Between The Lines: What looks like greed is actually a bid for survival

Published on Thursday 27 August 2009 21:24

BARELY had Diageo announced its profits for 2008-9 (operating profit up 10 per cent to £2.44 billion, though pre-tax profits are flat) than it was being accused of greed.

It was an inevitable charge, given that it has announced plans to shut its Kilmarnock and Port Dundas operations and cause 900 employees to lose their jobs – albeit offset by the creation of 400 jobs in Fife.

From the point of view of the workers affected, and of the general public, it is an easy leap to make: a big multi-national company makes billions of pounds of profits, but throws hundreds of people out of work to make more billions, so it must be being greedy. But business life is not as simple as that.

Regular business readers will be familiar with some of the complications, but there is no harm in restating them. Of the operating profit, a big chunk – 1.62bn – goes to shareholders to pay them for the money they have loaned Diageo in the form of the capital the company needs for its distilleries, warehouses, machinery, and so on. The rest is needed for investment in marketing campaigns, equipment and creating new products.

Then you have to factor in the economic environment in which Diageo sells its products. As we all know, these are tough recessionary times in which people stop buying things they consider to be luxuries and non-essentials – such as alcohol. Without the revenue from sales, income drops, shareholders don't get the dividends they expected and unless the company cuts its costs, it will be bought by someone who will cuts costs and jobs, probably rather savagely.

And yet, remarkably, Diageo has managed to increase its operating profits over the past year. A lot of that is because people have switched from buying the more expensive brands to cheaper ones.

Organic net sales of Johnnie Walker – the relatively expensive whisky bottled and packaged at Kilmarnock – are down by 6 per cent. And yet if you look at the revenue from Johnnie Walker, it is actually up by 4 per cent. That is mainly because the value of the US dollar has risen relative to sterling compared with the previous year, so American sales of Johnnie Walker end up being worth more to the company despite being reduced.

And that's where running a business like Diageo gets complicated, because nobody knows what these currency exchange rates are going to do next year – they could move as much to the company's disadvantage as they have to its advantage in the last year.

A second complication is caused by the recession. In order to cut their costs, retailers and distributors have reduced the amount of stock they hold. This has magnified the effect of reduced consumer spending. Paul Walsh, chief executive of Diageo, says he thinks this shift to small stock levels is permanent.

This means that the management of how Diageo gets its cases of Johnnie Walker whisky into warehouses and shops around the world will have to become a lot smarter, because the one thing you don't want is for a sudden, unpredictable rise in sales somewhere to peter out because people have run out of stock to sell.

A third complication linked to this phenomenon, known as "de-stocking", is that Diageo has much bigger stocks of unsold drinks than it expected to have. And so too does virtually every other drinks maker in the world. Everyone will want to start shifting that excess stock just as soon as sales start to pick up again, something that may be starting to happen now but will certainly be happening in the next year or two.

And when you get more supply than there is demand, prices start to fall. This means that the competition in the drinks industry, already pretty intense, is going to get even fiercer over the next few years. And if Diageo is not able to compete on price, it is going to suffer.

Whisky now is a global product, and with the Scottish domestic market now accounting for less than 10 per cent of sales, it is the overseas market which will sustain the business in the future. As Walsh also pointed out yesterday, it is the new emerging markets – including Brazil, Russia, India, China – where the best prospects lie. They are hard to get into, often there are discriminatory tariff barriers to overcome, and there are cheaper domestic spirits to be competed with.

Whisky producers also fret that, with governments around the world struggling to raise tax revenues to pay off huge national debts, alcohol will be a prime target, not least because price-raising – as is now being championed by the Scottish Government – is seen as an effective way of curbing alcohol abuse.

Faced with all that, there can only be one conclusion: the whisky distiller that does not cut costs now will be, in all probability, a dead distiller in a decade or so. The stark truth is that Diageo's closure and job-cutting plans are not about greed, they are about survival.

&#149 Comments and criticisms welcomed, please e-mail: [e-mail]