BUSINESS CITY COMMENT – Recession Proof?

01 March 2006 By db staff writer

“standfirst”>After a decade of solid growth there are indications that the UK economy is starting to slow down. Will the drinks industry begin to regret its headlong pursuit of premium brands? asks Justin Pugsley

The City sees the 2006 outlook for the drinks sector as being fairly positive, but there are nonetheless some clouds on the horizon, notably the uncertain outlook for the UK economy. Although the sector is seen as relatively defensive in times of recession, that defensiveness could have been weakened by the industry’s headlong pursuit into premium drinks brands.

After over a decade of solid growth all is not well with the UK economy. Some pundits even go as far as believing that the UK’s golden era of low inflation and steady economic growth could be ending.

Indeed, the pessimists can point to the recent employment statistics. In the three months to November the number of people out of work rose by 111,000 to a three-year high of 1.53 million, taking the unemployment rate up to 5%. This coincides with a general slowdown in the growth of economy to 1.8% last year from 3.2% the year before.

Economists blame this slowdown on several factors including excessive red tape, relatively higher borrowing costs, declines in North Sea energy output and most importantly the slower pace of consumer spending. This last factor is of considerable interest to the drinks industry.

“The beverage sector is traditionally seen as fairly defensive in times of economic slowdowns,” comments Keith Bowman, an equity analyst with stockbrokers Hargreaves Lansdown. “Even if the economy went off a cliff edge I wouldn’t normally expect beer sales to fall rapidly. There’s always demand for alcohol whether people are drowning their sorrows or celebrating.”

But in defence of the big beverage companies analysts point out that players such as Diageo, Scottish & Newcastle and SAB Miller have large international brand portfolios and are not overly dependent on the UK.

Barclays, for example, recently issued a buy recommendation on SAB Miller – despite its disappointing third-quarter results. “SAB Miller has a strong position in a number of the world’s fastest-growing beer markets such as Eastern Europe, Latin America and China. That should help the company to maintain its record of strong earnings growth over the next few years,” says a spokesperson from Barclays. This reflects general investor thinking on the big beverage groups. Not much fear of a UK slowdown for them, then.

Premium approach

After crunching the numbers, numerous analysts are also increasingly taking a shine to Scottish & Newcastle, thanks to its focus on premium beers and its strong presence in Eastern Europe. Also attractive is the competent management, which has been winning followers in the City. However, because the company is the UK leader it is the most exposed of the UK-listed giants to any domestic slowdown.

Even more exposed to a slowdown are regional brewers such as Wolverhampton & Dudley and Greene King, which are currently busy driving consolidation in the pub sector.

Meanwhile, Diageo has also pursued premiumisation across its beverage divisions, which  has so far been successful. It has also moved into the wine sector, which still holds promise of further growth in the UK.

Diversification, consolidation and premiumisation are a logical response to stagnating beverage markets in developed countries.

“It remains to be seen if premiumisation will remain a sustainable trend because the lower end of the market is being abandoned and no one is trying to fill it,” says Elaine Bucknell, sector quantitative analyst for utilities and beverages, with stockbrokers Brewin Dolphin Securities. In the meantime, she remains positive about the big UK-listed beverage companies and the outlook for the UK drinks sector generally.

A stronger economy with wealthier consumers certainly spells opportunities for greater premiumisation. Over the last decade or so, the UK economy has performed exceptionally well by historical standards. However, should the economy stumble this time around the premiumisation strategy could turn out to be the Achilles’ heel of the industry.

“In a bad economy premium brands could suffer,” warns Bowman. He adds that some of the more fashion-conscious brands would also take a hit if consumers became more concerned with value.

Another consideration is that hard-pressed consumers could switch their consumption, preferring to buy more from the supermarkets rather than going to pubs and bars where beverages are more expensive.

Brokers Panmure Gordon warn that if consumer confidence was to slip further it could have a negative impact on the licensed retail sector.

But offsetting that, they say: “Management and asset quality has improved significantly and we believe that the likelihood of corporate activity should minimise the downside.”

For the beverage companies the on-trade margins tend to be higher than for off-trade business where supermarkets are constantly engaged in margin-crushing price wars.

In a recession there’s little doubt that the supermarkets would carry on trying to lure consumers with heavy discounts on beverages – discounts usually subsidised by the manufacturer.

However, the buying power of the licensed retail sector is likely to increase in the future as it consolidates, a move led by the likes of Punch Taverns, Greene King, Enterprise Inns and Wolverhampton &

Dudley. Indeed, consolidation among the regional players, which is driving down costs, could be their best defence against any sustained economic slowdown.

A considerable preoccupation for the drinks sector right now is the smoking ban in on-trade establishments. Despite the rather discouraging Irish experience and the JD Wetherspoon experiment with non-smoking pubs, both Bowman and Bucknell think the negative impact in the UK will be short-lived. They contend that the UK market is more diversified than Ireland in terms of smoking and non-smoking pubs. They also agree  that the current format of UK legislation is very difficult to implement. 

Encouraging factors for the drinks industry this year include longer drinking hours, which could see greater volumes consumed. But the big one will be the World Cup this summer. The better the England football team performs, the better it will be for the on-trade as fans pack the pubs to cheer on the national team.

Positive outlook

Fortunately, there are signs that the UK economy may be picking up. The all important housing market is showing signs of revival and economic growth may be improving too. The Bank of England, for instance, expects growth this year to range between 2% and 2.5%. That’s not spectacular by past standards, but it’s probably enough to keep UK consumers spending and, crucially, enough to sustain the industry’s move into premium brands. With luck 2006 won’t be the year the drinks industry’s defensive qualities are put to the test.