Redhook Ale Brewery Q2 2007 Earnings Call Transcript

Aug.16.07 | About: Craft Brew (BREW)
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Redhook Ale Brewery (HOOK)

Q2 2007 Earnings Call

August 16, 2007 11:30 AM ET

Executives

Paul S. Shipman - Chief Executive Officer

Jay T. Caldwell - Chief Financial Officer

David J. Mickelson - President and Chief Operating Officer

Analysts

Fred Malloy - Analyst

Alan Seymour - Columbia Management

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2007 Redhook Ale Brewery Earnings Conference Call. My name is Grace-Ann, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's conference. [Operator Instructions].

I would now like to turn your presentation over to your host for today’s conference, Mr. Paul Shipman. Please proceed sir.

Paul S. Shipman - Chief Executive Officer

Hello, it’s Paul Shipman here. Welcome to the Redhook Ale Brewery question-and-answer conference call to discuss our quarter ended June 30, 2007. I am here with Dave Mickelson. We are on the road. And Jay Caldwell is back in Woodinville. I am going to begin. Jay is going to start with some comments… actually start with the Safe Harbor statement.

Jay T. Caldwell - Chief Financial Officer

Hello, It’s Jay Caldwell. Welcome to Redhook's 2007 second quarter conference call. Redhook would like to remind everyone that this call may contain forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These 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 expressed, implied or forecasted in any such forward-looking statements. Expressions of future goals or similar expressions reflecting something other than historical fact are intended to identify forward-looking statements. For a list of factors that could cause Redhook's actual results to differ materially from those described in the forward-looking statements, please refer to the Safe Harbor statements in Redhook's most recent filing with the Securities and Exchange Commission. Unless required by law, Redhook undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. A copy of Redhook's most recent filings with the Securities and Exchange Commission are available in the Investor Relations sections of Redhook's website located at www.redhook.com.

Paul?

Paul S. Shipman - Chief Executive Officer

Okay. In January, as many of you know, Redhook announced the agreement in principle on a term sheet to join our Company with the Widmer Brothers Brewery of Portland, Oregon. We appreciate that our investors have been very patient while our management and directors have worked diligently in the best interest of our shareholders towards the merger of the two companies. These deals are complicated. Ours is further challenged by carefully working on details involving three companies due to the nature of Anheuser-Busch's investment in both Redhook and Widmer. Our existing partnerships between AB and Widmer remains solid. It just takes a lot of time to work through the various interest of all parties. We continue to work towards this goal and pledge to make a public statement as soon as we have something definitive to report.

Dave?

David J. Mickelson - President and Chief Operating Officer

Thank you, Paul. Continued high levels of contract brewing had a significant impact on our second quarter results. Of the 19,800 barrel increase, 18,800 of the increase came from contract brewing. While total of the Company shipments excluding beer shipped under the contract brewing arrangements increased 1,000 barrels during the quarter, shipments in our Midwest and Eastern markets including Widmer Hefeweizen license, brewed under our licensing agreement increased 9.4% compared to second quarter of last year. And when we look at only shipments of Redhook branded products in these markets, we are very pleased with the 18.8% increase. Unfortunately, the improvement in the Redhook branded product shipments was reduced by an 8.2% decline in shipments of the Widmer Hefeweizen license in these.

Unfortunately, Redhook's business in the West serviced by Craft Brands alliance remains challenging after declining 5.2% in the second quarter. The Craft segment remained strong nationally by all indications. However, we saw evidence of some softening in the Northwest, according to scanning data that impacted the industry as a whole.

Additionally, we regularly evaluate pricing opportunities and took some increases earlier this year. It appears to have had a negative affect in a few markets, especially, Oregon where we saw a significant decline compared to a year earlier. This was further impacted by a loss of distribution in a few packages at chain stores as a result of the price increase.

Our Washington state home market remains extremely competitive. However, we did manage to grow this business by 0.5% off our largest base. Long Hammer IPA has been a successful re-branding effort with strong growth nationally. But we have continued to battle as competing for the attention we seek from our wholesalers in our secondary product. This was mostly evident in the west where the focus was on Long Hammer, but we ended up losing some ground on other products.

