Craft Brew Alliance's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Mar. 7.14 | About: Craft Brew (BREW)

Craft Brew Alliance (NASDAQ:BREW)

Q4 2013 Earnings Conference Call

March 7, 2013 11:30 a.m. ET

Executives

Andy Thomas – CEO

Mark Moreland - Chief Financial Officer and Treasurer

Ken Kunze - Chief Marketing Officer

Scott Mennen - Vice President, Brewery Operations

Analysts

Michael Halen - Sidoti & Company

Tony Brenner - ROTH Capital Partners

Wendy Nicholson - Citigroup

Steve Kasba - RJ & Associates

Jim Cole - Lombard Securities

David Cohen - Midwood Capital

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 Craft Brew Alliance Incorporated Earnings Conference Call. My name is Janet, and I will be your operator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Andy Thomas, CEO. Please proceed.

Andy Thomas

Thank you. And good morning everyone. It’s my pleasure to present the Craft Brew Alliance investor conference call to discuss our results for the fourth quarter and the full year 2013. This is the first call since our leadership changes that took effect on January 1 of this year. We will be switching up the format a bit.

To more closely parallel our operating priorities and provide an additional level of transparency into those priorities, specifically starting with this call, we will be giving airtime to those members of the new leadership team with specific responsibility for areas of particular interest for the time period in question. For this call in our prepared remarks, I will be addressing the general business and industry environment as well as providing a high level overview of our results and priorities. Mark Moreland, our Chief Financial Officer will walk us through pertinent details of our financial results. Ken Kunze, our newly appointed Chief Marketing Officer will provide commentary and perspective on our portfolio, brands, and sales results, and Scott Mennen, our newly appointed VP of Brewery Operations will provide insight into our operations related gross margin situation and some forward looking initiatives for progress in that area. In keeping with past practice, we will then open up the call for questions.

Before we begin, I’ll ask Mark to read our Safe Harbor statement.

Mark Moreland

Thanks, Andy. And good morning everybody. As a reminder, this call may contain forward-looking statements. Forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those described in any such forward-looking statements. The Risk Factors section in our most recent Form 10-K list some of the factors that could cause Craft Brew's actual results to differ materially from the forward-looking statements made on this call. Craft Brew undertakes no obligation to update publicly any forward-looking statements, except as required by law.

And with that, over to Andy.

Andy Thomas

Thanks, Mark. As this is my first call as CEO, I’d like to take a bit more time than what will become a norm, to provide our investors with some perspective on our industry, some color on the state of our business and provide some clear remarks on our priorities going forward. But before doing so, I'll begin with a ‘thank you’ and with a foundational reflection.

My ‘thank you’ goes to our former CEO Terry Michaelson, not only for his stewardship of CBA since its formation in 2008, but for his tireless commitment to a development and realization of our strategy. I am fortunate to be taking the helm the company with such a sound strategic foundation.

And as for the reflection, it’s an ironically sober one that acknowledges the tremendous progress that we've made in growing our top line, contrasted with the recognition of just how much unrealized potential and opportunity that top line progress now affords us to improve and sustainably grow our bottom line.

To be less abstract, let me quickly move to my perspective on our industry, on the state of our business results for 2013 and connect those dots with respect to our clear priorities going forward. In 2013, the beer industry was again down roughly 1% and again pressured from pricing environment. However the craft segment regardless of the definition [indiscernible] again grew by double digits and reached the record levels of volume, of value and of consumer and trade acceptance.

In its further support of our belief that craft beer is more a movement than a trend, the number of breweries grew by over a third from 2751 to 3699 creating an unprecedented level of dynamism and competition. In the midst of this unprecedented competition, in 2013 CBA had a record year on the top line and based on available competitive information, not only pays with the best of the performance of several key benchmark national and super regional competitors.

For full-year 2013 we grew owned brand sales by plus 8%, grew owned brand shipments by plus 7% and posted a first-ever double-digit growth in owned branded depletions of plus 11%. In support of that topline, our spend was well managed and efficiently deployed, and we were able to realize our topline targets in even more efficient ways than previously planned -- a testimonial to the increasing strength of our brands and trade efforts.

And to complete the snapshot of topline progress, all of this success was largely built upon momentum in the last three quarters of the year. As many will recall, CBA began 2013 with a relatively weak Q1. Of course, there is a ‘but’. Despite the success in gaining topline momentum and despite the depth management of spend and allocation of our resources, our gross margin continued to be relatively unresponsive, driven largely by challenges in managing the complexities of product mix, geographic mix and slower than expected progress in optimizing our infrastructure to more efficiently service the evolved demands of our portfolio and geographic footprint.

So what now? Simply, we have the same level of resolve and the same track record of results to addressing our gross margin challenges that we brought tackling our topline challenges three years ago. That said, looking forward CBA is committed to and will have a laser focus in two areas. Firstly, continued strength and development of our topline results, and secondly, meaningful improvement in our gross margins and bottom line.

The pursuit of these priorities calls for meaningful change in how we attack the issue. We can firstly with changes to our leadership team and secondly with changes to our sense of urgency and our definition of success. With respect to changes in our leadership team, as announced last fall, our new leadership team is expressly designed to balance a deeper level of experienced senior leadership with more focus on those specific areas that will define success against these priorities.

In the area of keeping the topline moving, leadership is highlighted by the infusion of seasoned beer and CPG marketing talent in our new CMO and continued emphasis on the decentralization of our sales resources as embodied in having a General Manager East and a General Manager West, an intentionally strong statement of our respect for the value owed and the diversity of our wholesale and trade relationships.

