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Diageo Ends Cuervo Talks, Will Terminate Distribution Deal

Diageo Plc (DGE), the world’s largest distiller, abandoned talks to acquire Cuervo tequila and will seek to end its 26-year-old agreement to distribute the brand, fueling speculation that it may try to find a substitute.

Discussions with Cuervo owners JB y Compania SA de C.V. and Lanceros S.A. de C.V. failed to bring an agreement that would have created value for Diageo shareholders, Paul Walsh, chief executive officer of the London-based distiller, said in a statement today. Diageo’s accord to distribute the tequila outside of Mexico is due to expire at the end of June.

Diageo may now set its sights on Beam Inc. (BEAM), which owns the tequila brand Sauza, said Anthony Bucalo, an analyst at Groupo Santander. The U.K. company has held talks with Suntory Holdings Ltd. about a potential joint offer for the U.S. distiller, an official at the Japanese company said yesterday, though they aren’t currently in negotiations.

“Our expectation was that cooler heads would prevail,” Bucalo said in a report, referring to the failure of Diageo to reach an agreement with Cuervo’s owners. “The operational bright side is that this failure to come to terms with Cuervo clears the regulatory path in an advantageous way for Diageo on the issue of tequila.” Sauza is the No. 2 brand behind Cuervo.

Diageo fell as much as 1.8 percent in London trading and was down 1.5 percent at 1,857.5 pence at 2:29 p.m. The decline trimmed the shares’ gain this year to 32 percent.

The stock “may be weak on the loss of the Cuervo agreement and concern about a possible high-multiple Beam deal,” according to Bucalo, who recommends buying Diageo.

‘First Setback’

Diageo will look at small brands to acquire in the premium spirits category, Larry Schwartz, head of the company’s U.S. unit, said on a conference call today.

“Acquisitions, partnerships we might pursue,” Schwartz said. “Innovation will be big.”

The loss of the Cuervo distribution agreement would trim expectations for Diageo’s earnings per share from 2014 onwards by between 2 percent and 3 percent, James Edwardes Jones, an analyst at RBC Europe Ltd., said in a note.

“This is the first setback for Diageo we can recall in a good 18 months,” he said. “We do not believe the absence of a tequila brand materially alters the Diageo investment case.” The end of talks frees up some previously earmarked borrowing capacity for other possible acquisitions, he said.

Cuervo Option

Diageo has distributed Cuervo outside Mexico since the U.K. company was created by the 1997 merger of Guinness and Grand Metropolitan, which gained the agreement through an acquisition in 1986.

The agreement gave Diageo an option to buy the company. It had hired Goldman Sachs Group Inc. and HSBC Holdings Plc for advice in exploring gaining control from Cuervo’s family owners, the Beckmanns, people with knowledge of the matter have said. The brand was expected to be valued at more than $3 billion.

Cuervo will probably announce a new distribution partner, potentially Bacardi or Pernod-Ricard SA, according to Laetitia Delaye, an analyst at Kepler Capital Markets in Paris. Pernod spokeswoman Stephanie Schroeder declined to comment.

Diageo is seeking growth in markets outside Europe as part of its plan to get half of its net sales from developing markets by 2015. The maker of Johnnie Walker last month bought a stake in India’s United Spirits Ltd. (UNSP) to gain leadership in the world’s largest whiskey-consuming nation.

Falling Sales

Cuervo generated 300 million pounds ($482 million) of net sales last fiscal year, a decline of 3 percent, according to Diageo. Its largest markets are the U.S., Canada, Spain, Greece and the U.K.

Diageo said today that it will continue to perform strongly in North America and sees “no material impact” on first-half results as a result of Hurricane Sandy.

“Overall consumer confidence remains positive” and retailers are optimistic about the holidays, Schwartz said.

Operating profit as a percentage of sales can improve by 1 percentage point in North America in 2013, he said on the call.