London-based Diageo (DEO), by far the largest spirits marketer in the world since its acquisition of most of Seagram's brands in late 2001, has been upending the way business is done in the U.S. in an effort to jump-start a slow-growth sector. Some of its innovations, like Smirnoff Ice, a "malternative" beverage that's brewed like a beer but positioned like a sophisticated cocktail, have proved to be big successes, despite some sales slippage in recent months. Diageo's attempt to air liquor ads on TV, after the industry's voluntary ban spanning several decades, so far hasn't provoked a consumer backlash, although it still hasn't been able to coax a major networks into running its commercials.
Other initiatives, like winnowing a patchwork of distributors to a single one for each state, are well advanced but not yet proven. And Diageo has suffered some significant setbacks, including the failure of Captain Morgan Gold, a malternative based on Captain Morgan Rum. Also, a decentralization of marketing activities was reversed when it resulted in regional managers going their own way with ads and promotions.
Lately Diageo's aggressiveness seems to have awakened opposition by the powerful U.S. beer lobby. Most recently, that was reflected in a ruling by government regulators that will require malternatives like Smirnoff Ice to be reformulated. BusinessWeek sat down with the two executives who have been most instrumental in developing the North American strategy, Diageo CEO Paul Walsh and North American President Paul Clinton, to discuss the thinking behind these daring moves. Following are edited excerpts:
Q: You've invested a lot in ready-to-drink products like Smirnoff Ice and brooked a fair amount of controversy, since those products carry a spirit name yet receive the preferential treatment of beer with regard to retail availability, excise taxes, and access to TV advertising. Why is that segment so important to you?
Walsh: Ready-to-drink is our biggest driver of innovation, and it has given our spirits brands access to new consumers and new drinking occasions. Diageo now has 31 ready-to-drink products in 39 markets. Future growth will come from both the continued rollout of Smirnoff Ice into new markets -- it's already a billion-dollar brand -- and from renovations and new product launches in existing markets. [That's not to mention] that marketing behind ready-to-drink products continues to create a halo effect for the parent brand.
Q: One sign of this category's huge influence seems to be the beer producers' reaction. While they're also marketing malternatives, they recently got the U.S. Treasury Dept. [which regulates alcohol products] to change the rules for how these are formulated. The brewers claim consumers are being misled because in this country Smirnoff Ice, despite carrying the Smirnoff name, doesn't actually contain vodka.
Walsh: That's purely self-serving rhetoric in order for the beer companies to protect their own franchise. The reality is the consumer doesn't care. When we have tested their attitudes, alcohol is alcohol. Another reason why the beer players don't like the notion of alcohol being alcohol is that they have a very advantageous tax regime. So once you get your mind around alcohol being alcohol, then you go down the equivalency route that they find terrifying.
Q: You've brought up that taboo term to the American beer industry: Equivalency, or equalization, the notion that alcohol in whatever form -- beer, wine, or liquor -- should be treated the same. What exactly are your ambitions there?
Walsh: We haven't lobbied for change in duty rates and have no plans to argue for equivalence in duty. I do believe that we should have equal access to the consumer, so if a beer brand can advertise, I don't see why our products can't be advertised. If a beer brand can be sold, as was the case up until a few months ago, at orchestral events in California, yet spirits couldn't, that's not a level playing field.
Q: Following that logic, you've been very aggressive in trying to garner access to network TV. Your agreement last year with NBC on a major media buy seemed to be a breakthrough, but then it backed out. What happened?
Walsh: My gut tells me that they got twitchy that they may lose revenue from the beer players, although I have no proof. It got pretty far along. We had made the ads. We're now showing them on spot TV. We're in dialogue, but we still haven't cracked the code in getting access to network TV in the U.S. We're trying to demonstrate that we have a very robust marketing code. If you look at our ads and contrast them to some nonspirit ads that are out there in the U.S. at the moment, then you tell me why they can show those ads, and I can't show ours. I think it's ridiculous.
Clinton: We still believe we belong on network TV, and we believe we'll be back relatively soon. In any given month, we're on up to 300 TV stations with our spirit brands, locally procured. And through our "virtual network," we can pretty much cover the country now. But we would love to have access to the efficiencies of network coverage.
Q: Although still a big category, malternatives have lost considerable momentum in recent months. Are you worried you may have placed too big a bet on this sector? You even purchased and upgraded a giant Pennsylvania brewery just to produce the malternatives. What happens with that capacity if the category fades?