In the area of gross margin and bottom line, it means experience and singular focus to take each of our major operational challenges -- brewery operations and supply chain, each now led by a dedicated Vice President, and it means a higher reliance on the synergies of shared services through creation of a chief of staff and the continued rigor of our CFO in understanding the financial and the analytic drivers of our business.

And with respect to our sense of urgency and definition of success, as shared in our press release, which is simply believe that we can grow between 500 and 700 basis points in gross margin and can do so within the next 3 to 5 years again while continuing to deliver healthy growth our topline.

In this call and over the coming months we will share with you overall results as well as qualitative progress against these priorities. Starting today with Ken covering our topline results and initiatives, and Scott addressing some of our operational initiatives and the gross margin, including expansion of our brewery footprint.

So first, on to Mark for a flyover of financials and on to Ken and Scott to provide some more concrete details. Mark?

Mark Moreland

Thanks, Andy. As we discussed, the core theme coming out of 2013 is that we had a strong brand portfolio that’s performing well and have opportunities to ensure we generate increasing margins on that topline growth.

Turning our attention to the numbers. Our 11% depletion growth for the year and 10% depletion growth for the quarter were the primary drivers of our total revenue growth of 6% and fourth quarter revenue growth of 5%. Consistent with the general theme, our full year EPS dipped slightly to $0.10 for the year which is down $0.03 versus last year and EBITDA declined by about 3% to $12.7 million.

For the quarter, EPS was $0.04, up $0.02 from last year and EBITDA was up 20%. Looking at the quarterly trends for the year, the last three quarters of the year exhibited strong top and bottom line trends but from an earnings standpoint, they kind of offset the loss generated in Q1.

On the top line, Ken will provide deeper insight to the fundamentals that drove our 10% depletion growth for the quarter and which resulted in branded beer shipment increase of 7%. As we have seen for 2013, there were significant quarterly swings in the relationship of shipments and STRs with the full year showing depletion growth of 11% versus branded beer shipment growth of 8% which indicates an overall slight lowering of wholesaler inventories. With an eye to 2014, we continue to expect quarterly fluctuation in depletion and shipment growth rates but anticipate fairly tight alignment overall for the year.

We have spoken about gross margin to be our number focus for 2014. We believe we have a team in place to help drive improvements during the year and begin upward trajectory on our margin for our 2013 performance. Scott Mennen will provide further insight on our plan on this front in a moment.

In 2013, we experienced a 150 basis point reduction in our margin rate to 28.1% driven by 140 basis point reduction in our beer business and a 240 basis point reduction in our pubs. On the beer business, margins were pressured both by our Q1 underperformance driven by low capacity utilization and growing pains in our supply chain operations predominantly in the forecasting, warehousing and shipping operations, which drove up our cost structure.

The pub margins were impacted by the renovation of our Woodinville brewery pub which was closed for three months and incurred reopening start-up costs. Sales, general, and administrative costs were up $1.6 million or 4% for the year, driven by both headcount additions and increases in packaging design and development costs.

Looking forward to 2014, our guidance is as follows: Depletion growth estimate of 7% to 11%; average price increases of 1% to 2%; growth in contract brewing revenue of 25% to 50% as a result of new partnerships; our gross margin rate of 28.5% to 30.5%. As we continue to optimize our brewing locations and improve our capacity utilization and efficiency, as Andy mentioned, we expect our gross margin rate to expand 500 to 700 basis points over the next five years. SG&A expense ranging from $52 million to $54 million primarily reflecting reinvestment into our sales and marketing infrastructure. And lastly, capital expenditures of approximately $15 million to $20 million, continuing our investments in capacity and efficiency improvements, quality initiatives and pubs.

In closing, we remain staunchly bullish about long-term health of our brands, the capability of our sales and marketing teams to drive growth and the capability of our operations and supply chain teams to capture significant cost opportunities. In all, our assembled team has the collective ability to drive significant overall margin growth.

And with that, it’s my pleasure to turn it over to Ken Kunze, our Chief Marketing Officer.

Ken Kunze

Thank you, Mark. Good morning, or perhaps I should say aloha from the beautiful state of Hawaii, home of our Kona brand. At Craft Brew Alliance, we believe we have an advantage strategy in an advantaged category. Both Q4 and full year 2013 results continue to reflect our progress in implementing our portfolio strategy. We define our portfolio strategy as targeting more craft consumers across more beer occasions. And we do that by positioning our brand as follows:

First, Redhook is positioned as an entry level or cross-over craft brand focusing on Audible Ale and Long Hammer IPA, leveraging partnerships with the likes of Buffalo Wild Wings, Dan Patrick and the leading [ph] website theCHIVE to efficiently support our national footprint.

Second, Kona is positioned as a craft imported from Hawaii. Kona is more a lifestyle play focused on the section of the Longboard Lager, a very drinkable Big Wave Golden Ale, and the launch in 2014 of Castaway IPA along with continued mainland expansion.

Third, Widmer Brothers is positioned unapologetically as a pure craft brewer made from the finest ingredients with the most complex balanced and innovative craft liquids, rooted firmly in our Pacific Northwest craft roots and brothers Kurt and Rob, founders of the craft movement and who in 2014 celebrate 30 years of paving the way for all the craft growth within the category today.

