Diageo’s Liquor Business – The Maturing Inventory Financial Analysis Problem
Sometimes inventory is a pure pass-through, such as for typical trade businesses. Sometimes it is developed and transformed via work conducted within the firm into a final product, such as for typical producing businesses. And sometimes it simply transforms itself into the final product – without any meaningful contribution of the company. This latter case is a quite interesting one from a financial analysis point of view because it has some effects which differ from our typical accounting understanding. This is why it is worth to shed some more light on it here.
Self-transforming inventory itself can be split into two versions. The first one has already been discussed in this blog (LINK). It is about IAS 41 Agriculture. This standard covers the accounting treatment for so called biological assets. These are assets which are to be sold at a later point in time via the normal revenue generating process of the company and which are somehow in a living state. This could be animals (like salmons in a salmon farm) or living plant (like typical agricultural assets). The standard generally requires such assets to be measured at fair value less costs to sell. As a matter of course this accounting treatment is a tricky one as it requires an often at least softly-subjective assessment on fair values of such inventory-assets without any clear market indication for them. But today we rather want to look at the other version.
This second version is about similarly characterised inventory which, however, does not fall under the category of biological assets (although the fundamental difference is quite small). This could be e.g. some sort of art, wine or – as in our case – liquor. Diageo plc. is a UK-based international alcoholic beverages company, one of the world’s largest distiller and runs amongst others brands such as Johnnie Walker (Whiskey), Don Julio (Tequila) or Captain Morgan (Rum) but also many other famous liquor products. Many of these liquor products cannot be sold shortly after production (distillation) but require a maturation stage which makes them to the product that customers want to buy, e.g. for some whiskeys not rarely much more than ten years, for others only two or three years. You can see the similarity to the IAS 41 biological assets here, but for some reasons Diageo’s ageing liquor products do not fall under this standard. They are rather accounted for according to the normal ‘lower of cost or market” inventory accounting principles of IAS 2. Of course there are some differences between typical IAS 41 inventories which usually cannot be sold to the end-customer before reaching maturity and liquors which often could be sold before but will not find the price or attractiveness that typical customers require or a seeking for. But the economic differences are quite small in reality. Anyway, Diageo has to account for its ageing liquors according to IAS 2.
Let’s first have a look at how Diageo’s maturing liquor business developed over time.
Source: Diageo Annual Reports (ARs), absolute numbers in mio GBP, financial year end: June.
Obviously, Diageo has increased its maturing inventory business over the last years, both in absolute as well as in relative terms.
For better understanding what this means for financial analysis it is now first necessary to have a general look at the financial consequences of selling such maturing inventory which does not fall under IAS 41. In a normal business environment where these inventories gain in value (financial, not accounting) over time we would see a higher gross margin in the accounts as compared to a company which sells non-maturing inventory. This is simply the case as the costs of goods sold are fuelled with the accounting inventory value which is usually at original ‘cost’. The price-to-be-paid for this higher gross margin is that during the build-up phase of such businesses the revenues and the gross profit lags comparable companies which do not sell maturing inventories (simply because the company cannot sell anything until the inventory is matured) and by a higher inventory stock even in a steady state as the company always carries some maturing inventories which are not yet ready to be sold.
We show this by a hypothetical (and simplified) example of two companies – Company (1) which sells the inventory it bought at the beginning of the period at the end of the same period, and Company (2) which waits for maturation of inventory for three periods and sells the inventory at the end of this period t+3.
It is further assumed that the maturing inventory gains in (fair market, not accounting) value every period exactly by 10% (which is also the cost of capital of both companies) and that both companies are able to sell the inventory at a price 10% higher than beginning of period value. These assumptions help us to isolate the different financial, value and accounting impacts.
Furthermore, in our simplified example there are no other costs to the company, no interest payments (they are all-equity financed) and no taxes. Furthermore, we only look at a no-growth scenario.
The table below shows the first 8 periods of Company (1).
We think the numbers are not a big surprise. ROE is calculated here in accounting terms, i.e. by dividing gross profit for the period by beginning of period capital (inventory). The present value (beginning of period 1) is calculated by discounting future cash flows – which here equal the gross profits – at the cost of capital of 10% until eternity.
Now let’s have a look at the same table for Company (2).
Company (2) here starts with this business from scratch in period 1. During the first three periods they do not generate any revenues because inventory is still in a maturing state. Due to the periodization principle of accounting during these periods (costs of input products only show up as expenses in the period they are sold) no COGS are recorded, neither. Then starting in period 4, revenues are recorded. The respective COGS relate to the inventory at ‘cost’ (or better: at lower of cost or market – which is ‘cost’ here). Due to the fair value increase of inventory Company (2) can now generate much higher gross profits and gross margins than the comparable Company (1). Interestingly, the period 0 present value of both strategies is the same – this is because our assumptions are that the fair value of maturing inventory increases exactly at the cost of capital over time.