Walsh: We would have to think that through carefully, and I don't really know the answer. If volumes continue to fall, we have an issue there. But I don't think they will, and certainly we're not seeing that with [recently launched line extension] Smirnoff Triple Black, which is off to a very good start.
Clinton: We're in the beer business [with Guinness and other beers], and we'd like to grow our core beer business. We're looking at lots of different options. The brewery gives us that [strategic] flexibility.
Q: Tell us more about your approach to marketing and new products. You seem to have scrapped widely held assumptions about who drinks beer, wine, or liquor, and when and where.
Clinton: We've come up with models of consumer-motivation states and occasions, and we have what we call the "Diageo way of brand-building" -- DWEEB. It allows us to start ignoring product categories as the way to go to market, which is kind of a producer-led approach, and start to think about how the consumer views things. They don't see the separation that the producer mentality would construct. They see it as: How am I feeling, and who am I with, and what am I doing? That's what's going to influence their decision on what they're going to consume. It could be a beer, a wine, or a spirit.
That has allowed us to open up our thinking and hopefully create some greater growth opportunities. So that's how Smirnoff can compete in beer occasions -- not because it's a vodka, but because the consumer wants what Smirnoff brings in what used to be a beer occasion. [Where there's a gap,] that's where our innovation team focuses its development. Thus, we saw Smirnoff didn't get consumed in some of the refreshment-oriented occasions, even though consumers gave it permission to do so. That created the opportunity for Smirnoff Ice.
Q: The success of Smirnoff Ice seemed to confirm that you've figured out how to spot those untapped consumption opportunities and devise new products to fill them. Then you flopped with Captain Morgan Gold. What happened?
Walsh: We learned from Captain Morgan Gold that white spirits translate far easier than brown spirits, as you do all sorts of things with flavoring that's harder to do with brown. In our quest to come up with a different flavor for Captain Morgan, we developed something that was extremely sweet and alienated many consumers.
Q: You certainly seem willing to invent other kinds of products as needed to fill a perceived consumer demand.
Walsh: If we don't have the right brand to renovate in the superpremium category, we're able to innovate. Ciroc, for example, is our new high-end French vodka made from snap-frost grapes [rather than grains]. Its launch in the U.S. ends a period of absence for Diageo in one of the fastest-growing segments of the North American spirits market.
Q: A few years ago you decentralized marketing, moving control of the marketing budget entirely to five regional units. Soon those managers started moving in their own directions on advertising and promotion -- risky for what are, after all, national brands. Now you're reversing that. What was that all about?
Clinton: We probbably went a step too far on strategic marketing because of our desire to get really focused on the marketplace. As a result, we adjusted the model. It was just too complicated. There were just too many perspectives involved. The core consumer-positioning strategies, the growth drivers, now reside in one group.
Q: You've also created turmoil in the industry with your rationalization of distribution under the rubric "Next Generation Growth." You've had distributors bidding against each other for exclusive rights to carry your brands in an entire state, with 26 states converted so far. What's your thinking there?
Walsh: We need to optimize our routes to market, and very often this requires us to challenge orthodoxies while respecting established systems and laws of the land. Our negotiations were structured around two goals: We wanted a dedicated sales force for Diageo premium drinks brands, and we wanted to work with distributors to maximize the effectiveness of our marketing spend. When NGG is completed, it will give us 2,500 dedicated salespeople, which will put us in a very unique and strong position in the very important U.S. marketplace.
Q: Why did it take until now for somebody to do this? Simply a question of the market clout you've accumulated by now?
Walsh: You have to remember how Diageo came about. First it was Grand Metropolitan, acquiring brands but leaving them with different distributors. You then had Grand Met merge with Guinness, who had their own distributors, to form Diageo. We then acquired Seagram's, and they had their own distributors. So we had our brands all over the place. That's crazy from a marketing execution view.
Now we've brought all our brands together, given them to one distributor, and put in place some pretty clear requirements, such as dedicated salespeople. We will then force them to invest in information technology. There's a dearth of information we get about our brands. Here, today, we don't know where we have stock out. Beer guys have been doing this for 10 years. We need to invest together with the distributor in technology.
Q: With all these radical initiatives, do you consider yourself a trailblazer in the U.S.?
Walsh: Nah. I think we're very thoughtful, and we may be more bold than people thought we would be. But if you want the performance, you have to change the paradigm.