in the prior year

 

85


Business review (continued)

 

Return on invested capital (%)

The return on closing invested capital of 26.7% for the year ended 30 June 2015, calculated as reported profit for the year divided by net assets as of 30 June 2015, decreased by 200bps compared to return on closing invested capital of 28.7%, for the year ended 30 June 2014 driven by the acquisition of USL, the partially offset by the impacts of exceptional gains on the sale of businesses in 2015 and lower exceptional operating charges.

The investment in USL has rebased return on average invested capital (ROIC)(i). Adverse exchange and lower income from associates reduced ROIC in the year

 

LOGO

14.1% (1.1)pps 0.2pps (0.4)pps (0.3)pps (0.2)pps 12.3% 2014(ii) 2015(ii) USL Operating profit after tax Exchange Associates and joint ventures including FX Other

 

 

 

(i) ROIC calculation excludes exceptional items.
(ii) For the years ended 30 June 2014 and 30 June 2015 average net assets were adjusted for the inclusion of USL as though it was owned throughout the year as it became an associate on 4 July 2013 and a subsidiary on 2 July 2014.

The additional investment in USL and full consolidation of its results reduced ROIC by 1.1pps. Exchange movements reduced operating profit, but the impact on ROIC was partially offset by exchange reducing invested capital. Lower income from associates reduced ROIC in the year.

 

 

86


Business review (continued)

 

Income statement

 

                                                                                              
     2014
£ million
    Exchange
(a)
£ million
    Acquisitions
and disposals
(b)
£ million
    Organic
movement
£ million
    2015
£ million
 

Sales

     13,980        (509     2,321        174        15,966   

Excise duties

     (3,722     172        (1,425     (178     (5,153
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net sales

     10,258        (337     896        (4     10,813   

Cost of sales(i)

     (4,006     61        (666     26        (4,585
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     6,252        (276     230        22        6,228   

Marketing

     (1,620     47        (74     18        (1,629

Other operating expenses(i)

     (1,498     68        (85     (18     (1,533
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating profit before exceptional items

     3,134        (161     71        22        3,066   

Exceptional operating items (c)

     (427         (269
  

 

 

       

 

 

 

Operating profit

     2,707            2,797   

Non-operating items (c)

     140            373   

Net finance charges

     (388         (412

Share of after tax results of associates and joint ventures

     252            175   
  

 

 

       

 

 

 

Profit before taxation

     2,711            2,933   

Taxation

     (447         (466
  

 

 

       

 

 

 

Profit from continuing operations

     2,264            2,467   

Discontinued operations (c)

     (83           
  

 

 

       

 

 

 

Profit for the year

     2,181            2,467   
  

 

 

       

 

 

 

 

(i) Before exceptional operating items

(a) Exchange

The impact of movements in exchange rates on reported figures was principally in respect of the Venezuelan bolivar, the euro, the Russian rouble and the US dollar.

In February 2015, the Central Bank of Venezuela opened a new mechanism (known as SIMADI) that allows private and public companies to trade foreign currency with fewer restrictions than other mechanisms in Venezuela. As a result, the group has

used the SIMADI exchange rate to consolidate its Venezuelan operations for the year ended 30 June 2015. For the year ended 30 June 2014, the group applied the Sicad II exchange rate to consolidate its operations in Venezuela.

Applying the SIMADI consolidation rate of $1 = VEF197.30 (£1 = VEF309.76) compared to the Sicad II rate of $1 = VEF49.98 (£1 = VEF85.47) would have reduced net assets and cash and cash equivalents as at 1 July 2014 by £60 million and £52 million, respectively, and would have reduced the previously reported net sales and operating profit for the year ended 30 June 2014 by £57 million and £36 million, respectively.

 

87


Business review (continued)

 

The effect of movements in exchange rate and other movements on profit before exceptional items and taxation for the year ended 30 June 2015 is set out in the table below.

                     
     Gains/
(losses)

£ million
 

Translation impact

     (72

Transaction impact

     (89
  

 

 

 

Operating profit before exceptional items

     (161
  

 

 

 

Net finance charges — translation impact

     (7

Mark to market impact of IAS 39 on interest expense

     8   

Impact of IAS 21 and IAS 39 on net other finance charges

     1   
  

 

 

 

Interest and other finance charges

     2   

Associates — translation impact

     (20
  

 

 

 

Profit before exceptional items and taxation

     (179
  

 

 

 

 

                                           
     Year
ended
30 June
2015
     Year
ended
30 June
2014
 

Exchange rates

     

Translation   £1 =

     $1.57         $1.63   

Transaction   £1 =

     $1.58         $1.59   

Translation   £1 =

     €1.31         €1.20   

Transaction   £1 =

     €1.23         €1.26   

 

88


Business review (continued)

 

(b) Acquisitions and disposals

The impact of acquisitions and disposals on the reported figures was primarily attributable to the full consolidation of United Spirits Limited (USL) from 2 July 2014 and the acquisition of the Mexican distribution rights of Don Julio, partially offset by the disposal of The Old Bushmills Distillery Company Limited on 27 February 2015 and Gleneagles Hotels Limited on 30 June 2015.

