Paper Example on US-China Trade War: Impact on Spirits Industry

Introduction

The world’s largest economies—the United States and China—have been involved in a heated trade war for the past five years, which has negatively affected the spirits industry. The US accuses China of intellectual property theft and unfair trading practices (BBC 2020). On the other hand, China believes that the US is trying to curb its global economic dominance through tariffs. As a result, both countries have imposed trade tariffs worth hundreds of billions on each other’s commodities. Notably, President Trump has formulated policies that aim at promoting the consumption of American products by increasing the prices of exported commodities (BBC 2020). He has imposed tariffs exceeding $360 billion on Chinese commodities. In retaliation, China has managed to impose tariffs exceeding $110 billion on US products (BBC 2020).

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In 2018, China imposed a 25% tariff on US whiskey commodities, which created challenges for the rapidly growing industry (Newhart 2018). The US whiskey and spirit industry exports in China had foreseen a 1200% growth in the past two decades. For example, America’s spirits exports to China hit $12.8 million in 2017 from $ 959 000 in 2001 (Newhart 2018). Although Diageo's CEO Ivan Mendes claimed that they have a little presence in China's beverage industry, the 25% tariff reduced consumer confidence in its products (Newhart 2018). As a result, its sales in China decreased significantly (Newhart 2018). Notably, China targets companies in regions that support Trump’s policy such as Tennessee and Kentucky, where most of Diageo’s US brands are located. Similarly, President Trump imposed tariffs on European imports worth more than 7.5 billion in October 2019 (Afanasieva 2019). Diageo was the most devastated with more than $93 billion of its products such as Baileys and single malt whiskey being exposed to the taxes (Afanasieva 2019). The company reacted by incurring the cost without transferring them to American consumers despite the loss.

According to Baekert and Hodrick (2016), governments can make tax decisions that directly or indirectly affect a multinational’s operations. If the trade war between China and the US continues, some industries may be forced to undertake precautionary measures to mitigate financial risks such as passing the extra costs to consumers (Afanasieva 2019). Notably, the war is getting messy as both countries now target multinationals and industries that were not initially related to the trade war.

Corona Virus Pandemic

In 2020, the outbreak of the COVID-19 outbreak has had a tremendous impact on the global economy affecting all industries significantly. The pandemic has caused economic disruptions as many nations strive to enhance safety measures to curb its spread. In the last three months, most nations undertook measures such as lockdowns, halting international flights, closing places of worship and communal gatherings, and encouraging social distancing. The guidelines were per the World Health Organization's guidelines to prevent the spread of COVID-19, which is contracted by coming into contact with an infected person’s respiratory fluids. As a result, most businesses such as restaurants, bars, and non-essential businesses closed down to ensure the safety of their consumers and workers.

Diageo was not spared by the economic turbulence since most of its products are consumed in open places such as bars and restaurants. The closure of such retail outlets had a downward surge in its sales revenue for the past months. In its COVID-19 brief in April, Diageo announced a decline in sales due to the closure of restaurants and bars in China and the Asia Pacific region (Diageo 2020e). The company also announced its emergency measures to mitigate risks, which included cutting spending, which was not favorable with the current environment (Diageo 2020e). The company has also extended support to its suppliers to help them remain afloat.

Notably, as the world eases the restrictions, Diageo’s sales revenue may increase gradually. Currently, nations have relaxed restrictions to promote economic sustainability. The firm can rebound through retail sales in Europe and the US. Additionally, the firm has set aside $100 million to support bar reopening in preparation for business resumption (Diageo 2020d).

Dividend Policy

Diageo pays dividends twice per year for all its share categories. The payments are divided into interim dividends, which are issued in April and a final one in October. Noticeably, 40% is paid in April while 60% is issued in October (Diageo 2020a). Additionally, the firm pays its dividends in the sterling pound, which are then converted and disbursed by Citibank ADR depositary in US dollars (Diageo 2020a).

Moreover, Diageo allows its shareholders to reinvest their dividends. In the US, reinvestment is done through the International Direct Investment Plan for Diageo ADR, which is run by Citibank (Diageo 2020b). In the UK, Link Market Services Trustees limited offers the plan (Diageo 2020a). The reinvestment process presents an opportunity for shareholders to build up their stake in the company. Notably, the firm encourages the reinvestment plan to increase its shareholder's equity top to facilitate its expansive operations. Organizations with dividend reinvestment plans encourage long-term investment and increase investment funds (Diageo 2020a). In the case of Diageo, its dividend policy enhances its performance by providing it with adequate capital to invest globally.