And lastly, Omission, a malt based beer that’s uniquely brewed to remove gluten. Omission is positioned against the growing group of consumers who are seeking to avoid gluten consumption as well as individuals with celiac disease. Omission is tagged even to the fast-growing gluten free food and beverage market that’s exploding across supermarkets today. Omission meets the FDA standards for gluten free and has recently earned The Celiac Sprue Association’s recognition seal, the largest non-profit celiac association in the US. Omission met the industry's most stringent gluten detection test in earning this recognition, and because it’s brewed of malt, the lager, pale ale and IPA meet the taste profile of the most discriminating beer drinker.

Today our portfolio is fairly equally weighted across the three primary brewing balance. Given our portfolio strategy we expect that to shift over time to the brands targeted against the largest segments of future craft consumption served by some of our most profitable beers, specifically Kona, Redhook and Omission.

Moving to results. Redhook’s STRs were up plus 15% for the full year 2013, the second year of positive growth in our turnaround after a decade of decline. Growth was driven by our focus behind the successful launch of the very approachable Audible Ale in January and the growth of Long Hammer IPA which is up plus 13% for the year. The SKU rationalization process implemented in 2013 did not negatively impact volume trends with Redhook plus 16% in Q4.

For Kona, STRs grew plus 23% for the full year and plus 21% in Q4. Kona continues to see health growth in its home market of Hawaii while establishing beachheads on the mainline. Longboard Lager and Big Wave Golden Ale, our two focused brands, are very profitable brews and now comprise 70% of the Kona portfolio. In 2014 we will be investing in our first media support behind the Kona brand. The work will focus on bringing Liquid Aloha, Kona’s tagline to life, while reminding folks on the mainland to live the aloha spirit of Hawaii. .

Turning to Widmer Brothers, STRs were down an expected minus 3%. As highlighted on previous earnings calls concerning Widmer Brothers, 2013 was focused on resetting the future direction of the Widmer Brothers brand, to align with positioning beer styles and branding to ensure long-term success.

The Widmer Brothers portfolio remains over weighted against Hefe, the original American Hefeweizen, the brand that created the American Hefeweizen style. While we believe Hefe will continue to play a critical role in the portfolio we will continue to take time to rebalance the portfolio. Progress has been made in addressing these opportunities with the launch of Alchemy Pale Ale in April of 2013 and the current launch of our best ever IPA Upheaval which by the way is getting great positive buzz from retailers, bloggers and consumers alike. Alchemy and Upheaval are the two focused brands for Widmer Brothers and are critical steps to rebalance and reposition Widmer Brothers portfolio and brand against core craft drinkers.

Widmer Brothers is the brand of portfolio most targeted against a consumer who appreciates complex, expensive beers to brew in what we believe to be the smallest most limited size segment of the growing craft market. As a result, while Widmer Brothers will continue to be a critical part of the portfolio moving forward, it will underinvest in contributing to incremental volume gains and margin improvement relative to its current size in the portfolio.

Omission, our gluten free offering, grew STRs of 155% in 2013. In IRI for the most recent 52-week ending February 16, Omission has a 31 share of the gluten free market in only its second year and drove 91% of the growth in the segment. With a recent national mandate from Darden banner, 2014 will see more gluten avoiders being introduced to the great taste of Omission in 2014.

Lastly, from a brand perspective, I’d like to share a few words about Square Mile Cider Company, CBA’s foray into the burgeoning cider market. We believe we have a unique top version of a craft cider that fits within the portfolio. Encouraged by the success of our test markets, CBA expanded Square Mile Cider to 10 western states in Q4 with package expansion in the six pack 12 ounce bottles. While encouraged by the prospects, we will continue our targeted and methodical addition of Square Mile to our portfolio, to better understand how consumer demand will develop for the cider category.

One final point, regarding our geographic split, our current mix of business remains heavily weighted to the west with more than 50% of our incremental volumes coming out of the eastern and south-eastern US. The rapid growth is putting strains on our current brewing and supply chain footprint which Scott Mennen will address in a minute.

In closing, for 2013 CBA consistently delivered strong topline performance across its portfolio with the exception of Widmer Brothers for reasons highlighted above. While never satisfied, we are confident in our strategy and the progress we’re making in implementing it.

With that, I’d like to introduce Scott Mennen, head of brewing operations who will address how he is supporting our portfolio strategy and the shifts within the mix from a brewery standpoint.

Scott Mennen

Thank you, Ken. As Andy referenced earlier on the call, I would like to take a few minutes to discuss two key initiatives for 2014, our SKU rationalization efforts and the evolution of our brewery footprint. Both of these initiatives will help support our growth while reducing our overall cost structure and thus support CBA’s top goal of improving gross margin 500 to 700 basis points over the next 3 to 5 years.

CBA has a strong but broad portfolio of beers and ciders, made of Kona, Redhook, Widmer Brothers, Omission and Square Mile brands. Within this portfolio, there is a wide variety of styles including PAs, pale ales, lagers, wheat beers, gluten-removed beers and plus-hop ciders. In addition, we continue to see geographical expansion of our customer base, more people are enjoying craft beers in all areas of the country. This broad portfolio, variety of styles, expanding geographical presence have created some unique operating challenges which we're deliberately and systematically addressing in the near term while ensuring our actions help us bridge to our long-term goals.

There are some significant changes we're implementing this year to help us address our current gross margin pressure in our business. Working closely with our sales and marketing team, we’ve eliminated over 25% of our SKUs for 2014. The SKU rationalization process will improve the focus of our sale and operating groups while reducing complexity and reducing our cost structure. The most significant of these changes for 2014 is the expansion of our brewery footprint to support our strong volume growth and reduce operating costs. Yet another initiative toward improving gross margin.

