Boston Beer - Hangover Continues

| About: Boston Beer (SAM)
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Boston Beer is feeling the pain from increased competition in a fast-moving craft beer segment.

First-quarter results reveal further operational weakness, as management cuts the full-year sales and earnings outlook.

The market is not convinced that the management team understands the severity of the situation as no large changes are being announced.

While there are still downside risks, after shares retreated 50% from the 2015 highs, I see increased pressure from investors and potential M&A as upside triggers.

Boston Beer (NYSE:SAM) is facing some real troubles. The company has been admired by beer drinkers and investors for a long period of time. This leadership position in a fast growing, but small craft beer segment, has been driving excellent investment returns for long-term shareholders. The sad thing is that this success has backfired.

Growth in the craft beer market resulted in a boom in the number of small craft producers while the big legacy beer brewers have dived into the market as well. This increased competition has weighed heavily on the results of Boston Beer, which is really facing an operational crisis. While the company is still the market leader in a lucrative and very interesting market segment, market share losses are quite aggressive.

This has caused quite some anxiety among investors as the management seems slow to act in a fast-moving market. This observation and market share losses reveal potential further downside risks, although it is important to realize that shares are already down 50% from the 2015 highs.

After this large correction, I have a few reasons to be upbeat on the medium-term prospects. Market leadership, modest sales multiple and potential M&A can all act as triggers for investors to potentially recover some of the losses.

Competitors Are Pilling Into Craft Beer

As traditional beer producers have been facing flattish and even declining volumes in recent years, large brewers have turned their attention to the small, but fast-growing craft segment. Many of the leading brewers have made numerous craft acquisitions, often paying very fat sales multiples.

This deal frenzy, accompanied by the steep valuation multiples, has provided support for shares of Boston Beer as well. This follows frequent market rumors that the company itself might be up for sale, allowing a potential buyer to become the market leader in the craft beer business.

That deal has never materialized while the entrance of the large beer brewers certainly resulted in increased competition. At the same time, thousands of local brewers came into existence, as this increased competitive marketplace has weighed on the market share of Boston Beer's brands.

Troubles Really Intensify In Q1

Last week, Boston Beer reported a 5% fall in its first-quarter depletion volumes. It is evident that Boston Beer is losing market share as the overall craft market is still growing at very healthy rates, something recognized by CEO Martin Roper.

Management believes that market share losses are the result of increased competition and a greater interest in variety and innovation among drinkers. This has hurt the demand for the flagship Samuel Adams brands and cider family of Angry Orchards brands.

To combat this, Boston Beer has introduced new varieties such as Sam Adams Nitro, White Ale, Nitro IPA and Rebel Grapefruit IPA, among others. The actual sales additions from these introductions are still small, although momentum continues to build. While such initiatives are to be applauded, the actual sales contributions are too small to offset the declines at the core brands of the company.

The softer results do not come completely unexpected. While depletion growth totaled 4% for the entire year of 2015, depletions were down by 3% in the final quarter of that year. Despite the fading momentum, management still guided for full-year depletion growth of around 5% for 2016 when it released the fourth quarter results for 2015.

Given the -5% print for the first quarter, this kind of growth is no longer attainable. Depletions are now seen anywhere between -4% and +2%, suggesting just 1% growth at the midpoint of the range.

In all honesty, I must admit that the 5% targeted depletion growth for 2016 sounded quite optimistic, certainly as fourth-quarter numbers were down for 2015. What is somewhat worrying is that management is admitting that operational uncertainty has only increased, as the range of the guidance is quite wide.

Margins Take A Beating, As The Full-Year Outlook Has Been Cut

Slower growth is obviously a worrying trend, yet real troubles often start when a business is reporting a decline in sales. In such an environment, it is very hard to effectively manage the cost base in order to protect margins.

It is very clear that Boston Beer has been facing these kinds of headwinds in the first quarter. On the back of a 5% fall in sales, gross margins were down by 150 basis points towards 48.5% of sales, as capacity utilization rates came under pressure.

While the company managed to limit the increase in marketing costs, general cost inflation and new product introductions have been weighing on margins as well. Operating margins therefore fell to just 5.6% of sales, being down nearly 5 percentage points compared to the same quarter last year. The actual margins are quite poor for a beer business, with net earnings amounting to just $7 million on a $202 million revenue base. It should be said that the first quarter is typically seasonally slow.

The lower volumes require management to cut the full-year gross margin forecast by a percent towards 51-53% of sales. Net earnings are now seen at just $6.50 to $7.30 per share, marking a big reduction from the previous outlook for $7.60-8.00. Besides lowering the earnings guidance, the range of earnings outlook has actually widened, indicating that operational uncertainty is definitely on the rise.

Valuation Looks More Appealing

Boston Beer's shares fell "only" 8% in response to the big cut in the full-year earnings guidance, potentially as investors never believed that the original targets would be attainable. Shares now trade at $160 per share, as the outstanding share base has been reduced to 13.1 million shares following recent buybacks. As a result, the market capitalization of the company has fallen towards $2.1 billion, as Boston Beer net holds roughly $50 million in cash. The balance sheet remains very healthy, as many established beer businesses often operate with a net debt load of a 2-4 times EBITDA.

If you back out the net cash holdings, shares now trade at 22-23 times earnings. This looks to be a very high multiple, certainly as volume and earnings trends are about to turn negative. Worse, it seems that intense competition is not anticipated to back off any time soon. Founder and Chairman James Koch believes that the number of US craft brewers could more than double in the coming years, potentially hitting the 10,000 mark.

While the number of craft brands keeps increasing, actual sales per brand might be under pressure. This will limit the profitability of the overall sector and individual brands, as many players are not likely to gain the necessary scale. While Boston Beer might potentially use its strong balance sheet to engage in M&A, it has historically relied upon innovation as the most cost-effective way in order to grow the business.

Final Thoughts, Uncertain Times

If volume trends keep trending lower, it is obvious that more downside potential might reveal itself, even as the stock is already down 50% from the high.

That said, the company remains a market leader in a potentially lucrative segment, as the overall valuation has dropped towards $2 billion. Given the strong balance sheet, and the fact that the sales multiple comes in just above 2 times, we might see some stabilization as well. Part of this stabilization (at least in terms of the share price) might result from potential M&A talks, as I cannot imagine that large beer brewers would not be interested to acquire the market leader in craft.

Perhaps an M&A move is even needed to ensure the long-term viability of the brand. The beer business is based on scale, as well as distribution and branding power. With Mr. Koch potentially selling the business, and high multiples being paid across the sector, a sale of the company could take place at a very rich premium.

Heineken (OTCQX:HEINY) reportedly valued its 50% investment in Lagunitas at $1 billion, for a 5 times sales multiple. Of course, Lagunitas is much smaller, and is able to post much higher growth figures.

A potential take-out or stabilization of the business leaves plenty of room towards the upside for investors at current levels. Important to realize is that the management is facing a big task, and its credibility has taken a real hit given the dismal trends revealed over the past year. With volumes being down 5%, at a time when the overall craft market grew by nearly 20% in 2014, Boston Beer is surely doing something wrong. Management probably needs to take some drastic measures, something which it failed to do, at least until now.

All in all, I see both risks and opportunities, although I feel that it is late to lean towards the short side at the current levels. I would be cautiously optimistic on the current valuation, although that is largely based on potential for M&A. The real appeal has to be created by the improved operations on an organic basis, as the latest quarter leaves no clues that such operational improvements will reveal themselves any time soon.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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