What has impacted our business in the East is with our licensed Widmer Hefeweizen. Our Hefeweizen category is getting increasingly more competitive but most within our existing wholesalers’ portfolios and from most other brewers, both domestic and Craft competing in this area. We must compete successfully for distribution growth and wholesaler attention. Jay?

Jay T. Caldwell - Chief Financial Officer

I would like to comment on our second quarter results.

Redhook generated gross sales net of certain fees paid to Anheuser-Busch of $13.370 million compared to $11.144 million in the second quarter of 2006, an increase of 20.9%. Dave mentioned this increase in revenue is driven by a substantial increase in beer brewed on a contract basis. While we would like to see that revenue increase driven by a more significant increase in shipments of Redhook products, the contribution of the contract brewing revenue is nonetheless a favorable contributor to our bottom line. And we discussed for many years in our quarterly and annual reports, the Company's capacity utilization has significant impact on gross profit as Redhook breweries move closer to their operating at theoretical and maximum design production capacities. Company's profitability has favorably affected, because fixed and semi-variable operating costs such as depreciation in production salaries has spread over a larger sales base. In the second quarter of 2007, this expectation was played out, while shipments increased 26.1%, our cost of sales lag was an increase of 21.4% and decreased on a per barrel basis when compared to the second quarter of 2006.

As we pointed out in our 10-Q, we do expect that our cost of sales and gross profit will be negatively impacted in the future quarters by an increase in the cost of our barley grain. While we were able to withstand the brunt of this market increase over the past year, because we had fixed price purchase contracts in place our recently expired contracts with grain vendors were replaced with contracts to set the price substantially higher.

Unfortunately, the $208,000 improvement in gross margin and the $151,000 increase in Redhook share of profit in Craft brands in 2007 second quarter were largely offset by $344,000 increase in SG&A expenses as compared to a year ago. This SG&A increase was driven by a $110,000 in legal, consulting, and meeting costs in connection with merger discussions, a $115,000 increase in stock compensation expense, and a $65,000 increase in the sales and marketing expenditures and a $54,000 increase in administrative salaries and related expenses.

The Company was favorably impacted by an $81,000 increase in other income, including $28,000 increase in interest income due to higher average cash balances and higher interest rates and insurance recovery following losses incurred during the December 2006 storm at our Washington Brewery.

Finally, although, the Company's income before income taxes was higher in the second quarter of 2007, as compared to the same 2006 quarter, an increase in provision for income tax has resulted in a decline in our net income. The Company has estimated its effective book tax rate to be 45% in 2007. However, our projected cash payment of taxes is expected to be less than 3% of pre-tax book income.

Paul?

Paul S. Shipman - Chief Executive Officer

Okay. Let's open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions].

You have question from the line of John Sabo of Point Bridge Capital [ph].

Unidentified Analyst

Good morning. I just wanted to make sure, I heard you correctly, Paul, in your introductory remarks, you said that back in January. I think you said, you had actually signed a term sheet with Widmer? And today--?

Paul S. Shipman - Chief Executive Officer

Well actually… yes. Let me just see what I said here. Well, it’s agreement in principle on a term sheet. We didn't sign anything.

Unidentified Analyst

Okay. But when you say agreement in principle on a term sheet that would sort of imply that financial terms were fairly well scoped out, or not… or is that not the case?

Paul S. Shipman - Chief Executive Officer

I think that term sheet can take many different forms. It was couple of pages, as I recalled, and not intended to be a public document. Tending to be a basis on which to move forward and be not definitive.

Unidentified Analyst

Okay.

Paul S. Shipman - Chief Executive Officer

The definitive agreement would be a much more detailed document with schedules attached to it and… but we decided not to go… sometimes you can go from the term sheet to a letter of intent and then to the definitive agreement. We elected to go from the term sheet to the definitive agreement, that's a… it's a process.

