Diageo - research-doc.credit-suisse.com

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29 October 2015

Europe/United Kingdom

Equity Research

Beer & Alcoholic Beverages

Diageo (DGE.L) UPGRADE RATING

Upgrade to Outperform ■ Upgrade to Outperform: We believe DGE's increased focus on volume

growth can help draw a line under two years of earnings downgrades. We

raise our underlying FY17-18E EPS estimates by c2-4%, offset partially by

non-core disposals and FX. We increase our TP to 2100p (from 1780p).

■ Transitioning towards volume growth: We believe DGE's accelerated

focus on mainstream/value spirits is a necessary move to broaden its pricing

architecture, which creates new opportunities whilst addressing consumer

polarisation and the high dependence on premium scotch. After recent

underperformance, execution is the biggest risk, as this emphasis differs

from the previous premiumisation-led model. However, the major

investments in route to market should help address the increased complexity.

■ Margin potential: DGE's evolution comes at a cost – two-thirds of its £500m

gross productivity savings will be re-invested, and there is some negative

mix impact in the short term. Nevertheless, we believe the FY17-19 100bps

margin guidance is at least underpinned by the net savings, with some

potential leeway in the outer years if it delivers on the volume growth.

■ Improving FCF and buyback potential: Operating cash conversion now

has the highest weighting in management remuneration, with the biggest

opportunity in working capital. We estimate £700m, or 12%, potential upside

to our FCF forecasts if DGE can close half the gap versus its consumer

staples peers by FY18. With M&A unlikely and the dividend cover low, we

see scope for share buybacks from FY17 which could be c2% EPS accretive.

■ Scope for a re-rating vs peers: DGE has underperformed its staples peer

group by 15% YTD, and now trades at a 5% P/E discount – successful

execution could lead to a premium rating. This is supported by a 3.3%

dividend yield which, with buybacks, could drive 13% TSR CAGR FY17-19E.

Share price performance

1683

1783

1883

1983

Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15

Price Price relative

The price relative chart measures performance against the

FTSE ALL SHARE INDEX which closed at 3496.19 on

27/10/15. On 27/10/15 the spot exchange rate was £.72/Eu 1. -

Eu .91/US$1

Performance over 1M 3M 12M Absolute (%) 7.4 2.9 4.1 Relative (%) 1.1 6.7 2.0

Financial and valuation metrics

Year 06/15A 06/16E 06/17E 06/18E Revenue (£ m) 10,813.0 10,486.9 10,841.8 11,432.2 EBITDA (£ m) 3,465.00 3,392.93 3,557.83 3,796.31 Pre-tax Profit Adjusted (£ m) 2,829.00 2,828.65 3,051.86 3,323.45 CS adj. EPS (p) 88.47 88.13 94.60 102.30 Prev. EPS (p) — 88.15 94.20 101.10 ROIC (%) 13.46 13.62 13.99 14.59 P/E (adj., x) 21.06 21.14 19.69 18.21 P/E rel. (%) 153.4 134.1 132.5 138.8 EV/EBITDA 18.4 18.4 17.4 16.2

Dividend (06/16E, p) 59.22 IC (06/16E, £ m) 17,985.01 Dividend yield (%) 3.2 EV/IC 3.5 Net debt/equity (06/16E, %) 80.8 Net debt (06/16E, £ m) 8,037.9 Number of shares (m) 2,514.35 Free float (%) 90.81 BV/share (06/16E, £) 3.4

Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates.

Rating (from Neutral) OUTPERFORM* Price (27 Oct 15, p) 1,863.00 Target price (p) (from 1,780.00) 2,100.00¹ Market cap. (£ m) 46,842.42 Enterprise value (£ m) 62,562.4

*Stock ratings are relative to the coverage universe in each

analyst's or each team's respective sector.

¹Target price is for 12 months.

Research Analysts

Sanjeet Aujla

44 20 7888 0353

[email protected]

Pavan Daswani

44 20 7883 0539

[email protected]

Charlie Mills

44 20 7888 0325

[email protected]

29 October 2015

Diageo (DGE.L) 2

Diageo DGE.L Price (27 Oct 15): 1,863.00p, Rating: (from Neutral) OUTPERFORM, Target Price: (from 1,780.00) 2,100.00p

Income statement (£ m) 06/15A 06/16E 06/17E 06/18E

Revenue (£ m) 10,813 10,487 10,842 11,432 EBITDA 3,465 3,393 3,558 3,796 Depr. & amort. (399) (391) (404) (426) EBIT (£) 3,066 3,002 3,154 3,370 Net interest exp. (412) (368) (318) (286) Associates 175 195 216 239 Other adj, — — — — PBT (£) 2,829 2,829 3,052 3,323 Income taxes (466) (508) (569) (628) Profit after tax 2,363 2,321 2,483 2,695 Minorities (87) (89) (100) (117) Preferred dividends — — — — Associates & other (51) (13) — — Net profit 2,225 2,218 2,383 2,578 Other NPAT adjustments 156 (52) — — Reported net income 2,381 2,166 2,383 2,578

Cash flow (£) 06/15A 06/16E 06/17E 06/18E

EBIT 3,066 3,002 3,154 3,370 Net interest (416) (323) (283) (261) Cash taxes paid (489) (508) (569) (628) Change in working capital 117 (53) (171) (209) Other cash & non-cash items 273 442 542 585 Cash flow from operations 2,551 2,560 2,672 2,857 CAPEX (638) (598) (564) (572) Free cashflow adj. (22) (24) (33) (47) Free cash flow to the firm 1,891 1,939 2,075 2,238 Acquisitions (1,283) (140) — — Divestments 978 1,115 50 50 Other investment/(outflows) — — — — Cash flow from investments (943) 377 (514) (522) Net share issue/(repurchase) (7) (5) (5) (5) Dividends paid (1,413) (1,542) (1,597) (1,688) Issuance (retirement) of debt — — — — Other (962) (62) — — Cash flow from financing activities

(2,382) (1,609) (1,602) (1,693) Effect of exchange rates — — — — Changes in Net Cash/Debt (774) 1,328 556 642 . Net debt at start 8,592 9,366 8,038 7,482 Change in net debt 774 (1,328) (556) (642) Net debt at end 9,366 8,038 7,482 6,840

Balance sheet (£ m) 06/15A 06/16E 06/17E 06/18E

Assets Cash and cash equivalents 472 472 472 472 Accounts receivable 2,435 2,377 2,418 2,500 Inventory 4,574 4,679 4,860 5,061 Other current assets 189 189 189 189 Total current assets 7,670 7,717 7,940 8,222 Total fixed assets 3,690 2,972 3,134 3,285 Intangible assets and goodwill 11,231 11,181 11,129 11,074 Investment securities — — — — Other assets 3,213 3,221 3,230 3,240 Total assets 25,804 25,091 25,432 25,820 Liabilities Accounts payable 3,108 3,102 3,154 3,227 Short-term debt 1,921 1,921 1,921 1,921 Other short term liabilities 261 261 261 261 Total current liabilities 5,290 5,284 5,336 5,409 Long-term debt 7,917 6,589 6,033 5,391 Other liabilities 3,341 3,271 3,201 3,131 Total liabilities 16,548 15,144 14,570 13,932 Shareholders' equity 7,771 8,447 9,344 10,351 Minority interest 1,485 1,500 1,518 1,538 Total equity & liabilities 25,804 25,091 25,432 25,820 Net debt (£ m) 9,366 8,038 7,482 6,840

Per share data 06/15A 06/16E 06/17E 06/18E

No. of shares (wtd avg) 2,515 2,517 2,518 2,520 CS adj. EPS (p) 88.47 88.13 94.60 102.30 Prev. EPS (p) — 88.15 94.20 101.10 Dividend (p) 56.40 59.22 62.18 65.29 Div yield 3.03 3.18 3.34 3.50 Dividend payout ratio 63.75 67.19 65.73 63.82 Free cash flow per share (p)

75.19 77.02 82.40 88.82

Key ratios and valuation

06/15A 06/16E 06/17E 06/18E

Growth (%) Sales 5.4 (3.0) 3.4 5.4 EBIT (2.2) (2.1) 5.1 6.9 Net profit (6.6) (0.3) 7.4 8.2 EPS (6.6) (0.4) 7.3 8.1 Margins (%) EBITDA margin 32.0 32.4 32.8 33.2 EBIT margin 28.4 28.6 29.1 29.5 Pretax margin 26.2 27.0 28.1 29.1 Net margin 20.6 21.2 22.0 22.5 Valuation metrics (x) EV/sales 5.9 6.0 5.7 5.4 EV/EBITDA 18.4 18.4 17.4 16.2 EV/EBIT 20.8 20.8 19.7 18.2 P/E 21.1 21.1 19.7 18.2 P/B 6.0 5.6 5.0 4.5 Asset turnover 0.42 0.42 0.43 0.44 ROE analysis (%) ROE stated-return on equity

32.6 26.7 26.8 26.2 ROIC 13.5 13.6 14.0 14.6 Interest burden 0.92 0.94 0.97 0.99 Tax rate 15.9 18.4 18.7 18.9 Financial leverage 1.3 1.0 0.9 0.7 Credit ratios (%) Net debt/equity 101.2 80.8 68.9 57.5 Net debt/EBITDA 2.7 2.4 2.1 1.8 Interest coverage ratio 7.4 8.2 9.9 11.8

Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities

(EUROPE) LTD. Estimates.

