Management Discussion and Analysis

58 Management Discussion and Analysis ECONOMIC SCENARIO Global economy: Despite tangible signs of recovery in 2014, the global economy remained on a subdued growth path, growing 3.1% in 2015 against 3.4% in 2014. With a 6.8% growth (against 6.6% in the previous year), the emerging and developing Asian countries were the key contributors of the global growth, led by India and China. Indian economy: Buoyed by positive policy initiatives, India has evolved as one of the fastest-growing emerging market economies in the world. Increased private consumption, led by rising incomes and declining oil prices, steered the Indian economic growth story during 2015-16 to 7.6% real GDP growth from 7.2% in 2014-15. INDUSTRY OVERVIEW India has a young population, with a median age of 25 years 50% of the 1.2 billion population are under 25 years of age. 65% are below the age of 35. A favourable demographic divide with around 270 million in the working age population by 2030 augurs well for the industry. With the increase in affluence we can see improvement in lifestyles and increasing aspirations leading to upgrade to higher brands by the customers. As per the data published by the Finance Commission the annual tax revenues of the State Governments are about ` 303 lakh crs. Of this Alcobev industry s share of close to ` 106 lakh crs which is more than a third of such tax revenues of the State Governments (Source - Wikipedia). SEGMENT-WISE AND PRODUCT-WISE PERFORMANCE Global: The global spirits market comprises vodka, gin, tequila, rum, whisky, brandy, cane, natural spirits and flavoured spirits. While Asia-Pacific is the largest market for alcoholic products, followed by North America and Europe, the BRIC (Brazil, Russia, India and China) nations are driving growth in the spirits market. Whisky and tequila are expected to be the fastest growing spirits category with a compounded growth of 3.8% and 2.9% during the period. Whisky is expected to overtake vodka to be the second largest spirits category with a total consumption of 467.4 mn cases. Asia (especially China and India) will account for majority of this growth; North America, Africa, Middle East and other duty free markets are also expected to drive growth. (Source: IWSR, Acute market research) India: The Indian Total Beverage Alcohol (TBA) industry comprises four segments beer, distilled spirits, wine and country liquor. IMFL (Indian-made foreign liquor) products account for nearly 70% of the total market. India is one of the fastest growing alcohol markets in the world. Four out of the top 5 and 7 out of the top 25 highest selling whiskies are from India. As the world s second most populous nation and fastest growing economy, the opportunity for growth in the Indian spirits market remains highly attractive. Spirits, led by whisky, is the most popular alcohol, consumed by nearly 88% of alcohol consumers in India, with beer and wine contributing to the remaining 12% consumption. (Source: Persistence market research)the Indian spirits industry is one of the most regulated, with prohibition in force in a few states, sales being limited in certain states to government approved stores, and drinking prohibited in public places. Current available data estimates the Indian TBA market at circa ` 40k Crore, with spirits accounting for approximately 70% market share, beer circa 26%, and ready to drink, wine and others circa 4%. In recent years, the industry has witnessed realignment in terms of consolidation and margin pressure due to rising costs, thereby leading to tapered growth. Despite the slowdown, the country s alcohol industry will still be the world s second fastest growing industry. Strong premiumisation trend: Driven by a significant West-influenced cultural change, the alcohol industry in India is witnessing a strong trend towards premiumisation. During the year under review, your company has achieved a sales volume of over 93 mn cases and declined 1% compared to prior period (previous year 94 mn cases, excluding royalty and franchise markets). Net sales of your company s brands grew 13% in the financial year ended March 31, 2016 and stood at ` 90,919 million net of duties and taxes (previous year ` 80,493 million). Direct distribution of the Diageo brand portfolio drove 8 percentage points (ppts) of net sales growth. Sales volume of your company s brands in the Prestige and Above segment

