Boston Beer - Sufficient Appeal After A Disastrous 2015

| About: Boston Beer (SAM)


Investors in Boston Beer have seen terrible returns over the past year, despite a hot overall beer sector.

Increased competition is leading to slower growth, yet the market positioning and long-term track record remains very strong.

A guidance for solid growth into 2016, very strong balance sheet, runaway beer valuations and active M&A landscape make me constructive on the shares at current levels.

The Boston Beer Company (SAM) has delivered great returns for long-term investors over the past decade, as the emergence of craft beer really took hold.

Over the past year, shares have lost nearly half their value as investors are worried about the impact of increased competition in the market for craft beers. This is despite the fact that the beer market continues to consolidate, established players trade at premium valuations and smaller craft brewers are being bought at much higher multiples.

While growth is undoubtedly slowing down, I am comforted by the valuation, the relative valuation, strong market positioning and very strong balance sheet. These factors and the huge great retreat in the share price make me a buyer at current levels, as I think that the bad news has been priced in already.

An Amazing Growth Story, Falling Short At The Moment

Boston Beer Company is a product of the 1980s after Mr. Koch found his great-great grandfather's recipe. It took the company little over ten years to grow to the size by which the company was large enough to go public, with an initial offering taking place in 1995.

The company sold shares for $20 at the end of that year, far above the preliminary indicative offering prices. Initially, the stock has been quite a disappointment. Shares fell to high single digits, and as a matter of fact, it took shares until 2004 to recover to the IPO price. From that moment onwards, actual revenue gains have translated into a higher share price. Shares hit a high of $50 in 2007, but again hit a low of $20 during the crisis of 2009.

Over the last 6-7 years, shares have embarked on a great run, actually hitting a high of $325 at the start of 2015. This means that investors saw the value of their investment increase by a factor of 15 times. This run-up coincided with shareholders and consumers getting really enthusiastic about craft beer. With the craft segment growing fast, and traditional beer volumes being stagnant, large breweries have increasingly become more serious about the segment. While growth is good, the trouble is that it has attracted a lot of competition for Boston Beer as well.

The impact of increased competition has already been seen in 2015, as growth rates have been slowing down. These adverse trends have triggered a 45% retreat in the share price of Boston Beer, despite the consolidation taking place in the industry. After such a huge drop, I think that shares represent a nice opportunity, even as long-term momentum remains relatively strong.

A Great Growth Story

Boston Beer has been on fire over the past decade as revenues have pretty much quadrupled from $250 million in 2005 to nearly a billion by now. This corresponds to an impressive revenue compounded annual growth rate of 15% per annum.

While gross margins have come under a bit of pressure, they remain impressive at more than 50%. Even as gross margins have seen a bit of pressure, Boston Beer has managed to expand its operating margins on the back of effective sales leverage. Economies of scale in this area aided operating margins to improve from 10% of sales in 2005 to some 17% by now.

The real achievement has been the fact that the company managed to avoid dilution of the shareholder base. As a matter of fact, Boston Beer has been buying back some of its own stock, thereby reducing the outstanding share base by a tenth. The combination of revenue growth, margin gains and share buybacks allowed earnings per share to increase by 7-8 times versus 2005, supporting the multi-year momentum run in the stock.

While such a growth scenario looks very good, there are some negative sides to the growth as well. As Boston Beer needed to grow its capacity to support growing sales, expansion has tied up a lot of cash flow. The company has invested roughly half a billion into the business over the past decade, equivalent to the cumulative earnings being reported over that period of time.

While growth is certainly very good, actual cash flow conversion has been somewhat disappointing, although slower current growth has a real positive impact on this cash flow conversion.

Looking At The Valuation

While Boston Beer has managed to grow sales by 15% per annum over the past decade, recent growth trends have been falling way short to those levels. Third-quarter revenue growth came in at 9% on the back of a 6% increase in depletion growth.

While the 6% depletion growth number is solid, being equivalent to the growth rate reported for the first three quarters of 2015, the real shock came when the company updated the full-year guidance. The company sees full-year depletion growth of 3-6%, a 3% cut from the previous guidance.

This is a huge cut as it implies that fourth-quarter depletion growth is seen anywhere between -3% to positive 6%. The comforting statement in the third-quarter earnings report is that depletion growth is anticipated to recover to the mid to high single digits into 2016. This seems to suggest that the slowdown is a temporarily phenomenon, although I think that the risks are seen towards the lower end of the guidance.

