Diageo Lessons on Internal Control

Talk about going on a bender: the SEC just fined spirits maker Diageo $5 million for forcing its distributors to buy more liquor than they needed, and then neglecting to tell investors that Diageo’s inflated sales numbers would eventually dry out. 

In the world of funny numbers, what Diageo did is known as channel stuffing, and it’s a scheme older than blue label scotch. A company strong-arms its retail partners into buying more goods than they need, so the company can make its sales look better. Eventually those partners have too much inventory — one might say their storerooms get loaded — and they stop buying, at which point the company’s sales tip over. 

So what internal control failures allowed this to happen at Diageo?

As the SEC complaint details, Diageo was working with its largest and most profitable subsidiary distributor, Diageo North America (DNA). Diageo (based in Britain) would make its liquor and then sell to DNA, which then resold to other liquor distributors across the United States, who then sold to restaurants or your liquor shop on the corner. By 2014 and 2015, when said channel-stuffing took place, DNA accounted for roughly one-third of Diageo’s $24.6 billion in revenue and 40 percent of $4.3 billion in operating profit. 

As a routine part of operations, DNA tracked its shipments of Diageo products to local distributors, and then the distributors’ sales of those products to retailers — something known in the business as “depletion.” From there, DNA could calculate how much Diageo inventory the local distributors were carrying, in a metric called Days Sales Inventory. “DSI” lets a manufacturer know: if we stopped shipping goods to our resellers today, how many days until their supplies would run out? 

One key point: when Diageo calculated DSI, it didn’t include estimates for any newly launched “innovation products” (stuff like Captain Morgan white rum or Guinness Dublin) because nobody really knew what those sales might be.

By 2014 and 2015, liquor sales were sluggish, which meant depletion rates were falling and local distributors’ inventory was rising. But DNA had financial targets to meet, so its sales employees kept pressuring local distributors to buy more Diageo inventory than they needed. DNA sales teams also increasingly relied on “innovation products” as part of those shipments, because it was harder to prove what an appropriate, data-driven amount of those new products should be.

By 2015, so many distributors were stuffed with Diageo inventory that DNA revamped its sales agreements for 2016, where DNA would lower its future shipments of liquor, and eventually the excess inventory would get sold back to historically appropriate levels. 

That was the disclosure violation that triggered the SEC enforcement. Diageo knew it was shipping too much liquor to distributors, and knew those orders would fall in future years — and disclosed none of that to investors. 

As the SEC complaint said: 

Diageo failed to disclose the trends of shipping in excess of demand and the resulting inventory builds; the positive impact those trends had on sales and profits, and the negative impact they reasonably could be expected to have on future growth… The failure to disclose this additional information left investors with the misleading impression that Diageo and DNA were able to achieve growth in certain key performance indicators through normal customer demand for Diageo’s products. 

Internal Control Issues

This case is interesting first because DNA relied on innovation products to mask its channel stuffing. Why? Because the company lacked historical data about appropriate amounts of inventory to ship, so it would be harder for critics to prove DNA executives wrong. 

Channel-stuffing itself is nothing new in the annals of fraud, but it is getting harder to do as business software gets better at tracking sales and inventory. More data and more analytical power means better data analytics, so audit and finance teams — assuming they take full advantage of said data analytics — are better positioned to identify suspicious patterns. 

The exception, of course, is when you don’t have historical data to study. So for fraud risk enthusiasts, that’s one internal control issue to consider: which products or services within the company’s portfolio have no historical record? How vulnerable to fraud might those items be? 

Second, DNA employees left multiple clues about the channel stuffing in their own emails. 

For example, in fiscal 2014 one DNA employee wrote: “They [the distributor] are suggesting they are long on Innov Inventory and are bringing some data. We will handle… We clearly have been pushing Innov for all its worth on ships.” Another DNA employee told one of his customers: “I know I say this every time the shipments discussion comes around….but this is a critical one for me.”

In hindsight, of course the language in those emails looks suspicious. The challenge is to find those vocabulary red flags in advance. That’s not easy for every company, but the technology does exist to monitor emails and perform “sentiment analysis” that detects potential misconduct. 

Third, remember that the issue here was failure to disclose relevant information to investors. Diageo executives knew they were channel stuffing in 2014 and 2015, and that their destocking plan would cause a material hit to financial performance in 2016 — and they didn’t tell that to investors. That’s what landed the company a $5 million penalty from the SEC. 

Securities rules are clear on this point. As the SEC complaint says, companies must disclose:

“the most significant trends in … sales … since the latest fiscal year,” as well as to “discuss, for at least the current financial year, any known trends, uncertainties, demands, commitments or events that are reasonably likely to have a material effect on the company’s net sales or revenues.”

Diageo approved a plan of destocking. It clearly knew about problematic trends. So either the management team preparing that plan didn’t coordinate with Diageo’s team making securities disclosures; or senior management did know the plan should trigger new disclosures and decided not to make them anyway.

If Diageo didn’t disclose because one part of the company didn’t know what another part was doing, that’s another example of siloed risk management gone wrong. If senior managers did decide not to disclose, that’s poor leadership from the top.

So those are our three internal control lessons: (1) look for new products or services as potential fraud risks; (ii) develop methods of studying employee communication for red flags; and (iii) ethical, competent leadership at the top — or the lack thereof — trumps all. 

I’ll drink to that.