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Executives

David J. Mickelson - President, Co-Chief Executive Officer, Chief Operating Officer

Mark D. Moreland - Chief Accounting Officer

Terry E. Michaelson - Co-Chief Executive Officer

Anne Mueller - Director of SEC Reporting and Investor Relations

Analysts

[John Stabo - Flintridge Capital]

[Chris Reynolds - Newberg & Berman]

[Fred Malloy] - Private Investor

John Kohler - Oppenheimer & Close

[Steve Olson] - Private Investor

[Aram Fudt - Ferdal & Capital]

[Jim Cole - Lambert Securities]

Craft Brewers Alliance, Inc. (HOOK) Q2 2008 Earnings Call August 19, 2008 11:30 AM ET

Operator

Welcome to the second quarter 2008 Craft Brewers Alliance, Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Dave Mickelson, Co-Chief Executive Officer.

David J. Mickelson

Welcome to the Craft Brewers Alliance question and answer conference call letting us discuss our results for the quarter ended June 30, 2008. Mark Moreland our Chief Financial Officer and I will give a few brief comments and then we’ll open up the call for questions. Mark joined Widmer in the spring and has been working tirelessly in building an effective accounting department to handle the combined new company’s requirements. Terry Michaelson, the Co-Chief Executive Officer of Craft Brewers, is also on the line to help address questions as is Anne Mueller, Director of SEC Reporting and Investor Relations.

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

Mark D. Moreland

We’d like to start by reminding 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 and similar expressions reflecting something other than historical fact are intended to identify forward-looking statements. For a list of factors that could cause Craft Brewers’ actual results to differ materially from those described in the forward-looking statements, please refer to the Safe Harbor statements in our most recent filings with the SEC. Unless required by law Craft Brewers 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 SEC are available in the Investor Relations section of our website located at www.craftbrewers.com. As it relates to today’s discussion please note the numbers we report represent only historical Redhook results unless specifically noted otherwise. While we are very much aware of your interest in the combined company results, we are prevented from disclosing pro forma combined results until later this quarter when we’re able to meet all the requirements of the SEC.

David J. Mickelson

As most of you if not all of you know, we’ve spent a tremendous amount of time and energy devoting ourselves to the closing of the Redhook and Widmer merger that went effective July 1. There has been much transition associated with merging the two companies but the tremendous amount of integration activity intensified over the last six months has really paid many dividends in allowing us to hit the ground running from an operational standpoint. Production, sales and marketing functions are integrated and operating cohesively. The biggest area of transition most recently has been in the new company’s financial and accounting department where we feel we have put together a very strong group of professionals highly dedicated and experienced to lead this functional area successfully. I can let Mark describe this activity in further detail.

As this group consolidates into one location, there are a number of prior Redhook accounting people moving on to the next stage of their professional careers and I personally want to thank them for their help and professionalism in executing the transition. I specifically want to thank Jay Caldwell, the recently departed Chief Financial Officer of Redhook, who cared deeply for his staff and for the success of the transition up to the last day of his employment. I’d also be very remiss if I didn’t personally thank [Paul Shipman] for his 27 years of leadership, motivation and friendship as founder and now-departed Chief Executive Officer of Redhook. While Paul has exited from day-to-day activities as Chairman Emeritus, he remains committed and supportive of the future success of Craft Brewers and is an invaluable resource for our leadership when needed.

The 2008 second quarter was disappointing from an operating perspective because of lower volume than anticipated with both the Redhook and Widmer brands. Also the impact of significantly higher raw material costs, the inflationary impact on many other operating costs, the impact of rising fuel costs on freight, and the ramp up of investment in sales and marketing both on infrastructure and programs on a national basis.

The revenue per barrel in the second quarter increased 3.8% due to pricing increases and a small shift in mix towards more package volume versus draft; however, excluding the effect of contract brewing volume the Redhook declined 4,100 barrels or 7.3%. While the pricing has been increased and we continue to look at each and every market to assess further increases, the impact from price increases in the second quarter was not sufficient to cover the increase in costs, very evident in seeing the decline of gross profit to 7% of net sales compared to 17.2% in last year’s second quarter. While we are forced in the current environment to take pricing increases wherever possible, we appreciate that the impact can result in lower volume and requires careful analysis.

The cost front is very challenging. We’ve experienced significant increases in raw materials in excess of 200% in some areas. We’re not prepared to alter recipes when the result is a lower quality product. We’re reviewing all purchase relationships and processing procedures including alternative vendors and programs however to see if we can be more efficient. For the most part we view these as the hard-to-control costs that are just part of doing business that must be managed as tightly as possible. We continue however to look very closely at all controllable operating expenses and have initiated a tight expense control program to extract savings throughout all functional areas of the company beginning in the third quarter.

In addition to sales activity being impacted by higher pricing, Craft industry experienced a slower growth rate than in any period in recent quarters. Based on certain industry statistics while the growth of the Craft category on a percentage basis has been in the 10% to 15% range for a number of quarters, we saw a slowdown into the low single digits during the second quarter. Economic conditions suggest reduced disposable income is available for specialty products. The on-premise sector has also been impacted as fewer people are going out for dinner and drinks and instead spending the money on gas just to get to work.

This is another challenge we face but we don’t want to make excuses. It just means we need to work harder to out-execute our competitors. That landscape has also changed as we see the continued growth and strength of brands competing in the specialty category produced by large domestic brewers such as the highly successful Coors product Blue Moon. This product which has generated tremendous appeal in the wheat beer category has crossed over very successfully into the Craft space. There are other similar examples from domestic brewers as well such as the Michelob Craft family of beers produced by Anheuser-Busch that are having success in regional pockets throughout the country.

What we realize is that we have to face this competition boldly despite limited resources and execute successful programs at the ground level. We must carefully and thoroughly evaluate our brand portfolio and be quick to market with exciting new products and programs that meet consumer expectations. A small example of this execution will be a limited release program of specialty beers such as the September re-release of an iconic Redhook product called Double Black Stout that is delivered at a very high price point intended to generate new distribution at higher margin.