On February 10, we announced our partnership with Blues City Brewery, in Memphis, Tennessee as reported in numerous industry and business media. We will use this partnership to brew over hundred thousand barrels of beer. Production is scheduled to begin late in spring with shipments early this summer. We've been working closely with the team of Blues City over the past six months and are looking forward to producing some of our larger volume beers at this centrally located brewery.

In addition, we will have a full time CBA brewmaster on site to oversee the operations of the Blues City, from the brewing process to quality assurance. The brewmaster’s primary responsibility is to ensure the beers we brew in Memphis are identical in taste and quality to the beers we brew at any of our locations. In addition, Blues City will also bring increased flexibility to our brewing operation to allow us to leverage specific expertise and strengths of our breweries to drive further efficiencies.

Our partnership with Blues City will have a significant benefit to our business creating a dynamic brewery structure in the east and west that drives improvements in our cost structure. The partnership also brings benefits to our consumers who will be getting their beers faster and fresher to our expanded footprint.

In addition to these key initiatives, we continue to focus on disciplined execution of brewery operations with increased focus on day-to-day management. We’ve expanded the use of important manufacturing tools such as KPI and performance dashboards to increase visibility and drive positive results. We're very excited about the opportunities in 2014 and look forward to discussing the results of our SKU rationalization and the impact of our partnership with Blues City in future calls.

Now I’ll turn it back over to Andy for closing comments.

Andy Thomas

Thanks Scott. I began with a "thank you” and I’ll end there as well. This time with a thank you to all of you -- our investors, those analysts who cover us, our interested parties and importantly to our hard-working passionate and dedicated employees, be they in Portsmouth, New Hampshire; Portland, Oregon; Woodinville, Washington, Kona, Hawaii; or working remotely somewhere between.

I have said before that CBA is unique in having the soul of a craft brewer with the body of a big brewer. And in that statement lies the very reason that all of you can trust that we will succeed in synchronizing strong sustainable growth in both the top and bottom line results.

And with that, I will open it up for questions. Janeta?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Michael Halen with Sidoti.

Michael Halen - Sidoti & Company

Thanks for taking my questions. How many states is Kona distributed in currently and how many additional states do you plan to distribute in by year-end 2014?

Ken Kunze

This is Ken. We are currently in 36 states and in the process of rolling out 4 more which will bring the total of 40 states in 2014.

Michael Halen - Sidoti & Company

And are there any plans for geographic expansion for cider in 2014?

Ken Kunze

At this point we’re still evaluating and so we don't have anything confirmed.

Andy Thomas

Michael, this is Andy. Just to chime in, as Ken said, I think there's so much activity going on in cider now and you folks don’t just cover us and cover a lot of others. So just to take a step back and offer a little bit of perspective on that. We see explosive growth in cider just like you guys do. But what we are also mindful of is right now it’s becoming a very crowded category rapidly and is becoming a little bit of a battle of the titans again where you’ve got Boston with Angry coming out, A-B is adding Johnny Appleseed already to the fight with Stella Cidre. You have got MillerCoors and Tenth and Blake coming out with Smith & Forge. You’ve got the folks at Heineken saying they’re going to refocus on Strongbow and that’s in addition to our friends at Vermont Hard Cider who have Woodchuck. And I haven’t even got into all of the small local ciders on the top of that, for a section in most stores that’s probably I don’t know anywhere from a fourth to eighth the size of the craft segment and for one out of a number of handles on the stanchion at your on-premise account.

So all that said we’re interested in it, we’re participating in it, we’re being very methodical about it. But we’re also trying to be very thoughtful about going too far too fast and having that divert any resources from job number one which is keeping topline humming and getting gross margin moving in the right direction.

Michael Halen - Sidoti & Company

Can you also give any color in terms of your international expansion goals in 2014?

Andy Thomas

Yes, sure. This is Andy again. So internationally we’re off to a great start. We were right slightly ahead of our targets for last year and this year we will expand probably into three to four more countries. The emphasis is going to be -- consistent theme here guys and CBA is taking the seeds we’ve planted over the last couple years and helping them to grow more so than planting a lot more seeds. So what does that mean for international in concrete terms, we’re seeing a really strong growth in a couple of European countries, Italy and the UK to single out a couple. We’ve got a really positive response from our initial foray into places like Puerto Rico and the Caribbean. Our Asian business continues to be particularly strong for the Kona brand in markets like Japan and we’re looking at some expansion into Pacific Rim, specifically with the Omission brand. So that will be the highlights of where our international expansion is but a headline there is full steam ahead, I can honestly tell you I don't think we’ve had any negative surprises with that expansion and have been positively – have gotten positive response in most countries to all brands in the portfolio.

Michael Halen - Sidoti & Company

And just one last one, and this is for Ken. So, I am sure, Ken, that you have a full plate right now. Can you let us know what your primary focus is for 2014, and if you could maybe prioritize a few of the initiatives that you view as most important to address in 2014 and 2015?

Ken Kunze

So I think Kona’s number one priority, we’re going to test some above, we’ve created a 360 campaign with that. So I think in a lot of ways as we look forward we think Kona has a tremendous amount of run room. So we want to better understand how we can create more demand around that brand. I think Redhook in terms of what we are doing with the different partnerships and then Omission for us I think is a little bit under the radar screen and having come from food, I know how retailers and consumers are demanding gluten-free, so I think with a little bit of love on the product, we can make some tremendous inroads in terms of Omission and this offering.

