Walsh eyes game-changing curtain call

Diageo’s shares have outperformed the FTSE 100 Index for most of this year but they were marked down yesterday when the world’s biggest alcoholic drinks group announced its results for the year to the end of June.

Analysts felt the 2% organic growth in pre-tax operating profit was at the lower end of their expectations, but closer analysis of the figures gives grounds for optimism.

For a start, the second half of the year revealed a growing momentum in key markets and allowed the group to increase the final dividend by 6%.

In addition, all key markets are showing signs of continuing growth, albeit faltering in mature regions such as the US and Europe, and Diageo has laid the foundations to prosper from an eventual upturn by increasing its organic marketing spend behind its global priority brands by 14% since Christmas. A global restructuring of distribution and production has yielded £200 million of cost savings.

This maintains the very solid record of continuing focus on returns to shareholders that has been the hallmark of Paul Walsh’s programme since he became chief executive 10 years ago – and it is set to continue. While cautious about the global recovery, Walsh is confident that the group’s strengths will allow him to “at least” maintain the 6% rate of dividend growth when he announces next year’s results.

Fundamental to that is Diageo’s “very strong” free cash flow of £2 billion in the past 12 months. That, he says, gives him “enormous firepower” to increase dividends, return cash to shareholders via a renewed share buyback programme or make further acquisitions.

Earlier this year Diageo bought 43% of Chengdu Swellfun, and now Walsh would like to take a controlling stake in the Chinese white spirits company.

Debt reduction in the past year and access to lower interest rates mean Walsh would have no problem in funding a deal, but the reluctance of Beijing to allow foreign control of significant domestic groups means Diageo needs patience at the negotiating table. A deal later this year is a possibility, however.

While greater access to the Chinese market would boost Diageo’s drive in Asia, it is not, however, the company-changing deal which is Walsh’s trademark.

Leading the dismemberment of Seagram was transformational, as were the disposals of Pillsbury and Burger King to focus on spirits and beers.

Significant acquisitions, not least of Bushmills and Ketel One, have boosted Diageo’s armoury. But Walsh has very able regional lieutenants to conduct in-fill deals and achieve organic growth. He is concerned with the bigger picture.

Company sources hint that he would love to achieve a final transformational deal before looking for a fresh challenge after a decade at the helm.

As ever, Walsh would not overpay; any target would have to leverage the group’s portfolio and meet the strict criteria on return on capital – so Foster’s is a non-runner.

What Walsh wants, they believe, is to land the 66% of Moët Hennessy Diageo does not own. That would give much greater access to Asian markets especially and would fill the glaring holes in Diageo’s own portfolio – Cognac and Champagne.

The stumbling blocks to fulfilling that ambition are Bernard Arnault’s willingness to sell what many regard as a non-core division of LVMH, and price – how much of a premium would France’s richest businessman want?

But Walsh, 55, has never been daunted by obstacles. If he could surmount them and then orchestrate the absorption of the world’s biggest Champagne and Cognac houses into Diageo’s portfolio, he would be able to hand over an undisputed world leader to his successor. And that £2bn a year free cashflow could be an integral part of his strategy.

Finance on Friday, 27.08.2010