Unidentified Analyst

Okay. How would you characterize, what's the remaining issues that would be involved between the three parties? Would it be more financial in nature? Or would it be more the social issues as to structure, and who is going to be doing what… could you help us with that a little?

Paul S. Shipman - Chief Executive Officer

We are getting down the road. There's not many issues remaining.

Unidentified Analyst

All right. Would that imply then that we should be hearing something relatively soon… sooner rather than later or?

Paul S. Shipman - Chief Executive Officer

Process about setting up an expectation, I mean we will let you know.

Unidentified Analyst

Okay. Would it be fair to say that beyond some of these expenses you have detailed on the call and in your statements, is that the Widmer merger negotiations have had an impact on your operations whether it's been distracting to sales and marketing people or whether it’s forgone strategic opportunities such as contract brewing, for example. Can you give us an idea as to how this may have impacted the Company over the last quarter or two?

Paul S. Shipman - Chief Executive Officer

I think that… we have been too preoccupied to assess what the impact might be. I think that what you are talking about is a typical pattern in these situations that I wouldn't think that… we highlighted in our conversation today. I believe it was $110,000 in the quarter that was direct expense attributable to the deal. As far as the indirect consequences, I don't have an estimate. I think that the category continues to be robust. We are doing well. We… and… I don't see a desire… I don't have a desire to elaborate further on that.

Unidentified Analyst

Okay. Fair enough. Let me just ask one more question, then I will get back in the queue. I guess one thing that sort of stood out in the quarter was the fact that your revenue was up so substantially and your gross margins were not as good. And given some of the issues we have talked about in the past about the considerable operating leverage that exists in this business. It was little surprising in some respects?

Paul S. Shipman - Chief Executive Officer

I am going to ask Jay to elaborate. But basically the contract… the character of our contract brewing a year ago, even though it was fewer barrels, it was draught for the most part, I mean the preponderance. And that draught business is better margin. When you get into the package business, package business in contract is kind of low margin business. It’s a… and then… Jay, can you elaborate on that?

Jay T. Caldwell - Chief Financial Officer

Yes. The increase in revenue was driven largely by the contract brewing as been mentioned and that's carrying a much narrower gross margin than the sales to the wholesale distribution channel through Anheuser-Busch. So, while that we do make a positive margin on the contract brewing and it helps us absorb our overhead for the breweries, the ratio is not as positive as if we were getting that increase solely through the wholesalers. So, I think, that's really driving what you are seeing John. It’s really a shift of mix between channel.

Unidentified Analyst

Okay. Yes. I certainly understand that. I guess that the specific question I had about this was when you set the contract pricing with Widmer, how much did you consider the fact that some of the profits form those sales would come back to you through the equity income line at CBA? In other words is this reflective of what the contract brewing might look like… the economics would look like if there where a party other than Widmer? Or given that special relationship you have with that company, is it different?

Paul S. Shipman - Chief Executive Officer

That's an excellent question. I think that clearly our relationship with Widmer is a very close relationship. The companies are teamed up in… on many different levels. And when we go to negotiate an arrangement with them, we are fully aware of the fact that we are serving in the West, the CBA in which we are partners. If there was a third party stranger that came to us for business, we would approach it entirely differently, we would be much more attuned to the margin impact. We have resisted low margin contract brewing. Consequently other than the Widmer relationship we really haven’t done any other contract brewing. My view is that contract brewing if you do it at a little margin and you don’t have a strategic reason or a relationship like we have with Widmer, it just is a way of wearing out the equipment. It doesn’t really get you anywhere.

Unidentified Analyst

Okay. Thank you.

Operator

[Operator Instructions].

And your next question comes from the line of Fred Malloy.

Fred Malloy - Analyst

Hi, Paul. Against the backdrop of the Craft… total Craft Brand sales increasing by the 7% and our Redhook’s portion was decreasing by 5%. And in fact, one-third of Redhook’s total shipment is contract brewing, and your relationship with Widmer is set to… contract is set to expire on December 31, of this year. And given that Widmer has a large expansion process underway, what are you doing to maybe look for other resources of revenue if this contract…. if it should… the relationship... the two companies should not merge?

