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* Had been expected to buy a stake in $3 bln Cuervo
* Distribution deal ends in June, all talks terminated
* Sauza maker Beam may feature on Diageo shopping list
* Diageo shares fall 1.6 pct; Beam up 2.8 pct; Pernod up 1 pct
By Rosalba O'Brien
LONDON, Dec 11 (Reuters) - Diageo has pulled out of talks to buy a stake in top-selling tequila brand Jose Cuervo in a surprise move that fuelled speculation that the world's biggest spirits maker could now set its sights on smaller rival Beam Inc.
The collapse of discussions with Cuervo, which has a distribution deal with Diageo due to end in June 2013, will leave Diageo without a major tequila brand and Cuervo without a distributor outside its home market of Mexico.
Shares of Beam, which owns the world's No. 2 tequila, Sauza, closed up 2.8 percent at $61.56 in New York, while Diageo shares closed down 1.6 percent at 1856 pence in London. Shares of French rival Pernod, which an industry source said could now link up with Cuervo, closed up nearly 1 percent in Paris.
"With this development, the probability (of a deal for Beam) looks higher," said Morningstar analyst Kenneth Perkins, noting that Diageo executives have hinted in the past that Beam had some attractive assets, namely a range of bourbon whiskeys.
Faced with sluggish growth in recession-hit European economies, Diageo has been looking to tap burgeoning middle classes in Africa, Asia and Latin America, where it aims to make around half of its turnover by 2015.
A deal with Jose Cuervo, valued at about $3 billion, would have given the British group access to the emerging Mexican spirits market and a stronger product range there to go with its Johnnie Walker whisky and Smirnoff vodka brands.
Diageo, Cuervo's distributor outside Mexico, had been expected to take a stake in the business with the possibility of gaining majority control at a later date.
But the firm said in a statement on Tuesday that discussions had broken down without agreement, after the two companies had been wrangling over price for more than a year.
RBC analysts noted that Cuervo only accounted for about 3 percent of Diageo revenue and 2 percent of profit, and said the failure of the deal might free up funds for other transactions.
A weekend newspaper report said Diageo had held talks with Japanese brewer Suntory over a joint bid for Beam worth over $10 billion. Diageo declined to comment.
"Whether Diageo was just using the threat of buying Beam as a bargaining tool with Cuervo is hard to say. But now the market will probably ascribe a higher probability that Diageo will take a look closer at Beam's portfolio," said analysts at Davy.
Some analysts, however, have said Diageo may not want to pay the price Beam would command, while anti-trust regulators may also prove to be a hurdle. The maker of Jim Beam, Maker's Mark and Knob Creek bourbons beat quarterly profit expectations last month and is considered a success story since going public late last year..
It has also bulked up with several acquisitions of its own, adding brands like Pinnacle vodka and Skinnygirl.
The company's shares gained 13 percent since Nov. 27 amid speculation about a takeover. Adding in Tuesday's jump, Beam's market capitalization stood at $9.85 billion.
A Beam spokesman declined to comment on rumour or speculation.
Cuervo is owned by the Beckmann family, heirs to the Cuervo family who founded the company in the Mexican town of Tequila in 1795. The business is the clear leader in tequila's two biggest markets, the United States and Mexico, ahead of Sauza.
However, Cuervo's U.S. share has been gradually declining. It was one of Diageo's lowest margin brands and was not realising its potential in the United States, Diageo's Walsh said when talks started in 2011.
Beckmann-owned Proximo would be the most likely distributor for Cuervo in the United States once the Diageo agreement ends, UBS analysts said.
"Cuervo has two problems at the moment: they are mono-product and mono-geography. They absolutely need to diversify the business to maintain its value," an industry source said.
The source added that Pernod Ricard, the world's second-largest spirits group and the firm behind Absolut vodka and Mumm champagne, could now look at Cuervo, and also Beam.
"Having more tequila in their portfolio would not hurt," the source said. Pernod sells small, high-end tequila brands, but like Diageo, does not own a mass-market brand.
Premium tequilas, which are high margin and high growth, are made entirely from the blue agave plant that grows in the Mexican state of Jalisco, while cheaper brands are mixed with spirit derived from sugar cane and other sources.
Diageo said it plans to return to the No. 1 maker of tequila in North America through innovation, acquisitions and partnerships. The company's North America President Larry Schwartz told analysts that if Diageo were to buy another tequila, it would like it to be 100 percent agave, but still be affordable.
Like Cuervo, Sauza's main brand is a mixed tequila, but its Sauza Blue, Hornitos and Tres Generaciones lines are pure agave.
Diageo could also focus on innovating with its high-end Don Julio brand, while it digests other acquisitions.
Last month, it paid $2.1 billion for a majority stake in India's largest spirits company, United Spirits, and it has also secured smaller deals for producers of baiju, cachaca and raki in China, Brazil and Turkey.
The group, whose brands also include Smirnoff vodka, Tanqueray gin, and Baileys liqueur, was advised on the Jose Cuervo talks by Goldman Sachs and HSBC. The Beckmanns have been advised by Barclays.