The economy, cost environment and competitive landscape have created a headwind that we must manage through successful. However, we remain very confident in the high quality and diverse portfolio of products that we produce, market and sell with a tremendous team of employees.

Mark D. Moreland

For the second quarter 2008 the company generated total net sales of $10.7 million representing a decline of 9.5% on shipments of 76,200 barrels which represents a 20.5% volume reduction. Both shipments and net sales were impacted by a significant reduction in contract brewing for Widmer which was driven by Widmer’s startup of their expanded brewery in Portland. Excluding the contract brewing, which is now an interrupt company transaction, total sales were down 4.8% and volume was down 9.8%. The non-contract business was down as a result of an 11.5% barrel decrease from the AB territory of the Eastern and Midwestern states and an 8.9% barrel decrease in the CBA territory of the Western states.

The shift in contract brewing also impacted the full-year results. For the six months ended June 30 net sales were $20.2 million down 1.4% on shipments of 144,600 barrels which represented a decline of 10.2%. Excluding contract brewing gross revenue was up 1% and shipments were down approximately 5%. Non-contract shipments were down in both the AB territory and CBA territory by 4% and 5.1% respectively.

Price increases at the wholesale level have helped offset the decline in volume and at the lower volume the contract brewing for Widmer which was still below wholesale cost. Gross margin has been impacted by both the volume decline which resulted in higher overhead rates and commodity price increases for grains, hops and energy. Gross margin for the quarter was $0.8 million a decline of $1.3 million from last year and for the six months declined $1.7 million to $1.1 million.

In part these margins are also impacted by the contract terms of both our contract brewing with Widmer where the pricing was below break-even and our sales to CBA made at a contractual price. The contract price is based on a formula tied to the prior year sales and does not take into consideration the rapid increase in raw material prices particularly those we saw for hops, barley, malt and wheat in the second half of 2007. As a result Redhook sales to CBA were also below break-even and we relied on our investment in CBA which benefited from increased wholesaler and retailer prices to generate sufficient margin o make the channel sales profitable. However for the second quarter and year to date CBA’s contribution to Redhook decreased by $330,000 and $258,000 respectively when compared to 2007. These results reflect CBA’s higher sales and marketing spends as a result of new program launches and integration efforts between CBA and AB territories.

Redhook’s operating expenses increased by $417,000 versus last year driven by the rollout of Kona in the Southeast markets and integration related expenses. The company incurred merger expenses itemized on the P&L of $1.1 million compared to $110,000 last year. In addition to the expensed merger costs Redhook capitalized $410,000 of merger costs in the second quarter bringing the total capitalized since October 1, 2007 to $688,000 primarily as a result of the aforementioned factors.

The company generated net loss for the quarter of $1.4 million or $0.16 per share. On a combined company basis Craft Brewers’ working capital has declined over the six months ended June 30 as a result of capital expenditures and merger related expenses. On a pro forma basis working capital has declined by $6.1 million since December 31, 2007 prior to making non-cash purchase price accounting adjustments.

Year to date the stand-alone company Redhook generated approximately $160,000 in cash flow from operations and used $2.6 million towards capital expenditures. As Dave mentioned earlier the company has initiated a tight expense control program and is closely managing its capital expenditures. We expect the company’s ongoing capital needs will be funded by operating cash flow and the $9 million of availability under its existing credit line.

I’ll turn the call back to Dave for closing comments.

David J. Mickelson

With regards to the impact of the much publicized merger of Anheuser-Busch into the InBev organization, while there may be uncertainty in the AB organization we are not a party in any way to those discussions and we don’t know what if any effect it will have on our relationship with AB at this time. We remain proud of our distribution relationship with AB and their strong network of independent wholesalers which we do business with.

Your management team is very engaged and committed to improving performance. Now that our companies are merged we see tremendous opportunity and are highly motivated to succeed. We have a unified mission to meet that goal.

I’d like to now open up the call for questions. As a reminder we have myself, Terry Michaelson, Mark Moreland and Anne Mueller available for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from [John Stabo - Flintridge Capital].

[John Stabo - Flintridge Capital]

With regard to the price increases, I noticed that Anheuser-Busch is talking about pulling their price increases forward and I think some others have talked about pulling year-end price increases forward as well. How does that play into your thinking with regard to pricing going forward? And then could you also give us a sense of how the price increases in the second quarter may have impacted volumes? Do you have an idea of how elastic the demand was relative to the price increases you put in in the second quarter?

David J. Mickelson

I’ll talk for a little bit and then maybe Terry may want to add something to this. But the one good aspect with all that’s going on is that the pricing umbrella, the cost side has impacted the entire beer industry so the pricing umbrella has remained in place so that there’s strength that the large domestics continue to come up and strengthen their pricing and the imports are poised to do the same thing with some of the same issues. We do have the ability to go up. The question is how high can we go, and in the Seattle market as just one example the front line price of our products is $9.99 a six pack. In many parts of the country you may see it at $7.99 perhaps. Maybe that’s on deal; maybe it isn’t. But it’s challenging at that $9.99 price point without some kind of ad activity or post op or discounting against it to get a lot of activity. That doesn’t mean the market won’t move that way to a degree but early reports suggest that we get up to a limit there where you might start seeking alternatives to that that are a little less expensive. Right now there seems to be some room in there. The question is who all gets to grab that margin because I think the retailer takes some and the wholesaler needs some and certainly the brewery needs some. So in terms of volume in the second quarter I think there were in certain markets definitely the impact of raising prices and a softening of demand. But I think it’s hard to separate from fuel prices at the same time and other economic factors.

Terry, do you want to add anything?

