Boston Beer: Foam, Facts And Fallacies

| About: Boston Beer (SAM)

Summary

Examines whether or not Boston Beer is a buy after a 50% decline in stock price.

Includes brief overview of beer industry and reasons for Boston Beer's success.

Considers a number of reasons commonly given for decline and considers alternative explanations.

Evaluates performance and current market valuation.

The last few years have been a rollercoaster ride for the Boston Beer Company (NYSE:SAM). With the constant ups and downs the company has faced in a rough and tumble industry, it's a wonder that the executives don't puke up all of that booze.

At the depth of the financial crisis in 2009, nobody predicted that company stood on the cusp of explosive growth that would more than double revenue and triple profit in just six years. Excited by the company's future prospects, investors sent the stock price soaring from a low of $20 a share to a high of $314 by early 2015. Then the price collapsed by half, and as of this writing stood at $162 a share.

Commentators have identified negative sales growth as the immediate catalyst for the price deflation, with changing consumer preferences, increased competition, and flagging enthusiasm lurking in the background as more fundamental causal forces.

What happened to Boston Beer, really? Is this company's stock a bargain, or should it be avoided?

In the Beginning

With over 4,000 craft breweries in operation today, founder Jim Koch's 1984 vision may not seem so revolutionary to a contemporary drinker. But in 1984, brands like Budweiser (Anheuser-Busch InBev (NYSE:BUD)) and Coors (NYSE:TAP) were as ubiquitous and iconic as Coke and Pepsi. Big Beer appeared invincible, and taking on these massive corporations was viewed as tantamount to suicide. How did Koch and his company find success in such an environment?

In his book Quench Your Thirst, Koch articulates his view that value is a function of both quality and price. Clearly Boston Beer focuses on the former, while giants like Anhauser-Busch and Coors compete on the latter (more on them later). Koch writes that "better" is better because it avoids commoditization of a product and a race to the bottom.

Koch also devotes considerable space in his book to highlighting the importance of a firm's salespeople. Selling--the art of actually going out and talking to customers and making a case for your produce-is an area where Boston Beer thrived in the early days. Back then Koch set a goal of getting Sam Adams Boston Lager into a list of 100 bars in Boston, which he eventually accomplished.

But without a quality product and a story, there wouldn't be much of a business-and Boston Beer had both. The label of "craft" evokes the image of a handmade product, one that is obviously better than a commoditized rival. Even the name of the flagship beer, Samuel Adams, underscored the company's revolutionary nature. Nearly everything about Boston Beer was unique, and Koch sought to make the difference between his company and the competition very clear in the minds of drinkers.

In Boston Beer, Koch seems to have created a business culture that works. In his book, he offers a humorous yet penetrating insight into how and why companies tend to get trapped in a cycle of "stupidity," observing how the hierarchy of the modern corporation erects huge barriers on information reaching top management, resulting in leaders losing touch with reality.

Koch outlines various strategies for tearing down these hierarchies and fostering creativity. In fact a standing rule at Boston Beer is that any employee can tell a boss "f you" to convey strong disagreement, even to Koch himself. By his own admission, Koch now spends most of his time preserving and reproducing the company culture of innovation and openness. He does so partially by eliminating the pretentions of his high position-to this day, Koch claims to drive a budget car and fly economy. Unlike many other public companies, Boston Beer can also boast that it has never implemented a layoffs as a cost cutting measure.

The Beer Business

Alcohol occupies a rather unique position in American business, as producers are bound by law to sell their products to stores through distributers. Thus beer operates under a three-tier system, with producers selling to wholesalers and wholesalers selling to retail stores. This unusual arrangement often comes under fire from producers who argue that the law makes it nearly impossible to switch distributers, who enjoy the privilege of being able to lock in even the smallest breweries. A number of so-called "pay for play" scandals have erupted where distributers essentially bribed bar owners to keep their draft lines flowing while cutting out competitors. The reputation of Craft Brewers Guild, the largest distributer of craft beer in Massachusetts, is now in tatters after state regulators found that they engaged in this illegal practice.

Regardless of what one thinks about the system, it doesn't look to be going anywhere. It seems likely that beer distribution will retain its oligopolistic character, with a few major players in each state controlling most of the business.