Business Overview Strategic Review Statutory Reports Financial Statements grew 10% in the financial year ended March 31, 2016 and stood at 34 mn cases (previous year 31 mn cases). Net sales of the Prestige and Above segment grew 26% and stood at ` 46,013 million net of duties and taxes (previous year ` 36,500 million). Direct distribution of the Diageo brand portfolio contributed 19ppts net sales growth to the Prestige and Above segment. The Prestige and Above segment represents 37% of total sales volumes and 51% of total net sales, with 4ppts and 5ppts improvement respectively compared to prior year. REGULATORY SCENARIO IN INDIAN MARKET The alcohol industry in India is highly regulated under the legislative power of individual states. Additionally, national laws and regulatory bodies, such as the Food Safety and Standards Authority of India (FSSAI), also significantly impact the alcobev industry. A spate of recent regulations have further tightened the regulatory controls on the industry. Some of the recent developments include: Prohibition of liquor: In April 2016, Bihar became the fourth state in India to implement a total liquor ban. This move is estimated to impact the IMFL industry, hotels and the Bihar state government by approximately ` 4,000 cr, in the form of the taxes and duties earned from liquor sales. Also on the flip side, banning alcohol encourages bootleggers and increases the sales of poor quality counterfeit products, posing serious health risks to consumers. (Source: Hindustan Times) Goods and Service tax (GST): The GST, projected to be the single most important tax reform after 1947, is a single, comprehensive tax that will subsume all the other smaller indirect taxes on consumption like service tax, etc. However, tax on alcoholic beverages has been carved out as an exception to the definition of GST itself in present drafts of the law. GST is the opportune moment for the government to bring transparency in the sector by improving governance and compliance. Inclusion of the alcobev industry under the GST ambit will enhance revenue for states, reduce evasion of taxes, and improve governance and compliance through transparency. In addition, it will curb the production of illicit alcohol which has seriously harmful effects on a consumer s health. Price control over raw material: The increasing price of ethanol - one of the primary raw materials used in the production of alcohol beverages has seriously impacted the industry cost structure in recent years. Prices of ethanol, which accounts for nearly 40% of the total cost of materials, has increased over the past few years following the implementation of the ethanol blending programme (EBP) by the government. The mandatory EBP implementation has triggered increased demand for ethanol from the oil marketing companies (OMCs), which are required to blend 5% (proposed to move to 10%) ethanol in petrol for environmental reasons. India currently has an annual demand of 460 crore litres of ethanol as against the availability of only 250 crore litres, creating a demand-supply gap. During the sugar year 2014-15, OMCs have achieved a blending percentage of only 2.3 per cent (Source: Business Standard April 25 th, 2016). As shown above, the tax revenues of the State Governments contributed by the Alcobev industry is about a third of the Total tax revenues of the State Governments. The State Governments should therefore be more focused on collection of excise duties and let the market forces determine the prices of the products instead of controlling the prices of the products as some State Governments do at present. Continued current drought conditions and the Government s plans to scale up EBP to 10% with no commensurate increase in supply, will result in a shortage of ENA for potable alcohol as well as upward pressure on prices. Fortunately, the government is looking to source ethanol from low-cost alternative sources like bio-waste and feedstock such as wheat, straw, rice straw and corn straw, among others. If successful, this is likely to improve ethanol availability in the country and stabilise prices. Annual Report 2016 59

60 BUSINESS ANALYSIS Company overview (USL) is a subsidiary of Diageo plc - a global leader in beverage alcohol with an outstanding portfolio of brands across spirits, beer and wine categories. In 2013-14, Diageo plc acquired a 54.8% shareholding in United Spirits, making India one of its largest markets. USL is the largest Indian spirits company, selling over 93 mn cases annually. The company, which is engaged in the manufacture, sale and distribution of beverage alcohol, has a portfolio of 140 brands, of which 15 brands sells over one mn cases and 3 brands sell over 10 mn cases annually. USL has a popular brand portfolio, including much-loved brands such as McDowell s No.1, Royal Challenge, Signature, and Antiquity and is engaged in selling Scotch whisky, IMFL whisky, brandy, rum, vodka, gin and wine. Headquartered in Bengaluru, the company also imports, manufactures and sells Diageo s iconic brands, such as Johnnie Walker, VAT 69, Black & White, Smirnoff and Ciroc, in India. Strengths Brand legacy: USL is the largest spirits manufacturing company in India and the second largest (by volume) globally, with a strong portfolio of 140 popular and trusted brands across categories. Product portfolio and diversity: The company s product portfolio extends across whisky, vodka and rum segments, and caters to diverse consumer tastes