Terry E. Michaelson

Yes, I would just say that we have added a very experienced person into the revenue management area and we’re utilizing that to really become much more effective in analyzing each market, what’s happening with sales as we raise, as we do different programs, what’s the impact on volume so we can calculate it as John has asked what the true impact is. I think that’ll give us an advantage over most of our competitors. It’s not traditionally been a strength of the Craft brewing industry in analyzing that. So I think as we move forward we’re going to be looking at each region and opportunities for our brands within what’s happening in the category. And in the second quarter as Dave did mention, I think there was an impact on sales. We know both from what the pricing increases were in certain markets where our pricing ended up being reflected a little higher than some of our key competitors at the shelf which sometimes happens as we take price increases and other Craft brewers pricing in their own direction don’t do that. The second thing that certainly had an impact on it is that we also had some programs last year with discounting in June that we’ve targeted to different periods of the year this year so any time we do that it certainly has an impact on volume as well.

[John Stabo - Flintridge Capital]

And Terry, do you see that it’s linear; in other words, if you took a 1% price increase you’d see a 1% decline in volume? Or is it more than linear; in other words, a 1% increase in price is a 2% decline in volume? And I’m just trying to understand, are we at a tipping point or near a tipping point from an absolute pricing standpoint or is the relative pricing still the big driver in terms of the price elasticity?

Terry E. Michaelson

That’s an interesting question. I wish to some extent it was that easy. What you’re seeing in the segment now is some segmentation of the pricing so that you have some as Dave referred to our specialty products we’re introducing in the fall; you have a very high end segment that’s actually doing very well at this point where there are four-packs of beer being sold for $10.99 or $11.99. So very specialized products that are actually doing very well. And then you’ve got the core Craft pricing which the Redhook and Widmer brands have lived within, and then you really have an above premium pricing where things like Shock Top and in some markets Blue Moon live. So there’s a real segmentation happening. So the answer really is that it depends on the brand and it depends on the region and the impact. For instance right now in our portfolio Kona is very strong especially in some new markets so increasing the prices on that brand we haven’t seen a negative impact on volume at all. I wish it was as simple as we could look across all the states and look at that but it really has to be analyzed on a per brand per region basis and we’re going to need to look at how we’re going to play in the different segmentation that’s occurring in the pricing in the segment.

[John Stabo - Flintridge Capital]

Do you think that your pricing strategy will be more effective in improving the revenue realization in the third and fourth quarters due to some of these changes you mentioned related to this new person coming in or is it going to take a little longer to get that going?

Terry E. Michaelson

We’re optimistic. I think it’s a long-term process. Again we don’t want to give you the specifics of the forward-looking in terms of revenue and honestly we’re not certain at this point because we’re so new into it. But we’re optimistic that we’re going to start showing some results in specific areas in the near future. Honestly by the end of the year as we produce some results I think at that point we’ll be able to talk with much more clarity.

[John Stabo - Flintridge Capital]

I also noticed I don’t want to call it a geographic retreat but on the East Coast you saw a lot of the geographies with volume declines. Is that part of an intentional strategy where you’re trying to maximize the capacity utilization versus the freight and shipping costs? In other words, it doesn’t make as much sense now to ship to further away points. Or was it just a lack of follow through on the demand side as you entered those markets last year?

Terry E. Michaelson

I think it was probably a combination of a number of things. I do think that any time two companies go through something this significant there’s a lot of focus on the merger and integration activities so that certainly has an impact on how effective we are in the market. And I think it would be a mistake for us to not feel that was a part of it. We certainly are looking at the expense aspect of it but I think more so we’re looking at what regions we think we can get a very solid position where there is a lot of momentum. We do believe over the long haul that success in this segment as we’ve looked at other people like Sam Adams that has been very successful, it has to do with getting a solid position, a strong market share position in key regions. So as we look at this growth we’re going to want to make sure that we look at where we can maximize brand potential in key regions and that may be that in the short term you see some decline in some areas and some increases in some others. And I think again as we go through the next 12 to 18 months I think that’ll become clearer.

Operator

Our next question comes from [Chris Reynolds - Newberg & Berman].

[Chris Reynolds - Newberg & Berman]

I have a question for you about this InBev Anheuser-Busch combination. Can you outline how you were planning to proceed in terms of the combined company with Anheuser-Busch in 2008 and 2009? Because I would think if there were probably marketing and production strategies that would have been significant or they would not have thought that the combination made a lot of sense. Maybe you can just outline how you anticipate running the business and how that might change now that you’ve pulled the two companies together and then how the merger with InBev might affect that? I guess I’m struggling a bit to see how it’s potentially positive that Anheuser-Busch is merging with InBev.

David J. Mickelson

I tried to pre-empt that a little bit in the document because we simply aren’t privy to those discussions at this level yet. There’s a lot going on in that organization right now and they’re working on a lot of things that take a lot more time and energy away from them than worrying about the little transaction with Redhook and Widmer that’s now Craft Brewers Alliance. The people we’ve been doing business with at Anheuser-Busch are there and they’re open to us and we continue to work well together. We continue to be an independent company in many respects too though and have never relied completely on that organization. For instance they’ve never sold our product; they’ve never pushed our products; they’ve done various things to help along the way but we can only take the stance right now of business as usual until we, not that we aren’t trying to anticipate what options might exist, but I think it’s very difficult for us to get in a discussion about something we’re not a party to. And I think frankly it’s an area we’re not allowed to go to.

[Chris Reynolds - Newberg & Berman]

In terms of maybe changes that were contemplated with Anheuser-Busch because I think that there must have been a larger strategy to expand the Craft brewery’s business underneath the Anheuser-Busch umbrella and given the increased scale and production there were probably activities that they planned for 2009 that would have been positive. Is that the case and can you comment about that?