And the last thing would be really just during kind of – had great launch behind Upheaval while we work to focus on -- selectively focus on Hefe, where we put our efforts.

Operator

Your next question comes from the line of Tony Brenner with ROTH Capital Partners.

Tony Brenner - ROTH Capital Partners

A couple questions. First, Mark, why are per-barrel excise taxes significantly lower in the fourth quarter? I believe they were last year, as well.

Mark Moreland

Per barrel excise taxes – Tony, we accrue at a rate on a per barrel basis, it could be – I will give you a call back, it could be a mechanical thing, it might be some of the contracts, but it would be pretty normalized, we just don’t see that one metric. So good question.

Tony Brenner - ROTH Capital Partners

Could you talk a little about CHIVE Black Lager? Is that proving to be a successful partnership and is it enough to move any needles that are visible?

Mark Moreland

I think I would -- the reason we got into the partnership of theCHIVE is really to support the Redhook brand and so some of the positive growth that we’re seeing on Redhook we think that the relationship with theCHIVE is helping to drive that. I would say KCCO line launched the Black Lager launch, the very end of the year and there is a tremendous amount of buzz and excitement around it. But it’s still pretty small at this point.

Andy Thomas

Tony, this is Andy. I will jump on it. First, I will try to hue for asking Mark a question something – which I would expect from you, so we owe you a beer. And secondly with respect to KCCO, as Ken said, it’s really all about programing around Redhook with KCCO and theCHIVE. But with respect to that specific brand it’s done in what we wanted to, we launched in November December, it's really early and we are kind of following a scarcity model on it, to achieve demand high and keep interest high. That said we’re starting to get some leading indicators which suggest to us that there's a lot of run room there. And what those leading indicators are not only the throughput in the scarce accounts that we’ve distributed into but also interest from national accounts on both from the on and off premise areas that are looking to basically mandate it. So more to come on KCCO in the Q1 call. I think as you hopefully all you folks start to know about us we try not to account the proverbial chickens before they're hatched. So off to a good start and once we have some concrete results to share with you, after the first quarter we will be sure to do so.

Tony Brenner - ROTH Capital Partners

And even after you adjusted wholesaler inventories in the first quarter a year ago, depletions have increased at a more rapid rate than your owned-brand shipments throughout 2013. So as we go into the new year, how would you characterize your wholesaler inventories now? Are they pretty lean? Are they right-sized? Or is there any reason to think that through 2014 that your own shipments will again lag depletions?

Andy Thomas

So I will start with the last part of the your question and I will work from there, Tony. This is Andy again. There is no reason to believe that our shipment should lag our depletions this year in a perfect state. So I will start out there, we’re not anticipating that in any way shape or form. What I will say is actions speak louder than words and as I mentioned in the intro we put a dedicated seasoned vice president over supply chain because we know it wasn't working the way it needed to on a number of levels. There hasn't been the synchronous movement between our depletions and our owned brand shipments probably for about 18 months which was a bit of a concern for us candidly. We think we've started to catch up to that and get ahead of the curve and there is a lot of shifting sands right now as we’re trying to buy down what was wholesaler inventory on any of that 26% of the SKUs that have reduced, those were out there, so those basically have to get sold through. So that will have an impact on that depletion shipment ratio. But broadly speaking to be clear we don't expect there to be the lack of synchronicity between shipments and STRs this year, that you’ve seen over the course of the last 18 months, whether that right-sizes in one quarter or two I am not entirely sure.

And then the last piece of your question, I would characterize wholesaler inventories coming into 2014 somewhere between right size and a bit on lean side which is exactly where we want them to be to ensure that we are able to implement some of the initiatives that we have on the focus priorities for the year.

Operator

Your next question comes from the line of Wendy Nicholson with Citi Research.

Wendy Nicholson - Citigroup

So my question is on the gross margin forecast, and I guess there are a couple of questions. The range for gross margin in 2014 is fairly vague, the 200 basis-point range. And can you give us a sense of what factors would lead you to comment at the high end of the range versus the low end of the range? And I don't know if you disclosed it, but can you give us a sense of how much the gross margin varies either by brand or by product type, so for example, for cider, if that's growing at an outsized rate? Is there any drag there or benefit? Just maybe some more dimensions so that we know what the specific drivers of the gross margin expansion are going to be

Andy Thomas

Thanks, Wendy. First off, I will say thanks on behalf of the team for continuing coverage and taking up the charge from Vivien. Appreciate the great work that Citi does, it's always encouraging for us to see your continued interest. So I do want to start out with a thank you. With respect your question, that’s a really good one, I might answer in 3 three parts. First, I would like to give a little bit of color into what we think is going to move gross margin and hopefully that will inform a little bit why we think the range is what it is and I can give some color on what those drivers of which part of the range. So we break down the gross margin initiatives into three buckets. The first bucket is all about portfolio, the second bucket is all about brewing operations and the third bucket is all about supply chain.