Sources of Capital

Sales income in North America, Asia Pacific, and Europe are the primary source of Diageo’s revenue stream. Notably, North America is the largest market for Diageo’s premium drinks that accounts for half of the firm’s operating profit and about a third of its net sales (Trefis Team 2020). The market is comprised of three segments namely Diageo Canada, US Spirits, and Diageo Guinness USA. North America’s revenue collection increased to $6 billion in 2020 from $5.3 billion in 2016, realizing a $0.5 billion increment in three years (Trefis Team 2020). Additionally, the region's sales growth as of the year ending 30 June 2019 was at 5% because of an increase in beer and scotch market share (Trefis Team 2020). Secondly, Europe is the second-largest source of revenue contributing about $3.8 billion in 2019 a decline from $ 4.1 billion in 2018 due to Brexit issues. Thirdly, Asia Pacific is the third source of sales revenue contributing about 95 million unit sales in 2019 (Trefis Team 2020).

The company also uses shareholder’s equity as a source of finance by issuing ordinary shares and dividend reinvestment plans. Diageo is traded publicly on the London Stock Exchange and New York Stock Exchange (Diageo 2020b). Noticeably, high sales revenue, and increasing shareholder equity provides the MNC with adequate capital to engage in growth strategies across the world. For instance, in 2018, the company acquired United Spirits-India’s leading alcoholic beverage producer, which gave it a footprint to push its sales in India and East Asia.

Financial Performance Analysis

Return on Equity

Return on Equity measures the financial performance of a company by dividing the net income by total equity. Noticeably, it measures how effectively an organization is utilizing its shareholders to create profits. In this case, Diageo’s ROE increased to 32.86% as of the fiscal year ending 30 June 2019 from 26.84% in 2018 financial year. The increase in signifies growth in its business operations. The company is using its shareholders' value to grow its operations worldwide. Currently, the company operates in more than 180 countries in the world (Diageo 2020c). The good ROE is an indicator of its growing stock rates and exemplary performance against its rivals such as Bacardi Ltd. Notably, the change can is also reflected by a 6.1% sales growth rate in 2019, compared to 5% in the previous year (Diageo 2020e).

Return on Assets

The company’s Return on assets (ROA) ration increased to 10.66% in 2019 from 10.58% in the previous fiscal year. According to Lewellen (2004), ROA measures how well an organization utilizes its assets to create value. By comparing between 2019 and 2018, a positive trend is evident, which signals the effective use of assets to create value. ROA is a vital tool for investors to identify the attractiveness of a firm. Higher values compared to other ventures in the industry or previous years reveal growth and profitability (Lewellen 2004). Organizations with negative ROA reveal inefficiency in converting investment into income are less likely to attract investors. Additionally, their stocks may fall or realize sluggish growth in the exchange market.

Return on Capital Employed

Diageo’s return on capital employed (ROCE) increased to 19.52% as at the end of the 2018 fiscal year from 17.81% in 2018 financial year. The increase in 2019 surpasses 2017 value 18.11% to signify a surge in the company’s operations. According to Lewellen (2004), ROCE assesses a firm’s capital efficiency and profitability. It helps managers and company executives to identify how well the business is generating profits from its capital. Unlike ROE and ROA that measure profitability based on shareholder’s equity, ROCE includes both debts and equity (Lewellen 2004). Noticeably, it shows the amount of profit a firm creates per $1 of capital invested. In this case, Diageo improved its profitability in 2019 from a dropdown in 2018.

Analysis of the Profitability Ratios on Diageo

By comparing Diageo’s profitability ratios for the fiscal year 2019 and 2018, a positive impact on its performance is noted. Although the company realized a minimal change in ROA, the other ratios reveal an increase in sales revenue and profitability. The profitability can be linked to increased sales growth in 2019 compared to 2018. In 2019, the firm realized a 6% growth in its sales and 5% growth in 2018, revealing an increasing growth rate (Diageo 2020c).

Diageo attributes the increase in its profitability and efficiency ratios to its organic growth, favorable exchange rates, and acquisitions and disposals. Firstly, the company reported an increase in organic growth rates across all its regions of operation. Notably, North America reported a 5% net sales growth in its three key markets, including Canada (Diageo 2020c). Whiskey and vodka were gained significant market share in the region due to innovations and improvements in 2019. Europe reported a 4% growth rate mainly driven by sales increase in its beer and spirits brands such as Guinness Draught, Smirnoff, and Captain Morgan (Diageo 2020e). Noticeably, Africa delivered a 7% growth in net sales, especially in East Africa and Africa Regional markets (Diageo 2020c). They both contributed 13% and 8% of sales growth in the year primarily due to products such as beer and spirits. Moreover, the launch of the White Walker by Johnnie Walker brand in collaboration with the HBO network also contributed to sales growth in most regions such as Europe and South Africa. For instance, in SA, scotch sales increased to 8% primarily due to the brand, which attracted most customers (Diageo 2020c).

Secondly, favorable exchange rates enhanced profitability in 2019 compared to 2018. The shifts in exchange rates between countries had an impact on reported net sales. Noticeably, the weakening of the sterling pound against the US dollar in 2018 increased the company’s profit before exceptional items and taxation (Diageo 2020c). According to Hodrick and Bekaert (2020), fluctuation in exchange rates affects profitability in multinationals as they export goods and import inputs. A company's value is expressed in the present values of its future profit...