Mixed drinks on an empty stomach

Diageo is off its food but will its new liquid diet work?

Don't drink on an empty stomach. The advice has long been a touchstone for all but the least experienced toper - but last week Diageo decided to ignore it.

Don't drink on an empty stomach. The advice has long been a touchstone for all but the least experienced toper - but last week Diageo decided to ignore it.

The drinks conglomerate, formed by the 1997 merger of Grand Metropolitan and Guinness which united the Irish stout with such spirits brands as Smirnoff vodka and Bailey's Irish Cream, announced that it was getting out of solids.

The $10.5bn (£6.9bn) sale of its Pillsbury food business to America's General Mills will take at least a year and a half to complete - but eventually will leave Diageo as the world's largest dedicated drinks company.

It remains to be seen if investors will have the stomach for the purer tipple.

In the three years since the £23bn merger, investors have waited patiently for John McGrath, Diageo's chief executive, who retires later this year, to come up with a buyer for Pillsbury, a laggard weighing on Diageo's share price like a stodgy lunch.

Their appetite was whetted last month when Diageo came up with the hors d'oeuvre: Burger King, the fast food chain that sat with equal discomfort in its portfolio, would be floated off. This deal was essentially forced on Diageo by a combination of unhappy investors and vociferous franchisees.

The franchisees have not given up the fight, saying late last week that they may combine to make an offer for the ailing burger flipper.

Diageo investors may have preferred an irrevocable split with Pillsbury but the complicated terms of last week's deal - which leaves Diageo with a 33 per cent stake in the enlarged General Mills - were said by Diageo chief executive-elect, Paul Walsh, to be the best on offer. As he has run Pillsbury for the last couple of years, he should know what he is talking about.

"It was unavoidable to have a stake in the food business," says one analyst. "The only alternative was to sell for cash, but who's got $10.5bn to spare? They'll get out eventually."

"A clean exit wasn't feasible because no one would pay a premium for such a rag-bag of brands," added another.

But if analysts were supportive, investors were not. Many pointed out that there were at least three frustrated bidders for Nabisco - Danone, Nestlé and Cadbury Schweppes - which may have come up with the requisite cash.

Diageo's shares fell in anticipation of the deal, and its confirmation has failed to buck the move. This was largely a reaction to Diageo's other announcement: that it intended finally to merge its spirits business, UDV, with its Guinness beer interests.

The muted City reaction suggests that, even now, the jury remains unconvinced on the deal which originally gave rise to this cor- porate chaser.

Alan Gray, drinks analyst at Charterhouse Securities, says: "I'm sceptical about any merger. Many of them don't add very much value apart from cutting costs and boosting profits in the short term.

In this case, that's where we are. They said it would take three years before cost savings were realised but so far the savings are only in line with or below expectations, and the deal has yet to deliver higher volumes."

The performance of Diageo's share price in the intervening years bears out Mr Gray's view. After post-merger euphoria drove the shares within an ace of £8, they had fallen below £4 earlier this year, before a resurgence of interest in such old economy stocks saw a revisiting of £6.

To a degree, Diageo's misfortune has been brought about by trends beyond its control, not just the market's preference for technology stocks - but also a general decline in the popularity of spirits.

In the last 10 years, as Britain has become a nation of wine drinkers, consumption of beer and spirits has fallen by 16 per cent and 21 per cent respectively. Worldwide, sales of whisky in particular and spirits in general are still recovering from the economic turmoil in Asia and Latin America. The industry may have prospered in Britain and the United States, but that has not been enough.

But the experience of Allied Domecq, the UK's other big spirits group whose share price has been just as volatile, but rather more buoyant, suggests there is more to Diageo's difficulties.

One shareholder says: "With this sort of activity, it's difficult to pin down the underlying performance of the business. I'm suspicious that they keep moving and I'm a bit cynical about the amount of value that will be created."

Nobody is disputing that the merger will save money, not only from the wage bill but also by facilitating the closure of head offices in countries where both businesses have operations.

Improving the productivity of its bottling plants and sharing the cost of consumer research are two other economies that spring to mind.

But that is less than half the story. By exposing UDV and Guinness to each other, Diageo hopes the assets of one side will benefit the other.

UDV, for a start, has an extensive distribution network spanning far more countries than Guinness, which may be a global brand but sells in large quantities only in the UK and Ireland.

The high-profile launch of bottled Guinness is no coincidence. Selling the black stuff from the barrel is an exact science and a bottled variety will make life easier for potential vendors wherever they may be. It will also be more convenient for Diageo to distribute Guinness through the same channels as its bottled spirits.

What Guinness brings to the party is the marketing expertise which, according to a recent survey by Interbrand, makes it one of the world's most recognised brands.

Unfortunately, the same survey suggested that alcoholic brands owned by the same company do not necessarily sit well together. The market remains to be convinced that having a whisky brand, for example, makes it easier to sell gin.

"The market isn't that enthusiastic about putting the beer and spirits sides together," says Mr Gray. "They see the businesses as being very different. Beer is low margin and high volume, and spirits the opposite. Essentially, they are quite different markets."

Diageo begs to differ. A clue to its integrated strategy was the launch of Smirnoff Ice, a bottled vodka mixer with a "sessionability" designed to appeal to beer drinkers out for the duration.

"The market is changing," says a Diageo source. "We have stopped looking at it like a product and more in terms of what the consumer wants. More and more, the decision of what to drink is driven by a 'need state'. Are people drinking to quench thirst, for relaxation, or to enhance a meal?"

The desire to attract beer drinkers is part of an attempt to extend the boundaries of spirits consumption beyond their traditional limits. That strategy, Mr Walsh hopes, will tap a market said to be worth an additional £5bn.

Simultaneously, Diageo's thirsty eyes will be focused on the prospect of picking up brands such as Martell cognac from Seagram, the Canadian spirits combine which has been put up for sale following the merger of its parent with media giant Vivendi.

However, that deal could summon the return of the spectre which has haunted Diageo so often before: Bernard Arnault. It was the chairman of the French luxury products group LVMH, then a director of and major shareholder in Guinness, who proved such an obstacle to the tie-up with GrandMet.

Three years on, he is still lurking. The two companies have a lucrative distribution deal which could be jeopardised if Diageo decides to go head-to-head with LVMH's Hennessy label by acquiring Martell. Mr Arnault may even decide to sell LVMH's residual 3 per cent stake in Diageo.

Given the perils of owning a multiplicity of alcoholic brands, Mr Walsh will have to hope that another drinking aphorism applies only to boozers and not the companies which supply them - never mix your drinks.