Don't Discount Diageo plc Just Yet

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With all the attention Diageo (NYSE: DEO  ) is paying to the high rollers who like to sip on some super premium and ultra premium spirits, it seems the distiller has neglected the little guy, who can't afford $100 for a bottle of Ciroc or DeLeon, and allowed him to wander away from its standard premium vodka Smirnoff.

The global drinks giant reported that sales were up 2%, driven higher by a near-5% increase in North American revenues and a Western Europe that was recovering. It was offset, however, by the weakness it experienced in emerging markets like China, Thailand, and Nigeria. As CEO Ivan Menezes told CNBC: "Western Europe is turning the corner. The emerging markets are all mixed up."

Still, there's good reason Diageo focused on premium spirits. It comprises 60% of its business and has proved to be both profitable and high-margin, with super premium and above products in particular driving growth. Yet there was a void that opened up last year following the expiration of its contract with Casa Cuervo that needed filling, one that it did in spades with its recent partnership with rap impresario Sean Combs for DeLeon tequila and its even more recent acquisition of Peligroso

The segment expanded at a 10% rate in 2013, far outpacing the 3% growth experienced by the overall spirits market and, as I've noted previously, it's being driven by drinkers who are seeking out better taste, quality, and craftsmanship. 

Still, the distiller's results are worrisome for the rest of the industry as they report their own results. After all, Diageo has a scale unavailable to most of its peers, and U.S. markets are supposed to serve as a shield from broad global vagaries. But the Chinese government's crackdown on extravagance apparently is having a big impact nonetheless. Distillers of baiju, a vodka-like spirit distilled from grains, engaged in heavy discounting in the period, causing sales at Shuijingfang, the baiju maker in which Diageo has a controlling stake, to plunge 66%. Overall, Diageo's sales fell 22% in China.

Beam (NYSE: BEAM  ) , which is in the process of being acquired by Suntory for $16 billion, has sought to strengthen its distribution in several key emerging markets, including Brazil, China, and India. Brown-Forman (NYSE: BF-B  ) was only just recently citing the 7% increase emerging markets contributed to its results while analysts had anticipated the Asia-Pacific region would provide distillers with a key growth opportunity.

Smirnoff is the world's top premium spirit brand by volume, but Beam has been making inroads on its turf for sometime now with the launch of its flavored Pinnacle vodkas. It was the reason Diageo responded with its own Smirnoff varieties as well as the Sorbet line it launched last year. The super premium Circoc vodka brand (the other Combs partnership Diageo has), came out with a new amaretto-flavored iteration that was well received in Great Britain, and catapulted it to the sixth biggest brand in the 13 weeks of distribution.

But its rivals were out discounting their vodkas to take share from the spirits maker, and while it worked in some measure, Diageo maintains holding the line on pricing was the right move to make. Even if it's shares face weakness today, I continue to believe it will be more than just the flavor of the month.

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Rich Duprey

Rich has been a Fool since 1998 and writing for the site since 2004. After 20 years of patrolling the mean streets of suburbia, he hung up his badge and gun to take up a pen full time.

Having made the streets safe for Truth, Justice and Krispy Kreme donuts, he now patrols the markets looking for companies he can lock up as long-term holdings in a portfolio. So follow me on Facebook and Twitter for the most important industry news in retail and consumer products and other great stories.


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