Desnoes & Geddes Limited Wine and spirits giant unable to overcome taxation pressures Najja Daley Senior Financial Analyst

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1 November 05, 2010 Desnoes & Geddes Limited Wine and spirits giant unable to overcome taxation pressures Najja Daley Senior Financial Analyst Sell Price at 05 November 2010 $3.76 Price Target $ Week Range $3.31 $5.25 Company & Industry Overview Desnoes & Geddes Limited (D&G), incorporated in Jamaica and currently trading as Red Stripe, is a 58% subsidiary of Udiam Holdings AB, a company incorporated in Sweden. The ultimate parent company is Diageo PLC, incorporated in the United Kingdom. The principal activities of the company include the brewing, bottling and distribution of beers, stouts and spirits. Currently, the products being distributed by the company include Red Stripe, Red Stripe Light, Red Stripe Bold, Heineken, Guinness, Dragon Stout, Dragon Stout Spitfire, Malta, Smirnoff Ice as well as Smirnoff Black Ice and Smirnoff Vodka. Red Stripe is the company s leading brand and accounts for a large portion of the company s sales. It was first brewed in Jamaica in 1928 & is now available in 20 markets worldwide although almost exclusively brewed in Jamaica. KEY FINANCIAL STATS YE 2009 YE 2010 $ 000 $ 000 Turnover 13,447,889 13,332, % EPS % Equity 6,246,636 6,677, % D&G SHARE PRICE/VOLUME CHART The company s operations are split into two segments; one segment which conducts business in the domestic market, and one which caters for the export markets including USA, UK, Canada, Sweden, Norway, France, Italy, Belgium, Switzerland and Spain. Both segments are involved in the bottling and distribution of premium drinks. Currently, the distribution of revenues between these two segments is 71% and 29% for the domestic and export segments respectively. Lascelles DeMercado could be considered D&G s closest competitor, though only in the distribution of spirits which is the smaller segment of D&G s operations. There are no other significant players in the beer market that provide any significant level of competition for D&G. The company may also face competition from somewhat dissimilar products such as tonic wines which may be considered substitutes for beer. There exists no reliable independent sales statistics from which to determine market share data for D&G. STOCK DATA Market Cap ($ 000) 10,562, Shares Outstanding 2,809,171,264 Free Float 14.76% Trade Volume 0 The alcoholic beverage industry is characterized by a tax regime that sees a 25% SCT charged on beers and spirits and a flat rate of US$0.40 per litre being charged on wines and liqueurs. This schedule allows for more competitive pricing on tonic wines and puts D&G at a competitive disadvantage.

2 Macroeconomic Overview The contraction in the Jamaican economy persisted with Q2 year-on-year real GDP surfacing at -2.0%, extending the nonexistence of positive growth since the final quarter of The lagging effects of unfavourable weather conditions and the protracted global downturn continued to hurt both the goods producing and service sectors. Growth in the Productive sector shrank 2.5% following lower outputs from three of the four sub-sectors. Mining was the lone sub-sector that recorded positive growth due to increased levels in crude bauxite production. All other segments continued to see downtrends in their respective productivity levels. In particular, Agriculture declined 3.1%, the first quarterly decline since September 2008 due to lower output levels stemming from the drought conditions that prevailed in prior months. The Food, Beverages & Tobacco component of the manufacturing industry declined by 3.2% in the quarter ended March The performance for the review quarter represented the ninth consecutive quarterly decline and continued to reflect producers response to lower consumer demand; and the negative impact of the global economic crisis on the industry. The contraction in the real value added for the sector was attributable to the decline in the real value added for the Beverages & Tobacco sub category, as there was a 20.2% reduction in the output of Beer; a 33.8% fall-off in the production of Stout; and a 26.5% decline in Rum & Alcohol production. D&G s subpar performance was in line with the these indicators, as the depleted purchasing power created by enervated economy trickled down to the beverage industry and ultimately translated to a 84% decrease in profits for the company. With no improvements in the situation expected in the near to medium term, D&G is expected to struggle commensurately. QUARTERLY REAL GDP INFLATION TOTAL SALES SWOT Analysis Strengths The company bottles and distributes some of the most recognizable brands in the world (Red Stripe, Heineken, and Smirnoff). The company presence in the beer market is rivaled by none. The company has a wide and efficiently established distribution network. The company is backed by the Diageo, the largest producer of spirits in the world. Weaknesses The company is subject to heavy taxation from the government. The company s marketing costs are disproportionately high relative to sales. The company s sales are very sensitive to consumer spending power GROSS/NET PROFIT Opportunities There is potential for the company to increase its presence in overseas markets. Threats The continued weakness in the local and international economies threatens the revenues of D&G. The new tax regime has made the company s products less attractive relative to competitors.