After the distributers come retail stores. Much of the growth in craft beer stems from expanded shelf space for a larger variety of brews, especially in big chains like Walmart and Kroger. But because larger brick-and-mortar chains predominate, their expansion (or lack thereof) has a major effect on the ability of their suppliers to grow as well. As Koch stated on a recent earnings conference call, the business starts and ends with retailers.

So far the effect of online retailing has been pretty marginal for alcohol. Amazon (NASDAQ:AMZN) and apps such as Drizly are trying to partner with local liquor stores to deliver booze, but the laws and logistics of shipping a controlled substance have stymied major growth.

Show Me the Money!

The friends and family members who provided Koch's startup capital have a lot to be happy about if they still hold their stake (fun fact: one of those initial investors was none other than now-billionaire hedge fund manager John Paulson, who reportedly has never sold a share). According to Koch, an initial $1,000 bet on Boston Beer was worth $4 million in 2015. Even after last year when the share price fell by half, the stock's gains are still double those of the S&P over the past twenty years. Return on equity has exceeded 18 percent every year in the past ten years. The balance sheet contains a token amount of debt and over $70 million in cash and substantial cash flow.

Now to the valuation, starting with the dough that Big Beer has forked over for acquisitions. Heineken (OTCQX:HEINY)is said to have valued Lagunitas at $1 billion when it took a 50 percent stake in 2015. That's five dollars for every dollar of revenue (a total of about $200 million at the time). At that rate Boston Beer could have sold for $4.8 billion, although that is probably too optimistic given the size difference between the two companies.

But a few months ago Molson Coors acquired the 58 percent of MillerCoors it didn't already own for $12 billion. That's $2.68 for every dollar of additional revenue-for a company with shrinking sales! According to the same simple valuation multiple, the much smaller Boston Beer could be sold for $2.5 billion versus the $2 billion value that the market currently assigns the company.

Assuming that Boston Beer's multiple is closer to Big Beer, which it probably isn't, that's still a big margin of safety. Even with craft beer's recent boom and subsequent contraction, prospects for future growth remain solid, especially in the South where craft beer consumption per capita is relatively low. There are also plenty of opportunities for Boston Beer's smaller brands such as Twisted Tea, Coney Island Root Beer, and Travelers. Their overall contribution to sales isn't large, but they are growing fast.

Recent Challenges: Facts and Fallacies

Today the beer landscape would be unrecognizable to a drinker of the few craft brews available in the 1980s. There are over 4,000 craft breweries in operation, and Koch reckons that there could be as many as 10,000 before market saturation. The established narrative among many stock analysts is that Boston Beer is facing a two front war against smaller players vying to represent craft and bigger players seeking to ratchet up pressure on price and distribution. Supposedly Boston Beer is stuck in an awkward position, unable to maintain the "craft" image but also unable to take on the behemoths.

Is this depiction accurate? To analyze the situation seriously, one must acknowledge that those 4,000 craft brewers are not a homogeneous group. The myriad of tiny microbreweries are as much of a threat to Boston Beer as my local diner is a threat to IHOP. The real competition within "craft" beer comes from other brewers of comparable size, especially those now aligned with Big Beer.

Take a look at what is considered craft beer these days. The definition espoused by the Brewers Association, the main craft beer trade group, says that a craft operation is one that produces less than 6 million barrels per year and is not majority owned by a large corporation. Boston Beer faces attack from other "craft" brewers who claim that the maker of Sam Adams doesn't represent the movement. But most of these breweries are themselves major corporations valued at nine or ten figures! The whole business often reaches the level of sheer farce; just months after saying in an interview that Boston Beer was totally out of touch with craft, Lagunitas' Tony Magee sold half his company to Heineken.

Craft beer, as defined by the Brewers Association, is in fact a highly concentrated industry despite appearances. As of 2014, close to half of craft beer's sales accrued to the top ten breweries. So what exactly should we call these breweries if they aren't craft? Lately the term "better beer" has been creeping into the industry vocabulary. Big Beer often refers to its craft acquisitions as the "premium" segment of the market. I think both of these terms capture what the top fifty brewers actually represent-to call them "craft" by any serious definition of the word is simply absurd.

Whatever the case, Big Beer's shift toward purchasing stakes in smaller craft breweries or acquiring them outright is not a favorable development. Ballast Point, Goose Island, and Elysian are now wholly-owned subsidiaries of major beer corporations. Lagunitas, Founders, and Brooklyn Brewery sold large portions of themselves to bigger players.