David J. Mickelson

I wouldn’t say that Anheuser-Busch had any plans for our company certainly in 2009 but we certainly do, having our equity interests in Kona and our sales and marketing effort here that’s working very well as well as our relationship with the independent but strong company there in the Midwest Goose Island. Our strategy hasn’t differentiated there and wasn’t really different going into 2008 that I could comment on. I’m a little confused I guess by the question. AB is a partner of ours in distribution and we have some benefits administratively through that organization and relationships that are beneficial sometimes in purchasing and some of those areas and those continue to be good relationships that we continue to build on. From that standpoint things aren’t different. How AB views the Craft category, we don’t know that yet. We know what they have done historically and we have some insight on that that’s public information but nothing internal. That’s what we go with but I wouldn’t say our strategy with AB had been altogether different during this year than it had been in previous years except as one big company to give us the opportunity to be more efficient in all of our [inaudible] and we still have those opportunities.

Terry, am I missing anything?

[Chris Reynolds - Newberg & Berman]

No, no, that’s helpful. I just always viewed the combined company that you’ve created which really seems like it has the opportunity to be a growing and profitable entity on a stand-alone basis that because of your additional scale that perhaps Anheuser-Busch would allocate more of their own corporate resources to try to gain market share in the Craft segment in general and those activities would be transmitted through your corporation. I think you’re saying you have an independent strategy and AB is part of that and it’s very important but Anheuser-Busch’s general strategy with the Craft segment prior to the InBev transaction really hadn’t changed a lot over the year or so and has not changed as a result of the two companies coming together.

David J. Mickelson

Right. And they’re very supportive of our segment within the kind of homespun Craft area but you can see that they’re also participating very actively in that segment now. On the other side with the InBev they have many products that can compete in similar spaces as well. So I think we have no alternative but to aggressively pursue our growth through the channels in partnership with AB when we can but definitely take advantage of the opportunities and not sit around and wait for what might be because we just don’t know that yet.

Operator

Our next question comes from [Fred Malloy] - Private Investor.

[Fred Malloy] - Private Investor

In the investment community there’s some belief that this merger with InBev and AB can somehow nullify the distribution agreement; that they can unilaterally cancel the agreement without financial repercussions from AB. Could you shed some light on that to clarify that?

David J. Mickelson

It is not my belief that they can just get out of the relationship unilaterally. I think naturally when the documents were produced I can remember that we didn’t have unilateral rights to just go and switch out at any time. There is a procedure or a process to go through from our side to sever the relationship that would be challenging and difficult to do and likewise I think they would have legal repercussions if they were to do that. But short of preparing for that, I don’t see that as something that’s easily or quickly done but short of preparing for that I hate to comment too much and make some assumptions here I might be wrong about. That’s something I could look into and talk about on the next call.

[Fred Malloy] - Private Investor

Yahoo and MSN are still directing to Redhook’s website instead of CBA’s website for financing information. Maybe you can have your accounting department update that.

David J. Mickelson

Anne can offer a real brief. This is one of those things that kind of tags on for too long but we’re trying. But go ahead Anne.

Anne Mueller

Basically because the QSIP number changed, it’s a matter of working through the vendors at MSN or Yahoo or anybody you use in getting them to update the cross references. So it’s just hard to find those vendors and contact them and get it taken care of. We’re working on it and we’ve knocked out a couple of them but there are some that are trailing yet. We’re getting there.

David J. Mickelson

Some we send repeated notices and repeated notices and have different people do it and it’s challenging to get to the right people to update that. But thanks for the reminder. We know that we have some out there that aren’t quite right and we’ve got to get it fixed.

[Fred Malloy] - Private Investor

I know that the Redhook has been resistant to television advertising or cable advertising but because the two companies are now combined and you have a pretty heavy market I would think between say I-405 from Albany to Bellingham, I would think that you might be able to get some pull for your products if you did selective advertising. I know Widmer in the past has done some and so has Samuel Adams. Is your marketing department going to review that now that the companies are combined?

David J. Mickelson

The point you get to from a national perspective we still remember very much so that the key states of Washington and Oregon where the breweries both at Widmer and Redhook originated still are very strong in their home markets despite some challenges with a lot of competition and what not. They are key markets up and down that corridor and the Widmer product the trail into television has been very interesting because the Widmer Hefeweizen is such a visual products and it makes a lot of sense in some areas there. And frankly there are avenues to go about which are a little more reasonable than they’ve ever been historically but at the same time with that reasonableness comes a lot of fragmentation of where your audience is and how you reach them. But I think the role of TV is something that remains very expensive but one in which we are dabbling in.

Terry, do you want to comment a little bit about the role you see for TV?

Terry E. Michaelson

Yes. I think the bottom line is we are assessing it. Each brand has its own unique personality and the challenge is to find what media or what kinds of marketing programs work the best. At this point most of Redhook’s are focused on the more gorilla kinds of activities because of what we’re trying to create with the image especially for the IPA. But I certainly do believe that there would be a potential for something like TV advertising certainly on cable channels, those kinds of things, as we get into the further branding of the Redhook different products. But at this point it doesn’t really fit with what we’re doing with the brand right now.

[Fred Malloy] - Private Investor

At the shareholder meeting at Redhook we saw a mixed pack of Craft brands products. Would they be thinking about doing something like that for Costco or Sam’s Club, possibly some time? I know in the past we’ve seen Sam Adams and some of these others do such. I don’t know what kind of success it met with but have they thought about doing that?

Terry E. Michaelson

We are considering all of those. Widmer has had a mixed pack of 12-packs. We are concerned at this point at least with mixing the different brands together because we certainly want the consumers to see each brand as unique. We don’t want to do anything that takes away from that uniqueness but those kinds of trial packages are very hot at this point. The trouble for brewers is they’re expensive because they’re not as easy to package but Sam Adams has been very successful and we are evaluating that for all the different areas and potentially down the road as we get to a place where we’re more and more confident that the brands are keeping their unique personalities, we may find ways in the Costcos, the Sam’s Clubs, those kinds of things to actually combine them. But I don’t think we’d do that at the beginning.