3 Financial Statement Analysis MARGIN TRENDS For its financial year ended June 2010, Desnoes & Geddes Limited reported net profit attributable to shareholders of $789 million down 49% or $762 million from the $1.55 billion reported for the 2009 financial year. Total sales fell marginally by 0.9% to $13.3 billion for the year, with sales in the domestic segment registering a 2.8% decrease to $9.4 billion, partially offset by a $155 million sales increase from the export segment. The dull domestic performance was attributable to lower consumer disposable income due to the challenging economic environment, and severe tax pressures that D&G has come under from the government. Cost of sales for the year increased by 4.6% to $7.4 billion from $7 billion due to increased raw material price, and resulted in gross profits of $3.7 billion which were 18.7% lower than the 2009 level. Total marketing expenses increased 11% to $1.5 billion from $1.3 billion. The company increased its spend in the domestic market by $70 million in order to sustain sales of its core brands, and by $80 million in the export segment as they launched Red Stripe Light in North America. Administrative expenses increased 4.8% to $1.1 billion as procedures put in place by the company to contain expenses were fairly successful. Interest income fell 53.3% to $8.5 million while Employee Benefits Income of $186 million offset interest expense of $60.7 million and led to net profits of $789 million. Earnings per share fell 49% from cents to cents. As at June 2010, D&G s asset base stood at roughly $11 billion, 8.7% more than the $10.1 billion reported in June Shareholder s equity increased 7% to $6.7 billion. GROWTH TRENDS RETURN ON EQUITY/ASSETS Segment Highlights SEGMENT RESULTS Domestic Export Jun-10 Jun-09 Jun-10 Jun-09 $ 000 $ 000 $ 000 $ 000 Turnover 9,400,189 9,671,275 3,932,247 3,776,614 SCT (2,227,725) (1,817,448) Marketing Expense (876,000) (806,000) (623,000) (543,000) Segment Profit 2,192,995 3,032,992 11, ,655 SEGMENT CONTRIBUTION Domestic Export Turnover 70.51% 29.49% Marketing costs 58.44% 41.56% Operating profit 99.46% 0.54%

4 Company Outlook Desnoes & Geddes financial year proved to be too challenging to conquer, as the weakening economy, increased competition, lowered spending power of consumers, and heavy taxation policies instituted by the government all contributed to the company s 49% drop in net profit. The company experienced falling sales volumes in the domestic market caused by the diminished purchasing power of consumers. The price increases which the company has been using to curtail the falling volumes are no longer proving viable as a means to counter these pressures. Taxation Burden The company is facing a seemingly insurmountable foe in the form of the government s taxation policies. This was highlighted in the fact that the company s SCT charge rose 23% despite a $270 million decrease in domestic sales on which the SCT is payable. Company management is assiduously taking on the arduous challenge of negotiating with the government regarding a revision to the new tax structure which led to the 84% decrease in quarterly profits. They have also inevitably cut 150 jobs in a bid to contain costs. New Offerings & Export Market During the most recently completed financial year, D&G has kept with its strategy and introduced new products to its line up including Red Stripe Bold and Dragon Stout Spitfire. These offerings however will do nothing for the company if it is unable to reinvigorate domestic sales. They have stated that they are seeking to expand the export segment but will not provide much respite as the meager margins enjoyed by this segment render it futile in the fight to grow profits. It is therefore imperative that the company increases domestic volumes if it is to grow profits going forward. Increasing raw material costs due to inflation and the volatility of the Jamaican dollar, and expenditures on marketing will continue to eat into operating profits if not matched with some level of increased revenues. Going Forward Looking to the future, the short to medium term outlook for D&G appears quite bleak. In the absence of a repeal of the new tax regime, these severely depressed levels of volumes and profits will have become the new normal. Further price increases to increase revenues will not work as the further pressure placed on domestic consumers in this environment will most likely result in further reductions in volumes and will ultimately result in decreased shareholder wealth going into the future. SCT CHARGE DIVIDEND PER SHARE SHAREHOLDERS EQUITY EPS (cents) Projections & Valuation Forwards revenues for the 2011 financial year are expected to reach $13.3 billion. The newly implemented tax structure is expected to further pressure the company and as such bottom line profit is projected to approximate $720 million for the next financial year. This equates to an EPS of cents. Utilising a multi stage DDM with a DPR assumption of 85% and short and long run growth estimates of between 2% and 6% based on significant pullback expected from the taxes, D&G s fair value is estimated at $2.61. Given the current market price of $3.76, D&G is recommended as a SELL at this time.

