ROCE Analysis Final Draft

INTRODUCTION
The intent of this report is to study and analyse the financial statements of two companies to assess profitability
and solvency from an investor’s perspective. The companies selected are Diageo PLC and Britvic PLC. Both
companies are publicly listed but they operate in different industries. Diageo is a leading British manufacturer of
alcoholic beverages while Britvic operates in the soft drinks industry. Both total beverage alcohol (TBA) and soft
drinks are a part of consumer goods industry, however, they present unique challenges of their own. This is
reflected in the capital structure and the operating structure of the businesses. The focus of this report is to analyse
the return on common equity as a function of leverage that arises in financing activities and leverage that arises in
operations. Analysis of past and current financial statements, trend and comparative analysis, economic and
statistical considerations are made to reach the conclusion.
BACKGROUND, FINANCIAL RESEARCH & KEY NON-FINANCIAL INFORMATION

COMPANY BACKGROUND
One of the world’s leading producers of branded spirits, Diageo PLC was formed in 1997 after the merger of Grand
Metropolitan and Guiness plc. Post the merger the company primarily focused on alcoholic beverages as its core
industry and therefore, sold most of its existing businesses in industries like restaurants, hospitality, and food
processing. Some of the popular brands under its ownership include Johnnie Walker blended scotch, Smirnoff
vodka, Crown Royal Canadian whiskey, Captain Morgan rum, Casamigos tequila, Tanqueray gin, Baileys Irish Cream,
and Guinness stout. Furthermore, Diageo owns 34% of Moet Hennessy, a subsidiary of LVMH Moet Hennessy-Louis
Vuitton, and 56% of United Spirits of India. In spirits, Diageo’s major global competitors are Pernod Ricard, Beam
Suntory, Bacardi and Brown-Forman, each of which has several brands that compete directly with Diageo’s brands.
In addition, Diageo faces competition from regional and local companies in the countries in which it operates. In
beer, Diageo also competes globally, as well as on a regional and local basis (with the profile varying between
regions) with several competitors, including AB InBev, Molson Coors, Heineken, Constellation Brands and Carlsberg.
Diageo's constant effort to expand its portfolio of brands by acquiring newer businesses and disposing of the lesser-
performing ones has made it the giant it is today.
Founded in 1845 in the Essex County, the company started producing fruit juices under the name, British Vitamin
Products Company. Subsequently, the company rebranded and manufactures, markets and sells branded still and
carbonated soft drinks under its current name, Britvic. Since its inception 179 years ago, the company has
witnessed numerous acquisitions and mergers, like the acquisitions of brands- Tango & Corona from Beechams in
1987. Today, majority of the company’s operations are concentrated in the UK and Ireland with operations in over
100 countries globally. Additionally, the company has an exclusive 20 year franchise bottling agreement with the
American giant, PepsiCo for the production, distribution and marketing of its brands in the UK. This agreement
gives them exclusive access to brands such as Pepsi MAX, 7UP, Mountain Dew, Lipton Iced Tea and Rockstar Energy.
Its portfolio of in-house brands includes Robinsons, Tango, J2O, Fruit Shoot, Teisseire, Maguary, Dafruta, Bela Ischia,
Ballygowan, etc. Britivic’s major global competitors include The Coca-Cola Company, PepsiCo, Nichols, Refresco,
Primo Water, Sumol+Compal, etc.
KEY FINANCIAL & NON- FINANCIAL INFORMATION

