What is Diageo getting in United Spirits deal?

When Diageo announced the three-stage deal to take a 53.4% stake in India’s United Spirits, analysts gulped. Chief executive Paul Walsh has a track record of hard bargaining, so paying £1.29 billion to control even the company with the world’s biggest volume sales of spirits is heady.

Diageo CEO Paul Walsh

Walsh reckons that such is the dynamism of the Indian spirits market that it will grow by about 15% a year and that his United Spirits stake will boost Diageo’s earnings per share in year two and provide a return on the cost of capital by year six. But in comparison with the purchase of Turkey’s Mey Icki last year, the numbers are big.

Diageo is paying just over 20 times last year’s earnings before interest, tax, depreciation and amortisation (Ebitda) whereas it won Mey Icki for a multiple of 9.9 – and payback on the Turkish deal will be quicker.

What’s more, despite his protestations to the contrary, everyone knew that United’s chairman, Vijay Mallya, was effectively a forced seller because of the huge debts at his Kingfisher airline. He needed the cash. So why the £1.29 billion price tag?

Walsh argues that last year’s United Spirits’ earnings, on which the deal is based, were depressed by several factors, so the numbers look artificially high.

In, addition, there is a scarcity value to the deal; no-one else can get their hands on United Spirits, which will make India Diageo’s second largest market after the United States. The late Patrick Ricard deployed a similar argument when he was accused of overpaying for Absolut vodka in 2008, but already that is recognised as a transformational step in Pernod Ricard’s fortunes. Industry observers concede that controlling United Spirits offers Diageo at least the same potential.

So what is Diageo getting, assuming the relevant authorities approve the purchase?

United sells 122m cases of spirits a year, with 22 brands each selling more than a million cases. While it has flagship products such as Whyte and Mackay Scotch, much of the output from its 40-odd plants around the sub-continent is at the commodity level, where margins are comparatively low. It also exports to 37 countries. The United Spirits takeover will mean that 45% of Diageo’s sales will come from the developing world.

Most of United’s production is consumed by the burgeoning Indian middle class, which, Diageo says, will more than quadruple to 600 million people in just over a decade. By adding Diageo’s expertise in moving brands up market and widening margins (premiumisation), it expects to leverage its returns. That growth, Diageo predicts, will be led by whisky and vodka, which will more than triple their current sales value.

United holds 41% of the Indian market for spirits, its nearest rival, with about 10% being Pernod Ricard. That is a strong route to market, but while Diageo plans to use it in the long term to maximise throughput of its global premium brands such as Johnnie Walker and Smirnoff, the immediate task will be to move United Spirits’ own brands such as McDowell’s whiskey and Romanov vodka upmarket. For the time being, Diageo will retain its separate distribution network in India for its global brands.

Ironically, Diageo had the opportunity to grab what is now Pernod Ricard’s Indian arm back at the turn of the century when the two groups dismembered Seagram. Diageo opted for Seagram’s South Korean business, which then seemed much more attractive but which has proved troublesome for several years, leaving the Indian arm to its French rival. Such have been the growth dynamics in India that with hindsight the French undoubtedly got the better of the deal and Diageo is now playing catch up in a big way.

Talks reportedly began between Diageo and the flamboyant Mallya back in 2008 but the Indian tycoon’s inflated estimate of his business’s value and a determination to sell only a minority stake meant they came to nothing. Crucially, although he remains chairman of United Spirits under the terms of takeover, Diageo will control the company, its finances and its direction.

Investors feared that future development of the business might be erratic if Mallya retained any executive control over United Spirits. Satisfyingly for Walsh, Diageo’s shares put on 5% on the day the takeover was announced, making the company worth £45.2bn and by far the most valuable premium drinks company in the world.

Last year alone Diageo had free cash flow of £1.6bn and is funding the takeover of United Spirits from cash and its existing lending lines, so there should be no problem about it retaining its investment grade status as a borrower, a crucial factor in the US markets. The effective takeover of United Spirits will be completed in three stages by next spring, assuming it meets no regulatory hurdles from the Indian authorities.

Doubts linger as to whether Brussels will be keen on Diageo adding Whyte and Mackay to its already formidable portfolio of Scotch brands. Walsh says the deal will not unravel if he has to sell off the brand, but undoubtedly he would prefer to keep it – and the accompanying inventory of maturing spirit. Industry sources suggest that his biggest rival, Pernod Ricard, would be an eager buyer of Whyte and Mackay if a sale is forced. Both groups are investing heavily in new Scotch production facilities to meet demand from emerging nations.

In the past two or so years Walsh has made seven bolt-on acquisitions and seen Diageo’s value rise steadily in the process. But he is not stopping there. Diageo says it is in the market for further acquisitions as appropriate, and believes it will have no difficulty funding them, such is its record of success over the past 13 years since Walsh took over the helm and reshaped it into a global alcohol business.

The most significant hurdle for him to overcome is the ownership of José Cuervo, the world’s leading Tequila brand, which Diageo distributes. Walsh has told the owning Beckmann family that when the arrangement between them runs out next summer, he either wants a large equity stake in the brand (preferably full ownership, which would cost about £2bn) or he will walk away from it.

He is not prepared to enter a new distribution agreement. That, he says, would be insufficiently rewarding to Diageo’s shareholders – essentially he thinks the Beckmanns are riding on the coat-tails of Diageo’s success with its global brands without paying a proper price. Time is getting short for a deal, but Walsh’s offer is on the table.

Meanwhile, Diageo has also agreed to form a 50:50 operation with Mallya in South Africa to develop sorghum beer; if that flourishes, they may co-operate elsewhere in the beer market.

But there is one area in which they are on a collision course. Mallya’s United Breweries, India’s biggest beer group, sponsors the Force India F1 Grand Prix team for its Kingfisher brand; the cars also carry a large Whyte and Mackay logo. Walsh and Diageo are major backers of Mercedes MacLaren, whose cars are emblazoned with Johnnie Walker marketing.