If Pernod Ricard is successful in its bid for Allied Domecq, Diageo will acquire the New Zealand wine producer, Montana, for £320m. Chris Brook-Carter asks if the deal signals renewed enthusiasm in wine on the part of the world's largest spirits producer.

The deal by Diageo to acquire Bushmills may be making the headlines, but its move to secure an option to buy the New Zealand wine maker Montana may have greater strategic consequences for the company and the industry in the long term.

With Pernod set to pay £7.5 billion (US$19.3 billion) for Allied Domecq - if it can hold off any late charge by potential rival suitor Constellation Brands - Diageo last week said it had the option to buy most of Allied's New Zealand wine business for about £320m (US$834m), if the French bid was successful. The deal would see Diageo pick up the Montana wine business, with the exception of the Corbans, Stoneleigh and Church Road wine brands.

In handing Diageo Montana - and Bushmills, which is covered elsewhere on the site today - Pernod has strengthened its hand in the battle for control of Allied considerably, with Diageo undertaking to cease discussions with any third party in connection with the sale.

In the eyes of most observers, the move more or less guarantees the success of Pernod's takeover efforts. In return, Pernod has had to sacrifice one of the last remaining international wine brands on the market. Montana, which is the primary brand within the Allied NZ portfolio, is the leading New Zealand wine brand by some distance. It has genuine international reach from a country that consistently commands some of the highest price points in markets around the world.

"Pernod would probably have liked to keep that asset," one analyst told just-drinks.com. Performing at a premium to Pernod's primary wine brand, Jacob's Creek, Montana would certainly have seemed to be an ideal fit in the French company's portfolio.

However, Pernod Ricard is famously single-minded about wine, with its international focus firmly fixed on Jacob's Creek. This outlook, added to the more important task of assimilating the far higher-margined spirits brands it will inherit from Allied, may have made Montana less of a priority than its position, on the UK wine market in particular, may have suggested. There is also the potential issue of competition. Montana controls a sizeable majority of the New Zealand wine business and Pernod, with its existing New Zealand business, which includes the recently acquired Framingham, may have been wary of catching the eye of the regulators - though the analyst considered this unlikely.

Diageo for its part will have felt it too has done well. Given it was not even at the table when Pernod began its efforts to acquire Allied, and that most observers felt the French group remained in the driving-seat whichever side Diageo backed, CEO Paul Walsh will feel satisfied his company has come out with a result from all this.
Matthew Jordan analyst at DKW told just-drinks: "Montana is a very good premium international brand, one of the few premium wines available in the industry with an international profile. It gives Diageo a wine with good international potential, premium to Jacob's Creek, and could galvanise them to make more of their wine division."

Montana is the first step into the Australasian wine market for Diageo and could in future serve as good launch-pad for Oz acquisitions. Though it is the second wine acquisition in recent history for Diageo, behind Chalone, it is of far greater significance than that US purchase.

"The legacy of the Guinness/Grand Metropolitan days has left Diageo reliant on a predominantly Californian portfolio," explained Natasha Cazin, beer and wine analyst with Euromonitor International. "The ongoing absence of an Australasian (Australia and New Zealand) wine in its portfolio has been a major shortcoming, and means Diageo is missing out significantly from the potential sales in this area, particularly in its key domestic UK market."

She continued: "An acquisition of Montana would not only give Diageo the opportunity to take advantage of the huge sales potential of New Zealand's exported wines but it also puts it in a far stronger position to exploit the flourishing Australian market further down the road."

Montana's premium positioning will also fit nicely within the Diageo ethos and its bias towards white wines will also reduce the level of working capital spirits companies often find hard to digest when looking at wine acquisitions.

Montana does have a significant bulk business that seemingly does not fit in well with Diageo, but there is no reason why this could not be auctioned off successfully after the acquisition, or some of its volumes used to attack the US market with a new brand along the lines of Yellow Tail.

However, Diageo's renewed interest in the wine industry has received mixed reactions. "Diageo's revived willingness to participate in M&A in the wine market provides the company with a new growth avenue, in which Diageo had previous appeared uninterested," analysts at WestLB wrote in a research note.

Other commentators cast doubts on the deal, focusing particularly on the age-old problem of return on capital in the wine business. "Diageo is so disciplined when it comes to return on investment that it's really tough for them to buy a wine company," one analyst explained to just-drinks.

The price of £320m is fair, particularly by recent standards, and may still be adjusted to reflect information available following completion of the acquisition of Allied Domecq. "Diageo will exercise the option subject to determining that the acquisition of Montana can achieve appropriate growth and returns for shareholders," Diageo wrote in a statement.

That it can achieve these "appropriate" levels of return, however, are far from certain. "We think the market will focus intently on the returns from this business and we are struggling to see how the return can meet WACC by the fourth full year on the basis of the numbers outlined. This is because we do not expect Diageo to be able to take on Montana's brands without significant incremental overheads," a research note from Morgan Stanley said last week.

Looking longer term, there will be concern from investors unconvinced that Diageo's future lies with a larger foothold in the unpredictable and costly wine industry.  "While Diageo has always said it is interested in wine assets, it has shied away from making any major acquisitions because it did not believe it could achieve high enough return on investment in the wine sector," wrote Morgan Stanley. "We think investors will be concerned if the criteria have eased."

All that said, having been at one point no more than an observer, Diageo entered this party with nothing to lose, and has once more emerged in credit. Walsh still has plenty of room to manoeuvre in the Montana acquisition and from this point of strength, it is unlikely he will move unless he is convinced the outcome will be positive.