1683

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1983

Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15

Price Price relative

The price relative chart measures performance against the FTSE ALL SHARE

INDEX which closed at 3480.7 on 27/10/15

On 27/10/15 the spot exchange rate was £.72/Eu 1. - Eu .91/US$1

29 October 2015

Diageo (DGE.L) 3

Key charts Figure 1: Diageo's underperformance has been led by

c30% EPS downgrades over the past couple of years –

increased focus on volume growth and mainstream

spirits could give the business more resilience Diageo consensus EPS revisions – pence

Figure 2: Mainstream spirits can help recruit new

consumers into the category, particularly in emerging

markets – Diageo can leverage its beer business in Africa

to improve scale in mainstream spirits Spirits and beer pricing architecture in Africa indexed to 100

2010

2011

2012

20132014

2015

2016

2017

60

70

80

90

100

110

120

130

140

150

Oct

-07

Mar

-08

Aug

-08

Jan-

09

Jun-

09

Nov

-09

Apr

-10

Sep-

10

Feb-

11

Jul-1

1

Dec

-11

May

-12

Oct

-12

Mar

-13

Aug

-13

Jan-

14

Jun-

14

Nov

-14

Apr

-15

Sep-

15

120

100 100

75

50

0

50

100

150

200>300

Source: Thomson Reuters Source: Company data

Figure 3: Diageo's focus on scotch has been too

premium. Following recent weakness, DGE can use

excess scotch capacity to focus on younger liquids at

more affordable price points (and still good margins) Ratio of scotch industry stock/consumption –years

Figure 4: Diageo's 100bps FY17-19E margin guidance is

underpinned by its net cost savings, with potential leeway

in the outer years if it delivers on volume growth Diageo FY17-19 100bps EBIT margin guidance breakdown - bps

6.0

6.5

7.0

7.5

8.0

8.5

9.0

Margin impact 2017E 2018E 2019E Accumulated Comment

Negative geographic margin mix -15 -28 -26 -69Negative impact of lower margin USL

business growing faster than other regions

USL margin expansion 15 16 12 43Group contribution from margin expansion

within USL (c100-150bps pa)

Net geographic mix impact 0 -12 -15 -26

Gross productivity gains 109 149 175 433£500m gross productivity savings over

FY17-19

Re-investment -73 -99 -122 -2952/3rds of productivity gains re-invested

back into the business

Net productivity gains 36 50 52 138

Mix and productivity impact 37 38 38 112 In line with company target of 100bps

Volume leverage 60 60 60 180Operational leverage from c3.5% volume

growth p.a.

Price & mainstream spirits -ve -ve -ve -veNegative impact from weak pricing and initial

roll-out of mainstream spirits

Source: SWIR, Credit Suisse research Source: Credit Suisse estimates

Figure 5: Share buybacks from FY17E could help drive

13% total shareholder return, ahead of consumer staples

peers Diageo FY17-19E potential total shareholder return breakdown - %

Figure 6: Diageo trades on FY16E calendarised 20.5x P/E,

a 5% discount to peers – successful execution could lead

to a premium rating Diageo FY16E calendarised P/E v European consumer staples - x

8%

2%

3%

0%

2%

4%

6%

8%

10%

12%

14%

EPS CAGR Potential buyback

accretion

FY16 dividend yield

10

12

14

16

18

20

22

24

26

28

Source: Credit Suisse estimates Source: Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 4

Table of contents Key charts 3 Introduction 5

Spirits business model is changing 5 Mainstream spirits opportunity 7

1. Focus on mainstream brands is overdue 9 2. Secondary scotch 13 3. India now contributing to growth 15 4. Value brands in North America 17

Can Diageo execute? 18 Route to consumer work supports volume focus 18

Margin potential well underpinned 20 Cash flow improvement 23

Scope for share buybacks 25 Relative valuation looks inexpensive 27

Target price – increase to 2,100p 29 Credit Suisse HOLT® 30 Key risks 32 Company overview 33 Financial Model 34

29 October 2015

Diageo (DGE.L) 5

Introduction Spirits business model is changing

Price/mix used to be the main topline driver

Traditionally, the international spirits companies have relied on price/mix as the most

significant topline growth driver, riding the premiumisation wave in recent years. As shown

in Figure 7 between FY07 and FY14, Diageo delivered c4% average organic revenue

growth, of which c70% was driven by price/mix.

Figure 7: Diageo has averaged 4% organic revenue

growth Diageo organic revenue growth - %

Figure 8: Price/mix was the key driver, accounting for

c70% of organic growth over the period FY07-14 Diageo organic revenue growth split - %

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Volume Price/mix Organic revenue

2007-14 : DGE delivered 4% organic revenue growth

Volume

30%

Price/mix

70%

Source: Company data Source: Company data, Credit Suisse research

Increased emphasis on volume growth

However, in an increasingly competitive pricing environment, weaker emerging market

growth and a polarisation of the consumer (growth in the high-end and low-end squeezing

the middle), the international spirits companies need to find new growth drivers.

Indeed, Diageo is in the process of addressing its portfolio, acknowledging that it can do

more to increase spirits penetration (taking share from other alcoholic beverages), and

that long-term premiumisation works best with broad-based price ladders, particularly in

emerging markets

At its FY15 results, CEO Ivan Menezes said, "In the emerging markets, GDP growth has

slowed. In addition, currency weakness has made imported premium spirits relatively more

expensive but has opened up the opportunity for Diageo’s mainstream spirits".

Increased focus on the lower end provides the scope to draw in new consumers,

particularly in the challenged emerging markets, by reaching more affordable price points,

and formalising the alcohol category, which has the potential to make the business more

resilient in times of economic difficulties.

We assess four key parts and the implications of Diageo's increased focus on volume

growth:

■ Mainstream and local spirits in emerging markets, particularly Africa

■ Secondary scotch in emerging markets

■ Contribution of the recently acquired United Spirits business in India

■ Value brands in the US

29 October 2015

Diageo (DGE.L) 6

Critically, we believe Diageo's recent investments in its route to market support the

execution of this strategy over coming years after two years of no organic growth.

Figure 9: Diageo's topline weakness has led to c30% EPS

downgrades in consensus over the past couple of years –

increased focus on mainstream spirits could give the

business more resilience Diageo consensus EPS revisions - pence

Figure 10: Diageo has underperformed European

consumer staples by c15% year to date Diageo share price performance v European consumer staples (Jan 2011 = 100)

2010

2011

2012

20132014

2015

2016

2017

60

70

80

90

100

110

120

130

140

150

Oct

-07

Mar

-08

Au

g-0

8

Jan

-09

Jun

-09

No

v-0

9

Ap

r-1

0

Sep

-10

Feb

-11

Jul-

11

De

c-1

1

May

-12

Oct

-12

Mar

-13

Au

g-1

3

Jan

-14

Jun

-14

No

v-1

4

Ap

r-1

5

Sep

-15

90

100

110

120

130

140

150

160

170

180

190

Jan-1

1

Apr-

11

Jul-11

Oct

-11

Jan-1

2

Apr-

12

Jul-12

Oct

-12

Jan-1

3

Apr-

13

Jul-13

Oct

-13

Jan-1

4

Apr-

14

Jul-14

Oct

-14

Jan-1

5

Apr-

15

Jul-15

Oct

-15

Series1 Series2

Source: Thomson Reuters Source: Thomson Reuters

29 October 2015

Diageo (DGE.L) 7

Mainstream spirits opportunity Focus has been too skewed towards premium scotch and beer

Diageo's emerging markets (excluding the recently acquired USL business) have been

driven traditionally by relatively premium scotch and beer (in Africa), which today account

for 42% and 30% of sales in these regions, respectively. However, mainstream affordable

spirits account for just 5% of net sales in these markets (and c15% of volumes).

Figure 11: DGE's emerging markets (ex USL) make up

36% of net sales FY15 Diageo net sales split by region - %

Figure 12: Relatively premium scotch and beer dominate

Diageo's EM business, with mainstream local brands

accounting for 5% of net sales FY15 Diageo emerging market (ex USL) net sales split by category- %

Africa

13%

LatAm

10%

Asia-Pac EM

7%

Eastern Europe

& Turkey

5%

USL

9%

Developed

markets

56%

Scotch

42%

Beer

30%

Mainstream

spirits

5%

Other

23%

Source: Company data, Credit Suisse research Source: Company data, Credit Suisse research

Diageo's increased focus on mainstream spirits is due partly to the difficulties it has

encountered in beer and premium scotch over the past couple of years.

Beer (predominantly Africa) has underperformed

At the heart of its beer business in Africa lies a conflict of interest – Diageo owns 100% of

its spirits business in the region, although it has significant minority interests in its beer

business. Furthermore, spirits are higher margin and higher return than beer. As such,

management is incentivised to use its beer infrastructure to further leverage its spirits

portfolio.

This has meant that Diageo hasn’t always had the same focus as its 100% beer-focused

competitors such as Heineken and SABMiller, leading to underperformance in volumes

and organic revenue. We estimate Diageo's African beer business has averaged 7%

organic revenue growth since 2009 (with flat volumes), half the rate of SABMiller.

For example, in Nigeria, Diageo focused on its higher-end beer brands allowing the

competition to take meaningful positions in the faster-growing value end as the macro

environment became challenged and competition intensified. The importance of the value

end is critical as this is how the industry draws consumers from the large illicit segment.

29 October 2015

Diageo (DGE.L) 8

Figure 13: Diageo's African business is dominated by

beer FY15 Diageo Africa net sales split

Figure 14: Diageo's beer business has underperformed

peers, due partly to a lack of portfolio focus 2009-14 Diageo Africa beer organic revenue vs peers - %

Beer

66%

Spirits

34%

0%

2%

4%

6%

8%

10%

12%

14%

16%

SABMiller Heineken Diageo beer

Source: Company data Source: Company data, Credit Suisse research

Premium scotch has been impacted by FX moves

Outside of beer in Africa, scotch is the key driver of Diageo's emerging markets,

representing c60% of its EM spirits sales (excluding beer and USL). Once again, Diageo's

focus historically has been on increasing supply in the more premium aged scotch to meet

strong demand from these emerging markets.

Figure 15: Scotch is the main driver of Diageo's emerging

markets outside of beer, accounting for c60% of EM net

sales (ex beer and USL) FY15 Scotch as % of Diageo net sales by region

Figure 16: Diageo's scotch business is relatively premium

and underpenetrated in the value segment 2014 Diageo volume market share in scotch by segment - %

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Africa ex beer LatAm Asia-Pac ex USL

Scotch Other

37%46%

13%

63%54%

87%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Total Premium Value

Diageo Others

Source: Company data, Credit Suisse research Source: Company data

More recently, premium scotch has been negatively impacted by significant currency

declines across these emerging markets—being manufactured and priced in hard

currency, emerging market consumers have effectively experienced big price increases,

leading to volume declines. This has been exacerbated by destocking, as demonstrated

by the underperformance of the relatively premium Johnnie Walker brand within Diageo's

scotch portfolio in Figure 17.