(c) Exceptional items

Exceptional operating charges of £269 million (2014 — £427 million) in the year ended 30 June 2015 comprised:

 

    £47 million (2014 — £98) in respect of the Global efficiency programme announced in January 2014;
    £35 million (2014 — £35 million) in respect of the Supply excellence restructuring programme;
    £41 million in respect of the impairment of the group’s 45.56% equity investment in Hanoi Liquor Joint Stock Company; and
    £146 million in respect of settlement of several related disputes with the Korean customs authorities regarding the transfer pricing methodology applicable to imported products. Total payments to settle these disputes in the year were £74 million as £87 million was paid to the customs authorities prior to 30 June 2014, and was previously accounted for as a receivable from Korean customs.

In the year ended 30 June 2014 exceptional impairment loss of £260 million in respect of the Shui Jing Fang brand and £4 million in respect of tangible fixed assets was charged to other operating expenses.

Non-operating items in the year ended 30 June 2015 include a gain of £103 million (2014 – £140 million) following the acquisition of additional equity shares in USL which increased the group’s investment in USL from 25.02% to 54.78%, excluding

the 2.38% interest owned by the USL Benefit Trust (2014 – 10.04% to 25.02%). On 2 July 2014 when USL became a subsidiary of the group a gain was recognised on the difference between the book value of the 25.02% investment and the fair value. The gain is net of a £79 million cumulative exchange loss recycled from other comprehensive income and £10 million transaction costs.

On 27 February 2015, the group completed the purchase of the 50% equity interest in Don Julio B.V. that it did not already own (giving Diageo 100% ownership of the brand and production facility) and the Mexican distribution business of Don Julio. As a result of Don Julio becoming a subsidiary of the group a gain of £63 million arose, being the difference between the book value of the joint venture on the date of the transaction and the fair value. In addition, the group reacquired the production and distribution for Smirnoff and Popov in Mexico. As part of the transaction, Diageo also agreed to sell 100% of the equity share capital in The Old Bushmills Distillery Company Limited resulting in an exceptional gain of £174 million.

On 30 June 2015, Diageo completed the disposal of Gleneagles Hotels Limited to the Ennismore group resulting in an exceptional gain of £73 million.

In the year ended 30 June 2015 a provision of £30 million was charged to non-operating items in respect of a guarantee provided to a third party financial institution.

Discontinued operations in the year ended 30 June 2014 comprised a charge after taxation of £83 million (£91 million less tax of £8 million) in respect of the settlement of thalidomide litigation in Australia and New Zealand and anticipated future payments to thalidomide organisations.

Cash payments in the year ended 30 June 2015 for exceptional restructuring items, the legal settlement in Korea, the guarantee and thalidomide were £117 million (2014 – £104 million), £74 million (2014 – £nil), £30 million (2014 – £nil) and £19 million (2014 – £59 million), respectively.

Dividend

The final dividend was 34.9 pence per share, an increase of 9% from the year ended 30 June 2014. The full dividend was therefore 56.4 pence per share, an increase of 9% from the year ended 30 June 2014. Following the approval by shareholders, the final dividend was paid on 8 October 2015 to shareholders on the register on 14 August 2015. The ex-dividend date was 13 August 2015. Payment to US ADR holders was made on 14 October 2015.

 

89


Business review (continued)

 

MOVEMENTS IN NET BORROWINGS AND EQUITY

 

                                           

Movement in net borrowings

   2015
£ million
    2014
£ million
 

Net borrowings at the beginning of the year

     (8,850     (8,403

Free cash flow (a)

     1,963        1,235   

Acquisition and sale of businesses (b)

     (306     (534

Net purchase of own shares for share schemes (c)

     (8     (113

Dividends paid to non-controlling interests

     (72     (88

Purchase of shares of non-controlling interests (d)

            (37

Net movements in bonds and other borrowings

     (315     (157

Equity dividends paid

     (1,341     (1,228

Other movements

     2        1   
  

 

 

   

 

 

 

Net decrease in cash and cash equivalents

     (77     (921

Net decrease in bonds and other borrowings

     315        157   

Exchange differences (e)

 &