The danger to Boston Beer's revenue and profits is clear from this industry trend. As Dave Infante writes in Thrillist, acquired breweries that once had limited ability to purchase inputs now have access to whatever they desire thanks to "Uncle Inbev's" vast hop farms. The economies of scale enjoyed by the major players could end up squeezing out smaller rivals through downward pressure on prices. But so far that hasn't happened, and the economics seem to allow for Boston Beer's existence and perhaps even favor it. During the craft beer boom, the major chains didn't quite know how to successfully push the product, so they ended up devoting a huge amount of shelf space to many brands. At the distributer level the attitude was much the same. Please excuse the block quote as I steal shamelessly from Beer Business Daily's excellent 2010 interview with Koch:

When you look at one of these distributors that take on so many craft brands, they typically take 50 suppliers and 800 SKUs to equal Sam Adams' volume, with tougher profitability. So it's going to be heck of a lot easier and a lot more profitable to double your Sam Adams volume than to take on 50 suppliers and hand sell 800 SKUs. How far can beer SKU proliferation go when a c-store can only hold 90 SKUs and a grocery store can only hold 210 and on-premise can take 20 or 30? Nick Lake was right when he told your readers that in virtually all markets, the top 4 to 6 craft and domestic specialty brands represent between 60 to 90% of craft/domestic specialty volume. And that percentage is growing, despite the SKU proliferation. I don't think wholesalers have thought out the fact that it takes about $2.50 to $3 a case more to handle a slow moving SKU with little repeat business from a small volume supplier than it does to handle the faster moving SKUs with brand loyalty from larger craft suppliers. Wholesalers are leaving money on the table by not recovering the extra costs of handling these slow moving SKUs from the very small volume suppliers.

For a while Koch's logic didn't pan out. But the lack of expansion in retail space means that reality is setting in, and Beer Business Daily now reports that chains like Walmart and Kroger plan to reduce SKUs in favor of brands with faster turnover.

Conclusion

Boston Beer is plainly a well-run company as can easily be seen through both its performance and internal structure. The company's finances are solid, unlike some of its smaller rivals who face heavy losses after expanding too quickly and building up too much capacity. At $2 billion, Boston Beer is a relatively small public company, and a few sharp declines are a statistical inevitability. Fortunately its balance sheet is well-positioned to weather a few down years.

The recent soft growth seems to have less to do with some sort of identity crisis and more to do with lack of retail expansion and saturation of the developed beer markets. The growth of craft beer as a whole, which correlates closely with Boston Beer's own performance, slowed noticeably in the past two years.

Still, the competitive challenges are real and can't be ignored. Executives at the company seem concerned, but not yet alarmed. Drinkers will notice that Boston Beer recently implemented the first major packaging overhaul in company history, jettisoning its longtime Sam mascot. Personally I like the changes, at least from a marketing standpoint. Unlike the cartoony look of the old packaging, the new design does a better job of conveying the essence of the product. The winter seasonal package features a warm and festive look. A photo of the historic Sam Adams statue in Boston's Copley Square now adorns the flagship Boston Lager, evoking the image of a timeless, historical product. The company also plans to add additional seasonal beers to its main lineup.

It's a start, but it would be nice to see a bit more action at the grassroots level. It bothers me that the company doesn't have a real taproom in Boston proper where locals and visitors can hang out and try new beers. Yeah, there is the brewery in Jamaica Plain, but it's basically a token showpiece. Unlike, say, the Harpoon brewery in the Seaport District, the Boston Beer Company's brewery isn't a place to hang out and grab some beers. It doesn't have a real taproom, parking is limited, and the only place to get food is across the street. The Jamaica Plain brewery just doesn't offer the experience that much smaller companies give their visitors. For a company of Boston Beer's size, that just doesn't make sense.

Still, because I haven't seen any solid evidence that Boston Beer is seriously slipping, I remain skeptical about reports of its demise. Samuel Adams still stands as by far the most popular craft beer in the United States, one of the few "better" beers found pretty consistently at bars around the country. Like any good brand, I really can't imagine a world without Sam Adams Boston Lager.

Therefore, I am pleased to disclose that I own shares of Boston Beer, and I plan to buy more.

Disclosure: I am/we are long SAM.

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

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