Luxury at a premium for Diageo

INSIDE the Parisian headquarters of LVMH's luxury goods empire, executives can often hear their immaculately dressed, softly spoken chief executive playing classical music on the grand piano that sits outside his office.

It is not known if France's richest man sat down to play on Tuesday evening when news broke that Paul Walsh, the beer drinking chief executive of Diageo, was hatching a 10.6bn bid to break up his empire. If he did, presumably he didn't choose anything too soothing.

For 25 years Bernard Arnault has been busy accumulating some of the most sought-after brands in the world, such as Hennessy cognac, Glenmorangie whisky, Krug champagne and Louis Vuitton, earning himself a reputation as one of the most ruthless and competitive business tycoons in his sector. Collectors seldom relish selling what they have bought, but for the 60-year-old chairman and controlling shareholder of LVMH, a break-up of the company's cocktail of fashion and premium drink brands appears to make economic sense.

For Walsh, who spent last week attending a series of strategy meetings with his board at Gleneagles hotel, a deal would give him access to a highly profitable and high-quality business as well as placing some of the world's oldest champagne labels, including Mot & Chandon, Krug and Dom Prignon, under British ownership. Not only would it revitalise Diageo's drinks portfolio it would also provide a route into the attractive cognac sector. Walsh often talks about premiumisation and it is widely understood that the long-term growth in the industry is going to be at the higher end.

"Diageo would strengthen its position in the luxury end of the spirits business near the bottom of the economic cycle, thus leaving itself well placed to benefit from a return to trading up as the world economy recovers," said drinks analyst Matthew Webb at Cazenove. Or as one source close to LVMH said: "We know they want the brands."

But this week, as Walsh plots his acquisition strategy he knows a deal with LVMH is only part of a much wider jigsaw. Since Diageo was created from the merger of Guinness and Grand Metropolitan in 1998, Walsh has built up an enviable array of brands such as Johnnie Walker, Smirnoff vodka and J&B whisky. But with European rivals Pernod Ricard snapping at his heels following a series of big acquisitions, he could do with more.

It is no secret that he would love to do a merger with a beer company such as SAB Miller to create a global beer behemoth. Walsh is already in talks with Indian tycoon Vijay Mallya with a view to buying a stake in India's largest drinks group and there have also been rumours that Walsh may put together a friendly deal with Brown-Forman, the maker of Jack Daniel's and Southern Comfort. For many analysts LVMH is a smokescreen and the more important question is: where does Diageo grow from here?

"Diageo has three big gaps in its portfolio," says Gerard Rijk, an analyst with ING. "The first one is cognac and champagne, or the remaining stake of Mot which they don't control. The second is a big bourbon brand, like Jack Daniel's or Jim Beam. And three is Jose Cuervo, the tequila brand, which they distribute."

Another City drinks analyst said: "Since Diageo was formed they have wanted to be big in what they called 'total beverage alcohol' through a merger with a beer company. Since then beer has moved a long way down the path of consolidation so there are companies now that are the same size as Diageo, including SAB Miller, Heineken and InBev. What Diageo is waiting for at the moment is for a beer company to come forward and say we want that as well."

Walsh and Arnault go back a long way. When Guinness and GrandMet were merging in 1997 Arnault's LVMH had a 14.2% stake in Guinness and as its biggest shareholder had a major say in the merger.

Then, Arnault proposed merging the wines and spirits businesses of Guinness, GrandMet and Mot Hennessy and pouring away Guinness brewing, Pillsbury and Burger King, giving him a 35% stake and effective control of the resultant group.

Arnault's assault was fought off, but Diageo went on to follow most of his advice, selling Pillsbury and Burger King, though it kept beer. Arnault sold his resultant stake in Diageo but the Mot Hennessy joint venture survived.

Today Diageo has a 34% stake in Mot Hennessy and the two companies are believed to enjoy a good relationship. Walsh counts Mot Hennessy's chief executive Christophe Navarre as a friend as well as business associate. LMVH was formed out of the merger of champagne producer Mot & Chandon and cognac producer Mot Hennessy, which then merged with Louis-Vuitton in 1987 to form today's luxury super-conglomerate.

But both the fashion and drinks sectors have been hit by the global downturn. The question troubling Arnault is which is the best way forward for his group. Does he keep his portfolio of high fashion, accessories and perfume brands such as Louis Vuitton, Fendi, Marc Jacobs and others under the same umbrella as its prestigious wine and spirits brands, or should he concentrate entirely on the fashion side?

Selling Mot Hennessy would raise a substantial amount of cash, up to 10bn, which he could reinvest in expanding his fashion portfolio. It would also provide a useful war chest to launch an assault on some of the world's flagship fashion brands. He is known to want Herms and could be attracted by Armani or Chanel. Sources say drinks were never part of Arnault's vision; he inherited them and, as he has said, fashion is his passion, not viticulture.

Arnault has also not been immune to the global downturn. He lost 6bn last year as LVMH shares dropped 29%, falling from being the world's 13th biggest billionaire to the 17th in the latest Forbes rich list with his worth estimated at 11bn.

So far Arnault has been quick to dismiss rumours of a sale. According to sources close to the situation Diageo, advised by Goldman Sachs, has offered LVMH 8.9bn, but the French luxury goods group, advised by Lazard, wants 10.6bn. Arnault quickly responded with a statement denying it was "in discussions to divest Mot Hennessy". But bankers and analysts have said the wording of the denial has left the way open for a deal.

Alan Gray, an analyst at Sutherland's Edinburgh and the author of the annual Scotch Whisky Industry Review, says: "I thought for a long time that this was a distinct possibility partly because of the long-standing connection between the two companies. Arnault had built up a stake in what was then Guinness and Grand Met and when they became Diageo he ended up having a stake in both. Strategically, I always thought that would be a springboard for a bid."

Any deal comes on the back of an increase in merger activity in the drinks sector. Pernod Ricard recently sold Wild Turkey to Campari and Brown-Forman, the maker of Jack Daniel's, is understood to be holding merger talks with Bacardi.

It is understood that Walsh has already sounded out bankers at Goldman Sachs and Credit Suisse with a view to drawing up a 5bn rights issue should the acqusition go ahead. One issue to be resolved would be Glenmorangie, the whisky firm that LVMH acquired for 300m in 2004. Analysts say Diageo would be forced to sell it for antitrust reasons.

Back in Paris, Arnault's business mantra is simple: "Be in the right place at the right time." For Walsh the timing could be perfect.