Diageo: Sometimes, You Just NEED Tequila

Sometimes, you just need tequila.  It’s not really a matter of wanting it.

Perhaps it’s due to an inner self loathing, or perhaps it has something to do with the naughty fun involved with grabbing a slice of lime off the navel of a perfect stranger at a bar with your teeth.  Whatever your reason might be, when you need tequila, you need tequila.

Right now, Diageo (NYSE: $DEO), needs tequila.

badgesThe world’s largest seller of premium spirits pulled out of negotiations to buy Jose Cuervo, the world’s top-selling tequila brand.  Diageo currently has a distribution deal in place with Cuervo, but it is scheduled to expire in June of 2013.

So, shortly after the next Cinco de Mayo, Diageo is going to find itself without a major tequila brand.  For a global conglomerate looking to maintain and expand its presence in promising emerging markets like Mexico, that is distinctly no bueno.

Diageo’s shares reacted badly to the news, but it is Berkman family, the owners of the Cuervo brand, that are likely to be the real perdedores here.  Cuervo sells a single product—tequila—that is only popular in Mexico and in the United States.  And within the United States, its popularity is limited mostly to margarita cocktails in Tex-Mex restaurants and to college frat parties.

Demographics are also moving against the fermented cactus juice.  The Baby Boomers and my own Generation X moved beyond the tequila-drinking stage of their lives years ago, and today’s young drunken louts tend to prefer vodka-based drinks.

What’s more, for a mega-distiller of Diageo’s size, Cuervo  was barely a drop in the bucket, accounting for barely 3% of company sales.  The bulk of Diageo’s business is scotch whisky and vodka.

This is a long way of saying that Cuervo needs Diageo more than Diageo needs Cuervo.

Still, Diageo’s product portfolio is incomplete without a major tequila brand.  This has led to speculation that Diageo might make a move on Beam, Inc. (NYSE: $BEAM), the maker of its namesake Jim Beam Straight Kentucky Bourbon and of the world’s number two tequila by sales, Sauza.

I wrote about a possible Diageo-Beam merger last month (see Whiskey Stocks to Burn the Throat) and noted that the possibility of being acquired by Diageo was one of the reasons that Beam and rival Brown-Foreman Co (NYSE: $BF-B) traded at a premium earnings multiple.

But Beam would be a hard acquisition for Diageo to digest.  We’re talking about a stock with a $10 billion market cap (the Jose Cuervo deal that fell through was reportedly worth only $3 billion).  Even for a $74 billion company like Diageo, that’s a lot of pesos for tequila market share.  (If Diageo did decide to make a bid for Beam, tequila wouldn’t be the primary motivation.  Beam’s bourbon brands are far more valuable.)

Diageo isn’t left completely  high and dry in the tequila war.  It still owns the Don Julio brand, which competes with Patron at the premium level where margins are higher.

But with Cuervo slipping away and a Beam merger unlikely at this time, Diageo may simply have to be content with wearing a smaller sombrero for now.

Disclaimer: Sizemore Capital is long DEO and BEAM. This article first appeared on InvestorPlace.

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