across social strata with its luxury, premium, prestige and popular spirits categories. Geographical spread: USL has a strong footprint, with 82 (74 excluding Royalty and Franchise units) manufacturing facilities spread across 23 states and 3 union territories in India, enabling faster turnaround of products and minimal exposure to risks related to changes in state policy. Strong supply chain network: The company enjoys long-term business relations with leading raw material suppliers, ensuring uninterrupted production and supplies. The company also has a strong network of distributors to ensure streamlined and timely supplies to 81,000 retail outlets across India. R&D expertise: The company has a state-of-the-art Technical Centre for research on new product development, analytics and sensory sciences, process R&D, special spirits and flavour management. It also employs highly qualified and experienced scientists who work consistently and with dedication towards innovative product and process development. People power: The Company s success is led by an empowered and committed team of over 5,500 employees, who are partnering it in the realisation of its vision. Business performance On a transformational journey since the last few years, USL is powered by the vision to become the best performing, most trusted and respected consumer goods company in India. It has a strategic roadmap, founded on five strategic pillars, to steer its future growth trajectory. The five pillars underpinning the company s growth are: 1. strengthening core brands 2. evolving the route to the consumer 3. driving productivity 4. corporate citizenship 5. creating a future ready organisation

Business Overview Strategic Review Statutory Reports Financial Statements From renovating brands to rationalising its manufacturing footprint and strengthening its route to the consumer, USL has been making significant strides in its journey of transformation. Its strategic success is clearly manifest in the Company s improved performance, reflected in a stronger balance sheet. Revenue and revenue mix A strategic revenue mix, strengthened by enhanced brand salience, has steered the Company s growth charter over the past two years. USL is today a market leader by volume and value, and armed with the Diageo brand portfolio integration, it holds a place of pride in the Indian alcobev industry, with an outstanding portfolio of reputed brands across key categories and multiple price points. The company has successfully improved both top line and operating profit in a highly regulated and competitive environment, while further strengthening its core brands to leadership position across all segments. The company s performance in the popular segment reflects its prioritised geographical participation strategy, while its double digit net sales growth in the Prestige and Above segment clearly endorses the success of its premiumisation strategy. During the year, overall volumes were down 1% with net sales up 13% on stronger performance of the Prestige and Above segment. The integration of the Diageo brand portfolio also had a positive mix impact accounting for half of the overall positive mix. The main contributors were Johnnie Walker, Black & White, VAT69 and Smirnoff. Good performance of Black Dog in the premium segment and the re-launch of Royal Challenge and McDowell s No 1. whisky in the prestige segment also had favourable net sales mix impact. We have integrated the Diageo brand portfolio into USL in this fiscal year. The portfolio consists of over 20 brands, with the key brands being Smirnoff, VAT69, Johnnie Walker and Black & White, all of which are positioned in the premium and luxury segment. The Diageo brand portfolio added 1.3 mn cases volume. The Popular segment represents 63% of total volumes and 49% of total net sales, 4ppts and 5ppts respectively below last year. Popular segment volume declined 7% and net sales grew 2%. The reduction in volume was largely driven by the specific temporary pricing challenge on Haywards in Karnataka which impacted volume growth by circa (4) ppts. Despite this, overall Popular segment net sales grew 2% fuelled by good growth of our power brands which represent almost 80% of our net sales in the popular segment: McDowell s Rum and Brandy; Bagpiper; Old Tavern and Director s Special whisky. The Prestige and Above segment represents 37% of total volumes and 51% of total net sales, up 4ppts and 5ppts respectively when compared to prior year. In this segment, volume increased 10% with net sales up 26%. Excluding the Diageo brand portfolio, volume was up 6% and net sales up 8%. Robust growth of the segment was fuelled by our renovation strategy with the re-launch of Royal Challenge and benefited from the recent new look of McDowell s No.1 whisky. The Royal Challenge re-launch was completed at the beginning of this fiscal year and we have seen exceptional growth in each quarter with volume growth of 