[Fred Malloy] - Private Investor

One final thought. On maybe like the builders channel and so forth for the Long Hammer or possibly Mega Machines cable allows you to differentiate your products quite well and hit a more targeted market. It just might be food for thought.

Terry E. Michaelson

I think that’s the kind of thinking that we’d put into the advertising. That’s really what happens with Widmer at this point. It’s very specific markets, specific cable channels geared to the consumer base. I think that’s a creative idea.

Operator

Our next question comes from John Kohler - Oppenheimer & Close.

John Kohler - Oppenheimer & Close

Can you explain or give some volume figures for Western states? I know that the percentages were quite robust and I know that the Eastern was 36% of total company shipments but for say Arizona or Idaho, I was wondering if you had some volume figures?

Terry E. Michaelson

We don’t typically do it by individual state. I don’t know Mark if you have that handy. I’m trying to look for where I might have some. We separate by the AB territory and by -

Mark D. Moreland

Are you referring to the historical stand-alone Redhook or the combined company?

John Kohler - Oppenheimer & Close

Historical Redhook is fine.

Mark D. Moreland

If you look in the MD&A in both the Q in the full-year section you do break down the AB and Craft brands territories. Just to be clear the AB is the Eastern states; Craft brands is Western. But we don’t go below that level on our disclosures.

John Kohler - Oppenheimer & Close

I noticed that inventories were down quite a bit and I was wondering if you could explain perhaps why that would be as we enter a busier season?

Mark D. Moreland

I’ll ask Anne to correct me if I’m wrong here, but it would be predominantly because of lower production volumes. Anne, any other observations?

Anne Mueller

A lot of it’s just normal fluctuations. Sometimes at the end of the year we buy out some of our hops contracts so they may be a little higher but a lot of it’s just normal fluctuations and delivery timing.

John Kohler - Oppenheimer & Close

Okay, because I noticed that the June volumes were down but then if you look, the July volumes look like they might have improved a little bit, and I was just wondering if that might have had something to do with it, if it was an issue where you were essentially cleaning house ahead of the merger or what that might be?

Mark D. Moreland

The challenge is we are kind of changing companies on you between the June 30 and July 31 data so June 30 is stand-alone Redhook. Redhook was approximately two-thirds the size of Widmer so now the combined company you’re seeing on those July numbers are the combined company. And as we mentioned there has been a shift in production from Woodinville to Portland, so if you think about the combined company in July you had one division in Woodinville lowering its production volume as it shifted to another production plant in Portland. So really what you’re seeing is you’ll see lower activity, lower inventories in the historical company and once we provide the Q3 numbers you’ll see at least the combined company total inventory levels.

David J. Mickelson

And it’s still less than a 5% drop in the inventory. So the fact that we did actually pick up a little in July, again that’s just the swing of timing but it’s not a material change in the overall finished goods inventory.

John Kohler - Oppenheimer & Close

Do you have any figures for sell-through on Kona? I know that the increases are quiet sizable. I’m wondering how much of that is just channel fill or what kind of end demand you’re actually seeing?

David J. Mickelson

We don’t break that out specifically separately yet and in quarters to come we’re going to have to take a good look at what kind of disclosure we have there to provide you the ability to see a little more clarity. But a lot of the growth in Kona that did occur in the second quarter; a lot of it is new growth. So on a year-over-year comparable it’s not like a same store sales number or something like that because you really are looking at new distribution for a lot of that. What we can comment on and Terry you can correct me if I’m wrong is we’ve had a lot of sell-through in the new distribution that we have gained that we do have reorders and the brand has velocity to it within the channel. And we’re very encouraged by that but at the same time it’s a distant location and we need that product produced in Portsmouth and right now it’s coming across the country in a refrigerated truck and we’re getting really hurt on the freight component to it. But the market timing was important and the wholesalers were clamoring, as many are that don’t have it right now, but we can’t really quantify what that means in terms of sell-through and all that. But the market timing was important to gain the momentum that we had to actually expand some markets. Now we have to work and hustle to catch up on the production side to get all the legal and regulatory and brewing dialed in so we can produce it closer to home. We hope it will happen before the end of the year that we can make it align all the stars correctly on that.

John Kohler - Oppenheimer & Close

The Redhook brand sales through CBA have been declining for a while, or had been, and then you have Kona come in and it does really well. Can you actually possibly attribute or maybe it’s not so that the sales organization might have had an easier time selling Kona so focused more on that than the other two brands? I’m just trying to account somewhat for the soft volumes in the other two.

David J. Mickelson

Before Terry runs with this one, it’s easy to suggest when you take a look at it that “Hey, we’re taking our eye off Redhook and we’re moving the Kona.” There are a lot of different variables there. We’re putting a lot of emphasis behind the Long Hammer brand in our portfolio on the Redhook side now and that brand is performing well. It’s doing really well but it’s offset somewhat by a flagship or the historical flagship of the Redhook brand family being the ESB that has matured. It’s in a maturing subcategory of the Craft section and it’s performing in line with a lot of those in that kind of mature growth of the bell curve you might say, so it’s offsetting some of that. But I can tell you there’s no less effort across the board whether it be the Redhook, the Widmer, or the Kona. There are different incentives at different times. Wholesalers dictate where the success might lie; where the emphasis might be. But there are good stories within each brand family and there are challenges with each brand family.

Terry, do you want to add anything there?