In 2023, Diageo’s net sales grew 10.7% while the operating profit grew 5.1%, which reflects its ability to deliver
growth efficiently and create value constantly. Strong operating margin expansion in Asia Pacific, Africa and Latin
America and Caribbean was partially offset by declines in North America and Europe. The company witnessed a
17.6 % increase in its Basic EPS proving the overall profitability of the business. Other key indicators of financial
performance, like net cash from operating activities and free cash flow saw a decline of £911 million and £983
million, respectively. Despite the strong growth in operating profit, this decline can be attributed to higher working
capital outflows, tax payments, interest payments, and capital investment.
In this current climate where major economies are facing inflation, cost of living challenges and geopolitical
uncertainty, the company continues to grow at a 4% CAGR by retail sales value with spirits growing at 6% CAGR.
Seven out of its twelve categories have seen an increase in organic sales. Furthermore, there has been a shift from
value and standard to premium and super-premium categories. The company is committed to delivering organic
net sales growth between 5%- 7% and organic operating profit growth between 6%- 9% sustainably. This is despite
witnessing flat sales in the North- America region following a period of rapid growth, shifting consumer behaviour
following the Covid-19 pandemic and re-adjustment in working patterns.
Diageo is not only committed to establishing itself the leading performer in its industry but also to becoming the
frontrunner in environmental and social causes. By 2030, the company aims to achieve net zero carbon emissions
across all direct operations and work with suppliers to halve emissions in the supply chain. With this goal in mind,
45% of the company's energy usage is currently fueled by renewable energy, an increase of 1.9% compared to last
year. An aluminium recycling facility is being set up in the UK as part of a project to conserve raw materials and
reduce carbon emissions. This has been done in an effort to create a closed-loop, circular approach to aluminium.
Such investments enable the company to be more efficient, reduce resource consumption, develop innovative
solutions, and ensure a more resilient supply chain. Another of the company’s key efforts is promoting moderate
drinking and investing in education and programmes to discourage the harmful use of alcohol. The company has
increasingly promoted responsible drinking into its brand messages. Furthermore, they have established education
programmes to educate the public on the dangers of underage drinking.
In the fiscal year ending 2023, Britvic realised a 6.6% increase in revenue and 5.9% increase in operating profit from
the previous year. Metrics such as free cash flow and net cash flow from operating activities were broadly flat at
£129.8 million compared to £128.8 million and £238.4 million compared to £239.6 million, respectively, in the
previous year. The year 2023 also witnessed two acquisitions- Jimmy’s Iced Coffee and Extra Power brand from
GlobalBev. The former was acquired for a total sum of £24.8 million on August 1, 2023, and the latter for £24.0
million in October 2023. The result of the latter acquisition is not reflected in the current statements. Basic EPS is
48.3 pence, an 8.2% decrease from last year. The company attributed this to adjusted items which were primarily
non-cash.
Britvic demonstrated a steady revenue growth over the past five years and a CAGR of 5.2% despite the Covid-19
pandemic and subsequent high levels of inflation. Moreover, the company is committed to a dividend policy that
pays out half of its profits owing to a robust cash generative strategy and capital allocation policy. The brand’s
constant innovation is reflected in its ability to build higher margin categories such as flavour concentrates,
premium grape juice and Fruit Shoot.
ANALYSIS OF RETURN ON COMMON EQUITY