29 October 2015

Diageo (DGE.L) 9

Figure 17: Premium scotch volumes (Johnnie Walker)

have significantly underperformed over the past couple of

years Avg FY14-15 Johnnie Walker volume growth vs total DGE scotch volume - %

Figure 18: This has been magnified by slower EM growth

and currency volatility, which has led to significant

effective price increases for EM consumers Currency move in top 10 scotch industry emerging market (by volume) versus £ since Jan 2013

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

Africa LatAm Asia-Pac

Johnnie Walker Total

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

Source: Company data Source: Thomson Reuters

1. Focus on mainstream brands is overdue

Africa is the biggest opportunity for mainstream spirits

Diageo is putting incremental resources behind mainstream spirits, to help formalise further

the alcohol category in emerging markets—we believe the biggest opportunity is in Africa.

Figure 19 shows that Africans consume as many litres of pure alcohol as the global

average. The issue is that informal alcohol still represents c70% of volumes in Africa,

which is mostly made up of local brews and home-made spirits.

Figure 19: Total alcohol consumption in Africa is

estimated to be in line with the global average Pure alcohol consumption per capita - litres

Figure 20: However, informal alcohol still represents a

disproportionate amount of total consumption Informal alcohol consumption as % total

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Europe North America Latin America

& Caribbean

Africa Asia

25%

74%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

North America C&E Europe LatAm Africa

Informal alcohol Spirits Wine Beer

Source: World Health Organisation Source: Company data

Mainstream spirits are priced at around a third of premium spirits, thus helping target the

consumer at a lower, more affordable price point. Ultimately, we believe mainstream spirits are

just as good as, if not better, in terms of formalising the alcohol industry in Africa than beer.

We note SABMiller has recently stepped up its focus on mainstream beer across its

emerging markets, trying to reach consumers at more affordable price points, which has

led to an acceleration in volume growth in Africa and LatAm despite deteriorating macros.

29 October 2015

Diageo (DGE.L) 10

Figure 21: Mainstream spirits can help formalise the

alcohol category by reaching lower price points, which is

the biggest volume opportunity Price ladder of spirits by segment in Africa

Figure 22: SABMiller's increased focus on mainstream

beer at affordable price points has led to an acceleration

in volume growth despite weakening emerging markets SABMiller Africa and LatAm organic lager volume (March year end) - %

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2013 2014 2015 H1 2016

Africa LatAm

Source: Company data Source: Company data

Mainstream hasn’t been a big focus in the past

We believe Diageo has not focused sufficiently on mainstream and value brands in the

past, although this is in the process of being addressed.

■ Mainstream spirits represent 75% of total spirits market volumes in Africa (see Figure

23). The category is relatively fragmented, with many small players.

■ Diageo has, on average, a 60% market share in international premium spirits across

its main spirits markets in Africa, comparable with SABMiller's presence in the beer

category across the region. However, it only has a meaningful mainstream spirits

presence in three of its nine key African spirits markets (Kenya, Uganda and South

Africa).

■ Between 2003 and 2013, Diageo's mainstream spirits business recorded a volume

CAGR of c7%, only in line with its international premium spirits business.

Figure 23: Diageo's main African spirits markets are

dominated by mainstream spirits, which represent c75%

of market volumes Share of market volume within spirits - % serves

Figure 24: However, Diageo remains significantly under-

represented in mainstream spirits, contrasting with its

strong positions in premium spirits Diageo market share in international premium and mainstream spirits - %

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Kenya Tanzania Uganda Nigeria Cameroon Ghana

International Premium Mainstream

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

International Premium Mainstream


29 October 2015

Diageo (DGE.L) 11

Figure 25: DGE's mainstream spirits volumes have only

grown in line with international premium spirits over the

past decade 2003-13 DGE Africa spirits volume CAGR - %

Figure 26: Even SABMiller is targeting the mainstream

spirits opportunity – its Tanzanian subsidiary has seen

strong growth in mainstream spirits 2010-15 SABMiller Tanzania revenue growth in beer versus mainstream spirits

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

International Premium Mainstream Reserve

13%

27%

0%

5%

10%

15%

20%

25%

30%

Beer Spirits


Even the brewers are participating in mainstream spirits

The extent to which the mainstream spirits category in Africa has been underpenetrated by

the big spirits companies is characterised by SABMiller (Africa's largest brewer), stepping

up its focus on the mainstream spirits category in recent months given the growth potential

and relative fragmentation of the category.

SABMiller has an existing mainstream spirits business in Tanzania which has grown to

represent c20% of its local operations at relatively attractive margins. The company is

taking this expertise and now investing in local spirits operations in South Sudan, Ethiopia

and Nigeria.

Diageo can leverage its beer business to push mainstream spirits further

We believe Diageo should be able to leverage its beer scale in markets such as Nigeria,

Ghana, Cameroon, Ethiopia and Tanzania to gain a bigger presence in mainstream

spirits—given that beer and mainstream spirits have comparable price points (on a unit

alcohol basis), there is an overlap in outlet coverage universe and route to market, which

has worked well in East Africa. In particular, Diageo has used its beer scale to establish a

strong presence in mainstream spirits across Kenya and Uganda (c60% market share),

with market-leading brands such as Kenya Cane, Warigi (gin in Uganda) and Jebel (gin in

Kenya).

The results achieved in South Africa over the past decade also support our view that

Diageo can better leverage its beer assets in the region to gain scale in mainstream spirits.

In 2004, brandhouse was established, a cost-sharing JV between Diageo, Heineken and

Namibian Breweries, to sell Diageo's spirits, RTDs, ciders and Guinness as well as

Heineken and NBL's beer portfolio.

The scale and investment in the combined entity helped Diageo to gain significant market

share in spirits, rising to 40% in 2014 from 26% in 2005, and it became the market leader.

Diageo now believes it has sufficient scale to operate its spirits business on a standalone

basis, leading to the sale of its share of the JV to Heineken in July 2015.

29 October 2015

Diageo (DGE.L) 12

Figure 27: Beer and mainstream spirits offer comparable

price points and hence route to market overlaps Price ladder of beer and spirits by segment in Africa (mainstream = 100)

Figure 28: Diageo can do more in its beer markets to help

push mainstream spirits – Kenya and Uganda have

demonstrated this potential Diageo beer v mainstream spirits market shares (2014) - %

120

100 100

75

50

0

50

100

150

200>300

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Kenya Ghana Uganda Tanzania Nigeria Ethiopia Cameroon

Beer Mainstream spirits

Source: Company data, Credit Suisse research Source: Company data, Canadean, Credit Suisse research

Figure 29: Up until recently, Diageo had a total beverage

alcohol JV in South Africa with Heineken and Namibian

Breweries 2005-15 Diageo South Africa joint venture structure

Figure 30: Diageo leveraged the scale of the South

African JV to raise its spirits market share to 40% from

26% in 2005 Diageo South Africa spirits market share - %

0%

5%

10%

15%

20%

25%

30%

35%

40%

2005 2014


Mainstream spirits peers have generated strong growth at good margins

We believe incremental focus on mainstream spirits should help drive an acceleration in

Diageo's topline growth. We note mainstream spirits businesses such as Tanzania

distilleries, a subsidiary of SABMiller, and African Distillers in Zimbabwe have experienced

c20-25% sales growth over the past five years, despite macro issues.

Critically, we do not expect a significant margin dilution from growing mainstream spirits in

Africa, given the lower unit cost of production and A&P spend. We note:

■ Tanzania Distilleries generates c30% EBIT margins (on gross sales) in mainstream

spirits, helped somewhat by leveraging the beer business, where it has a c70-80%

market share;

■ ThaiBev generates c25% EBIT margins (on gross sales) in its spirits business, which

consists predominantly of local mainstream brands; and

■ African Distillers and Distell generate lower EBIT margins (c15%), due partly to scale.

We believe incorporating mainstream spirits into Diageo's existing infrastructure

29 October 2015

Diageo (DGE.L) 13

should allow it to generate better margins in mainstream spirits than these standalone

players.

From a manufacturing standpoint, Diageo is rolling out a low-cost portable spirits

production unit called 'the Cube', which can be attached to a brewery, requiring access to

just electricity and water. This helps to keep capex and unit production costs relatively low,

allowing it to reach affordable price points at attractive margins.

Diageo has stated in the past that the margins generated on mainstream spirits are

comparable with international premium spirits, whilst spirits margins in aggregate are

higher than those of beer.

As such, faster growth in spirits than beer overall should be margin accretive to the

business.

Figure 31: Other mainstream spirits businesses have

grown c2x the pace of Diageo's African spirits business 2010-15 DGE Africa spirits organic revenue CAGR vs mainstream spirits peers

Figure 32: …and generate relatively attractive margins

when done at scale FY15 DGE Africa EBIT margin vs mainstream spirits peers

0%

5%

10%

15%

20%

25%

30%

DGE spirits Tanzania Distilleries African Distillers

0%

5%

10%

15%

20%

25%

30%

Diageo Africa Tanzania

Distilleries

ThaiBev African

Distillers

Distell


*Note Tanzania Distilleries and ThaiBev margins are based on gross

sales

2. Secondary scotch

Recent scotch weakness frees up supply to reshape the scotch portfolio

The weakness in Diageo's scotch business in the past couple of years has coincided with

a planned increase in scotch investment. In June 2012, the company announced a £1bn

investment in scotch, of which half would be used to expand capacity, with the balance for

working capital purposes. This investment was predicated on scotch category volume

growth of 4-5%; however, this was revised recently to 2-3% in light of industry weakness.

The result is that the targeted investment for distilling capacity will be pushed further out

when demand returns to the category.

Although in the past Diageo has been focused on increasing supply in the more premium

aged scotch to meet strong demand, the company can now take advantage of industry

weakness to reshape its portfolio to younger liquids and therefore better target entry-level

scotch consumption at more affordable price points in emerging markets, further

leveraging its brands such as Black & White, VAT 69 and White Horse.