Terry E. Michaelson

We’ve talked a little bit over the last few quarters about the fact that brands in this Craft segment do experience different cycles and some brands are in a more mature cycle and being rejuvenated; other brands are new and fresh; and you can look outside our business to see that in what happened with Blue Moon that was around for a long time and all of a sudden it caught fire. There are other brands that were extremely hot in the market place that have slowed down. So as Dave said we certainly have a very disciplined approach from the sales side in managing the portfolio. We have goals for all the brands. We approach them in a very similar way but certainly in certain markets at certain times, the wholesalers and retailers and the consumers are much more excited about sometimes something new. And I think that’s to some extent what’s happening with Kona. It’s new and fresh at this point and the retailers and wholesalers are really reacting to that. That being said, as Dave said within the Redhook business there are some brands that are really selling very well at this point and we’re excited about some of the new entries that we have coming. So I think again over the next 12 to 18 months there’s a potential that you’ll be able to see how that cycle is playing out with Redhook with some of the new brands that are in place.

John Kohler - Oppenheimer & Close

Do you have a figure for capacity utilization for the quarter and what it might have been a year ago? You can use it against nameplate capacity or whatever figure you want to use but just an idea would be great.

David J. Mickelson

We really do have a lot of fun with this every call and I certainly don’t blame you for asking this question because capacity utilization is a very interesting and dynamic number based on the fact that we don’t have a flat line demand for our product 12 months of the year and we have a variable mix of products, many of which take longer to make than others. So we have tried to be very careful in adding a new section that we reviewed and very in detail with our production people as well to get a good straight forward method of evaluating the capacity. And I think it’s right on page 25 of the Q, it says that “Based on the Washington and New Hampshire breweries combined working capacity of 94,000 barrels and 89,000 barrels for the second quarter of 08 and 07 respectively, the utilization rate was 81% and 86% during those two periods.” What I’ll add to that is over the course of that quarter we were at 81% on an average basis but you’ve got to remember that certain beers take longer than others and at certain weeks we’d be going to the wall with brewing seven days a week 24 hours a day and then certain weeks to keep the product mix fresh and the inventory balanced we might have to back off that a little bit. But that is a number in the Q now that we feel good at representing in a fairly conservative approach to our capacity, but again it’s really challenging when you have the uneven level of demand throughout the year.

John Kohler - Oppenheimer & Close

I apologize. I missed that. But thank you very much.

David J. Mickelson

We snuck it in there.

Operator

Our next question comes from [Steve Olson] - Private Investor.

[Steve Olson] - Private Investor

Congratulations on completing the merger. Two questions that actually go back to the merger documents and then a question on the Kona brand. In the background of the merger it talked about a couple alternatives that were considered. One appeared to have been approved by the Board but then I guess there was some concern about the debt levels. It involved the exchange of 6 million shares and $25 million cash. In comparing that to what eventually was the 8.3 million shares, were there any other material differences between those two proposals?

David J. Mickelson

I don’t remember us providing a lot of detail on that but the Board had considered two different approaches early on and one was a much heavier debt load to purchase the shares of the Widmer principal shareholders and in hindsight with the change of the markets and whatnot I think you’d be looking at a debt load that the company probably wouldn’t be comfortable trying to service even if it were given to us from the bank. So fairly early on a decision was made to do it through an exchange of stock which was a much healthier outlook for the future of the company because of the reduced debt burden. Those are the only things that I thought we discussed right along those lines. Have I missed something in there in the description?

[Steve Olson] - Private Investor

No, the $25 million just seemed to me that the difference when you took the cash out it increased the shares by 2.3 million which implies a valuation between $10.00 and $11.00 per share and I was just wondering if there was anything else materially different in those two proposals. It seemed like that one had had some form of preliminary approval by the Board, but then again because of the debt level I think one of the company’s boards was concerned about the future debt level.

David J. Mickelson

Right. There were a few little factors in there that were less significant but you’re right. The debt load became the overwhelming issue about the success of the company going forward with $50 million versus approximately $25 million in very round numbers. So that was a strong part of it but there were a few other things considered at the Board level as to why they changed the structure of the deal, but it was primarily to create a healthier company for the future with less debt burden.

[Steve Olson] - Private Investor

Obtaining the A&B consent to the merger, was there an amendment to when their consent is required regarding the sale of some of the company’s assets or was it quantified?

David J. Mickelson

It’s a very brief document. I don’t think there was any change in terms of; there are certain amounts that are depicted in that agreement that relate to selling of assets and the value of which. Basically AB dialed in protections from selling to a competitor and that was the primary motivation to prevent that from being able to happen without them having some controls. I’m sorry I don’t have that. Do you remember Terry?

Terry E. Michaelson

Yes, what I can say is that the intent was to keep the agreement basically the same. What was changed is a few of those thresholds based on the size of the combined company and the asset base. So any changes that were made, and I can’t talk to you specifically about those because I don’t have the contract in place, but there were a few numbers that were moved and those were adjusted basically to keep the same basic direction in place but reflect the fact that obviously the company was much larger so it needed a larger threshold in terms of asset and approval.

Anne Mueller

There is an 8K filed on July 2 that summarizes the key points of that change in the document and then the exhibit to it is also filed. So you can see that, but it’s pretty brief.

[Steve Olson] - Private Investor

The best scenario to grow shareholder value I think we’d all agree is to increase the sales to better utilize the brewery capacity but just thinking about if that does not occur, the opportunities to maybe obtain value for some of the assets. That was the purpose of my question.

David J. Mickelson

Sure. Understandable.

[Steve Olson] - Private Investor

On the Kona, I was also trying to understand just the economics of the Kona going forward. Some of their sales have been in CBA and then I guess in Widmer it seems like Widmer has been buying products from Kona at quite a high per barrel price so I guess the product is actually brewed in the Widmer breweries by Kona? And then I’m uncertain about payment of royalties. I’m just trying to understand how, and obviously there’s an equity ownership in Kona, but when you get to the Continental US or the Eastern part of the US, how will the economics be? Is it somewhat similar to how it was with the Widmer Hefeweizen in the East? Is there a royalty payment that is paid?