Paul S. Shipman - Chief Executive Officer

Well, I think that whether or not there is a merger, we are going to have excessive of capacity at the Woodinville brewery in ’08. And we are on the look out, but we understand what the cash flow implications are, and we understand what the strategic implications are. There is one bright spot that I want to highlight and we talked about it here is the Long Hammer IPA is really doing very, very well. And we expect that product be an important part of our business in ’08, and it’s absolutely going in the right direction. And that’s a full margin product. So, as to other ways of utilizing the capacity in Woodinville in ’08, which is going to be excess capacity when the expansion in Portland comes online, we are on the lookout.

David J. Mickelson - President and Chief Operating Officer

In terms of the contract brewing arrangement and how it impacts our Eastern business, that’s a renewable deal…

Jay T. Caldwell - Chief Financial Officer

The license…

David J. Mickelson - President and Chief Operating Officer

Yes. The license part is a renewable deal. We have the sales force, we have the production facilities in that market. We envision the likelihood of that continuing to be very strong. Locally, the contract brewing arrangement at Woodinville was setup specifically as it was with the short-term nature of it simply to make sure that we kept it at a profitable number at the brewery, which now that we are looking at these malt increases, we would want to have the ability to adjust that contract there to keep… keep some margin at the brewery. And so that… that’s something that, that volume will largely go away, though we will have some contractual volume of the Widmer Brand likely to our contract in 2008 as well that will be entitled to brew at full margin to CBA.

Operator

Your next question comes from the line of Jeff Byer [ph].

Unidentified Analyst

Yes. Hi, guys. What's the size of cost of good is barley?

Paul S. Shipman - Chief Executive Officer

Jay, you got that right off the top of your head there.

Jay T. Caldwell - Chief Financial Officer

I do not, off the top of my head. The total direct cost of beer is relatively small compared to the overhead and other logistical cost of shipping the beer. Having said that, the increase in barley I think is a significant impact that we are looking at. I think that we are… we believe that this is impacting all brewers nationwide as well. Because it’s being driven not just by the contracts which we have signed it’s the underlying causes have to be affecting everyone. So, I will try to get what that overall percentage of direct costs is in total to you by the end of the call here. Just give me a few minutes.

Unidentified Analyst

Okay. And then… thank you. Next question on the Craft brands, I think last quarter you guys have brought in a new team member and just give an update on how that person is doing , maybe any new changes in tactics or anything going on over there?

Paul S. Shipman - Chief Executive Officer

The relationship in Craft brands is very strong. We can sit here and talk about the volume declines. In time our revenue, our distribution back from CBA has been growing. The volume that we do have is more profitable today then it was when we entered the agreement with them. We are working hard to restore our pricing level in the Q2 markets and that has been meaningful. It takes some time to do that but we are continuing to be aggressive on our pricing. By aggressive actually is the opposite when we think that, aggressive in taking increases where we have that opportunity. It doesn’t work perfectly well as I mentioned in Oregon for instance. But don’t forget that we are doing some really good things within the CBA territory on our brand as well and restoring the brand value equity there, and working with making it more a profitable contribution. And we are seeing the benefits of that in a few key markets. So, the new hire or the new CBA management structure, the slight change has had a good, a far refreshing look to the brand. The person that was handling before worked very hard on behalf of the brand. He just decided to go in a slightly different direction with a few people. And I think its working well. It's still early. But it is working well.

Unidentified Analyst

Okay. All right. Thank you very much.

Operator

And your next question is a follow-up from the line of John Sabo [ph].

Unidentified Analyst

Thanks. Just, I had a question about the tax accrual, and I guess I understand you're not going to be paying cash taxes, but would it be the way to think about it is that the offset on the balance sheet would be that deferred tax liability, is that the way to think about it.

Jay T. Caldwell - Chief Financial Officer

Yes.