So with respect to drivers in each, on the portfolio side it starts out with the focus on the brands that we think are going to not only drop the most to the bottom line but are going to help drive the portfolio strategy the most effectively in the eyes of consumers, retailers and wholesalers. So what it means is focus on seven primary brands and a reduction of 26% of what we all call tertiary SKUs. Those seven focus brands we’ve been very vocal about, on the Redhook side our Long Hammer IPA and Audible Ale. On the Kona brand, our Longboard Lager and Big Wave Golden Ale, on Widmer Brothers, our Alchemy and Upheaval, and then the Omission brand. In addition to that as I said we’ve reduced the SKUs, we’ve implemented our market tiering system which we talked about before and we will share more where we’re trying to do a better job of pairing up what brands we sell in what markets with what level of commensurate resources that we can deploy there. So there is a lot on the portfolio side that’s aimed at gross margin not necessarily in a cost reduction way but in being smarter about our business way and ensuring that we’re using the right tools for the right job if i can use that analogy. And all of that work is being done with Ken in concert with our general managers in the east and west in a pretty coordinated fashion.

Secondly, once we've got some stability there in terms of what we’re going after and where we’re going after it, so that's a portfolio rationalization and the focus in the market tiering, then we can kind of hand the baton over to Scott which is why he's on the call for us here. So say, okay, now that we know where we are going, how we’re going to best flex our infrastructure to get there.

So that means location allocation between our existing breweries, what beers do we brew, where, what kind of run times can we have for those with a smaller set of SKUs and larger volume on those SKUs, we can get more efficiencies as we start to deploy that and also where do we brew them and that’s where Memphis starts to enter the equation, because as you heard in Ken’s remarks, over 50% of our growth is coming from the east and southeast. Our breweries are tugged away in the northeast and northwest and on the beautiful land of Hawaii, we’re pretty far distanced from where some of the volume growth is coming from. And as you guys know from my repeated tirade on where the beer business is going, if we look at the emergence of places like Florida and Texas, it also make Memphis pretty important to us. So the second piece after portfolios bring operations, and that leads into the third piece which is supply chain. So once we know what we're doing where and we’ve demonstrated that we can get that done on top line, I will continue to point to our track record there.

Three years ago we couldn’t say that, we can now. As we start to get our arms wrapped around the brewing footprint, then we can start to reach to reflex our supply chain and start to optimize not only our shipments, start to optimize our freight lanes, start to optimize our trans-distribution strategy and the troika of those three things portfolio, brewery strategy and supply-chain are what we think is going to get us to a 500 to 700 basis points in the next 3 to 5 years. So last piece of your question why it ranges and where we’re in the ranges. There's a lot going on there. I am fully confident that we've got the right people and the right helm on each of those initiatives. But as you can imagine, Memphis is coming online midyear, we have a brewer there. There's a lot to make sure that we’re not just brewing beer in Memphis but we’re brewing our beer in Memphis at the quality standards and with the case that we want. So there is variability in whether that starts at a point in time, two weeks earlier, three weeks later. So we’re buffering that. Once that gets deployed everything else starts to flow from there. So if you look at the nature of our initiatives it’s difficult to pinpoint with a hundred percent reliability when we’ll be able to realize savings from them and the accretion to gross margin. And if you look at the ranges from gross margin when you annualize them there is a pretty big impact on when we’re able to deploy those in 2014 and 2015.

So those are kind of factors that impact the ranges, those are the areas and then I think you start to understand, we are on a calendar fiscal year and this year was like, Memphis starts mid year. So guiding on Memphis for the fiscal Memphis year versus guiding on Memphis for the CBA calendar year, starts to get a little bit challenging for us and we don’t want to get ahead of ourselves there.

Wendy Nicholson - Citigroup

And so if I take those three initiatives, when I think about the five-year target for gross margin, is it fair to say that those three initiatives, it's kind of a third, a third, a third in terms of the relative contribution? It sounds like the portfolio changes are going to have a bigger impact in the immediate term, but in aggregate, is it split across those three in terms of where you get the gross margin benefit?

Andy Thomas

It’s a great question. I would tell you this is just kind of got -- I think initially your instinct is that on – I think the initial benefit will be from the portfolio initiatives. But long term it should all be in the brewing operations and the footprint in the supply-chain. Somebody who ran a supply chain a while back on Heineken USA stage, when you really know what you're doing where you’re and going when you have the top line pull and I am confident we will have, I think we will be able to get significant benefit out of our supply chain while providing fresher high quality. beer to all of our consumers and retailers. So that’s something important for us and something I want to make sure everybody realizes on the call is it’s important when we talk about scale, when we talk about our guidance for next year. We’re guiding 7 to 11% growth in STRs despite that 26% decrease in SKUs. So when you kind of put those two factors together I think you understand the extent of our ambition for the top line and you start to understand basically the improvement that we will have in the consolidation of that and in the scale.

Wendy Nicholson - Citigroup

And then, just my last question on this subject, sorry, is just the degree of volume leverage -- so suppose with all the SKU reductions you end up coming in more on the 7% range or the lower end of the topline growth. Would that likely suggest that the gross margin would also come in at the low end of the range? I assume there is a correlation there.

Mark Moreland

Wendy, this is Mark. I would say within that 7 to 11 range the impact on leverage on margin would be pretty minimal relative to the portfolio changes and the brewery path forward [ph]. So I wouldn’t expect a huge range impact because of 7 to 11 variance in STRs.

