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Pour Beam Down the Drain, Pick Up Some Diageo

In case you had any doubts, it’s official. Diageo (DEO), the world’s largest spirits maker, will not be buying Beam, Inc. (BEAM) for its bourbon portfolio.

CEO Ivan Menezes said this week that Diageo would be expanding its existing portfolio of whiskeys and launching new ones, and adding for emphasis that “we don’t need to” buy Beam.

I told you so.

Late last year, Diageo had recently lost its distribution deal with Jose Cuervo, leading to wild rumors that DEO would buy Beam for its tequila assets. Beam’s Sauza is the No. 2 global tequila brand by sales.

Apart from the obviously backward logic of buying a large bourbon distiller to get a relatively small tequila brand, Diageo would have a hard time swallowing an acquisition of Beam’s size. Beam has a market cap of $11 billion (Diageo’s is more than $80 billion), and after years of pricey purchases, DEO and its shareholders have acquisition fatigue.

Purists will point out that Diageo is still very weak in bourbon and that acquiring Beam — and its Jim Beam, Maker’s Mark and Knob Creek brands — would fill that gap. Diageo currently only has one bourbon brand, Bulleit, and it is a relatively small player.

All of this is true, but there are a couple points to keep in mind:

  1. Bourbon is a very small market outside of the United States.
  2. Most drinkers make litter distinction between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky.

Per the first issue: Yes, the United States is the single most important market to be in globally. That’s not changing anytime soon. But it’s also a mature market and one where demographics are not necessarily moving in the right direction. Younger drinkers tend to prefer vodka cocktails, not whiskey.

And in any event, DEO is focusing its expansion efforts in emerging markets, where it plans to get more than half of its revenues by 2015.

Diageo’s scotch brands, such as Johnnie Walker, tend to be far more popular overseas. Most emerging-market consumers have literally never heard of bourbon. Try ordering one in a bar in South America or the Middle East and observe the confused look on the bartender’s face.

This brings me to point No. 2.

There are plenty of aficionados out there who take the distinctions between Kentucky straight bourbon, Tennessee whiskey and Canadian whisky seriously. In Kentucky, you might be required to give satisfaction in a duel for confusing bourbon with neighboring Tennessee whiskey. (I’m joking … Sort of. )

But all three whiskeys have a sweet flavor (as opposed to scotch’s smoky flavor) due to their use of corn as a major ingredient. And most drinkers are only vaguely aware that they are different products. I have no stats to confirm this, but anecdotal experience has shown me that 95% of the patrons in any bar in America wouldn’t know that Jack Daniel’s (a Tennessee whiskey), Jim Beam (a bourbon) and Crown Royal (a Canadian whisky) are different types of whiskey.

And on top of all that, Diageo is planning on expanding its bourbon offerings anyway.

This is a long way of saying that Diageo CEO Menezes is absolutely right.

Diageo doesn’t need Beam.

And that causes a little problem here. You see, Beam has had an elevated valuation for years in the belief that it would be acquired by Diageo or Pernod Ricard (PDRDY). Beam trades for nearly 30 times earnings, compared to 20 times for the larger and better diversified Diageo.

My advice? Pour BEAM down the drain and stock up on DEO.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long DEO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar, but also which stocks will deliver the highest returns. This series starts Nov. 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.

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