Terry E. Michaelson

There is some complexity to the Kona relationship because they’re basically two different relationships. One is a relationship where they utilize the Widmer brewery under an alternating proprietorship which is a technical structure that allows them to basically brew and keep the excise tax for a small brewer so it doesn’t come through Widmer or Redhook’s brewing structure. So they use that. Then the complexity is that because we’re trying to create kind of a seamless sale of products through the Anheuser-Busch network, Kona actually sells their product to Widmer, in this case Craft Brewers Alliance, at the same price that it’s going to be sold to the wholesalers. So basically there’s a portion of those sales that happen with Kona that’s a pass-through that’s no cost to CBAI and it’s just a way of getting the product to the Islands, which Kona has the ownership for. So CBAI doesn’t get any profit from Kona in the Islands other than what would come from the 20% stake that it has in the overall business. So that’s one relationship and that’s why that may look a little bit strange in terms of the margin.

The second then is a relationship where they brew again the product under the alternating proprietorship, sell it to CBAI at a margin for them that leaves an operating margin that allows CBAI to sell and market and maintain a margin that’s acceptable for us in terms of profitability on the Mainland.

So I know there’s some complexity. Very simply, one is a relationship where Kona owns the business on the Islands; the other is a sales and marketing agreement and licensing arrangement for the Mainland.

[Steve Olson] - Private Investor

I see. They’re using your brewery even if it’s for Island sales?

Terry E. Michaelson

Yes, correct.

Operator

Our next question comes from [Aram Fudt - Ferdal & Capital].

[Aram Fudt - Ferdal & Capital]

We’ve gone from a very inflationary bullish environment on commodities a couple months ago. Now we’re in one of the biggest bear markets in commodities. This u-turn happened in about four months. I was wondering if you could just talk about how this incredible volatility impacts your cost of goods. I would imagine there’s a delay factor. What is it? And how do you respond to this sort of volatility?

David J. Mickelson

There is a delay factor involved but what we’ve seen in the last year to year and a half in raw materials is unprecedented in our industry. We have had very little fluctuation in malted barley for instance in 20 years and then in one year’s time it doubles. So what we do is look at futures; we have the ability to leverage the volumes combined that we produce to get more favorable pricing than some people would on the spot market. But then you have to balance the risks associated with contracting out a year and they don’t want to go out very far because of that volatility anyway. So it’s something that has a material impact on our direct cost structure and we manage it the best we can through some forward-looking contracts in hops and barley malt and hope that the normalization through crop yields and kind of the perfect storm that hit the last couple years with yields both in Europe as well as in America being impacted; the large fire that significant hop producer in the [Mackinaw] Valley sustained with all the damage to their inventory for a year. We hope that there’s some normalization there that brings things back in line, but we’re never going to see the pricing environment we saw before.

Operator

Our next question comes from [John Stabo - Flintridge Capital].

[John Stabo - Flintridge Capital]

Putting Kona aside, how close are we to fully maximizing the production at each of the three facilities and did we see any of that in the second quarter sort of in advance of the merger?

David J. Mickelson

The capacity utilization numbers that we described in the second quarter, those are for the Redhook operating facility. So there’s no Kona produced in either Portsmouth or Woodinville so there’s really no bearing there. What was the rest of the question? I’m sorry.

[John Stabo - Flintridge Capital]

I guess what I meant was before the merger and after the merger I assume that you’re going to brew different brands and products at different facilities among the three. Is that right or not?

David J. Mickelson

Without question we’re going to have the flexibility to brew products in scale in different breweries versus others; the smaller brew house in Woodinville versus the larger brew house in Portland. We also have to take into account the proximity to market. Products going south of Portland will probably be emphasized production for the larger runs in Portland being that much 200+ miles closer to market and then some of the product going whether it’s Hawaii and/or heading in the Northwest territory coming out of Woodinville makes a lot of sense. So we have a lot more flexibility than we’ve ever been able to show before especially in the Western half of the country.

[John Stabo - Flintridge Capital]

And I guess the question is, are we halfway through that process? Are we two thirds of the way?

David J. Mickelson

I’d say we’re early. We’ve been brewing various Widmer products in Woodinville as you know under the contract brewing arrangement but the reverse has not been done. The expansion just came on line a month or so ago, so we’re early in that process still.

[John Stabo - Flintridge Capital]

Just to understand the capital expenditures, what should we expect for the combined company for the back half of the year in terms of total cap ex?

Mark D. Moreland

That is in the Q in the liquidity section. We’re forecasting full year for the first half Redhook, second half being the combined company of $7.6 million. We spent about $2.6 million in the first half.

[John Stabo - Flintridge Capital]

So $5 million and change roughly for the combined company in the back half?

Mark D. Moreland

Correct.

[John Stabo - Flintridge Capital]

I apologize, I don’t have the document in front of me so I’m kind of going from memory on this, but you did provide some disclosure about the debt levels. Is it sort of fair to assume that with that $9 million of available credit that the combined company had roughly $26 million of debt when the deal closed? Is that about right?

Mark D. Moreland

That’s about right.

[John Stabo - Flintridge Capital]

So you’ve got another $5 million that needs to be done in cap ex and seasonally we should see pretty good cash flow. I guess where I’m going with this is, do you see a scenario where we end up with a lot more than say $30 million worth of debt by the end of the year or could it actually be lower than the $26 million by the end of the year?

Mark D. Moreland

It’s a little tricky because we are providing forward-looking guidance. Suffice it to say that the company will be generating operating cash and the $5 million capital spend is what we are disclosing as far as back half spend.

[John Stabo - Flintridge Capital]

Given the economic environment and some of the other uncertainties that we’ve talked about on this call and I think you hinted at this in the document, what’s the rationale for further expansions of capacity and is any of that $5 million something that could be put on hold if you found the environment to get more difficult from here? What are you thinking in terms of capacity and cap ex say over the next year or two related to the capital structure?