Unidentified Analyst

Okay. So, when… so for example in the first quarter it went down because you had a loss, and then you kind of reversed that in the second quarter because you had a profit. Is that right?

Jay T. Caldwell - Chief Financial Officer

Right. Yes, our federal NOLs are not expiring. Basically if you look at it from the books standpoint, we are accruing taxes because we are expecting… the implication is that we are expecting year-to-date profit or profit for the year as a whole. Our… we are booking basically the 34% federal tax rate, about a 3.6% state tax rate and then there are permanent differences of about 7.4%. But we adjust that to the balance sheet to get to what we believe our taxable income will be and what the tax we will pay on a tax basis. And as I mentioned earlier in the call, we do believe that will be under 3%.

Unidentified Analyst

Okay, okay. And then, could you just help us with the… how those NOLs would be treated in a potential merger with Widmer. Would you still retain that in a…

Jay T. Caldwell - Chief Financial Officer

In a tax free exchange or purchase, we would retain the NOL's. It would be fully available to be utilized by a combined Company should it need the provisions of IRS Code 382 which is what we are targeting.

Unidentified Analyst

As which one? Which code?

Jay T. Caldwell - Chief Financial Officer

I believe it's 382.

Unidentified Analyst

382. Okay. And then could you just remind us again what the total amount of the NOLs are?

Jay T. Caldwell - Chief Financial Officer

I… yes, I believe they are about $20 million, not tax effected. Tax effected it’s about… just a moment, I will give you that number.

Unidentified Analyst

Okay. While you are doing that maybe I could just ask a follow up on the business. I appreciate the comments on the contract brewing. If you look out at the growth rate in the Widmer product, and given some of the good things that you are doing in trying to reposition the Hook brands, how soon would it be, before Widmer would be back into your Woodinville capacity? Would that be at some point in '08 or would it be more like '09 or 2010 kind of thing?

David J. Mickelson - President and Chief Operating Officer

Let's make a really big assumption that we… the merger goes through and we are one organization here. We'll see significant contribution out of the Woodinville plant as well. I think we have to maximize the freight benefit, there's a lot of Widmer and the products they have with their relationship with Kona Brewing Company. We want to maximize the benefit that we have in the two different breweries and the different sizes in production facilities i.e. Widmer has a much larger brew house, we have a smaller, we have more flexibility with some of the smaller products. So, I envision then us taking additional steps in terms of evaluating where's the best location to brew what beer in. Obviously, with beer going to Hawaii, it makes a lot of sense to brew it in Seattle right where the shipment leaves the dock from. But beer going to Alaska, to Washington, to Idaho, it would make a lot of sense to brew some of these brands in the Woodinville brewery. Similarly for the…brewing a lot of Red Hook Long Hammer it might make… for California… it will make a lot of sense to save couple of hundred miles off the freight and brew it in the larger brew house in Portland. But I think we are going to do a lot of things. But I don't say okay all the brewers are leaving Woodinville as soon as Portland expansion comes on line, that's not going to be the case. If we meet our objectives we believe both will be very, very busy. But we have to prove we can deliver that. So that was our goal, for a fairly quick use of both facilities.

Unidentified Analyst

Okay and then…

Jay T. Caldwell - Chief Financial Officer

Hey, I am sorry, John, I wanted to interrupt. The NOLs are about $25 million with a tax effective of about $8.5 million, Federal tax effected. Now, if I may, while I am still interrupting the grains as a percentage of total cost to sales is about 12%.

Unidentified Analyst

That's of the $9.847 million of cost of goods sold, it would be 12%... I am sorry did you say 12%?

Jay T. Caldwell - Chief Financial Officer

12%.

Unidentified Analyst

12% of that, okay. Okay. Great thanks.

Operator

Your next question comes from the line of Alan Seymour of Columbia Management.

Alan Seymour - Columbia Management

Okay, Hello? Hello? Yes. Could you talk a little bit about, more about the branding of Long Hammer? And how you are thinking about that and as well as how you see the progress in the last quarter and how you see it evolving over time if you might?

