Diageo stirs USL in bid to shake Indian market

Diageo may have got FMCG veteran Anand Kripalu to run United Spirits and appointed 3 directors on its board, but the road ahead is strewn with problems

Diageo, the global spirits major, is on a high.

Soon after acquiring strategic management control of Vijay Mallya’s crown jewel, United Spirits, Diageo has swung into action, making up for years of lost time in trying to figure out the Indian market.

It has appointed FMCG veteran Anand Kripalu as chief executive officer designate and brought in three of its nominees as directors on the board of United Spirits in an attempt to streamline and rationalise United Spirits’ operations.

Diageo will also bring its marketing muscle with which it wants to crack open a series of emerging markets across the globe.

For the record, Diageo has acquired six fast-growing companies in Turkey, Ethiopia, China, Vietnam and Brazil in the past two years, spending billions of dollars as it aims for as much as 50 per cent of its revenue from emerging markets by 2015 from 42 per cent now.

Marketing power

With United Spirits under its belt, Diageo has access to one of the best-oiled distribution networks in India which any FMCG company worth its weight would love to get, but will Diageo make the cut?

Unlikely.

At least not in the immediate future.

There are many factors which could hurt Diageo in India.

The input costs are shooting through the roof but liquor companies cannot increase prices on their own as price increases have to be approved by the government.

With elections due next year, effecting a price increase will be a big no-no for many states.

Couple this with legacy issues in Tamil Nadu, one of the top three spirits market in India where the government seems to be supporting local brands, and the debt burden of United Spirits, and you have the perfect spoiler for Diageo’s party.

United Spirits operates on a thin profit margin of 4 per cent and Diageo will be more than happy if it is able to hold it at that level in the near future before looking at raising it.

The market expects that Diageo will muscle it up to double digits -- a tall task in the current circumstances.

The market had similar expectations from Dutch brewer Heineken when it acquired a 37.4 per cent stake in Mallya’s beer company, United Breweries, in 2008.

Four years later, United Breweries is still struggling with gross profit margins of a little over 4 per cent.

Diageo, on its part, being what it is -- a global behemoth and willing to wait it out for the long haul -- is not unduly worried.

At least, on the face of it.

Gilbert Ghostine, Diageo’s Asia-Pacific president, says, “Diageo will bring in some good skill sets in terms of brand-building and innovation, and that combined with the route to market through United Spirits will make the company even more successful.

“The priority is focussing on building the brands and making the company more successful.”

He adds the top three priorities that will drive Diageo’s agenda for United Spirit are: compliance, culture and performance.

“They are finding ways to bring in more accountability.

“When so many changes are being made public, we can be sure the internal operations are being shaken up too,” says Gautam Duggad, analyst, Motilal Oswal Securities.

A step up the ladder

One thing is for sure: with Diageo in the driver’s seat, United Spirits will move up the value chain.

Thus, starting October, Diageo’s best-selling brands, including Johnnie Walker and Smirnoff, which play in the premium segment, will be distributed by United Spirits and placed alongside United Spirits brands like McDowell’s, Bagpiper and Romanov in retail stores. United Spirits, on the other hand, has marginally increased its volumes in the premium segment to 21 per cent with 29 million cases in the year.

Actually, Diageo is in a piquant situation when it comes to the premium segment in India, which is dominated by its global rival, Pernod Ricard, with brands like Royal Stag and Blenders Pride. Pernod Ricard has been able to crack the Indian market with the strategy of pricing a premium-end product aggressively and backing it with good marketing dollars.

For a fact, Pernod Ricard sells less than a fifth of United Spirits annual volumes of 123 million cases but makes more profits than United Spirits.

According to industry watchers, while the buzz around premiumisation of the Indian made foreign liquor market has been there for some time now, this segment still forms a small portion of the market.

Of the 305 million 9-litre cases of IMFL sold every year in the country, whisky accounts for 168 million cases with the premium brands accounting for close to 16 per cent of total whisky volume.

Still, there are a lot of opportunities for global companies in making a premium product attractive to the mass segment.

Pernord Ricard has built on the Royal Stag and Imperial Blue brands and made them affordable, despite their premium positioning.

“The Indian market is looking at better quality and I feel there is immense opportunity for players to grow the premium segment as a whole,” a veteran of the Indian beverages industry says.

