Diageo eyes move upmarket

Paul Walsh counts Scotch among his favourite drinks. But the Diageo chief executive has never made a secret of his penchant for champagne.

Although Diageo can claim many of the world’s leading brands in whisky, gin, vodka and beer, it does not own the most exclusive kinds of drinks: a cognac or a champagne.

While Mr Walsh’s arch-rival, France’s Pernod Ricard, can claim the Martell cognac and Perrier-Jouët champagne brands, Diageo has had to make do with a 34 per cent stake in Moët Hennessy.

The roots of that stake date back to a 12 per cent cross-shareholding by Guinness, the predecessor company of Diageo, and LVMH, put in place in 1988.

After a rocky start to its joint venture, Diageo has become ever closer to LVMH, with Mr Walsh and Christophe Navarre, chief executive of Moët Hennessy, considered friends as well as business associates.

So it is no surprise that Diageo, which ended the year to June 2008 with cash and cash equivalents of £683m and relatively low gearing, is pushing for full ownership of the highly profitable group, which has margins of about 34 per cent. “We know they want the brands,” one person close to LVMH said on Wednesday.

Any deal would see Diageo inherit Moët Hennessy’s wine brands, such as New Zealand’s Cloudy Bay, Glenmorangie whisky and a range of champagne and cognac labels, although it would probably have to sell Glenmorangie for antitrust reasons.

Such a transaction would not signal a reinvention of Diageo as a luxury house that would abandon mainstream brands such as Smirnoff vodka and Gordon’s gin, according to people close to the company. But analysts say it behoves Diageo to take its portfolio upmarket. “The long-term growth in the industry is going to be in the higher end,” one beverages analyst said on Wednesday. “It would be a considerable quality upgrade for Diageo to get fully into this business.”

Although sales of premium spirits and champagne have been dropping in many markets as countries fall into recession, analysts say the long-term trend towards people buying more expensive drinks remains unchanged, particularly in Asia.

Matthew Webb, analyst at Cazenove, said: “Diageo would strengthen its position in the luxury end of the spirits business near the bottom of the economic cycle, thus leaving itself well placed to benefit from a return to trading up as the world economy recovers.”

Sales volumes for champagne have been growing more than 2 per cent annually for the past two decades, with sales in Japan rising by 18 per cent and sales in the UK by about 4 per cent, according to Bernstein Research.

Owning Moët Hennessy would allow Diageo to fell its competitors in one swoop and control the global champagne business. LVMH’s champagne division, Moët & Chandon, owns brands such as Dom Perignon, Veuve Clicquot and Krug as well as mass market names such as Mercier, and controls more than 20 per cent of the global market by sales value.

With Diageo a willing buyer, the sticky issue for the company is at what price LVMH would be a willing seller?

“Clearly, strategically, it’s a good thing but it’s a question of price,” said Trevor Stirling, beverages analyst at Bernstein Research.

Cazenove argues that Diageo would have to pay between £9.2bn and £13.2bn to buy out LVMH’s stake, given the group’s high profit margins. That would value Moët Hennessy at between £14bn and £20bn.

Analysts said Diageo would likely need a rights issue to pay for an acquisition, with one estimating it could split the funding 50-50 between equity and debt. Diageo is relatively under-leveraged compared with spirits industry peers, with net debt of £7.9bn and a net debt to earnings before interest, tax, depreciation and amortisation ratio of 2.5 times.

Last year, Moët Hennessy contributed some £161m to profit after interest and tax.