Why Diageo Is Pushing for a Change to Tennessee Whiskey Laws, and How Jack Daniel’s Is Fighting Back

There's a battle brewing between Brown-Forman (NYSE: BF-A  ) (NYSE: BF-B  ) and Diageo (NYSE: DEO  )  -- and the dominance of Brown-Forman's definitive Tennessee whiskey, Jack Daniel's, could hinge on who wins.

On March 14, Brown-Forman put out a release accusing the world's largest spirits maker of undermining the official Tennessee whiskey designation. In the estimation of Jack Daniel's Master Distiller Jeff Arnett, this would "create an inferior product and give the upper hand to the Kentucky bourbon industry." Currently, Jack Daniel's (11 million) sells over four million more cases of its Tennessee whiskey than the leading bourbon brand, Jim Beam.

Redefining Tennessee whiskey
However, if the new law passes, it could water down the definition of Tennessee whiskey by allowing distillers to age the whiskey in reused oak barrels and store it somewhere other than Tennessee. This is something the federal law governing bourbon doesn't permit. In Brown-Forman's opinion, the inferior product will cause a "guilt-by-association" impact on Brown-Forman's flagship product, which is currently the best-selling U.S. whiskey across the globe.

Jack Daniel's has fought its own battle -- to be distinct, yet still identified with the quality of bourbon's tradition -- for years. The federal law governing bourbon standards has been on the books since 1964, while the Tennessee whiskey law came into being just last year. 

What's in it for Diageo?
If Diageo is behind the drive for new legislation, it could stand to benefit because it has its own Tennessee whisky, George Dickel, that it reportedly wants to store in its Stitzel-Weller Distillery in Kentucky. However, according to Brown-Forman spokesman Phil Lynch, Diageo's real motive is the threat Jack Daniel's poses to Diageo's leading Scotch whisky, Johnnie Walker. 

Until 2012, Johnnie Walker was the best-selling whisky in the world. It was ahead of every American, Scotch, Indian, Canadian, or any other type of whiskey. However, after over a decade of being on top, it lost its supremacy to an Indian whisky, United Spirit's McDowell No.1.

Even so, Diageo still moved 18.9 million total cases of Johnnie Walker (a 5% increase over 2011 figures) in 2012 compared to Jack Daniel's 10.7 million (a 1% increase over 2011 numbers) globally. In 2013, Lynch says it was a different story. Jack Daniel's grew 5%, while Johnnie Walker stayed flat.

Competing with Jack Daniel's
Diageo is not the only one pushing for the new law. Other distillers also feel that the current law -- supported by Brown-Forman -- favors Jack Daniel's over other distillers of Tennessee hooch, as its requirements (51% corn sour mash, charring in new oak barrels, mellowing with charcoal, and storing in Tennessee) mirrors the Jack Daniel's recipe. This leaves smaller competitors unable to differentiate their product and still retain the Tennessee whiskey moniker.

Barreling ahead
Another driver of the legislation is a shortage of oak barrels. Due to a rainy 2013, the timber harvest was light and the quality of the oak less than stellar. Industry insider Fred Minnick reports that one well-known distillery, Four Roses, recently had to cut back on its production as a result of the barrel shortage. Some other smaller distilleries are even having a hard time getting barrels made.

This could become a much larger issue as demand for bourbon and Tennessee whiskey continues to expand across the globe. Some distillers are already expanding distilling capacity and contemplating watering down proofs on their existing stocks due to the explosive growth of bourbon.

A Fool's take
Brown-Forman and Diageo are both solid companies, with Brown-Forman just raising earnings expectations after a tremendous quarter. However, Diageo is the world's top distiller with a broader product offering and could likely weather losing some of its Johnnie Walker market share better than Brown-Forman could continue its impressive growth with a drop in Jack Daniel's sales.

If the changes to Tennessee law do occur and Brown-Forman's fears of Tennessee whiskey being preceived as an inferior product to bourbon become reality, Brown-Forman faces a significant challenge. It's Jack Daniel's Tennessee Whiskey is its durable competitive advantage, a large percentage of its net sales, and the key to its future expansion.

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