Andy Thomas

Wendy, again if I could address one of your questions, so I will try to add some dimension to it too. We are mindful that not all of our brands split out the same amount of margin regardless of geographic locations. So you asked about that, you asked about cider specifically. We are no different than when you heard the folks from Boston saying cider margins create some pressure relative to some beer margins. And if you look at our portfolio a really complex highly hop crafted beer like Upheaval will be a more expensive beer for us to brew than a really crisp refreshing lager like Longboard. So that also creates a little bit of the gross margin, little bit skewed that we’re trying to solve for. So there's ranges, you can be assured we are not only mindful of those ranges, but we are factoring those into our guidance as well to make sure that we understand as we launch Upheaval which is a lower gross margin brand and as we’re putting more emphasis on Longboard Lager, or Big Wave which are higher-margin brands and then we take a look at where we’re going to brew those and how we’re going to deploy that beer for our supply chain efforts, we’re trying to connect all of those dots. So I don’t want to complicate the call but I do want to be transparent and let me know yes different parts of our business have different gross margin loads and we expect different levels of accretion from different factors there, and you can trust that that’s a lot of work we’re doing back in Portland.

Operator

Your next question comes from the line of Steve Kasba with RJ & Associates.

Steve Kasba - RJ & Associates

I appreciate the long-term guidance on gross margin. That's very helpful. Could you talk a little bit about SG&A? Would you expect that to grow in line with sales or to also help the leverage?

Mark Moreland

Hey Steve, it’s Mark. Yeah we really haven’t changed our perspective on SG&A, again we want to continue to reinvest into sales growth. That said we do expect some moderate leverage over time as we do grow. We're talking 10 and 20 basis points a year leverage, not anything real significant but we will continue to reinvest into our markets and our brands as we grow and in particularly from a craft beer competitive situation we need to invest in those markets to ensure we have traction with the consumers, traction with the wholesalers and we’re able to push the brands effectively in those markets.

Andy Thomas

Steve, I am going to throw it to Ken too to maybe offer a little bit of perspective given – and I want everybody on the call to understand, there are lot of the moves that are happening are calculated. So what I mean by that is we didn't go out and recruit Ken and bring him in because it's going to be business as usual in the SG&A area. So I just want to give Ken a little bit of airtime to offer some thoughts on where that might go as well.

Ken Kunze

One of the things that Andy is alluding to is, the media investment behind Kona. We were today classified as a test, so we have two markets really where we are going to have in terms of 360 campaign, but then we’re going to read it, we’re going to use IRI, we’re going to quantify it and based on those results we will be methodical in terms of how we invest it back into the brand based on the results that we see –

Andy Thomas

Guys, I want to – the reason I wanted Ken to kind of chime in there, and I want you guys to think with SG&A, it’s just going to continue to grow the same way it has relative to revenue. We are a growth company, we are bullish about the craft beer segment, we are bullish about beer. We really believe we’re onto something we’ve demonstrated that. Our gross margin charge isn't just to drop when they go to bottom line. It’s to make sure that we can continue to invest, keep the topline humming and drop some nice money to the bottom line at the same time and that will require investment in it sometimes. We are trying to be smart about it, we’re trying again not get ahead of ourselves. But I want to be clear we will not be afraid to invest behind the health and the long-term growth of our brands, but we’re going to do it in a pretty thoughtful way.

Steve Kasba - RJ & Associates

Could you talk a little bit about the new Kona launch? Is that going to go similar to the way Big Wave went or faster? Is it going national? Just a little bit about the rollout.

Andy Thomas

Yeah, I will toss that one over to Ken. Are you asking, Steve, specifically about incremental stage or about Castaway IPA?

Steve Kasba - RJ & Associates

Castaway IPA, yes. Are you going national with it or is it just into select markets, or just a little bit about the rollout?

Ken Kunze

So it’s going to go wherever we’re currently in distribution in the 40 states is how I would describe it and it’s actually following a product that we already have in market, Aloha series. So from that standpoint, in some ways it’s already been sold in, and it'll be a permanent replacement for that series. So the reason we are doing that is – it’s an easier way to get distribution because the SKU is already on the shelf essentially and we think the IPA is a stronger way to go relative to the seasonal offering at this point in Kona’s development at least on the mainland.

Andy Thomas

So the big 3 on Kona will be hopefully on the shelf, the first three priorities you will see are Longboard Lager, Big Wave Golden Ale, and Castaway IPA. Fire Rock is still part of the mix, but the fourth priority out of those four [indiscernible] also interesting into the mix.

Operator

Your next question comes from the line of Jim Cole, Lombard Securities.

Jim Cole - Lombard Securities

I was wondering with the addition of the Tennessee brewery, are our going-forward depreciation and amortization expenses going to be pretty much the same?

Mark Moreland

Hey Jim, it’s Mark Moreland. The depreciation amortization will be pretty consistent, the investments into that brewery are relatively modest. It is an operating brewery already and we’re putting some capital in to ensure it’s meeting our standards but it won’t dramatically impact the D&A levels.

Jim Cole - Lombard Securities

I guess they are strictly a contract brewer for you at this juncture?

Mark Moreland

We are brewing in the brewery, so we actually do – we have a person on-site and effectively we do the brewing ourselves in their facility.

Andy Thomas

And it’s kind of like going into somebody’s kitchen and cooking there. So you’re using their equipment but you are still the one that’s making the magic happening. You’re still the one that’s responsible for how the food tastes.

Jim Cole - Lombard Securities

My other question, I can't recall. Is advertising part of your CapEx expense?

Mark Moreland

No, it’s not. It’s in SG&A, it’s just a rate expense.

Jim Cole - Lombard Securities

And have you ever done an analysis on what dollar amount advertising increases revenues? Have you ever done that? And have you compared that with the CapEx? Has anybody ever tried to do an analysis on that?