David J. Mickelson

What we have commented on the last few quarters is we’ve heard, seen and had a desire to understand the capital requirements of our company and know that going forward in the future we need to demonstrate a sufficient return on assets that corresponds with our investment in our expansion projects. Regarding the second half expansion we’re looking at everything very closely as we should, not just in this environment but at any time regarding our expansion plans and evaluating whether it can be outsources in the future in lieu of further expansion even if we have the ability to expand the plan. We’re taking a close look at all that, not just for the sake of the expansion costs and whatnot but there’s also being closer to market with some products might make a whole lot of sense too. With our facilities being in the Northwest and Northeast, perhaps we can evaluate alternatives closer to some of our bigger markets.

Mark, did you want to add something? I just wanted to highlight that we’re really looking at holding back in the near term on the cap ex other than to complete the projects that are required to operate the breweries in the foreseeable future.

Mark D. Moreland

What I was going to add on is that a good portion of the back half spend is related to expanding Portsmouth that will permit more production of Kona on the East Coast which will get the product closer to market and that’s a very good return not having to ship the product across the US.

[John Stabo - Flintridge Capital]

By the way, are we going to see the other Widmer products on the East Coast at some point or are you going to pretty much stick to the Hefeweizen?

David J. Mickelson

Terry, that’s a good one for you.

Terry E. Michaelson

We are looking at rolling out the other Widmer products. It’s again going to be in phases but over the next 12 months you’ll see those rolled out into numerous different markets as well. As we’ve discussed one of the things that we think can be a strength of this company and that we need to take very seriously is our ability to put new fresh exciting brands into different categories whether those come from Widmer or Redhook or Kona and certainly not to just keep expanding the portfolio but look at what brands within the portfolio are in a cycle where it may be necessary for us to discontinue those as we add stronger new brands. So I think you’ll see a combination of existing and new brands in the market place over the next 12 months.

[John Stabo - Flintridge Capital]

Just one last financial question. I noticed in the Q Mark that the deferred tax valuation allowance was reversed and from that disclosure I wasn’t quite sure why or what the implications were. So if you could provide a little commentary, that would be helpful.

Mark D. Moreland

To be clear, in the June 30 results the deferred tax valuation allowance was not reversed. It’s still there. What we did disclose is part of the purchase price accounting is that that reserve will be reversed. And basically what that is saying is that the stand-alone Redhook entity had uncertainty about its ability to actually capture all those generated NOLs, the net operating losses benefits, before they expired so now it’s saying that once the companies combined the combined company management expects that the combined company will in fact be able to advantage itself of those net operating loss carry-forwards. So the combined company will relieve that reserve upon the Q3 filing.

[John Stabo - Flintridge Capital]

So if let’s say there’s a profit in the third quarter on a combined basis, then you would be reserving then at a full statutory rate?

Mark D. Moreland

Yes, you would have a normal provision on the profit and loss statement but from an expected cash impact of that we would be able to apply those NOLs towards that cash tax liability.

[John Stabo - Flintridge Capital]

So you would provision at the full rate and then you would knock down the deferred tax on the balance sheet, right?

Mark D. Moreland

I just want to clarify that that is kind of the normal status quo. As we relieve the actual reserve in the third quarter you will see that flow through the P&L but on a go forward basis you’ll see a normal provision and then there’ll be a cash benefit by the use of the NOLs.

[John Stabo - Flintridge Capital]

Could you say that again? It’s going to flow through the P&L in the third quarter? I thought it was a purchase accounting adjustment.

Mark D. Moreland

Correct. Normally when you reverse the reserve it does go through the P&L. You’re correct. It is a purchase price accounting adjustment. I apologize. So in Q3 normal provision and then going forward you’ll have normal provision and a benefit on the cash flow by using those NOLs.

[John Stabo - Flintridge Capital]

In terms of what we should expect from a disclosure standpoint, we will get a full combined set of financials I guess in November when you report again. Did I hear something about maybe some pro forma information sooner? Is there any chance we would get it sooner than November?

Mark D. Moreland

No. The intention is to file with the Q and you’ll see the Q3 is combined results and then there’ll be a pro forma year to date summary in there also.

[John Stabo - Flintridge Capital]

Are you also going to have a pro forma 2007 for comparison purposes or not?

Mark D. Moreland

No, we won’t.

Operator

Our next question comes from [Jim Cole - Lambert Securities].

[Jim Cole - Lambert Securities]

Congratulations on finally completing the merger. I know it takes a lot of time and effort. My question is, do you expect that we could just add the depreciation and amortization together, combine the two, and going forward should we look for that to stay about the same or go up or go down?

Mark D. Moreland

For the stand-alone Redhook entity that would be relatively consistent. The Redhook company will spend about $7.6 million for the full year on capital but as you combine in the third quarter with the historical Widmer entity, that number will go up significantly for the third quarter.

David J. Mickelson

As you add the two together, right Mark?

Mark D. Moreland

As you add the two together, correct.

[Jim Cole - Lambert Securities]

Would you say that if I combined those two numbers that going forward the numbers would stay about the same or would they increase or decrease?

Anne Mueller

I think you have to consider that the last financials you saw from Widmer were at 12/31 and since then they’ve placed in service a brewery so that would be depreciated and then purchase accounting requires some fair value adjustments too.

David J. Mickelson

I think until you see the third quarter it’s going to be hard to make that measurement because you put a $20 million asset in service in the second quarter. Is that a fair assessment there Mark?

Mark D. Moreland

Correct.

David J. Mickelson

I mean, what was done year to date at Widmer as of 12/31 is going to be light on depreciation.

Operator

There are no further questions.

David J. Mickelson

On behalf of your group here we just thank you for the good questions and the time spent with us this morning. We really look forward to talking in the fall about our combined operations for the first quarter of our being together. We have a lot of work to do until then and look forward to it then. So we’ll talk next quarter. Thank you very much.

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Source: Craft Brewers Alliance, Inc. Q2 2008 Earnings Call Transcript
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