Diageo Is Spiking the Booze Business

The British powerhouse's bold tactics could upend the industry in the U.S.

Paul S. Walsh sees a summer barbecue and asks, why reach for a beer when you can have a low-alcohol cocktail in a bottle instead? At a symphony in the park where tradition might call for a glass of wine, the CEO of Diageo PLC (DEO ) would substitute a Baileys Mini -- a single-serving version of Baileys Original Irish Cream liqueur. And while he's at it, Walsh would free up drinkers everywhere to buy booze on Sunday.

With a huge portfolio of brands including Smirnoff vodka, J&B scotch, and Tanqueray gin, booze powerhouse Diageo likes to think that it has the products to suit most any occasion. Where there are gaps, it's happy to invent new categories. And with deep pockets and an army of lobbyists, the London-based company has shown it's willing to battle the legal, advertising, and distribution hurdles standing in its way in the U.S.

By paying a lofty $5.3 billion to acquire most of Seagram's brands in 2001 and spinning off its Pillsbury (GIS ) and Burger King units, the company has staked all its chips on alcoholic beverages. And it's determined to play that hand aggressively. Walsh is betting he can beat the industry's sluggish 1%-2% annual growth by stealing share from beer and wine makers, coming up with products that will lure new drinkers, and by cutting costs. To pull all this off, he has to completely revamp the way liquor is sold and positioned in the U.S., moving an industry that's in many ways stuck in a Prohibition-era mind-set. "We may be more bold than people thought we would be," says Walsh, 48. "But if you want the performance, you have to change the paradigm."

A lot of the changes Diageo is pushing seem inevitable as the industry falls under the sway of a younger generation of managers who don't see why booze should be treated any differently than products like potato chips or deodorant. But by taking on so much at once, Walsh and his president for North America, Paul A. Clinton, have created a challenge of enormous complexity -- and the outcome is far from assured. They've expanded core brands such as Smirnoff and Baileys, but disappointed Wall Street when they failed to meet sales and earnings projections for the six months ended Dec. 31. And it's unclear whether they can assemble the right mix of products and advertising while challenging long-held laws concerning liquor sales. Diageo's shares trade at around 45, down from an all-time high of 55 a year ago.

One of the most successful moves so far has been the introduction of category-blurring "malternatives," which are brewed like a beer but taste like a cocktail. That helps bring in younger consumers who may one day graduate from Smirnoff Ice to Smirnoff vodka. With TV ads that try to give Ice a sophisticated appeal -- some show well-dressed young urbanites socializing in a night club -- Diageo hopes to differentiate it from the frat-boy image of beer. In just two years, industry-wide U.S. malternative sales have reached $350 million, grabbing beer share and raising hackles among public-interest groups by exposing more young drinkers to liquor brands.

If malternatives have provided a convenient back door to get Diageo's booze brands on the tube, the company hasn't hesitated to bang on the front door, either. The distiller infuriated beer companies by convincing NBC (GE ) to ignore voluntary restraints against liquor ads. NBC ultimately backed out, but Diageo forged ahead anyway, cobbling together a "virtual" network of about 300 local-TV stations. Diageo hasn't given up on wooing the networks. "We still believe we belong on network TV, and we believe we'll be back relatively soon," says Clinton.

Behind the scenes, Diageo has been just as aggressive. Since the end of Prohibition, distillers have been required to sell their products through independent distributors. That extra layer adds cost, but rather than stick with the traditional patchwork of small operators, Diageo over the past year has pitted booze wholesalers against one another by making them bid for exclusive rights for an entire state. That consolidation should result in big efficiencies. It also gives Diageo the clout to force distributors to invest in technology to track up-to-date sales data. As Walsh points out, "beer guys have been doing this for 10 years."

The strategy seems straightforward enough. Still, it's often one step forward, two back for Walsh & Co. Most ominously, Diageo recently came out on the losing end when the beer lobby persuaded the U.S. Treasury Dept. to require the reformulation of malternatives, to make them more like beer if they are to enjoy beer's benefits of lower taxation, broad retail availability, and access to TV. Besides being expensive to undertake, the changes could sour consumers on a segment where sales already are slipping. It's not a crushing blow. But it signals that Diageo's bold tactics have put the powerful brewing lobby on high alert. "With less aggression from Diageo, maybe it would have been a different outcome," says Philip Bowman, CEO of rival Allied Domecq (AED ) PLC.

Indeed, Walsh seems to be taking a more diplomatic approach lately with wholesalers, state legislators, and even rivals. But don't be fooled by a kinder gentler Walsh. He knows he can't sweet-talk his way to fast growth in this slow-growth industry.

By Gerry Khermouch in Stamford, Conn., and Kerry Capell in London

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