Despite good figures in the North American market, Diageo plc (ADR) (NYSE:DEO) (LON:DGE)’s half-year results in January were weaker than expected and it’s not surprising. In the emerging markets, which account for 43% of the drink giant’s sales, the company took a hammering:
“Sustained performance in the US and improved performance in Western Europe enabled Diageo plc (ADR) (NYSE:DEO) (LON:DGE) to absorb the current challenges in some of our emerging markets. We reacted quickly to the changing emerging market environment, reducing inventory levels in several key markets, which led to a weaker Q2,” reasoned chief executive, Ivan Menezes.
At the same time, however, he hinted that, going forward, Diageo plc (ADR) (NYSE:DEO) (LON:DGE)’s fundamental strategy would remain unchanged:
“Even when there are shocks and ups and downs, they [emerging markets] are growing faster than the developed world.”
Tumultuous times for emerging markets
The fact is, many countries in the emerging markets are undergoing economic upheaval, which could affect the profits of the corporations investing in them, and, ultimately, their share prices.
Take Argentina, for example. Diageo plc (ADR) (NYSE:DEO) (LON:DGE) had to raise the prices of drink products there as the peso nosedived. Argentina’s central bank sanctioned the biggest currency devaluation in over a decade to halt the drain on its foreign exchange reserves. The result has been a massive acceleration in inflation taking the rate close to 30%.
Diageo executives trying to drive growth in emerging markets
Similar mechanisms have been at work in other emerging markets too, making executives at Diageo plc (ADR) (NYSE:DEO) (LON:DGE) and other multinationals, who have been trying to drive growth in these countries, feel more than a little uneasy.
The typical economist’s view won’t make them feel any better. Most are quick to point out that growth in the emerging markets is rapidly decelerating with higher interest rates, out-of-control inflation and slower growth. Turkey recently doubled its overnight interest rates to protect its currency, as has India and South Africa. None of this has been helped by fear of a slowdown in China and a $10bn reduction in the Fed’s asset purchase program in the US. As a result, emerging market equities have fallen more than 10% in just a month.
Not all emerging economies are the same
That said, emerging economies are very different to what they were in the late 90s. Many have free-floating currencies, have reduced their external debts and raised their foreign currency reserves. Emerging economies should still grow faster than those in the West, but the gap is narrowing. The International Monetary Fund (IMF) says that growth will be greater in the UK than in Russia and Brazil this year.
Pernod Ricard SA (EPA:RI) (OTCMKTS:PDRDF) is one company that has recognized the problem and is changing its strategy to compensate. Chief executive Pierre Pringuet says the firm has reacted to austerity measures in China by shifting the emphasis away from luxury brands to less expensive ones:
“We remain confident in the medium and long-term potential of China, but we anticipate difficulties to persist for the full financial year,’ he said. ‘We want to prioritise the group’s future sales growth through a sound commercial policy and an appropriate level of investment.”
Unilever plc (ADR) (NYSE:UL) is another brand with a big stake in emerging markets. These countries contribute an estimated 60% of all sales. The firm issued a profit warning last September, its first in a decade, saying that growth in emerging markets would slow. It then surprised markets in January by reporting better than anticipated growth in Russia, Turkey, China and Indonesia, which offset declines in Vietnam, Thailand and South Africa, underlining the importance to segregate emerging markets into those that are likely to fare better than others. Whereas Ukraine, Argentina and Venezuela all face currency crises, Korea, the Philippines and Mexico could see much faster growth.
The lesson for investors is to realize that slower growth in on the way in many emerging markets. These declines will be reflected in the share prices of companies that with a big stake in those markets.