Comment 1: Once Company (2) has reached the steady state in period 4, however, its present value seems to be higher than that of the comparable company (1). This is the case here as now the negative cash flow periods 1-3 (where Company (2) spend money for building up inventory without generating revenues) are behind us. But this finding is also only due to the simplified nature of our example. We do not look at the question of how Company (2) covers the period 1-3 negative cash flows. Perhaps it does so via debt issuance (in our simplified example probably via equity issuance or use of the cash position as the cost of capital do not change over time). In reality it might well be that there is a net-zero or even net-negative effect of this strategy once entering into the stead state – but this is out of the scope of our analysis here. In a normal business environment – with no outperformance of fair value increases of maturing inventory vis-á-vis the cost of capital – the net-PV-effect of this strategy is always zero. So we cannot make hard statements on PV development, but we can definitely say that the gross profits and gross margins are higher for Company (2).
Comment 2: As we are looking at a no growth state without any inflationary effects it does not matter here which IFRS inventory valuation principle the company follows (FIFO or weighted average costs). In reality (i.e. an environment with price changes over time for input products) these numbers might, however, differ a bit from the clear-cut analysis above.
Comment 3: Accounting ROEs are higher here as compared to the Company (1) case. This is just an accounting issue as the periodical cash flow effects (input vs. output) go astray. This is an extremely important issue in general with regards to performance measurement but not the focus of this analysis here. If you want to know more about this general problem of financial analysis, wait for some later posts here in this blog or have a look at a recently published academic article by Felix Streitferdt, Max Levasier and me HERE.
This comparison of Company (1) and Company (2) is important for at least three reasons.
First, one of the most important finding in terms of factor investing in recent years was the analysis of Robert Novy-Marx on the “Gross Profitability Premium” (Novy-Marx, 2013, The Other Side of Value: The Gross Profitability Premium, in: Journal of Financial Economics, Vol. 108 (1), p. 1-28). He detected a systematic valuation premium for high gross-profit firms in the cross-section of average returns, at a similar size to the book-to-market premium of the famous Fama/French analyses. The most-plausible explanation for this finding is that companies with a relatively high gross profit have a high pricing power, i.e. for several reasons (strong brand, reputation, quality of products, etc.) they are able to sell their products at a relatively higher price than competitors, and this advantage translates into a strong and enduring competitive positioning. This is not new in terms of how value investors try to isolate high-quality companies but it has never before been formalized like this. Today quant investors as well as fundamental investors certainly look closer at the gross margins of companies than they did before Novy-Marx’ analysis.
However, The gross margin of companies which run a maturing inventory business – such as Diageo – is not necessarily a function of pricing power (in the case of Diageo: for some liquors: yes, for some others: no). It is mainly simply a function of the maturing inventory business per se and its accounting treatment, as was shown in our hypothetical example above. So investors might get trapped by misunderstanding Diageo’s assumably increasing gross margin because it has nothing to do per se with pricing power but rather with the nature of the business and the accounting which could not map this business properly.
Second, the real interesting case is when companies more or less slowly build up their maturing inventory business over time (as Diageo does it currently according to our analyses above but they have certainly already reached the kick-in phase). This strategy is not totally different from other build-up strategies that we have already discussed in this blog, e.g. the three-is-a-crowd strategy in the context of reverse factoring, see LINK .
To highlight the effects of this strategy we adjust our hypothetical example a bit. We now combine Company (1) and Company (2) in one case by simply assuming that the original Company (1) starts to substitute non-maturing inventory by maturing inventory step-by-step over time – here in periodical steps of 5 Euros out of the original 100 Euro investment in inventory. The total amount of how much inventory is bought stays constant over time (i.e. the sum of inventory bought maturing and inventory bought non-maturing remains at 100). Here is the new table.
Now, we can see some interesting patterns. Of course, during the first three periods of change the company records a negative gross profit growth but once the maturing inventory sales kick-in this changes to a positive growth (as the company now starts to approach the higher Company (2) gross profit level step-by-step). The gross margin does not suffer in the first three periods due to periodization rules of accounting. Cash flows, however, show a lagged effects (the company has to invest [cash-out] in order to realise the switch) due to the step-wise change to higher pronunciation of maturing inventory over time. And finally, the present value – here calculated over more than the here shown 8 periods but rather over the total life of this strategy – of this company’s equity is still at 100 Euros at the beginning (and as mentioned above: in an environment of financing requirements of negative cash flows and hence increasing net debt it would also not differ from the PV patterns over time from the above examples as long as fair value increases are exactly at the cost of capital).
And one important last point: inventory – and hence capital tie-up – increases over time.