Diageo's withdrawal from talks with United Spirits (UB Group) to buy a stake in the business could be a negotiating tactic by the British company to persuade UB Group to lower its price for a stake in the business.
If it is not, the withdrawal could be very damaging to the company's long-term growth prospects.
Buying a stake in United Spirits is the best, in fact the only realistic, option for Diageo if it wants to make an impact in India.
Golden future for Indian spirits
The 1.4 billion litre Indian spirits market is expected to post a 9% CAGR (740 million litres) over 2008-2013, primarily driven by Indian whisk(e)y.
Other categories are also expected to perform well, with blended Scotch anticipated to nearly double over the same period to 10 million litres, while vodka is predicted to grow by 150% to 115 million litres and rum by 28% or 56 million litres.
Most of this growth will come from low-margin local products.
This growth is being driven by a continued rise in number of consumers of legal drinking age, expected to increase by 11% over 2008-2013 to 800 million people, and, more importantly, growing prosperity.
Over the forecast period the number of households with disposable income of US$15,000 and above will grow by a 6% CAGR to six million, and those with an income of over US$25,000 to three million.
This rise in prosperity will allow consumers to trade up to more premium, often Western, offerings.
United Spirits the best route to India's golden future
Growth of more premium Western products continues to be hindered by the country's poor infrastructure and a Byzantine taxation and regulatory system.
United Spirits, which commands 49% of the country's spirits volumes and is the only company with pan-national distribution and production, is ideally placed to negate the negative factors and benefit from the country's growth.
However, United Spirits' financial position is poor.
Despite paying down some of its debt through a recent share issue, the company still has very high levels of long-term debt, over six times its EBITDA in fiscal 2009.
Thus, the company still needs a cash injection to lower its debt level. Diageo could well be gambling on United Spirits' still weak financial position and the fact that the company has no other realistic suitor.
Diageo should learn from the past
Diageo has shown a short-term outlook in the past, notably when it pulled out of Indian whisk(e)y and the Indian market in 2002 by selling its operations to UB Group.
This was a result of a short-term decision to focus less on emerging markets and more on its core North American and Western European markets.
Before its 2002 sell-off, Diageo's presence in India was larger than that of Pernod Ricard. Pernod Ricard is now the (distant) second biggest player in India, thanks to continued investment in the country, and is well placed to exploit the country's growth.
If Diageo had sustained its investment in the country it too could have been in an equally strong, if not stronger, position than Pernod Ricard.
It also need not have spent large sums of money on rebuilding its position in India, such as with its so far unsuccessful Radico Khaitan joint venture or the large sums potentially needed to buy a stake in United Spirits.
Diageo should still be looking to invest in United Spirits, even if it feels that it is paying over the odds.
The cost may seem too much now, but in five or 10 years time it could be perceived as a good deal.
If it is not a negotiating tactic, then it will be a big mistake not to invest, and could give other major international companies, notably Bacardi, an ideal opportunity to capitalise on India's significant growth prospects.
For further insight please contact Jeremy Cunnington, Senior Alcoholic Drinks Analyst:
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27 Aug 2009