LOCAL brewer, Desnoes & Geddes Ltd (DG) has attributed the 49 per cent fall-off in earnings for its fiscal year ended June 30, 2010, to the “difficult economic environment, the continuation of tax inequities, increased competition and lower consumer disposable income”. While each of these factors certainly had a hand in the firm’s recent performance, DG’s marketing and pricing strategies have ironically become contributing factors.

In the past two financial years, DG has continued to spend heavily on local and export marketing. While these strategies may have yielded desired results in previous years, the company has continued what now appears to be an ineffective strategy, thus placing itself in a potential “perfect storm”. In light of the challenging economic climate locally and the increase in the Special Consumption Tax (SCT) in May 2009, the company has also been battling with reduced demand for its products. Furthermore, sales are being impacted by increased competition locally, coupled with the fact that its flagship product, Red Stripe, is in the mature stage of the product life cycle.

In spite of these factors, DG continues to earmark at least 60 per cent of its marketing budget domestically as it seeks to “further strengthen brand equity and drive sales”. For the most recent financial year, the company invested an additional $70 million on domestic advertising and marketing, or an increase of almost over eight per cent to $876 million. In the previous year, domestic marketing costs were up 14.49 per cent to $806.2 million. In theory, boosting marketing expenditure would be the appropriate strategy for a growth Company seeking to grab market share in a competitive market. However, in view of the circumstances faced by DG – mature product life cycle, the soft local economy, and the increase in the SCT translating into a $0.15 reduction in EPS for YE 2009/2010, one wonders why the Firm has not yet taken the decision to reduce marketing costs.

Instead it has relied on significant price increases over the past two years in an attempt to maintain profits which has potentially resulted in its products being overpriced in the eyes of the consumer. At the same time, given that Domestic Turnover in YE 2009/2010 decreased by 2.8 per cent, it follows that there has been a significant fall-off in volumes. DG has not reported volume data in its most recent Management, Discussion & Analysis (MD&A) and we would encourage management to do so in the future so that a better understanding can be garnered. The large decreases in volumes drives up the company’s fixed costs per case since the costs are spread over a lower case output. As costs per case climb, management increases the price and sales volumes further suffer — the result — a perfect storm. At the same time, the marketing spend continues unabated, totaling $0.53 per share or almost twice DG’s actual 2010 EPS.

Apart from spending heavily on the domestic front, DG also increased spending on export marketing by 15 per cent to $623 million in YE 2009/2010. Though the company achieved some sales growth, it is notable that Segment Profit plunged to $11.82 million from $173.66 million. Interestingly, a year earlier when DG reduced costs by 31 per cent in this segment, profit came in at $173.66 million versus a Loss of $195.31 million in the previous year. It is staggering to conceive that the company has spent $1.96 billion on export marketing for the last three fiscal years, for a cumulative segment loss of $9.8 million over the period. Perhaps, if DG had continued to move away from its traditionally aggressive marketing strategy its latest results may have looked very different. One wonders how long the company’s management intends to subject shareholders to this onslaught of marketing costs without providing a reasonable return. Furthermore, as a subsidiary of Diageo Plc, the world’s biggest producer of spirits and a major producer of beer and wine, one would have anticipated greater use of overseas leverage as its seeks to further penetrate export markets.

Overall, marketing costs continue to account for the lion’s share or at least 50 per cent of the firm’s expenses (excluding cost of sales). Over the past five years, marketing costs have increased at an average rate of 17.06 per cent excluding YE 2008/2009 when marketing costs were down due to costcutting in the export segment. Marketing spend totaled $6.72 billion over the period, reducing average EPS by 52 per cent. DG has yet to lower the cost of marketing while at the same time finding appropriate tactics and solutions to generate increased sales, the company has noted, however, that increased focus is being placed on cost efficiency in other areas of its operations. In June, the Company made 60 positions redundant and maintained its hiring freeze. In its MD&A however, DG did not mention the cost of the redundancy exercise or the anticipated cost savings going forward; leaving no room for an assessment of the firm’s future performance in this respect.

Turning the focus to the stock’s performance, since the start of the quarter DG has slid 13.62 per cent to $4.06 (close price on September 7, 2010) as investors have begun to reduce their positions in the stock based on the continued decline in earnings. In terms of market valuation, DG is currently trading at a Price to Earnings Ratio (P/E) of 14.3 times and a Price to Book Value (P/BV) of 1.71 times compared with the industry average P/E of 6.1 times and P/BV of 1.79 times, indicating that the stock is overvalued.

Though DG remains a force to be reckoned with in the local beer market, as it markets and distributes some of the strongest brands across the island, the company is currently faced with realigning its marketing and pricing strategies to effectively compete in today’s economic climate and market conditions. Until it is able to do so the perfect storm will continue and may intensify. As a result, Stocks & Securities Ltd (SSL) expects the stock to underperform the JSE Main Index within the next 12 months.

Kimberly Thelwell is the Senior Investment Analyst at Stocks & Securities Ltd. You can contact her at kthelwell@sslinvest.com.