29 October 2015

Diageo (DGE.L) 14

Figure 33: Scotch industry capacity has increased by

around 30% over the past decade Scotch industry stock – m litres of pure alcohol

Figure 34: Combined with weak demand in recent years,

this has led to excess industry capacity, leading to an

increase in the average age of stocks Ratio of scotch industry stock to consumption –years

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

6.0

6.5

7.0

7.5

8.0

8.5

9.0

Source: SWIR, Credit Suisse research Source: SWIR, Credit Suisse research

Figure 35: Excess supply can be used for younger liquids

(3-5yr old scotch) in emerging markets over the next few

years as the % of 1-3yr-old scotch inventory has

increased Scotch industry inventory by age - %

Figure 36: Diageo's scotch portfolio is extremely skewed

to the premium Johnnie Walker franchise. We see scope

to broaden price points and category participation Diageo Scotch portfolio volume split - %

40% 43% 46% 46% 44% 43% 44% 47%

17% 16% 16% 17% 19% 20% 19% 16%

24% 21% 19% 17% 17% 19% 21% 23%

19% 20% 20% 21% 20% 18% 16% 14%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2006 2007 2008 2009 2010 2011 2012 2013

1-3yr 3-5yr 5-9yr 10+yr

JW Red Label

33%

JW Black Label

19%

JW Super De

Luxe

3%

J&B

10%

Bell's Extra

special

7%

Black & White

4%

VAT 69

3%

White Horse

4%

Other Blends

14%

Single Malts

3%

Source: SWA, Credit Suisse research Source: Scotch Whiskey Industry Review

Secondary scotch is not significantly margin dilutive

With younger qualities of scotch at more affordable price points, Diageo still has to distil

the liquid in Scotland, although these liquids can be shipped in bulk to end markets and

bottled locally. This reduces significantly the unit cost of production (lower packaging and

labour costs), whilst holding costs are quite comparable—thus enabling a lower price

point. While gross margins on secondary scotch are lower, so are the A&P requirements,

which leads to comparable profit after A&P margins.

Given the lack of scale in these brands, structure costs are higher as a percentage of net

sales. However, even on this basis, we estimate secondary scotch generates higher EBIT

margins than the rest of Diageo's group spirits portfolio, and thus is accretive to group

margins.

29 October 2015

Diageo (DGE.L) 15

Figure 37: Secondary scotch has slightly lower EBIT margins than premium scotch while

still generates higher margins than the rest of the business outside Scotch Diageo Scotch P&L structure versus other spirits (relative to premium Scotch net revenue of 100)

Per case

Premium

scotch

Secondary

scotch

Other

Spirits (ex

USL)

Net revenue 100 55 70

COGs -24 -18 -30

Gross profit 76 37 40

Gross profit margin - % 76.4% 67.9% 57.1%

A&P -23 -7 -9

as % net sales 23% 14% 13%

Profit after A&P 54 30 31

as % net sales 54% 54% 44%

Structure costs -13 -11 -10

as % net sales 13% 21% 14%

EBIT 41 19 21

EBIT margin - % 41% 34% 30%

Source: Credit Suisse research

3. India now contributing to growth

United Spirits represents around 9% of Diageo's FY15 consolidated net revenue, and will

start contributing to group organic growth from FY16. This business is made up of locally

manufactured Indian Made Foreign Liquor (IMFL), which generates £10 per case in net

revenue, around a sixth of the rest of Diageo's business.

Figure 38: USL represents c40% of Diageo's volume, and

c10% of net revenue Contribution of USL to Diageo's FY15 financials - %

Figure 39: USL generates significantly lower net revenue

per case given focus on local Indian whiskies Diageo net revenue per case by region - £

38%

9% 2%0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Volume Net revenue EBIT

USL Rest of group

0

10

20

30

40

50

60

70

80

90

100

Asia-Pacific North

America

Europe Africa Latin

America and

Caribbean

USL


In contrast to Diageo's other emerging markets, USL is already highly skewed towards the

low-priced segment, which accounts for c70% of its volumes. Therefore, the emphasis is

on growing the premium portfolio, which has a 2x higher price point and has grown in

double digits over the past three years to reach 30% of volumes.

29 October 2015

Diageo (DGE.L) 16

The key element of the USL strategy is to focus all marketing efforts in 10% of its 150

brands, predominantly prestige and above, which should drive further premiumisation and

profitability

Furthermore, USL is now selling some Diageo brands, which should benefit from USL's

distribution system (Smirnoff and Captain Morgan will be manufactured locally). Whilst still

small, these brands can ramp up quickly and are very margin accretive. In particular, we

believe there is a strong opportunity for Captain Morgan, noting that the rum category

represents c20% of India's IMFL market; however, we note there are no premium brands

in the market.

Overall, we do not expect significant volume growth from USL (c2-3%), as double-digit

volume growth out of the premium portfolio (prestige and above) continues to be offset by

some rationalisation within the regular portfolio. However, we believe this portfolio

transition should drive strong price/mix benefits (c7-10%).

As such, USL should be able to deliver double-digit growth, which we estimate could

contribute c1-1.5ppt to Diageo's group organic growth over the next few years.

Figure 40: The USL brand portfolio is premiumising USL volume mix by segment

Figure 41: USL's premium brands are priced at 2x regular

brands, thereby driving positive mix and margins Price of key IMFL brands based in Delhi (Indian Rupees)

21% 23% 27% 30% 34% 39%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2012 2013 2014 2015 2016E 2017E

Prestige Regular

based on Delhi prices

Type Owner Brand Price (Rupees)

Bottled in Origin Pernod Chivas Regal >3000

Bottled in India Pernod 100 Pipers 1200

Indian Made Foreign Liquor

Premium Pernod Blenders Pride 650-1000

Sub Premium Pernod Royal Stag 400-650

USL McDowell's No 1 300-400

Pernod Imperial Blue 300-400

Regular USL Bagpiper 200-300

ABD Officer's Choice 200-300

Economy Jagatjit Jagatjit Aristocrat <200

Source: Company data, Credit Suisse estimates Source: Credit Suisse research

Figure 42: USL's organic revenue is sequentially

improving, led by price/mix United Spirits organic revenue (March year end) - %

Figure 43: We estimate USL to contribute c1.0-1.5pp to

group organic revenue growth over the next few years USL growth contribution to Diageo - %

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Q2 15 Q3 15 Q4 15 Q1 16

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

2016E 2017E 2018E 2019E

Source: Company data Source: Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 17

4. Value brands in North America

Diageo's increased focus on the lower-end portfolio isn't focused solely on emerging

markets. Even in North America, Diageo is keen to improve volume growth in brands such

as Popov, Gordon's and Seagram's 7.

We believe Diageo has taken too much pricing in recent years on this part of its portfolio,

resulting in significant volume declines (see Figure 46), as these brands inherently have

higher price elasticity. However, the uneven macro recovery in the US suggests that there

is still consumer interest in this part of the portfolio if priced appropriately.

Once again, the margins of these brands appear favourable—while the lower price points

imply lower gross margins, the lower A&P requirements drive comparable profitability with

the rest of the portfolio.

Figure 44: Diageo took too much pricing FY12-14,

particularly in its low-end portfolio Diageo US spirits price/mix versus CPI - %

Figure 45: Value brands in the US represent c15% of

volumes Diageo value brands as % US volumes (2015)

0%

1%

2%

3%

4%

5%

6%

2011 2012 2013 2014 2015

Price/mix CPI

Value brands

15%

Rest of portfolio

85%

Source: Company data Source: Company data, AC Nielsen, Credit Suisse research

Figure 46: The decline in these brands has had a c1.5pp

negative impact on Diageo's US volumes growth Diageo volume growth of value brands v rest of portfolio - %

Figure 47: We estimate value brands in the US generate

comparable profitability to the rest of the portfolio given

low A&P requirements and provide some operating

leverage Hypothetical P&L structure of US value brands vs rest of portfolio (based on other spirits brands net revenue = 100)

-25%

-20%

-15%

-10%

-5%

0%

5%

2014 2015

Popov Gordon's Seagram 7 Crown Rest

Value

brands

Other

Spirits

Net revenue 59 100

COGs -21 -27

Gross profit 39 73

Gross profit margin - % 65% 73%

A&P -2 -17

as % net sales 4% 17%

Profit after A&P 36 56


Structure costs -11 -12


EBIT 25 44

EBIT margin - % 43% 44%

Source: AC Nielsen Source: Credit Suisse research

29 October 2015

Diageo (DGE.L) 18

Can Diageo execute? Diageo's increased emphasis on volume growth, with particular focus on its lower-end

mainstream brands, is a change in mindset versus previous years, which was generally all

about premiumisation to the higher-end portfolio and maximising price/mix.

This change in emphasis creates opportunities on one hand, while adding higher

complexity to the business model on the other. In particular, the strategy calls for a more

'push-driven' model, in contrast to the premiumisation 'pull-driven' model. This begs the

question – is Diageo's management capable of executing?

We believe Diageo has been making the necessary adjustments to its organisation over

the past 12-18 months in its route to market, with further investments to come.

Furthermore, the integration of USL brings with it an established mainstream spirits

business operating at scale, which provides some knowledge and expertise to the rest of

the organisation.

Route to consumer work supports volume focus

Substantial investment, biggest benefits to come in FY17

Diageo's 'route to consumer' project began in May 2013, with the aim of profitably driving

greater penetration of distribution across its target markets. We believe these practices are

not revolutionary and are already implemented by best-in-class global consumer products

companies. As such, this investment is addressing the under-investment of previous

years. Nevertheless, we still expect some tangible benefits to arise.

The key initiatives of Diageo's route to consumer investment include:

■ Maximise direct and distributor dedicated outlet universe coverage in a

profitable way. This requires identification of the total outlet universe, and then

estimating the profit potential from each outlet to assess in which of those outlets

Diageo should participate.

■ Efficient resource allocation to profitable, growing customers and channels.

Better optimise salesforce time, discounts, point-of-sale materials to the most

profitable and highest-growth customers/channels.

■ Measure and reward distribution penetration and rate of sale better. Enforce and

reward key KPIs such as salesforce productivity (e.g. calls per day), activation metrics

(number of display cases, share of shelf), and 'out of stocks'.

■ Create a sell-out culture. Since the start of FY14, Diageo has spent more time

tracking depletions (sell-out, measuring underlying consumer demand) as opposed to

shipments (sell-in, measuring sales to distributors), reviewing salesforce coverage and

brand distribution data. It is depletions, not shipments, that now form a key part of the

GM's annual bonus.

The project moved from the design phase (identifying outlet universe, revenue potential

and cost to serve) to implementation in calendar H1 2014, with the initial focus on 10

'Wave 1' markets (c£4bn of net sales or 35-40% of group total), where according to

management the opportunity is greatest – see Figure 48.

Wave 1 implementation is not yet complete; however by the end of FY15, these markets

had benefited from:

■ A 10% increase in the number of sales people (from 3,500 to 3,800)

■ A 30% increase in the number of outlets served (or 80k)

29 October 2015

Diageo (DGE.L) 19

This contributed c£90m to net sales in FY15, implying a c2.3% increase to the Wave 1

markets and 0.8% contribution to the group.

