Source: Bloomberg


Echo Hopkins’ love of tequila began with a happy hour margarita at the Blue Moon Mexican Café in Bronxville, New York. Four years later, her tastes have matured, and she now eschews cheap margaritas in favor of tequilas costing $10-plus a shot meant to be sipped and savored.
“As you move on from college you begin to realize you can enjoy tequila slowly,” said the 25-year-old art researcher.

Hopkins is the kind of consumer that spirits giant Diageo Plc (DGE) is counting on as it revamps its tequila business. With U.S. consumption of the fiery Mexican tipple climbing and more drinkers shifting upmarket, the London-based distiller last month said it would terminate a distribution deal with Jose Cuervo after 16 years.
As Diageo prepares to release results tomorrow, analysts say abandoning the deal with Cuervo, the world’s top-selling tequila, was a smart move — even if it meant losing $470 million in annual sales.
“It probably makes sense that Diageo walked away,” said Trevor Stirling, an analyst at Sanford C. Bernstein. “Diageo perceives that all the growth in tequila has been in premium brands. Cuervo isn’t premium.”
Larry Schwartz, Diageo’s North America president, in December said any replacement for Cuervo would have to be premium. Without naming any brands, Schwartz said the company was mulling whether to develop a high-end tequila, acquire a small brand pricier than Cuervo, or find a partner.
Diageo, which posted $16.8 billion in sales last year of brands ranging from Smirnoff vodka to Guinness beer, had been in talks to buy the Cuervo brand, which analysts say would have fetched some $3 billion. In December, Diageo said those negotiations had failed, and that by June Diageo would no longer distribute Cuervo. Diageo stock has since declined 1.2 percent.

Tequila, distilled from the roasted hearts, or pinas, of the spiky blue agave plant in Mexico, is gaining in popularity, especially in the U.S., its biggest market. American consumption rose at an average annual rate of 4.1 percent from 2006 to 2011, according to researcher International Wine & Spirit Research, almost double the growth of the total U.S. liquor market.
More important for Diageo, pricier varieties are expanding the fastest. The market for tequilas that sell for more than $20 a bottle has increased more than 10 percent over the last five years, IWSR reports, attracting global distilling companies.
In 2007, Davide Campari-Milano SpA (CPR) bought 80 percent of Cabo Wabo, a premium tequila, and it acquired San Nicolas, another upscale brand, the following year. In 2011, Pernod Ricard SA (RI) signed a joint venture with upmarket Tequila Avion.

Tequilas priced under $20, which make up over half of the U.S. market by volume and the bulk of Cuervo’s sales, have slid 1.1 percent over the past 5 years. Cuervo’s market share in the U.S. has fallen to 34 percent from 45 percent over the same period, Liberum Research estimates. The majority of tequila drunk is in cocktails like margaritas, according to Kevin Vanegas, Master of Tequila at Wirtz Beverage Nevada, a Las Vegas liquor distributor.
After Diageo announced it would no longer sell Cuervo, speculation mounted that it was eyeing Beam Inc. (BEAM), which makes Sauza, the third-biggest tequila brand in the U.S. The buyout speculation has sent Beam’s shares up 5 percent since then.
Sauza, which retails for about the same price as Cuervo, would do little to help Diageo meet its target of 6 percent annual sales growth, according to Liberum analyst Pablo Zuanic.
“There’s no point for Diageo to spend money and effort trying to get the non-premium market,” Zuanic said. “Their focus should be on premium tequila.”

Diageo may report a first-half sales increase of 5.6 percent tomorrow, excluding acquisitions and the impact of currency fluctuations, according to the median estimate of 11 analysts surveyed by Bloomberg. That would represent a slowdown from the 7 percent gain in the same period last year. Diageo has forecast a one percentage-point widening of its operating margin in North America to 39.1 percent this year, aided by pricier new products.
The high end of the tequila market is dominated by Patron, part-owned by Bacardi Ltd. Patron sold 1.66 million cases in the U.S. in 2011, double that of its next competitor, Grupo Cuervo’s 1800 brand, IWSR estimates. Potential targets abound: there are over 150 tequila distilleries in Mexico producing more than 1,500 brands, according to Vanegas.
All tequila is made from agave, but Jose Cuervo and Sauza are “mixtos,” containing as much as 49 percent alcohol made from non-agave sugars.

Like Cognac, Bourbon, or single malt scotch, tequilas vary by how long they’re aged. So-called anejo varieties sold by most brands at a premium, must spend at least a year in wooden barrels. High-end tequila should be sipped “like a fine whiskey,” said Vanegas — not downed in shot glasses alongside a lime wedge and a lick of salt, as is often the case in U.S. bars.
Diageo does own half of an upmarket tequila called Don Julio, alongside the Beckmann family, Cuervo’s owners. The brand saw sales growth of 26 percent last year versus a 5 percent decline for Jose Cuervo.
Diageo might lean on other spirits to get by without Cuervo. Over the past two years it has bought brands such as Brazil’s Ypioca cachaca and Turkey’s Yeni Raki to complement its dominant position in whisky and vodka. It was the first big European distiller to invest in a Chinese maker of its popular national spirit, baijiu.

With tequila drinkers, Diageo’s challenge is to get Americans to pay up for pricier brands like Don Julio now that it no longer distributes Cuervo. That may take some doing, according to enthusiasts such as Hopkins.
“There’s still a stigma attached to the frat boy culture of taking shots of tequila,” she said. “I’ve been out with people and ordered amazing aged tequila meant for sipping, and had them down it in one go.”


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