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Clampdown on Chinese officials' spending proves dispiriting for French distillers

LONDON -- A crackdown in China on spending by government officials appears to have had a ripple effect: a collapse in demand for premium cognac.

     In announcing its results for the fiscal year through March, French spirits distiller Remy Cointreau said net profit fell 52%. The company is heavily reliant on China, where its Remy Martin cognac brand has been bureaucrats' drink of choice for gift-giving and fancy dining.

     Cognac accounts for over 80% of the company's operating profit -- with half of all cognac profits made in China. But the Chinese cognac and armagnac market shrank 11% last year, according to data from the IWSR, a London-based wine and spirits research consultancy. Another 8% decline is forecast for this year.

     The premium end of the cognac market has been the most seriously affected. This is where Remy Cointreau is positioned, with cognac such as the $2,000-a-bottle Remy Martin Louis XIII considered a favorite among wealthy businessmen and the newly rich.

Quieter nights

In China, giving gifts is a common way to seal deals and cement relationships. But lately the lavish lifestyles of government officials have been drawing a lot of public attention. The Internet has been abuzz about pictures of officials sporting luxury watches and designer belts.

     As President Xi Jinping strives to consolidate his power, he has conducted the largest anti-corruption drive in recent history. Tens of thousands of officials have been disciplined; some high-level individuals have faced investigation and arrest. As a result, the gift market has shriveled, according to Remy Cointreau.

     The crackdown has also reached China's nightlife, with the government shutting down karaoke bars, clubs and massage parlors. This sector has been highly profitable for cognac producers, with French distiller Pernod Ricard doing 25% of its business through bars in China and another 20% through so-called KTVs, or karaoke establishments.

     While Remy Cointreau says sales in the night market have been relatively strong, Pernod Ricard blamed the crackdown on nightlife as a culprit behind falling sales. Pernod Ricard does not see the market recovering until 2015. Analysts at Nomura International said there is a risk demand may not revive even then, as consumers might move on to more standard fare and other international spirits.

     Pernod Ricard recently introduced a more moderately priced cognac, Martell Distinction, aimed at the younger, fashionable set. And while Remy Cointreau is reluctant to discount or follow competitors in launching more midpriced brands, it has also targeted the youth demographic with limited editions of its VSOP cognac, featuring the image of Taiwanese pop star Jolin Tsai.

     Another possible avenue for growth is home consumption. While Chinese traditionally go out to socialize, the emergence of the middle class is changing consumption patterns, and Western-style home entertaining is expected to increase. This, Remy Cointreau said, is cause for optimism in the medium term.

     For the time being, though, the slump in demand has prompted Remy Cointreau to "massively slow down" its activity in China, according to Chairman Francois Heriard Dubreuil.

     Remy Cointreau does not sell directly to consumers in China. Instead, it goes through a large number of wholesalers, with six levels of intermediaries. While curbing supply will impact short-term profits, the company defends the move as a way to maintain its premium status. Keeping stocks low prevents retailers from selling the spirits at steep discounts, which could damage the brand.

     Meanwhile, the company is trying to diversify away from China. It is banking on growth in markets such as the U.S. It also intends to keep spending on marketing to reinforce its luxury position.

     All the turbulence has taken a toll on Remy Cointreau's senior ranks, however. CEO Frederic Pflanz stepped down in January after just three months on the job. The head of the cognac division, Patrick Piana, resigned three weeks later. The company is currently being run by Heriard Dubreuil, a member of the dynasty that owns the business.

Toast to India

The decline in Chinese demand for premium spirits is not limited to cognac. Baijiu is the preferred drink within the Chinese Communist Party and the nation's best-selling spirit. Almost 1.2 billion casks were sold in 2013, according to the IWSR. But the market for top brands has dried up noticeably: British drinks group Diageo in January reported a 66% fall in half-year sales of its Sichuan-style Shui Jing Fang baijiu.

     Domestic distillers, such as Kweichow Moutai, have also been hit hard. Rabobank does not see the baijiu market stabilizing until 2015. Experts are pessimistic about the near-term outlook and deteriorating finances among producers.

     Like Remy Cointreau, other large spirits makers are looking elsewhere for growth. One potential destination is India, where there is room for more foreign companies in the whiskey market.

     The brew branded as whiskey in India is mainly made from molasses, which is then blended with a small amount of imported malt whiskey. In the past, high import duties hampered foreign producers' attempts to penetrate the market. Now, with duties falling and middle-class incomes rising, there is a growing appetite for traditional malt whiskey.

     The global market has seen a string of acquisitions of Scotch whisky brands by European and Asian companies, many of which aspire to expand in India.

     In April, Diageo made its second attempt to gain control of India's United Spirits, with a $1.9 billion bid. A successful takeover would give Diageo access to United Spirits' extensive distribution network, aiding the growth of its already rapidly expanding whiskey brands. Net sales of Johnnie Walker Scotch grew 87% in the half year through December, providing nearly half of Diageo's growth in India.

     To clear the path for a takeover, however, United Spirits was required by regulators to sell off its Whyte & Mackay Scotch whisky brand. Emperador, part of billionaire Andrew Tan's Alliance Global Group, bought the brand in May for 430 million pounds ($731 million). The deal should help Emperador move beyond its home territory of the Philippines. The company aims to double its net profit in the five years to 2017.

     Emperador's deal is the second major spirits acquisition by an Asian company this year. In January, Japanese brewer Suntory Holdings agreed on a $16 billion deal to buy American whiskey maker Beam, the producer of Teacher's -- a highly profitable brand in India. The purchase, aimed at offsetting the stagnant Japanese market, propelled Suntory into the ranks of major whiskey producers.

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