Premium bottles

The possibilities in the premium segment have shaken up United Spirits and are driving the company’s aggressive investment in Prestige and other brands.

However, it is way behind in terms of marketing and sales promotion spends against the total sales.

United Spirits spends between 8 and 9 per cent of its total sales on marketing and sales promotions against the industry average of 15 per cent.

United Spirits is now planning to scale up its marketing and promotion spend to 12 per cent of sales.

While integration efforts at Diageo and United Spirits are under way, industry experts believe the company will have to market its Indian brands cautiously.

United Spirits’ distribution network will give Diageo, which currently sells about 1 million cases through its India operations, access to a huge market in big cities and small towns across the country.

However, not everyone is impressed with Diageo’s efforts at premiumising United Spirits’ brand.

“United Spirits’ strength is its distribution network, and the reason it has grown so wide in terms of penetration is its lower-end offering.

But with the focus entirely shifting to premium brands, profitability of the trade will be hurt,” says Sunita Sachdev of UBS Securities.

“A company is built up in conjecture with its retailers, bottlers, suppliers, distributors, among others.

“Trimming the lower-end portfolio may jeopardise their profits.”

While there may be some rationalisation of lower-end brands -- either they may be sold off or franchised to a third party -- in the near future at least, United Spirits will have to depend on those brands to sustain the profits while relying on Prestige and other upscale brands to improve the bottom line.

United Spirits attributes about 75 per cent of its volumes to non-premium, lower-priced brands which see maximum demand from Tier-II and Tier-III towns.

That lends a second complication to United Spirits' ‘premiumisation strategy.’ The de-emphasis on low-end or mid-range products from United Spirits may cause retailers to stock other rival brands in their place.

This may force United Spirits to take a call on either giving up some of its hard-earned volumes or increasing prices of its products -- a move that may result in lower volumes, but would mitigate some of the losses.

Besides, Diageo will have to contend with the problem in Tamil Nadu that it has inherited in the deal.

Vijay Mallya has indicated that United Spirits has still not been able to crack the deadlock in Tamil Nadu, one of the top three liquor consuming states in India.

To add to United Spirits challenge will be the economic slowdown that is reportedly taking a toll on bill size and sales across the country.

Even as Diageo crystallises its strategy addressing these factors, it will have to face the issue of the overhanging debt of around Rs 8,000 crore (Rs 80 billion) under a leverage of almost three times.

Industry analysts indicate that as much as Rs 1,000 crore (Rs 10 billion) of debt will be reduced as a first step after the infusion of Rs 2000 crore (Rs 20 billion) by Diageo into United Spirits. Amid all this, Diageo is also awaiting an order by UK’s Office of Fair Trade on how it should address the aspect of United Spirits’ Scottish subsidiary, Whyte & Mackay.

If the UK trade office feels that this combination has resulted in a monopoly situation, Diageo will have to either sell this off or reduce United Spirits holding to less than majority.

The old order at United Spirits will indeed change.

After achieving shareholder control, management control and operational control, the next six months will see a complete changeover at United Spirits and 2014-15 may see a different game plan altogether emerging.

A SOBER ASSESSMENT

Factors which Diageo has to negotiate

• Input costs for alcoholic beverages are skyrocketing but price increases are capped
• Diageo’s push on premium positioning will take a toll on the bottom line in the near term
• Global rival Pernod Ricard has control over the premium segment in India and makes much more profits than United Spirits
• Smaller towns may not take immediately to high-end brands Factors which are favourable to Diageo
• Controlling stake in United Spirits
• United Spirits massive distribution network giving access to small towns and cities
• Deep pockets to invest on brands
• Ability to reduce leverage of United Spirits balance sheet to shore up profit margins
• Option of integrating its brands into United Spirits distilleries to reduce prices of its products United Spirits’ top brands
• McDowell’s No 1 Whisky
• McDowell’s No 1 Rum
• McDowell’s Signature
• Bagpiper
• Old Tavern Diageo's India brands
• Johnnie Walker
• Johnnie Walker Reserve
• Smirnoff Vodka*
• Captain Morgan*
• Rowsons Reserve (IMFL)
• VAT 69
• Romanov