5 DESNOES & GEDDES FINANCIAL SUMMARY Year Ended 30-Jun Income Statement ($ 000) Turnover 10,114,372 11,313,276 12,488,766 13,447,889 13,332,436 Special Consumption Tax (SCT) -1,383,870-1,619,117-1,792,988-1,817,448-2,227,725 Gross Profit 3,796,299 3,949,526 4,094,085 4,556,082 3,704,003 Marketing Costs -1,065,104-1,316,908-1,493,126-1,349,435-1,499,185 Trading Profit 1,996,463 1,897,865 1,560,004 2,035,792 1,048,497 Profit after Tax 2,211,847 1,421,874 1,042,449 1,551, ,398 Balance Sheet ($ 000) Total Assets 7,083,064 9,844,338 10,277,393 10,164,167 11,047,744 Total Liabilities 2,290,854 3,310,255 3,937,075 3,910,084 4,363,218 Shareholders Equity 4,784,763 6,526,636 6,332,871 6,246,636 6,677,079 Cash Flow ($ 000) CFO 1,782,754 1,944, ,332 1,894,588 1,108,557 FCFE 1,357,651 1,191, ,182 1,448, ,658 FCFF 1,360,304 1,191, ,074 1,437, ,705 Per Share Data ($) EPS (cents) Book Value Dividends Price Key Ratios Gross Profit Margin 37.53% 34.91% 32.78% 33.88% 27.78% Operating Profit Margin 19.74% 16.78% 12.49% 15.14% 7.86% Net Profit Margin 21.87% 12.57% 8.35% 11.54% 5.92% Return on Equity 49.52% 25.14% 16.21% 24.66% 12.22% Return on Assets 32.23% 16.80% 10.36% 15.18% 7.44% Dividend Yield 7.32% 7.52% 5.59% 8.75% 5.32% Valuation Metrics P/Sales P/E P/BV P/Cash Flow Du Pont Analysis Profit Margin 21.87% 12.57% 8.35% 11.54% 5.92% x Asset Turnover x Financial Leverage = ROE 49.52% 25.14% 16.21% 24.66% 12.22%

6 DESNOES & GEDDES INCOME STATEMENT AND PROJECTIONS ($ 000) Year Ended 30-Jun E Turnover 10,114,372 11,313,276 12,488,766 13,447,889 13,332,436 13,065,787 Special Consumption Tax (SCT) -1,383,870-1,619,117-1,792,988-1,817,448-2,227,725-2,195,052 Net Sales 8,730,502 9,694,159 10,695,778 11,630,441 11,104,711 10,870,735 Cost of Sales -4,934,203-5,744,633-6,601,693-7,074,359-7,400,708-7,120,854 Gross Profit 3,796,299 3,949,526 4,094,085 4,556,082 3,704,003 3,749,881 Marketing Costs -1,065,104-1,316,908-1,493,126-1,349,435-1,499,185-1,574,144 Contribution after Marketing 2,731,195 2,632,618 2,600,959 3,206,647 2,204,818 2,175,737 Selling and Admin. Expenses -746, ,406-1,038,061-1,090,874-1,142,988-1,182,993 Trading Profit 1,996,463 1,897,865 1,560,004 2,035,792 1,048, ,744 Interest Income 62,138 62,703 16,346 18,276 8,536 6,829 Employee Benefits Income 259, ,000 94, , , ,200 Profit before Finance Costs 2,328,380 2,064,726 1,670,350 2,199,441 1,243,033 1,129,773 Finance Cost -3, ,596-60,659-54,593 Profit before Tax 2,324,401 2,113,226 1,670,350 2,211,441 1,182,374 1,075,180 Tax -112, , , , , ,809 Net Profit 2,211,847 1,421,874 1,042,449 1,551, , ,370 EPS (cents)

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