Paul S. Shipman - Chief Executive Officer

The Long Hammer is the new branding, an identity of what used to be the Redhook IPA, and a parallel higher… high profile, fairly strong product. And the opportunity that we see is that the IPAs are a big slice of the Craft beer pie. And none of the IPAs are particularly dominant. There is a region-by-region, there are favorites around the country, but this is an area where our national heritage we think is a pretty strong aspect.

The… so we going into, what we're going to embark in… our objective is to move up the ranks just by showing off with the AB system, we can credibly expect to be somewhere in the top four or five, and then as we apply selling effort and marketing effort, we could move up. And if you add up all the markets in the country, we have the opportunity to become a clear number one cumulatively. And there's really… there's no one I can think of that we, that we can compete with across the entire country. So, strong… microbrewery beer, Craft beer is growing, IPA's are growing within the category. Redhook IPA, even though we applied very little marketing efforts to it was the best growing product within the portfolio. The rebranding allows us to have more focus on it. The focus is paying off already. Initially, paying off stronger in the Eastern part of the United States than in the West, but both areas are growing nicely. And I think that if I was to look into a crystal ball, I could see that product being as big as the Widmer Hefeweizen. I don’t see any obstacles in that. I don’t see any competitor able to apply the same type of effort in this segment.

Alan Seymour - Columbia Management

Do you see a particular demographic picking this up at all? I mean, as early adopters or a particular segment of the guide the market that tends towards the IPA part. Or is that just--?

Paul S. Shipman - Chief Executive Officer

It’s a, it's… you are getting down to the very fine detail when you try to look at a segment this small and… I think you'd be surprised at how broad the big…, when people buy these, when the people buy the products they make a personal connection to them, some try and they don't think of them necessarily as IPAs they don’t understand, some people think that the products are made in India.

Alan Seymour - Columbia Management

Right.

Paul S. Shipman - Chief Executive Officer

I mean, but the style of product I think is very evocative of some of the German lager beers, they have a nice hot profile and they… they don’t… ours especially has a pleasant drink ability. It's got what we here call a crossover, regular people who drink their Bud Miller and Coors.

Alan Seymour - Columbia Management

Right.

Paul S. Shipman - Chief Executive Officer

They can lap this stuff up. The product is scrumptious. It’s the best; it is in many ways the best product that we make.

Alan Seymour - Columbia Management

Okay. So, and so the question then is I think in… does the change in the name actually give you a better opportunity, is it more recognizable for somebody to sit down and say, "Oh yeah, have a Long Hammer" as opposed to like you used to say "Have a Heiniken" or something else like that. I mean, does that make it a lot easier to?

Paul S. Shipman - Chief Executive Officer

There's no question, it allows people to have a better connection to the product.

Alan Seymour - Columbia Management

Okay.

Paul S. Shipman - Chief Executive Officer

And part of what we aim for as Beer marketers is to make it easy for people to get, feel a connection to the brewery and the product.

Alan Seymour - Columbia Management

Okay. So if we start seeing Long Hammer T-shirts all over the United States we'll know you have been successful, right?

Paul S. Shipman - Chief Executive Officer

They are available. They are all ready yet. That product has had a really legendary life. It started out as Ballard Bitter. When we were just a little tiny brewery we used to sell it only within two miles of the Brewery. And so it quickly became our biggest product under that. And then we brought it in with the Red Hook, so it could be National and then we saw the potential and we have put a lot of effort into the… getting the branding correct. People like the name, it's memorable, it's… the people feel that connection, it has a story to go with it that is real and credible. And anyway, we are very excited about that product.

Alan Seymour - Columbia Management

Great. Thank you very much.

Operator

And you have no questions at this time.

Paul S. Shipman - Chief Executive Officer

Okay. Well the… I see the Dow is down 260 points. At any rate, I thank everybody for calling in and we'll talk to you in three months unless we talk to you sooner. Thank you.

Jay T. Caldwell - Chief Financial Officer

Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation and you may now disconnect.

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