Credit Rating Rationale in the

Distillers Industry: The Case

of Brown-Forman and Diageo

Financial Management and Markets Group work

 Two Giants of the Distillers Industry

GICS Sector: Consumer Staples GICS Sector: Consumer Staples

Sub-Industry: Distillers & Vintners Sub-Industry: Distillers & Vintners
Mark cap: 18.320B Mark cap: 50.335B
Headquarter: Kentucky, USA Headquarter: London, UK

S&PS RATING : A-
 The S&P rating process
Country Risk

CICRA
Adjustments
Industry Risk
Business Risk Profile

Capital Structure
Competitive Position
Final
Anchor Liquidity Rating

Financial Policy

Cash Flow/Leverage Financial Risk Profile

 Assessing the Industry Risk Porters Five Forces
FORCE COMMENT JUDGEMENT
Low Switching Cost but high differentiation
Buyer power High Customer Loyalty Weak
Buyer is not price sensitive
Buyer Power
5 Very dependent to raw materials
4 Supplier power Importance of the high quality of this raw Strong
3 materials
2
Degree of Rivalry Supplier Power
1 Products long aging period
New entrants Weak
0 Heritage and brand positioning

Beer/craft beer, soft drink and wine

Substitutes Price Moderate
Substitutes New Entrants Regulations
Highly consolidated market
Degree of rivalry Brand fragmentation Moderate
Target of markets subsections
 Assessing the Industry Risk
Beta Beverage Alcoholic (Unlevered) = 0.64 Demand for nondurable consumer products
Beta Diageo = 0.78
Low Industry is generally stable over time, however
Beta Brown-Forman = 0.82 Risk significant differences exist among regions.

Developed Markets
Automotive (Cyclical) vs Beverage Alcoholic Less favorable growth
trends
(Defensive) Industry High market penetration
80% Entrenched competition
60% Emerging Markets
Persistent growth in future
40%
Positive demographic

Sales
20% trends

0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-20%

-40%

-60%

-80%

Cyclical Industry (Automotive) Beverage Industry (Alcoholic)

Introduction Growth Maturity Decline
 Country Risk

Portion of Portion of
Credit Risk
Area Credit Risk Score Actual Significance Revenues in Area Actual Significance Revenues in
Score
Geographic Area Geographic Area

North America 1 Very Low Risk 34.0%

US 1 Very Low Risk 46%

Europe 2 Low Risk 24.0%

Europe 2 Low Risk 31% Africa 5 High Risk 13.0%

Latin America and

4 Moderately High Risk 8.2%
Caribbean

Australia 1 Very Low Risk 9% Asia Pacific 4 Moderately High Risk 20.0%

Overall Score 3 Intermediate Risk

Final Score 1 Very Low Risk
Final Score Adjusted for
2 Low Risk
Diversification Effect
 Competitive
Competitiveposition:
Position Qualitative Factors
Qualitative Factors
Brown-Forman Diageo
Good position in the spirits industry Leader in the spirits industry in terms of size and market share
Strong Brands but somewhat limited product range Owns one of the worlds most well-known brands
Too reliant on the Jack Daniels brand Diversity of products across types and price segments
Geographically diversified Very strongly geographically diversified
Limited presence in Emerging countries Strong presence in Emerging Markets
Certain materials are supplied from one or few key suppliers Diversity of suppliers

Diageo
Others 26%
35%

Pernord
Ricard
17%
Bacardi
Beam 10%
Suntory
6%
Brown-
Forman
6%
 Competitive Position Operating Efficiency
Cash Conversion Cycle Asset Turnover
500 0.9
The industry is characterized by
400 0.8
low inventory turnover and
0.7
consequently high inventory days 300
0.6
which increases the duration of 200
the cash conversion cycle. This is 0.5
100 0.4
mainly due to aging requirement
for many premium brands of 0 0.3
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
whisky and tequila
Brown-Forman Diageo Peer Mean Brown-Forman Diageo Peer Mean
The operating efficiency of both
companies has historically
followed quite closely the industry Gross Profit Margin Inventory Turnover
average 85% 1.6
75% 1.4
High proportion of variable to
fixed costs 65% 1.2
55% 1
45% 0.8
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Brown-Forman Diageo Peer Mean Brown-Forman Diageo Peer Mean

 Competitive position:
Competitive Quantitative
Position Factors
Profitability
EBITDA Margin Volatility of Profitability
40%

30% Company Standard Error of the Regression (SER) Score

20%
Brown-Forman 4.18% Low Volatility 2
10%

0% Diageo 8.11% Average Volatility 3

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 E 2017 E 2018

Brown-Forman Diageo Peer Mean

Diageo Final Profitability Assessment

33.4%
15% 30% Volatility 1 2 3 4 5 6

Level
Below Above
Average Above Average
Average Average 1 1 2 3 4 5

Average 1 2 3 4 5 6
Brown-Forman Below Average 2 3 4 5 6 6
35.47%
 Financial Risk Core Ratios
Coverage Ratio
CFO/Ebitda indicates the company's ability to cover total debt with
its yearly cash flow from operations.

