I just can’t get to a positive free cash flow.. Their net income barely hangs on in the positive, but after accounting for capex and likely scenario in each year of their production and sales, their valuation looks dismal. Let’s start from the beginning…
Craft Brew Alliance (CBA) was formed in 2008 through a merger of Redhook Brewery, Washington’s largest craft brewery (founded in 1981) and Widmer Brothers Brewing, Oregon’a largest craft brewery (founded in 1984). They also added to their portfolio in the same year, Hawaii’s oldest and largest brewery (founded in 1994), Kona Brewing Company. CBA has 5 brands:
- Kona Brewing Company
- Widmer Brothers Brewing
- Redhook Brewery
- Omission Beer – #1 beer in the gluten beer segment
- Square Mile Cider Company – #1 in hard cider in the Pacific North West
- Resignation Brewery (through theCHIVE.com) – first ever virtual brewery through an online media platform.
Management has been stable with the original CEO from the merger, Terry Michaelson, transitioning out of the role in 2013 but acting on as a senior advisor. The CEO that took his place, Andy Thomas, had been with CBA since 2011, and his prior experience includes executive position with Heineken. The Widmer brothers stayed on the Board but both have recently retired and the longevity of the Widmer brand remains to be seen, especially without the founders pushing for the marketing of their brand.
CBA distributes to retailers through wholesalers in the Annheuser-Busch network, and more than 90% of their sales come from this channel. A lot of risk in having the majority of their sales dependent on one distributor/wholesaler network…
CBA is riding the wave of the craft brew trend, but competition in this space is fierce, due to low barriers to entry (many local breweries can start with a business loan from the bank) and the attraction of a relatively high margin. In fact, in the last decade, the craft brew market has seen a double digit growth year over year. Craft brew now makes up ~21.7% of the total US beer market (as of Sep 2016). US craft beer production grew 20% CAGR from 2010-2015:
Source: WSJ Article
Breweries Association reported that in Dec 2015, the number of breweries in the US surpassed the previous record in 1873 with 4,144 breweries, many of which came online in the recent part of the decade. But, craft brew supply has now reached the demand, and we will likely start to see a plateau. The larger brands (Boston Beer, Sierra Nevada, New Belgium) have become stagnant because of so much volume in the marketplace, and it’s now the local breweries driving the growth of the market as opposed to the large brands. The 2 driving forces left in this competitive market to out-win competition are quality/innovative beers (such as introduction of nitro-infused beer) and lowering prices. (Source: Bevindustry.com Article)
Basically, craft brew has had a nice run, but we will be seeing more breweries in the near future, with the number of breweries starting to stagnate and decline in the next decade or two to come. And only the most innovative and creative/effective branding brew companies will survive.
Overall volume shipment of barrels has decreased in the last 2 years since 2014 because of declining popularity of Widmer and Redhook brands.
- CBA’s Q3 10Q reported a 9month year to date production decline of -4% yoy for beer distributed through Annheuser-Busch network; total FY decline of -5%
- Repositioning Widmer and Redhook brands in 2017 will see a decrease in shipment volume but offset by an increase of Omission and Square Mile
- Kona’s expansion of the Hawaii brewery to come online in early 2018
- Contract brewing has been experiencing a decline offset by international sales
Even though overall volumes have decreased, net revenue has increased because of a higher average selling price from shifting from draft to packaged goods sold. The Company unfortunately probably won’t benefit much more beyond the current draft to packaged ratio, and in fact, recent quarterly filing saw a slight shift back to draft:
Therefore, a similar level of draft to packaged goods ratio and therefore a similar level of average selling price per barrel are assumed in deriving revenue.
The only noteworthy things to mention in the above valuation are:
- I believe that with the expansions and greater marketing efforts to rebrand their dying brands, SG&A spend will increase in 2017 over budget. Then, they could see losses and in 2018, initiate a cost-reducing strategy, which will drive the SG&A back down to slightly below normalized levels going forward.
- Capex in FY2016 was estimated to be between $17-$19 million as reported in their recent quarterly. Capex of $20 million is expected to expand Kona brewery in 2017. Assumed conservatively for other brewery improvements to be only an additional $3 million.
And… now we’re back to square one. I am completely dumbfounded that the Company has been operating with a negative free cash flow. Clearly, a DCF valuation is not working here.
Key Risks & Opportunities Summary
Here’s my take. Widmer and Redhook brands have been around for a long time, but they never gained popularity outside of the Pacific North West (and a bit of lower West Coast). With a crazy influx of craft breweries in the last decade with local brands winning the hearts of beer fans in their communities, older brands just can’t keep up with the competition. Kona brings something unique, because it comes from the island, so it will be around for a while. And, CBA was smart to introduce Omission and Square Mile – something unique to the table. They better continue to introduce unique beer and grab niche markets, because the fate of Widmer and Redhook doesn’t look pretty. Either that or they better be keeping a watchful eye on undervalued brands that are sweeping the craft brew nation to acquire in the next couple of years.
It is slightly of concern that Annheuser-Busch is CBA’s exclusive distributor and that over 90% of their sales come from this partnership. But, it is not too alarming, because that’s just the nature of the business, and it is unlikely that A-B will suddenly raise their fees to ridiculous levels.
CBA’s capex levels have been pretty high and their expansion of the breweries for ~$20million a piece is scary. Their opportunity to fill the new increased capacity will come from increasing their international sales efforts and if they acquire or introduce a new unique brand.
What I see happening that is likely is that in a few years, CBA dismember their alliance of brands and either (1) operate as a lean company of one or two brands or (2) sell off their then-underperforming breweries for pennies and sell their more popular surviving brands to bigger brew companies like Boston Beer.