Mark Moreland

Jim, that’s a great question. It probably falls back to the cliche of you're spending half your marketing dollars effectively in market, and half not [indiscernible]. But we do try to measure individual launches whether it be in market spend or discounting, we do post audit on those kind of programs but as far as trying to measure the exact impact of, for example, the media spend that Ken mentioned where you’re doing cable and TV advertising, that’s going to be new to us. So the impact of that we will have to assess by market, so it’s a tough one till we actually launch that kind of program, we won’t know what impacts on the brands.

Andy Thomas

So we are going to do – use syndicated data to evaluate that in making a model in such a way that they isolate the impact of price and display relative to the media’s impact. So we are going to do that with the test that we mentioned. In terms of the relation to capital honestly I have never heard anybody try to do that. So I might not be understanding the question.

Jim Cole - Lombard Securities

I think you did. Thank you. One more quick question. Did I hear you say that the cider was a malt cider, and by that I mean, is that a barley malt cider? That doesn't sound right.

Scott Mennen

No, this is Scott. It’s a traditional cider, it’s a hop cider.

Ken Kunze

You know what – On Omission, no, Omission is malted beer, so some of the other gluten-free beers aren’t made with malt and therefore don't taste like beer. And that’s the unique positioning of Omission, that were made with malt and we are still gluten free and it tastes like real beer.

Jim Cole - Lombard Securities

No, I was mistaken, I meant hop. Is there hops in the cider?

Ken Kunze

Yes, there is. That’s one of the distinguishing qualities of the Square Mile Cider.

Operator

Your next question comes from the line of David Cohen with Midwood.

David Cohen - Midwood Capital

Looking at the incremental SG&A that you are looking to spend in ‘14 over ‘13, where are the key growth areas? And how much -- which of those are you able to measure an ROI on, or are they just necessary infrastructure spend that won't necessarily be tied to specific growth?

Mark Moreland

This is Mark. I will start by saying that the preponderance of the increase in SG&A guidance for next year is coming from investments in sales and marketing components and with that, I will let Ken opine on where those incremental investments are going?

Ken Kunze

So some of it is feet in the street, I think in terms of where we are, our development in the east. We are definitely adding resources there, and then Kona’s getting a significant chunk of the increased investment.

Andy Thomas

So David, with respect to ROI on those as Ken said, we know what we’re spending on Kona media for example and we will evaluate that and we will be as transparent as we can be with respect to kind of what that tells us. And then with respect to feet on the street as Ken said, we do have a significant part of the geography where we’re probably a little bit more leanly resourced than we already are. So that you could kind of characterize as infrastructure, so you won’t necessarily ROI on that this year but it’s something that will enable us foundationally to build upon in subsequent years to create that sustainability and growth that we are all striving for.

David Cohen - Midwood Capital

And with respect to the capital spend, how – I guess would you envision continuing this somewhat of a ramp versus, say, the last two or three years in more than just 2014, or do you get with this spend towards a capacity level that carries you three years beyond that, just to pick a number? How much runway are you getting with the growth in capital spend in 2014?

Mark Moreland

Sure, we need to continue to invest in the breweries, so you would expect a level similar to this for a while. We are investing in efficiency efforts within the breweries which are pretty costly. We are putting in some additional capacity. We are working with the Memphis brewery we talked about and we are also working to renovate and establish our R&R footprint more stably. So all those things do take capital and we are on a growth mode. So I won’t expect that number to come down significantly over the next few years.

David Cohen - Midwood Capital

My last question is as you look out three to five years or at a certain revenue scale, what does the margin structure look like down -- an operating margin structure given -- you have given some sense of where you think you take gross margin, but you're talking about reinvesting. Where can operating margins get to, whether it's three years out, five years out, or whether it is at a $300 million level or some relevant sales level?

Mark Moreland

Sure, if you kind of put the points that we talked about on the call, the gross margin 500 to 700 basis points, in about a five year period. So a nice expansion on the gross margin side. On SG&A we do expect some leverage over time. But as I discussed we will need to continue to reinvest back into sales and marketing to ensure we have the fire power in the market and the brands to keep the brands healthy. So I would expect some leverage over time on SG&A but it’s not going to be terribly significant, I will be looking 10 basis points to 20 basis points a year at least in the near-term. As we grow certainly you can look at the larger breweries in the US and the world and you could get scale to get very large and it’s important in a growth company and a growth category with high competition levels that you continue to invest.

David Cohen - Midwood Capital

So, you had an operating margin in 2013 of -- give me a second -- about 3%?

Mark Moreland

That’s right.

David Cohen - Midwood Capital

So, just translating some of the dynamics that are going into this, what is operating-margin potential -- if gross-margin potential could be 500 basis points higher, can operating-margin potential be 500 basis points higher or even more in some sort of steadier state?

Mark Moreland

Yes, gross margin 500, 700 basis points, similar to on SG&A, so we’d expect the operating margins to be incrementally higher than the gross margin results.

Operator

And at this time we have no further questions. I would now like to turn the call back over to Mr. Andy Thomas for any closing remarks.

Andy Thomas

Before I close ,just one final remark from our CMO here.

Ken Kunze

Now we just found out we got a really nice hit in the Wall Street Journal Live on – Widmer Brothers Upheaval, so on the Weekend Sip, so for those of you who can read the Wall Street Journal, and I am sure all of you do, check out the review of Upheaval and then go out and have one over the weekend.

Andy Thomas

And with that as a nice image in all of our minds I will close the call and appreciate everybody’s continuing support of CBA and being available for the call. We look forward to discussing the results of the first quarter of 2014 with you very soon and hope you enjoy that tasty Upheaval over the weekend. Thank you all very much.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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