ROCE ANALYSIS:
For analysing the Return on Common Equity (ROCE) of a company, it is imperative to first understand the
contributing factors- return on net operating assets (RNOA), financial leverage and the difference between the
RNOA and the net borrowing cost (NBC), also known as the operating spread. Return on net operating assets
(RNOA) is further driven by after-tax operating profit margin (OPM) and asset turnover (ATO). As the name
suggests, a higher RNOA is favourable to any firm’s success, but it is very rare that firms produce higher RNOA
through higher margins and higher turnover. However, there is a strong influence of the industry in determining
which of these drivers is high. The other contributing factors to a desirable ROCE are the financial leverage and the
operating spread. Leverage is defined as the extent to which a firm’s operating assets are financed by borrowing or
by common equity and hence, it excludes operating liabilities but includes financial assets. If the firm’s financial
assets are greater than financial labilities, it results in negative leverage. Financial leverage is only beneficial to the
ROCE when a firm earns more from its operating assets than its after-tax borrowing costs, i.e., a positive operating
spread. In essence, the shareholder profitability is broken down into what is due to operations and that which is
due to financing.
The comparison between the two companies reveals that Diageo’s RNOA is driven by higher after-tax OPM while
Britvic’s by higher ATO. This is explained by the respective industries the two companies operate in. The alcoholic
beverage industry (Diageo PLC) is relatively more capital-intensive than the soft drinks industry (Britvic PLC),
resulting in a lower ATO. Diageo’s asset turnover in FY22 is 0.7288, which indicates that for every £1 of net
operating assets, the company has generated £0.7288 in sales. The low efficiency is justified by the company’s
relatively conservative business approach post the pandemic. Additionally, the company’s North American arm of
the business was diversely affected by the acute shortage in aluminium can market. Furthermore, Diageo greater
global footprint implies higher number of manufacturing units globally. The soft drinks industry on the other hand
has much lower margins in comparison to alcoholic beverages, resulting in overall lower profitability margins.
Britvic’s RNOA for the period FY2020 to FY2022 indicates that it is generating greater returns from its operating
assets. The company has managed to do so by increasing both factors, after-tax operating profit margin and asset
turnover that drive the RNOA. The firm also managed to decrease its financial leverage year over year. FY2022 saw
a substantial increase in the firm’s RNOA which in turn positively impacted the operating spread too. This is despite
their increasing net borrowing costs.
A comparative analysis of the two companies shows a positive financial leverage and a favourable operating spread.
This is indicative of both companies’ ability to earn more from their operating assets than their after-tax borrowing
costs. Finally, Diageo’s overall higher ROCE in comparison to Britvic’s is also justified by its revenue and scale of
operations. Diageo, being a much bigger company in scale and value, is in a better position to grant or extend credit
terms, thereby reducing the investment shareholders put in the business.
CONCLUSION
In a market filled with volatility and uncertainty, the soft drinks and alcoholic beverages categories continue to
shine, outperforming the broader consumer goods sector. Despite the challenges their respective industries faced
since the pandemic, both companies continued to show increased demand. While Diageo's CAGR is between 4%
and 6%, Britvic grew at a CAGR of 5.2%, which is above their respective industry averages.
Diageo as a company is well diversified by category, geography and price point owing to their strategic acquisitions
and active portfolio management. Their business today is set up for consistent and sustainable long-term growth
with a focus on increasing market share in the TBA industry. Britvic, on the other hand, intends to expand its
portfolio of brands and competitive advantages to become a regular staple and an affordable brand. The company
aims to do so by evaluating the best use of capital and the appropriate level of investment to deliver long-term,
sustainable growth. While both companies are committed to ensuring optimal returns to their shareholders, it is a
bigger challenge for Britvic given their goal of entering newer sub-categories and expanding their regional
presence.
APPENDIX
 Enjoying Life’s Everyday Moments Annual Report and Accounts 2023. (n.d.). Available at: http://bit.ly/3vUgP86
 Britvic plc (2022). Enjoying Life’s Everyday Moments Annual Report and Accounts 2022. [online] Available at:
https://bit.ly/49hQFux
 Enjoying Life’s Everyday Moments. (n.d.). Available at: https://bit.ly/47UyCcM
 ENJOYING LIFE’S EVERYDAY MOMENTS Annual Report and Accounts 2020. (n.d.). Available at:
https://bit.ly/49mphM1
 ESG Reporting Index 2023. (n.d.). Available at: https://bit.ly/42rX0RN
 Diageo Annual Report 2023. (2023). Available at: https://bit.ly/42pzPaN
 Diageo Annual Report 2022. (2022). Available at: https://bit.ly/3u6ruwc
 Deloitte Malta. (n.d.). COVID-19: Impact on food & beverage consumer products companies. [online] Available
at: https://bit.ly/42pTQ0P

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INTRODUCTION

BACKGROUND, FINANCIAL RESEARCH & KEY NON-FINANCIAL INFORMATION

KEY FINANCIAL & NON- FINANCIAL INFORMATION

ANALYSIS OF RETURN ON COMMON EQUITY

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