Overall, management expects annual gains coming through to FY18, with the biggest

annual increment coming in FY17, by which time all Wave 1 markets, as well as some

Wave 2 markets, should have completed and the full benefits realised.

Figure 48: Diageo targeted route to consumer investments by market

Source: Company data

29 October 2015

Diageo (DGE.L) 20

Margin potential well underpinned Target 100bps margin expansion in FY17-19

Diageo targets 100bps group EBIT margin expansion in FY17-19, which is in line with

consensus expectations.

Below we attempt to break down this guidance, which has various moving parts.

Geographic mix impact

First, we expect Diageo's lower-margin regions to drive the greatest organic growth over

the period – in particular, we expect USL to see double-digit organic growth (contributing

c1.0-1.5pp to group organic revenue); however its underlying EBIT margins are c8%,

below the group average of 28%, which we estimate to be a c20-30bp negative drag on

group margins per annum – i.e. every c5pp topline growth at USL has a c10bp negative

group margin impact.

However, we believe this can be largely offset by margin expansion within the USL

business. Our USL analyst Arnab Mitra models a c100-150bp annual margin expansion,

as its incremental growth is coming from the higher-margin premium segment, whilst it is

rationalising its lower-end portfolio (see page 16/17).

Figure 49: Diageo's lowest-margin regions have the

fastest growth prospects. We estimate growth from USL

has a c20-30bp negative group margin impact Diageo FY17-19E organic growth vs FY15 EBIT margin by region

Figure 50: However, this is offset partly by margin

expansion within USL, as the incremental growth is

coming from the higher-margin prestige segment, which

generates 2x higher net sales per case USL volume mix - %

North America

Europe

LatAm

Africa

Other Asia-Pacfic

USL

0%

2%

4%

6%

8%

10%

12%

14%

0% 10% 20% 30% 40% 50%

FY

17-1

9E

Org

an

ic g

row

th

FY15 EBIT margin - %

21% 23% 27% 30% 34% 39%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2012 2013 2014 2015 2016E 2017E

Prestige Regular

Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates

Cost savings and re-investment

Diageo has committed to £500m of gross productivity gains in FY17-19 (c440bps of

margin), which we expect to be slightly more back-end loaded. The company hasn’t yet

revealed the precise details of the programme, although we expect a significant

contribution from more efficient trade spend.

The company aims to re-invest around two-thirds of this back into the business over the

period, which implies scope for a c140bp margin contribution from net cost savings after

300bps re-investment.

29 October 2015

Diageo (DGE.L) 21

Figure 51: We estimate net cost savings to positively impact margins by 140bps, with

c300bps re-invested back into the business Diageo margin impact of net savings and re-investment of £500m programme - bps

36

50

52

13873

99

122

295

0

50

100

150

200

250

300

350

400

450

500

2017 2018 2019 Accumulated

Net saving Re-investment

Source: Credit Suisse estimates

Volume leverage

If Diageo can successfully execute on delivering improving volume growth over the next

few years, we believe this could drive some good operational leverage, particularly as the

business builds scale in mainstream spirits.

Other things being equal, we estimate 1% volume growth drives c20bps margin

expansion. On this basis, our forecast of 3.5% volume growth could generate c60bps

margin expansion per annum.

Figure 52: Each 1% volume growth could improve margins by 20bps, other things being

equal Diageo hypothetical operating leverage analysis

DGE P&L

1% volume

impact Fixed Variable

Net sales 100.0 101.0

Cost of sales -42.4 -42.7 30% 70%

Gross profit 57.6 58.3

Gross profit margin - % 57.6% 57.7%

chge - bps 11

Marketing -15.1 -15.2 20% 80%

Other operating expenses -14.1 -14.1 60% 40%

EBIT 28.4 28.9

EBIT margin - % 28.4% 28.6%

chge - bps 21 Source: Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 22

Overall assessment of Diageo's margin target

In Figure 53, we attempt to break down the impact of the various drivers of Diageo's

margin guidance. The missing part to our analysis is the negative impact of weak pricing

(due to the competitive environment) and the initial impact from incremental volume

growth of mainstream spirits.

As we have pointed out previously in this report, these mainstream brands typically

generate comparable margins (after A&P spend); however, given Diageo's relatively low

scale at the moment, they incur higher structure costs, which brings down their EBIT

margin contribution. Therefore, there could be some initial margin dilution (perhaps

offsetting the volume leverage in FY17), but this should subside as Diageo then begins to

leverage its scale.

Therefore, we can conclude that Diageo's margin guidance is underpinned by the

productivity savings, at least in FY17.

Thereafter, we suspect that the guidance may have some leeway for volume leverage to

drop through to margins – however investors need to see some delivery of the volume

growth for this argument to gain traction.

Figure 53: Diageo's margin targets are at least underpinned by the productivity savings, with some leeway in the outer

years if it delivers on volume growth Diageo EBIT margin forecast breakdown by geographic mix, cost savings and topline growth - bps

2017E 2018E 2019E Accumulated Comment

Negative geographic margin mix -15 -28 -26 -69 Negative impact of lower margin USL business growing faster than other regions

USL margin expansion 15 16 12 43 Group contribution from margin expansion within USL (c100-150bps pa)

a Net geographic mix impact 0 -12 -15 -26

Gross productivity gains 109 149 175 433 £500m gross productivity programme over FY17-19

Re-investment -73 -99 -122 -295 2/3rds ofproductivity gains re-invested back into the business

b Net productivity gains 36 50 52 138

a+b Mix and productivity impact 37 38 38 112 In line with company target of 100bps

Volume leverage 60 60 60 180 Operational leverage from c3.5% volume growth p.a.

Price & mainstream spirits -ve -ve -ve -ve Negative impact from weak pricing and initial roll-out of mainstream spirits Source: Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 23

Cash flow improvement Historically, free cash flow conversion has been weak

Diageo's FCF conversion had weakened considerably in FY11-14, dropping from 82% to

50% over the period. This was driven predominantly by working capital (a step-up in

maturing stock, but also trade receivables), restructuring costs (supporting recent cost-

savings programme) and increasing capex (increased investments in EM).

Figure 54: Diageo's FCF conversion was relatively weak in

FY11-14, with improvements in FY15 as working capital

became a key feature of management remuneration Diageo FCF conversion (company definition) - %

Figure 55: Diageo's FCF has been impacted by working

capital (maturing stock), restructuring costs, pension

costs and higher capex FY10-15 free cash flow breakdown - £m

0%

20%

40%

60%

80%

100%

120%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

2010 2011 2012 2013 2014 2015

EBIT 2,751 2,884 3,198 3,530 3,134 3,066

Depreciation & amortisation 291 286 323 330 365 399

Working capital 329 -110 -529 -553 -597 117

Dividends received 111 138 166 203 228 183

Post employment payments -114 -119 -200 -498 -196 -70

Cash exceptionals -145 -259 -158 -61 -104 -191

Other items -48 39 205 80 -139 -48

Cash from operations 3,175 2,859 3,005 3,031 2,691 3,456

Net interest expense -305 -311 -391 -427 -432 -416

Tax expense -474 -365 -521 -556 -469 -489

Capex -374 -419 -484 -643 -642 -638

Asset disposals 143 47 39 39 80 52

Movement in loans -43 1 -1 16 7 -2

Free cash flow 2,122 1,812 1,647 1,460 1,235 1,963 Source: Company data Source: Company data

Improvement in FY15 as operating cash conversion incorporated in remuneration

Diageo management increased its focus on operating cash conversion (a company-

defined measure excluding maturing stock, pension costs, restructuring costs and dividend

income) in FY15 by introducing it as a key metric in management's annual incentive plan,

leading to a significant improvement in FCF conversion in FY15.

From FY16, operating cash conversion is the most important metric in Diageo's annual

incentive plan, with a weighting of c30%.

Figure 56: Operating cash conversion has the highest weighting in Diageo's annual

incentive plan Diageo annual management incentive plan structure

FY14 FY15 FY16

Net sales growth 30% 30% 25%

Profit growth 30% 35% 25%

Operating cash conversion 25% 30%

Individual business objectives 20% 10% 20%

Free cash flow 10%

Avg working capital as % net sales 10%

Total 100% 100% 100% Source: Company data

29 October 2015

Diageo (DGE.L) 24

Scope for further improvement

We believe Diageo has room for improvement in its working capital metrics. We note that:

■ Trade receivables as a percentage of net sales are among the highest in the

consumer staples peer group; however this is generally the case for spirits companies,

which have a higher exposure to i) a fragmented universe of on-trade outlets, and ii)

the US three-tier distribution system, both of which have structurally higher debtor

days.

■ Trade payables as a percentage of net sales are among the lowest versus consumer

staples peers—we believe this is where Diageo perhaps has the biggest opportunity,

as it isn't using its scale fully to improve terms with suppliers.

We expect Diageo to continue to invest in maturing stock to the tune of £160m per annum

(including £85m holding costs), which implies c4% growth per annum.

Other inventories also have scope to improve (eg, finished stock), as Diageo is changing

its approach to innovation, away from big pipeline fills, to one of a replenishment cycle,

particularly in the US market. Furthermore, the business as a whole is more incentivised

on sell-out than sell-in, is improving its forecasting capability and should be helped further

by its increased focus on trade terms.