2014 2015 2016 2017E 2018E 2014 2015 2016 2017E 2018E
CFO 649 608 524 782 744 CFO 2,145 3.352 3,406 2,978 3,270
Total Debt 1,005 1,183 1,501 2,366 2,441 Total Debt 11,693 14,721 12,428 14,683 14,890
CFO/D 65% 51% 35% 33% 31% CFO/D 18% 23% 27% 20% 22%
Weights .1 .15 .25 .25 .25 Weights .1 .15 .25 .25 .25

39% 23%
 Financial Risk Core Ratios
Net Debt to Ebitda
Net Debt/Ebitda is a debt ratio that shows how many years it
would take for a company to pay back its debt.

2014 2015 2016 2017E 2018E 2014 2015 2016 2017E 2018E
Net Debt 568 818 1,238 1,709 1,687 Net Debt 8,850 9,366 8,545 8,436 7,747
Ebitda 1,021 1,078 1,104 1,110 1,185 Ebitda 4,139 4,574 4,612 3,902 4,099
ND/Ebitda 0.55 0.76 1.12 1.54 1.42 ND/Ebitda 2.14 2.04 1.85 2.16 1.89
Weights .1 .15 .25 .25 .25 Weights .1 .15 .25 .25 .25

1.2 2.0
 Financial Risk
Financial RiskAssessment
Assessment Core
Core Ratios
Ratios
CFO/D ND/Ebitda
45% 2.5
Modest 40%
35% 2
Modest
30%
Intermediate
1.5
25%

Significant 20%
1
15% Minimal
10% 0.5
5%
0% 0
Brown Forman Diageo Brown-Forman Diageo

S&P considers a company to have modest risk when S&P considers a company to have minimal risk when
this ratio is between 35% and 50% and a significant this ratio is lower than 1.5 and a modest risk when it
risk when it is between 15% and 25%. is between 1.5 and 2.0.
 Anchor

Overall Risk Profile Table

Financial Risk
1 (minimal) 2 (modest) 3 (intermediate) 4 (significant) 5 (aggressive)
6 (highly AA A+/A
leveraged)
Business Risk

1 (excellent) aaa/aa+ aa a+/a a- bbb bbb-/bb+

2 (strong) aa/aa- a+/a a-/bbb+ bbb bb+ bb

3 (satisfactory) a/a- bbb+ bbb/bbb- bbb-/bb+ bb b+ A+/A A-/BBB+

Brown Forman Diageo
4 (fair) bbb/bbb- bbb- bb+ bb bb- b

5 (weak) bb+ bb+ bb bb- b+ b/b- Financial Risk - Modest Financial Risk Intermediate
6 (vulnerable) bb- bb- bb-/b+ b+ b b-
Business Risk- Strong Business Risk - Strong
 Capital Structure Adjustments
$2,500 Brown-Forman Diageo
Millions

Debt Maturity
$2,000
Currency Risk of Neutral Neutral
Debt
$1,500
Debt Maturity Neutral Neutral
$1,000
Profile
Interest Rate Risk Neutral Neutral
$500
of Debt
$0 Investments Neutral Neutral
Overall Neutral Neutral
Diageo Brown-Forman
Adjustment
Debt is predominantly bonds, issued in the companies domestic currencies
The foreign denominated ones can safely be covered by the companies extensive operations in this countries
Debt maturity is evenly spread with a weighted average of above 2 years for both
All bonds are fixed rate, thus both have limited exposure to interest rate risk
Liquidity Risk Adjustments Brown Forman
S/U Max Threshold S-U Max Threshold Judgement

4.5 2+ 5,575 USD >0 Exceptional

What if we exclude WC and

consider a stress scenario?

S/U Max Threshold S-U Max Threshold Judgement

Still
2.3 2+ 1,827 USD >0
Exceptional
Liquidity Risk Adjustments Diageo
S/U Max Threshold S-U Max Threshold Judgement

4.2 2+ 12,016 USD >0 Exceptional

What if we exclude WC and

consider a stress scenario?

S/U Max Threshold S-U Max Threshold Judgement

1.7 2+ 2,700 USD >0 Strong

 Financial Policy Adjustments
Both companies have comprehensive,
Brown-Forman Diageo transparent and sustainable frameworks that
can be assessed as supportive
Brown-Forman is regarded as a controlled-
Financial Policy company as the Brown family have substantial
Supportive Supportive
Framework
control over matters submitted for
shareholders approval
Financial
Negative Neutral Moreover, it follows quite an aggressive policy
Discipline of share repurchases which is expected to
continue in the future and be funded through
increase in debt
Final Adjustment Negative (-1) Neutral
Diageo has a much less aggressive dividend and
buyback policy
 Final Rating
Business RIsk 2 Business RIsk 2
CICRA 2 CICRA 2
Competitive Position 2 Competitive Position 2
Preliminary Position 3 Preliminary Position 1
Profitability 1 Profitability 2

Financial Risk 2 Financial Risk 3

Anchor A Anchor A-
Adjustments -1 Adjustments 0
Capital Structure 0 Capital Structure 0
Liquidity 0 Liquidity 0
Financial Policy -1 A- Financial Policy 0