We all know that Diageo and Pernod Ricard have held all before them in the spirits sector for a number of years. But a new report from Rabobank has shed light on how they have done it, and what the rest of the market needs to do even to come close to keeping pace with the industry's giants. Ben Cooper reports.

In the spirits market, the truism that 'the rich get richer, and the poor get...' appears as apt as it does in the world at large, a fact confirmed by a new report from the Food and Agribusiness (FAR) arm of Rabobank.

The report analyses the financial performance of western spirits companies between 2001 and 2007 to find which companies have increased value - defined in terms of the relationship between capital investment and EBIT - and how. According to the report, Value Creation in the Western Spirits Industry, there are two 'giants' of the sector.

Rabobank calculates that, in 2007, the 'EBIT pool' of the western spirits market - North America and Europe - was EUR7.9bn (US$11.95bn). Diageo and Pernod Ricard accounted for 48% of the industry's revenues, but for 57% of the EBIT pool.

Positing that the two 'giants' of the spirits sector have "gradually gained a very powerful position in the market, which will be decisive for the industry as a whole", is hardly telling us something new. But what the report has to say about the rest of the market is decidedly more illuminating.

It classifies Bacardi, Brown-Forman, Campari and Beam Global Spirits & Wine rather unflatteringly as "ambitious followers", which are "profitable but facing limitations". The four companies in the ambitious followers segment account for 22% of total revenues and 25% of the EBIT pool. Next come "single-brand heroes" and "local heroes". The rump of the sector is referred to as "tired heroes".

The report identifies four major drivers acting on all sectors of the spirits market: shifting consumer demand; increasing retailer power; increasing impact of legislation, and increasing competition and consolidation. While the report's review period only goes up to 2007, it states that the recession has subsequently affected consumer demand, changing a trading up dynamic to one of trading down, and also driving consolidation.

So what does Rabobank believe the future holds for the various cohorts within the spirits market? With the strongest brands already owned by relatively few companies, "future growth can only be realised at the expense of other players", the report states, adding that "this process alone will accelerate consolidation".

Not surprisingly, it forecasts continued the hegemony of Diageo and Pernod. But while the report says 'further value creation can be expected' by the big two, it expects both to face increasing challenges from monopoly legislation as they seek acquisitive growth. This may result in diversification in order to continue to increase value.

The report's authors anticipate that acquisition activity will be concentrated in the ambitious followers segment, as they bid to close the gap on Diageo and Pernod. That, however, is easier said than done. "The profit pool not already captured by the giants is limited, as is the number of obvious targets. It will remain a challenge to make the acquisitions required without diluting shareholder value."

With regard to single-brand and local heroes, the report suggests companies will use their strong cash flows to fund smaller acquisitions in other categories. It also notes that, while this means that some of the single-brand and local heroes will effectively follow in the same direction as ambitious followers, other companies have gone in the opposite direction. Both Constellation Brands and Remy Cointreau, it says, have given up their positions as ambitious followers and have preferred to focus on a narrow range of premium brands.

The category that appears to be destined to suffer most is, not surprisingly, the tired heroes. This segment accounts for 23% of total spirits revenues, but only 7% of the EBIT pool and a "negligible" share of the net profit pool.

Brands in this part of the market suffer constantly from a lack of investment, particularly when such investment is required by a change in legislation, or during a shift in ownership from one generation to the next, when transfer of capital needs to be financed, the report states. They are also often most at risk of being de-listed by retailers.

Some of these companies have managed to eke out better fortunes by repositioning themselves as niche brands, focusing on emerging markets, or positioning themselves as 'cost leaders'. Another strategy has involved consolidation, the bringing together of a group of tired brands, but this strategy is described as a "financial tightrope act". EBIT margins are higher, and return on capital employed is "acceptable", but at the expense of high debt.

These "changing tired heroes" aside, the future for most tired heroes "means milking tired brands, thus managing a gradual decline, and trying to prolong their existence with small innovations. Their options to create value are limited... The long-term prospect for most tired heroes is poor."

Notwithstanding the particular challenges facing the tired heroes, one striking feature of the spirits sector as a whole, the report concludes, is that the prime objective for spirits companies in general is to acquire premium brands with established distribution but unexploited brand value.

The size of the brands - and therefore the size of the acquisition - is limited by the financial clout of the acquiring company. But, it adds, "pearls" are now thin on the ground in the spirits sector and only the leading powerful companies have the capacity to add value to the premium that has to be paid for them, which also signifies that further consolidation is inevitable.