Figure 57: Diageo has one of the highest trade

receivables ratios versus peers, although this is generally

the case for spirits companies 2014 calendarised trade receivables as a % net sales

Figure 58: Diageo has the lowest trade payables ratios in

the sector, wherein lies the biggest opportunity 2014 calendarised trade payables as % net sales

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0%

5%

10%

15%

20%

25%

30%


Note Pernod excludes factoring

Figure 59: Diageo's trade receivables have increased in

recent years (note FY15 impacted by USL consolidation) Diageo average trade receivables as a % of net sales

Figure 60: Diageo's trade payables have increased in

recent years, more can be done (note FY15 impacted by

USL consolidation) Diageo average trade payables as a % of net sales

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


29 October 2015

Diageo (DGE.L) 25

Figure 61: Diageo could release c.£700m of working capital to our current forecasts

(12% uplift to FCF) if it closes half the gap versus consumer staples peers Diageo potential working capital improvement scenario - £m

CS estimate

Potential if

close half the

gap with peers

2015 2018E 2018E

Net sales 10,813 11,425 11,425

Maturing stock 3,586 4,066 4,066

Other inventories 988 994 800

Trade receivables 1,933 1,997 1,764

Trade payables -883 -1,001 -1,295

Net working capital 5,624 6,055 5,335

Net working capital ex maturing stock 2,038 1,989 1,269

as % net sales

Maturing stock 33.2% 35.6% 35.6%

Other inventories 9.1% 8.7% 7.0%

Trade receivables 17.9% 17.5% 15.4%

Trade payables 8.2% 8.8% 11.3%

Net working capital 52.0% 53.0% 46.7%

Net working capital ex maturing stock 18.8% 17.4% 11.1%

Change - £m

Maturing stock 0

Other inventories 194

Trade receivables 233

Trade payables 293

Net working capital 720

Net working capital ex maturing stock 720

Accumulated FCF to equityholder (FY16-18E) 6,252

Potential uplift - % 12% Source: Company data, Credit Suisse estimates

Scope for share buybacks

Share buybacks from FY17 could be 2% EPS accretive

We note that Diageo's balance sheet will de-lever to below its target range of 2.5x-3.0x net

debt/EBITDA by the end of FY16, helped by recent disposals of non-core assets. As such,

with our expectations of a sequential improvement in growth and margins in FY17, and

M&A unlikely, we believe management could look to increase returns to shareholders.

This is unlikely to be via dividends, as the dividend cover has fallen to c1.5x, leading

management to slow dividend growth to 'mid-single digit' until its target 1.8-2.2x dividend

cover is restored over coming years.

As such, we expect further cash returns to come in the form of share buybacks – we

estimate a £1.5bn annual share buyback at current valuation levels and cost of debt would

be 2% EPS accretive.

29 October 2015

Diageo (DGE.L) 26

Figure 62: Diageo's balance sheet is will de-lever to below

its target of 2.5x-3.0x net debt/EBITDA – with M&A

unlikely, management could raise cash returns Diageo net debt/EBITDA - x

Figure 63: This is unlikely through dividends, as we

expect the dividend cover to be restored to the

company's target level of 1.8-2.2x over coming years Diageo dividend cover - x

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5Target 2.5-3.0x

Historical average 2.3x

0.0

0.5

1.0

1.5

2.0

2.5

Historical average 1.9x Target 1.8-2.2x


Figure 64: This implies any increased cash returns are likely through share buybacks,

which were commonplace pre-financial crisis and years of M&A activity Diageo cash returns (LHS - £m) versus net debt/EBITDA (RHS – x)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0

500

1,000

1,500

2,000

2,500

Dividend Buyback Net debt/EBITDA (RHS) - x

£4.7bn spent on M&A

Source: Company data, Credit Suisse estimates

Figure 65: We estimate share buybacks from FY17 could be at least 2% EPS accretive per annum Impact of £1.5bn annual share buyback on Diageo's FY17-19E EPS

Comment

2016E 2017E 2018E 2019E 2017E 2018E 2019E 2017E 2018E 2019E

EBIT 3,002 3,154 3,370 3,610 3,154 3,370 3,610

Net interest cost -323 -283 -261 -235 -30 -60 -90 -313 -321 -325

Net other finance charges -45 -35 -25 -25 -35 -25 -25

Share of associates/JVs 195 216 239 264 216 239 264

PBT 2,829 3,052 3,323 3,614 -30 -60 -90 3,022 3,263 3,524

Tax expense -521 -569 -628 -693 6 12 19 -563 -616 -674

Tax rate - % 19.8% 20.1% 20.4% 20.7% 20.1% 20.4% 20.7% 20.1% 20.4% 20.7%

Minority interest -89 -100 -117 -137 -100 -117 -137

Net income 2,218 2,383 2,578 2,785 -24 -48 -71 2,359 2,530 2,713

Average number of shares - diluted 2,517 2,519 2,520 2,522 -73 -140 -200 2,445 2,380 2,321

Adjusted EPS - fully diluted 88.1 94.6 102.3 110.4 96.5 106.3 116.9

EPS accretion - % 2% 4% 6%

Balance sheet impact

Net debt 8,199 7,643 7,001 6,220 1,500 3,000 4,500 9,143 10,001 10,720

EBITDA 3,393 3,558 3,796 4,060 3,558 3,796 4,060

Net debt/EBITDA - x 2.4 2.1 1.8 1.5 2.6 2.6 2.6 DGE targets 2.5-3x net debt/EBIDA

Share buyback impact

Share buyback - £m 1,500 1,500 1,500 Assume £1.5bn buyback pa

Share price - pence 2,049 2,254 2,480 Assume share price increases 10% pa from current 1,863p

Number of shares acquired - m 73 67 60

Cost of debt 2.0% 2.0% 2.0% Recent debt issues in sector have been at c2% interest

Incremental net interest expense -30 -30 -30

Pre share buyback Cumulative buyback impact Post share buyback


29 October 2015

Diageo (DGE.L) 27

Relative valuation looks inexpensive Figure 66: Diageo has underperformed European

consumer staples by c15% year to date Diageo share price performance v European consumer staples (Jan 2011 = 100)

Figure 67: Diageo's underperformance has been driven by

c30% consensus EPS downgrades over the past couple

of years Diageo consensus EPS revisions - pence

90

100

110

120

130

140

150

160

170

180

190

Jan-1

1

Apr-

11

Jul-11

Oct

-11

Jan-1

2

Apr-

12

Jul-12

Oct

-12

Jan-1

3

Apr-

13

Jul-13

Oct

-13

Jan-1

4

Apr-

14

Jul-14

Oct

-14

Jan-1

5

Apr-

15

Jul-15

Oct

-15

Diageo European consumer staples

2010

2011

2012

20132014

2015

2016

2017

60

70

80

90

100

110

120

130

140

150

Oct

-07

Mar

-08

Au

g-0

8

Jan

-09

Jun

-09

No

v-0

9

Ap

r-1

0

Sep

-10

Feb

-11

Jul-

11

De

c-1

1

May

-12

Oct

-12

Mar

-13

Au

g-1

3

Jan

-14

Jun

-14

No

v-1

4

Ap

r-1

5

Sep

-15

Source: Thomson Reuters Source: Thomson Reuters

Figure 68: Diageo now trades on FY16E calendarised

20.4x P/E, a c5% discount to European consumer staples Diageo FY16E calendarised P/E v European consumer staples - x

Figure 69: Diageo traded at a sector premium when it was

hitting its previous targets in FY12-13 Diageo 12m forward P/E relative to European consumer staples

10

12

14

16

18

20

22

24

26

28

80

85

90

95

100

105

110

Jan

-03

Sep

-03

May

-04

Jan

-05

Sep

-05

May

-06

Jan

-07

Sep

-07

May

-08

Jan

-09

Sep

-09

May

-10

Jan

-11

Sep

-11

May

-12

Jan

-13

Sep

-13

May

-14

Jan

-15

Sep

-15

Source: Credit Suisse estimates Source: Thomson Reuters

29 October 2015

Diageo (DGE.L) 28

Figure 70: We expect Diageo to moderate its growth in

maturing stock to c4% per annum Diageo maturing stock - £m

Figure 71: Diageo's trades on a FY16E 14.5x EV/maturing

stock, a c10% discount to its historical average Diageo EV/maturing stock - x

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

8% CAGR 2006-15

4% CAGR 2016-19

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0


Figure 72: Diageo has guided to a slowdown in its

dividend growth to mid-single digits, from 8% growth in

recent years Diageo dividend per share - pence

Figure 73: Even on this basis, Diageo's 3.3% dividend

yield is among the highest in European consumer staples

outside of the tobacco stocks, backed by stronger FCF Calendarised FY16E dividend yield - %

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

8% CAGR

5% CAGR

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Source: Company data, Credit Suisse estimates Source: Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 29

Target price – increase to 2,100p

We raise our target price to 2,100p from 1,780p, driven by an improvement in our free cash flow forecasts.

We make the following assumptions;

■ Revenue growth: as per our explicit forecasts out to FY20, beyond which the growth rate fades to 2.5% (consistent with peers)

■ EBIT margin: We assume 30-40bps margin expansion per annum out to FY20, beyond which we assume 30bps

■ Capex/depreciation: This declines from 1.5x in FY16E to 1.2x in FY20E, consistent

with guidance of medium-term capex at 4-5% of net sales. Beyond FY20, we assume

capex/depreciation fades to 1.15x (consistent with peers)

■ Tax rate: We assume the tax rate slightly increases per annum to 21% in FY20 and remains at this level thereafter.

■ Balance sheet: We value the tax shield based on net debt/EBITDA at 2.75x, at the mid-point of management's target of 2.5-3.0x.

■ Valuation of associates: We value Diageo's 34% stake in Moet Hennessey based on the fair value derived in LVMH's recent accounts (which is based upon valuation multiples of comparable firms), with the remaining assets at book value, which implies an effective 24x P/E on Diageo's share of income from associates & JVs.

■ Valuation of minority interests: We value Diageo's minority interests excluding USL (mainly Guinness Nigeria, EABL, and Ketel One) on a valuation multiple consistent with Diageo, whilst we value the minority stake in United Spirits at 35x P/E (a 50% discount to its market valuation).

Figure 74: We raise out target price to 2,100p Diageo adjusted present value calculation - £m

Assumptions

Cost of equity 8.0%

Perpetuity growth rate 2.5%

Cost of debt 3.5%

Tax rate 19.8%

Cost of debt (post tax) 2.8%

Terminal capex/depreciation 1.15

Adjusted present value

Free cash flow NPV 27,342

Terminal value 28,533

Value of tax shield 3,830

Enterprise value 59,705

Net debt (calendarised) -9,092

Minority interest -3,121

Associates 4,767

Equity value - £m 52,258

Number of shares - m 2,515

Equity value per share - pence 2,078

Current share price 1,863

Upside/(downside) - % 12% Priced as of 27 October 2015


29 October 2015

Diageo (DGE.L) 30

Credit Suisse HOLT® Based on Credit Suisse HOLT, we derive a fair value of £19.53 per share for Diageo,

suggesting c5% upside potential.

The CFROI® chart at the top of Figure 75 is a reflection of our forecasts for sales, margins

and asset turns. Our assumptions result in a 2016 CFROI of 22.7%, reducing slightly to

c22.4% in FY18 before rebounding to 23.3% by FY20. This is driven by a steady increase

in EBITDA margins and asset turns.