61% and net sales growth of 50% in the full year. The new look McDowell s No 1 whisky was launched in the third quarter and posted 18% volume and 23% net sales growth in the fourth quarter resulting in overall volume growth of 8% and net sales growth of 13% in the full year (main variant only). The performance of Signature was muted with volume decline of 2% and negative price/mix of 7ppts. The re-launch of Signature started towards end of Q4 and we expect to see positive momentum in the brand in the next fiscal yer. Antiquity volume was up 18% with net sales up 10%. Black Dog performance was robust during the year and volume grew 23% with net sales up 24%. Nielsen tertiary share data is reflective of the above, showing strong share momentum on Royal Challenge with the McDowell s No.1 whisky franchise maintaining share for the year, and positive share gains on the core variant of McDowell s No.1. The full positive impact of the new look McDowell s No.1 whisky franchise (as depicted above) plus the fully renovated offering on Signature is expected to be seen in the coming year. (Source: Nielsen Corporation - Value share metrics for the 12 month period ending 31 March 2016). Annual Report 2016 61

62 We have also continued to see strong share momentum on the Premium Scotch portfolio. Black Dog, Black & White and Vat69, and on our Premium Vodka portfolio, led by Smirnoff. The core variants of Johnnie Walker Red, Black and Double Black have also shown positive share gains for the full year. The year under review also witnessed the continuation of the company s productivity journey, underlined by further efficiencies and strategic reinvestment in brands and capabilities. Carrying forward its Perfect Store programme, the company continued to enhance customer experience, boosting in-store brand engagement and increasing the number of perfect stores to circa 20,000 by year end. Net Debt Net debt reduction was driven by the divestment of non-core assets, mainly the sale of the United Breweries Limited Shares and the Bouvet Ladubay subsidiary. These divestments together with renegotiation of borrowings terms reduced the total interest cost. Significant improvement in overall financial flexibility, corporate governance and our compliance framework has resulted in our improved credit rating. During the year, ICRA Limited upgraded the Long Term Rating from BBB to A+, while the Short Term Rating improved from A3 to A1+. These improved ratings will enable us to access more economical sources of debt leading to lower interest cost and increased shareholder value. OUTLOOK As the world s fastest growing economy, with over 65 per cent population below 35 years, India s growth opportunity in the near and mid-term is exciting and invigorating. The building blocks needed for a sustained phase of young adult-driven growth are well in place, with aspirational consumer spending getting increasingly aligned to global lifestyle in the spirit of celebration. India is currently one of the most attractive destinations for the alcobev industry in the world, with a growth forecast of 13% CAGR in value over the next 5 years. With such an attractive opportunity landscape to steer growth, the industry looks forward to support from the government in the form of relaxation in regulations; single approval window for procuring licenses for manufacturing, storage and distribution; and transformation of physical control systems at the State Excise Departments to digital, online processes. The industry is of the opinion that government initiatives to streamline the systems and ease regulations would revolutionise the alcobev industry in India. Also, partnering with the government to promote responsible drinking would create a win-win situation for all. With a diverse portfolio of products catering to every taste preference and some of the industry s most loved brands; a pan-india reach and presence, and USL products being available in all cities, the company s transformation journey is on track, continuously gathering pace and momentum to script a new growth story. 11,032 People in India have died due to consumption of spurious alcohol during 2005-14. RISKS & CONCERNS, OPPORTUNITIES & THREATS Risks & Concerns The industry is highly regulated by the government with regulations pertaining to: pricing, licensing, setting up of new or expansion of existing brewing/ distilling and bottling capacities; manufacturing processes; marketing, sales & advertising; and distribution. Heavy taxes and duties levied on spirit manufacturers add to the industry concerns. Apart from Central Government regulations, every state of India has its own set of regulations, tax rates and duties for inter-state movement of liquor. Inclusion of alcohol within the purview of FSSAI to ensure quality standards will lead to further multiplicity and sometimes duplicity in regulations and regulators and sometimes inconsistencies in regulations for the industry.