Slower growth has a modest impact on earnings as well as the full-year guidance has been cut by ten cents towards $7.00-$7.40 per share. This suggests that earnings are seen anywhere between $0.98 and $1.38 per share, indicating a fall compared to the $1.40 being reported in the final quarter of last year.

The bright sight of lower growth is that capital investments come down as well. Capital spending is now seen at $60-$80 million, much lower than the +$100 million budgets of the recent years. Lower spending is providing a boost to cash flows as the company already holds $135 million in cash and equivalent, while it has no debt outstanding. Based on the 13.5 million shares which are outstanding, net cash holdings are actually equivalent to $10 per share.

This suggests that at $177 per share, operating assets are valued at $167 per share, which is equivalent to 22-24 times earnings.

The overall $2.4 billion valuation, or roughly $2.3 billion after taking to account the net cash position, translates into a 2.3 times sales multiple. This multiple is very modest to both promising craft brewers, but also in relation to established peers. This is certainly the case if we take into account the strong balance sheet, as most competitors operate with fairly leveraged balance sheets.

A Look At Recent Dealmaking In Craftland

The market for craft beer is hot, but except for an occasional rumor, Boston Beer is not really involved. While Boston Beer is not often named to be a target, established players are very active to acquire craft brewers.

Last year, Heineken (OTCQX:HEINY) bought a 50% stake in Lagunitas Brewing, a producer of pale ale. Lagunitas was rumored to generate revenues of $200 million, with Heineken reportedly paying $1 billion to acquire the company. That suggests a 5 times sales multiple, although the growth rates being reported by Lagunitas are much more impressive. Constellation Brands (STZ) bought Ballast Point last year as well. That $1 billion deal tag implied even higher multiples given that Ballast was only posting revenues of $115 million a year.

In that perspective, the 2.3 times sales multiple seem very modest. The other good news is that even while competition is increasing, a potential buyer would instantly own the market leading spot in the industry, with a very strong brand name. That makes Boston Beer a very nice target on paper, as any potential buyer would still need to convince Mr. Koch to sell "his" business.

A Look At Established Beer Businesses

Beer companies have historically traded at high valuations. The consolidated nature of the industry, and very defensive nature of the business, have been key drivers behind the high valuation. Many equity investors see shares as bond equivalent investments, in part because of generally decent dividend yields and predictable volume trends.

The beer deal of 2015 has arguably been the $106 billion purchase of SABMiller (OTCPK:SBMRY) by Anheuser-Busch (NYSE:BUD). This deal took place at 5 times sales. This is a huge multiple for an established player, a roughly 2 times premium at which Boston Beer is trading. This premium is driven by the higher margins being reported by SABMiller as well as the large potential synergies. Other hot names like Constellation Brands trade at very elevated multiples as well, as the Corona producer trades at roughly 6 times sales.

What stands out in general is that Boston Beer is reporting sluggish operating margins, at least versus competition. The main reason for this is the lack of scale. This is actually a good sign as it shows that the company has plenty of potential to grow earnings faster than sales, while the potential margin gains make it an acquisition target as well. The other main positive is the very strong balance sheet, with Boston Beer net holding cash.

Beer companies could easily support a 2-3 times leverage ratio which suggests that the company could operate with a debt load of $400-$600 million. This implies that the business could borrow some $500-$700 million to make acquisitions or potentially engage in a huge buyback program. Such a program could be large enough to buy back a quarter of the outstanding share base, although the accretion to earnings per share would be limited given the generous absolute valuation at which the stock is trading.

Final Considerations

After adding it all up, I get really constructive on the prospects at current levels. The company has strong brands, a great track record of growth, but the trouble is that the immediate outlook is very clouded. That being said, the company targets healthy volume growth into 2016 which combined with price hikes could allow it to deliver on 10% revenue growth. Given the poor volume outlook for the fourth quarter of 2015, I am well aware that the risks with regards to this projection can be found on the downside.

While the 22-24 times earnings multiple is somewhat high, the overall valuations in the beer industry are high. As a matter of fact, based on sales multiples, Boston Beer looks cheap compared to other craft brewers. Established competitors who often report no to very modest volume growth actually trade at much higher multiples. This major discrepancy is largely the result of the fact that margins reported by Boston Beer are much slimmer, resulting from the lack of scale.

The low multiples in relation to both established and craft producers, the very strong balance sheet, a market leading position and strong track record of the business are sufficient reasons for me to remain constructive. While competition is clearly intensifying, shares have already been cut in half over the past year.

While a takeover is not the most likely option, as Mr. Koch still controls the business, pressure is mounting to start creating value.

Disclosure: I am/we are long SAM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.