Figure 75 shows our model for Diageo in terms of sales, margins and turns. Our estimates

indicate a long-term topline growth rate of c5.5%. We expect asset turns to grow steadily

over the explicit period reaching 0.79 in FY20 and 0.83 in FY25.

Beyond the 10-year window, HOLT assumes the CFROI and discount rate fade to 6.0%,

while the asset growth fades to 2.5%—incorporating the economic reality of competition

and causing high returns and growth to regress to the mean.

By way of sensitivity, assuming that Diageo's CFROI fades by 7.5% per annum instead of

10% (consumer staples companies have a track record of being able to sustain their

relatively high CFROIs for a longer period of time), the HOLT warranted value rise to

£22.73, suggesting 22% upside from current levels.

29 October 2015

Diageo (DGE.L) 31

Figure 75: Credit Suisse HOLT suggests 5%potential upside from current levels in £millions, unless otherwise stated

Current Price: GBP 18.63 Warranted Price: GBP 19.53 Valuation date: 28-Oct-15

Sales Growth (parallel % point change to forecasts) Jun 14A Jun 15A Jun 16E Jun 17E Jun 18E

GBP -2.0% -1.0% 0.0% 1.0% 2.0% Sales Growth, % -10.3 5.4 -3.0 3.4 5.4

EBITDA Mgn, % 33.6 31.5 32.4 32.8 33.2

Asset Turns, x 0.78 0.8 0.8 0.8 0.8

CFROI®, % 24.3 23.3 22.7 22.4 22.5

Disc Rate, % 4.3 3.3 3.3 3.3 3.3

Asset Grth, % -9.8 3.3 -5.1 3.0 3.4

Value/Cost, x 4.6 5.2 4.3 4.1 3.9

Economic PE, x 19.1 22.1 18.8 18.2 17.2

Leverage, % 20.8 18.1 16.5 15.8 14.9

HO

LT

-

C

red

it S

uis

se

An

aly

st

Sc

en

ari

o D

ata

DIAGEO PLC (DGE)

EB

ITD

A M

arg

in (

para

llel

% p

oin

t ch

an

ge

to f

ore

cas

ts)

-2.0% -24% -14% -4% 8%

32%

21%

-1.0% -20% -10% 0% 13% 26%

0.0% -16% -6% 5% 17%

42%

1.0% -13% -2% 9% 22% 37%

2.0% -9% 2% 14% 27%

For display purposes, these charts have been capped as follows. CFROI levels are kept within 0% and 15%.

More than

10%

downside

Within 10%More than

10% upside

Source: Credit Suisse HOLT®. CFROI and HOLTare trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries.

-15

-10

-5

0

5

10

2011 2013 2015 2017 2019 2021 2023 2025

Sales Growth (%)

0

5

10

15

20

25

30

35

40

2011 2013 2015 2017 2019 2021 2023 2025

EBITDA Margin

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

2011 2013 2015 2017 2019 2021 2023 2025

Asset Turns (x)

0

5

10

15

20

25

30

2011 2013 2015 2017 2019 2021 2023 2025

Historical CFROI Historical Transaction CFROI Forecast CFROI

Forecast CFROI CFROI Discount Rate

CFROI & Discount Rate (in %)

-15

-10

-5

0

5

10

15

20

2011 2013 2015 2017 2019 2021 2023 2025

Historical Asset Growth Rate Forecast Growth Forecast Growth

RAGR Normalised Growth Rate

Asset Growth (in %)

Source: Company data, Credit Suisse HOLT, Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 32

Key risks ■ The return of target setting: Diageo has returned to setting group targets of mid-

single-digit organic growth and 100bps margin in FY17-19. Back in FY11, the

company set a target of 6% medium-term organic growth and a 200bp margin

expansion in FY11, which became a constraint on the business as economic

conditions changed, particularly in emerging markets. However, we believe Diageo is

now better invested, with a bigger focus on volume growth in the mainstream/value

segment, which is less economically sensitive.

■ Currency movements: Significant currency depreciation across emerging markets

have led to destocking, particularly of imported premium spirits, which are priced and

manufactured in hard currency. Whilst management has guided to a completion of

destocking over the next few months, any further currency volatility could lead to

further destocking by distributors in emerging markets.

■ Rise of craft spirits: As we wrote in our report "Rising threat of US craft spirits, July

2015", the US spirits market faces a growing threat of substitution. A market that had

been characterised by large-scale national brands is becoming increasingly focused

on local, authentic, small-batch production. We believe Diageo could be more exposed

than Pernod (the US represents c40% of group EBIT), and our forecasts for North

America capture continued market share losses.

https://plus.credit-suisse.com/r/h3yMtu

https://plus.credit-suisse.com/r/h3yMtu

29 October 2015

Diageo (DGE.L) 33

Company overview Figure 76: Diageo company overview in £millions, unless otherwise stated

Diageo (DGE.L) Shareholder structure

FY 2015 (y/e Jun) North America Europe LatAm Africa Asia Pacific Corporate Total Segment

Volumes (m cases) 47.3 44.1 21.6 26.2 107.0 - 246.2

% Volumes 19% 18% 9% 11% 43% -

Revenue 3,455 2,617 1,033 1,415 2,213 80 10,813

% of total revenue 32% 24% 10% 13% 20% 1%

EBIT Underlying 1,448 804 263 318 356 -123 3,066

EBIT margin - % 41.9% 30.7% 25.5% 22.5% 16.1% - 28%

% of total EBIT 45% 25% 8% 10% 11%

Key Markets

USA, Canada UK, Germany, Spain,

Russia, Turkey

Brazil, Mexico,

Argentina, Venezuela

Nigeria, Kenya, South

Africa

China, Australia, India,

Japan, Thailand, Korea

Main Brands

Smirnoff, Ciroc,

Captain Morgans,

Baileys, Popov, Ketel

One, Guinness

Smirnoff, Baileys,

J&B, Cuervo,

Guinness,

Tanqueray

Smirnoff, Buchanan's,

Ciroc, Captain

Morgans, Johnnie

Walker

Smirnoff, Bells, Black

& White, Guinness,

J&B, Johnnie Walker Johnnie Walker, Buchanan's

Competitors

Pernod, Beam Inc,

Brown Forman,

Bacardi,

Pernod, Bacardi,

Campari, LVMH

Bacardi, Pernod

Ricard, Lascelles

Demercado, LVMH,

Beam, Remy

Pernod Ricard, Remy,

Bacardi

Pernod Ricard, LVMH, Remy

Cointreau, Brown Forman

Segment

Diageo is the global leader in international spirits with dominant positions in N

America, LatAm, Africa and Europe. Created by the merger of Guinness and

Grand MET in 1997. Diageo's products are sold in over 180 countries.

Diageo is 100% free-float. The company has a 34% stake in Moet Hennessy, which it

accounts for as an associate

TOTAL COMPANY

Revenues EBIT Volumes

North America

32%

Europe24%

LatAm10%

Africa13%

Asia Pacific21%

North America

46%

Europe25%

LatAm8%

Africa10%

Asia Pacific11%

North America

19%

Europe18%

LatAm9%Africa

11%

Asia Pacific43%

Source: Company data, Credit Suisse research

29 October 2015

Diageo (DGE.L) 34

Financial Model Figure 77: Diageo forecasts by region in £millions, unless otherwise stated

2015 2016E 2017E 2018E

Revenue analysis

Volume -1.3% 1.8% 2.9% 3.7%

Price/mix 1.3% 1.5% 1.9% 1.7%

Organic revenue 0.0% 3.3% 4.8% 5.4%

M&A 8.7% -2.4% -1.5% 0.0%

FX -3.3% -3.9% 0.1% 0.0%

Total 5.4% -3.0% 3.4% 5.4%

Net sales 10,813 10,487 10,842 11,432

EBIT 3,066 3,002 3,154 3,370

EBIT margin - % 28.4% 28.6% 29.1% 29.5%

organic change - bps 24 9 32 39

change - bps -220 27 46 39

Organic EBIT 0.7% 3.6% 6.0% 6.9%

M&A 2.2% -1.7% -1.1% 0.0%

FX -5.1% -4.0% 0.2% 0.0%

Total -2.2% -2.1% 5.1% 6.9%

Net sales

North America 3,455 3,478 3,511 3,634

Europe 2,617 2,382 2,371 2,407

Africa 1,415 1,397 1,536 1,690

Latin America and Caribbean 1,033 945 994 1,069

Asia Pacific 2,213 2,253 2,397 2,601

Corporate 80 32 32 32

Total 10,813 10,487 10,842 11,432

Organic revenue - %

North America -1.4% 2.6% 3.5% 3.5%

Europe 0.1% 0.7% 1.5% 1.5%

Africa 6.4% 7.3% 10.0% 10.0%

Latin America and Caribbean -1.1% 4.3% 7.5% 7.5%

Asia Pacific -2.4% 4.6% 6.0% 8.5%

Corporate 3.2% 0.0% 0.0% 0.0%

Total 0.0% 3.3% 4.8% 5.4%

EBIT

North America 1,448 1,487 1,531 1,599

Europe 804 731 745 768

Africa 318 309 345 387

Latin America and Caribbean 263 235 252 277

Asia Pacific 356 352 392 443

Corporate -123 -113 -110 -104

Total 3,066 3,002 3,154 3,370

EBIT margin - %

North America 41.9% 42.8% 43.6% 44.0%

Europe 30.7% 30.7% 31.4% 31.9%

Africa 22.5% 22.1% 22.4% 22.9%

Latin America and Caribbean 25.5% 24.9% 25.3% 25.9%

Asia Pacific 16.1% 15.6% 16.3% 17.0%

Total 28.4% 28.6% 29.1% 29.5% Source: Company data, Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 35

Figure 78: Diageo P&L forecasts in £millions, per share data in pence, unless otherwise stated