Business Overview Strategic Review Statutory Reports Financial Statements Banning of alcohol in certain states of India is also a matter of concern, impacting industry growth whilst not delivering the stated objectives of public health. Manufacturing of fake and poor quality spirits leads not only to decline in revenues but also poses threat to the lives of the consumers. Non-inclusion of Alcobev industry within the ambit of GST remains a missed opportunity and a risk to the overall industry. The Company has taken steps to mitigate risks due to drinking and driving through its Responsible Drinking initiatives as highlighted in the CSR Report in pages 99 and 100 of this Annual Report highlighting social initiatives of the Company. Opportunities Rising urbanisation: In India, the urban population constitute the primary consumers of premium and super premium spirits. The country s urban population is expected to grow by 35% from 32 crore to 52 crore by 2020, creating a huge growth opportunity for the industry. (Source: Assocham) Population above legal drinking age: Almost half of India s population of 1.2 billion is aged between 20-59 years which is the prime age group for alcohol consumption. Rising disposable income: The per capita income in India has increased 88%, from ` 49,492 in FY2010 to ` 93,231 in FY2015, and is expected to increase further to ` 1,00,000 by FY2017. The rising disposable income is expected to drive demand for alcohol consumption in India. (Source: Business Standard) Lifestyle changes: Growing westernisation, increasing social acceptance of alcohol and, rising consumption among women consumers are some of the key factors contributing to significant lifestyle changes and thus driving demand. Entry barriers for new players: The alcohol industry in India, being highly regulated, has high entry barriers for new players, thereby creating a favourable environment for the existing players. Demand for spirits: Indians have higher preference for spirits containing up to 42.8% alcohol content. Moreover, beer being heavily taxed is priced at par, or even more than IMFL. This further enhances demand for spirits. (Source: The Times of India) Threats Improved quality and packaging of Indian Made Indian Liquor (IMIL), coupled with rising prices of IMFL, has led to increase in consumption of IMIL or country liquor Restrictions on foreign liquor in certain states of India has led to escalation in bootlegging and black marketing INTERNAL CONTROL SYSTEMS The company s internal control systems are commensurate with the size and industry in which it operates. USL has well-defined and adequately documented systems, policies, procedures and guidelines that have been reviewed by the Board and external parties. The company strictly follows the laws, rules and statues of the land. It ensures stringent compliance at all levels, and across all divisions and departments, for safeguarding its assets, prevention and detection of fraud and errors, completeness of accounting records and timely preparation of financial statements. Statutory Auditors have also confirmed the same in their audit report on the Financial Statements for the year. MANAGEMENT AND BOARD Pursuant to the acquisition of shares of the Company by Diageo plc s subsidiary Relay BV, in 2013 and 2014, the Company is a direct subsidiary of Relay BV and an indirect subsidiary of Diageo plc. Details on the changes in the Board and senior management are provided in the Corporate Governance Report. Annual Report 2016 63

64 HUMAN RESOURCES USL believes that its people are its most important asset and thus continuously strives to scale up its employee engagement through wellstructured systems and a visionary HR philosophy. Now a family of over 5,700 (including permanent employees at plants), the company is focussing on in its diversity and inclusion agenda, with special emphasis on the induction and retention of more women in the workforce. USL is committed to nurturing an open environment which allows for easy assimilation of ideas and enriches the organisation s collective knowledge pool. The company aspires to evolve into a future-ready organisation centred on promoting a collaborative and cohesive culture. During the year, the company delivered 3434 training days for its employees. The company continuously invests in role-based training and upskilling of its employees at all levels to ensure that they remain at the forefront of skill-set upgradation in the industry. Performance appraisals take place every six months, giving every employee sufficient time to meet his/ her role requirements in the next six months. The company maintains cordial relationship with its employees at all its manufacturing units. FORWARD LOOKING STATEMENT / CAUTIONARY STATEMENT This Report contains forward-looking statements that involve risks and uncertainties. Your Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Actual results, performances or achievements could differ materially from those expressed or implied in such forward looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements. This Report should be read in conjunction with the financial statements included herein and the notes thereto.