2015 2016E 2017E 2018E

Net sales 10,813 10,487 10,842 11,432

EBITDA 3,465 3,393 3,558 3,796

Depreciation & amortisation -399 -391 -404 -426

Adjusted EBIT 3,066 3,002 3,154 3,370

Exceptional items -269 -65 0 0

EBIT - reported 2,797 2,937 3,154 3,370

Sales of businesses 373 0 0 0

Net interest cost -360 -323 -283 -261

Net other finance charges -52 -45 -35 -25

Share of profits from associates/JVs 175 195 216 239

Clean profit before tax 2,829 2,829 3,052 3,323

Profit before tax 2,933 2,764 3,052 3,323

Underlying tax expense -517 -521 -569 -628

Tax on exceptionals 51 13 0 0

Total tax expense -466 -508 -569 -628

Effective tax rate - % 19.5% 19.8% 20.1% 20.4%

Tax rate - % 18.3% 18.4% 18.7% 18.9%

Clean profit after tax 2,312 2,308 2,483 2,695

Profit after tax 2,467 2,256 2,483 2,695

Minority interests -87 -89 -100 -117

Adjusted net income 2,225 2,218 2,383 2,578

Net income 2,381 2,166 2,383 2,578

Average number of shares - basic 2,505 2,507 2,509 2,510

Average number of shares - diluted 2,515 2,517 2,519 2,520

Adjusted EPS - fully diluted 88.5 88.1 94.6 102.3

Adjusted EPS - basic 88.8 88.5 95.0 102.7

EPS - fully diluted 94.7 86.1 94.6 102.3

EPS - basic 95.0 86.4 95.0 102.7

DPS 56.4 59.2 62.2 65.3

Dividend cover - x 1.6 1.5 1.5 1.6 Source: Company data, Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 36

Figure 79: Diageo cash flow forecasts in £ millions, unless otherwise stated

2015 2016E 2017E 2018E

EBIT 3,066 3,002 3,154 3,370

Depreciation & amortisation 399 391 404 426

Working capital 117 -53 -171 -209

Dividends received 183 186 208 229

Post employment payments -70 -70 -70 -70

Cash exceptionals -191 -65 0 0

Other items -48 0 0 0

Cash from operations 3,456 3,392 3,525 3,746

Net interest expense -416 -323 -283 -261

Tax expense -489 -508 -569 -628

Net cash from operating activities 2,551 2,560 2,672 2,857

Capex -638 -598 -564 -572

Asset disposals 52 50 50 50

Movement in loans -2 0 0 0

UK pension escrow payment 0 0 0 0

Free cash flow 1,963 2,012 2,158 2,335

Cash flow from other investing activities

Acquisitions -1,283 -140 0 0

Disposals/other 978 1,065 0 0

Total -305 925 0 0

Cashflow from financing activities

Share issues/(buybacks) -7 -5 -5 -5

Dividends to minority interests -72 -74 -83 -97

Dividends to shareholders -1,341 -1,468 -1,515 -1,591

Total -1,420 -1,547 -1,602 -1,693

Net debt - opening -8,850 -9,527 -8,199 -7,643

Change in cash flows 238 1,390 556 642

Exchange differences -7 -62 0 0

Acquired debt -869 0 0 0

Other non-cash items -39 0 0 0

Net debt - closing -9,527 -8,199 -7,643 -7,001

EBITDA 3,465 3,393 3,558 3,796

Net debt/EBITDA - x 2.7 2.4 2.1 1.8 Source: Company data, Credit Suisse estimates

29 October 2015

Diageo (DGE.L) 37

Companies Mentioned (Price as of 27-Oct-2015)

Anheuser-Busch InBev (ABI.BR, €106.15) Beiersdorf (BEIG.DE, €85.0) British American Tobacco (BATS.L, 3793.5p) Carlsberg (CARLb.CO, Dkr539.0) Danone (DANO.PA, €62.81) Diageo (DGE.L, 1863.0p, OUTPERFORM, TP 2100.0p) Heineken (HEIN.AS, €80.16) Henkel (HNKG_p.F, €98.45) Imperial Tobacco (IMT.L, 3454.0p) L'Oreal (OREP.PA, €171.1) Nestle (NESN.VX, SFr75.2) Pernod-Ricard (PERP.PA, €105.0) Philip Morris International (PM.N, $88.82) Reckitt Benckiser (RB.L, 6294.0p) Unilever (UNc.AS, €41.12) United Spirits Ltd. (UNSP.BO, Rs3143.45)

Disclosure Appendix

Important Global Disclosures

I, Sanjeet Aujla, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

3-Year Price and Rating History for Diageo (DGE.L)

DGE.L Closing Price Target Price

Date (p) (p) Rating

21-Dec-12 1807.50 1900.00 O

04-Mar-13 1975.00 1975.00

07-Mar-13 2000.50 2350.00

18-Apr-13 1978.00 *

11-Jun-13 1906.00 2350.00 O

12-Dec-13 1880.00 2200.00

28-Apr-14 1821.50 1950.00 N

18-Dec-14 1831.00 1850.00

13-Mar-15 1864.00 1700.00 U

20-Apr-15 1870.50 1800.00

08-Jun-15 1880.00 1800.00 N

28-Jul-15 1819.00 *

31-Jul-15 1789.50 1750.00 N

06-Oct-15 1819.00 1780.00

* Asterisk signifies initiation or assumption of coverage.

O U T PERFO RM

N EU T RA L

U N D ERPERFO RM

The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities

As of December 10, 2012 Analysts’ stock rating are defined as follows:

Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark*over the next 12 months.

Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months.

Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months.

*Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's c overage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing t he most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ra tings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin Ame rican and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 1 2-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, wh ich was in operation from 7 July 2011.

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Diageo (DGE.L) 38

Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.

Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.

Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation:

Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months.

Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months.

Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months.

*An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cov er multiple sectors.

Credit Suisse's distribution of stock ratings (and banking clients) is:

Global Ratings Distribution

Rating Versus universe (%) Of which banking clients (%)

Outperform/Buy* 58% (34% banking clients)

Neutral/Hold* 27% (33% banking clients)

Underperform/Sell* 13% (23% banking clients)

Restricted 2%

*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, an d Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdin gs, and other individual factors.

Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein.

Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research-and-analytics/disclaimer/managing_conflicts_disclaimer.html

Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties.

Price Target: (12 months) for Diageo (DGE.L)

Method: Our price target is derived from an APV (adjusted present value) - a hybrid discounted cash flow which splits the value of the tax shield from the operating cash flows (the latter discounted at a cost of equity of 8%). We value Diageo's 34% stake in Moet Hennessey based on the fair value derived in LVMH's recent accounts (which is based upon valuation multiples of comparable firms), with the remaining assets at book value. We value Diageo's minority interests excluding USL (mainly Guinness Nigeria, EABL, and Ketel One) on a valuation multiple consistent with Diageo, whilst we value Diageo's minority stake in United Spirits at a 50% discount to its market valuation.

Risk: Increased regulation in Europe/US. Level of investment required to build international markets. Competitor activity, excessive excise duty increases.

Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections.

See the Companies Mentioned section for full company names

The subject company (DGE.L, HEIN.AS, NESN.VX, BEIG.DE, BATS.L, IMT.L, PM.N, ABI.BR, UNSP.BO) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse.

Credit Suisse provided investment banking services to the subject company (HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N) within the past 12 months.

Credit Suisse provided non-investment banking services to the subject company (NESN.VX) within the past 12 months

Credit Suisse has managed or co-managed a public offering of securities for the subject company (HEIN.AS, NESN.VX, PM.N) within the past 12 months.

Credit Suisse has received investment banking related compensation from the subject company (HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N) within the past 12 months

Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (DGE.L, PERP.PA, HEIN.AS, NESN.VX, DANO.PA, BEIG.DE, BATS.L, IMT.L, PM.N, ABI.BR, UNSP.BO) within the next 3 months.

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Diageo (DGE.L) 39

Credit Suisse has received compensation for products and services other than investment banking services from the subject company (NESN.VX) within the past 12 months

As of the date of this report, Credit Suisse makes a market in the following subject companies (PM.N).

Please visit https://credit-suisse.com/in/researchdisclosure for additional disclosures mandated vide Securities And Exchange Board of India (Research Analysts) Regulations, 2014

Credit Suisse may have interest in (UNSP.BO)

As of the end of the preceding month, Credit Suisse beneficially own 1% or more of a class of common equity securities of (DGE.L, NESN.VX, IMT.L).

Credit Suisse has a material conflict of interest with the subject company (NESN.VX) . Credit Suisse AG is acting as an agent in relation to the company's announced share buy-back program for capital reduction purposes.

For other important disclosures concerning companies featured in this report, including price charts, please visit the website at https://rave.credit-suisse.com/disclosures or call +1 (877) 291-2683.

Important Regional Disclosures

Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report.

The analyst(s) involved in the preparation of this report may participate in events hosted by the subject company, including site visits. Credit Suisse does not accept or permit analysts to accept payment or reimbursement for travel expenses associated with these events.

Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares.

Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report.

For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit https://www.credit-suisse.com/sites/disclaimers-ib/en/canada-research-policy.html.

Credit Suisse Securities (Europe) Limited (Credit Suisse) acts as broker to (IMT.L).

The following disclosed European company/ies have estimates that comply with IFRS: (DGE.L, PERP.PA, HEIN.AS, CARLb.CO, NESN.VX, UNc.AS, DANO.PA, OREP.PA, HNKG_p.F, BEIG.DE, RB.L, BATS.L, IMT.L, ABI.BR).

Credit Suisse has acted as lead manager or syndicate member in a public offering of securities for the subject company (DGE.L, HEIN.AS, NESN.VX, BATS.L, IMT.L, PM.N, UNSP.BO) within the past 3 years.

As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report.

Principal is not guaranteed in the case of equities because equity prices are variable.

Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that.

To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

Credit Suisse International ................................................................................................................. Sanjeet Aujla ; Pavan Daswani ; Charlie Mills

Important Credit Suisse HOLT Disclosures

With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm’s compensation was, is, or will be directly related to the specific views disclosed in this report.

The Credit Suisse HOLT methodology does not assign ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the Credit Suisse HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default algorithms available in the Credit Suisse HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. The adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to produce alternative scenarios, any of which could occur.

Additional information about the Credit Suisse HOLT methodology is available on request.

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Diageo (DGE.L) 40

The Credit Suisse HOLT methodology does not assign a price target to a security. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variable may also be adjusted to produce alternative warranted prices, any of which could occur.

CFROI®, HOLT, HOLTfolio, ValueSearch, AggreGator, Signal Flag and “Powered by HOLT” are trademarks or service marks or registered trademarks or registered service marks of Credit Suisse or its affiliates in the United States and other countries. HOLT is a corporate performance and valuation advisory service of Credit Suisse.

For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.credit-suisse.com/disclosures or call +1 (877) 291-2683.

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Diageo (DGE.L) 41

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