Craft Brew Alliance: Still Frustrating, Still Too Cheap

About: Craft Brew Alliance, Inc. (BREW), Includes: BUD
by: Vince Martin

Q4 results from Craft Brew Alliance look frustrating - and 2019 guidance seems to support long-running concerns about operating expenses and capital expenditures.

Investors seem skeptical that Anheuser-Busch will make an offer by August, despite its incentives to do so.

But a deal remains possible - and on its own, CBA still has a path toward finally generating consistent free cash flow.

Downside risks persist, but Kona's strength is enough to take at least a long look at BREW.

At this point, it's actually not terribly difficult to build a short case for Craft Brew Alliance (BREW). Close to a decade's worth of performance suggests that CBA simply can't drive actual free cash flow. CBA couldn't take advantage of the craft beer boom earlier this decade, and now as that industry starts to struggle, 2019 guidance suggests more of the same:

BREW stock quote Source: author from BREW filings and press releases. 2019 estimates based on midpoint of company guidance

Adjusted EBITDA finally has surpassed capital expenditures - but not by much. Free cash flow was less than $500K in 2018; guidance suggests the figure will return to being negative this year (depending on how working capital plays out).

Meanwhile, the craft beer industry is starting to show signs of stress. On his company's Q4 conference call, CBA CEO Andrew Thomas cited industry figures showing ~flat growth in craft beer sales overall for 2018 - including a 3.1% decline in on-premise volume. CBA hardly seems immune: depletions (the change in volume at wholesalers) declined 2% for full year 2018.

More recently, the company posted a disappointing Q4, in which it missed tightened full-year guidance for depletions and had full-year gross margin come in near the low end of its projected range. 2019 guidance similarly looks disappointing: 2019 consensus EPS has come down to $0.18 against $0.29 before the report (and $0.32 two months ago).

Despite all those concerns, despite the seeming missteps on execution, despite the lack of free cash flow, BREW stock isn't cheap, or close. Thursday's close of $15.21 and the midpoint of 2019 guidance suggest forward multiples of 17.2x on an EV/EBITDA basis and something in the range of 70x net earnings. While traders target Boston Beer (SAM) from the short side, BREW's case seems potentially as compelling.

But I argued back in November, with BREW below $16, that the stock looked too cheap. Above $15, even with the risks, and even with an admittedly disappointing Q4, I still think that's the case. This story should get better in 2020. The weakness of late isn't necessarily surprising and is concentrated mostly in what are now smaller and much less valuable brands. An A-B deal isn't impossible, either - and suggests enormous and quick upside in BREW shares.

The risks have to be minded here, and investors betting on upside need to bear in mind that downside can be substantial, and volatility is likely to be high. The ability to look at BREW from very different fundamental perspectives extends to the qualitative case as well. Long term, however, I still believe BREW will move higher from $15 - though how and when that will happen is one of the biggest question marks here.

The A-B Buyout Offer

The elephant in the room at the moment is whether or not Anheuser-Busch (BUD) will buy out Craft Brew Alliance. Back in August 2016, CBA negotiated a new distribution agreement with A-B, which included a series of benefits, including shared brewing capacity and international distribution incentives. But, most notably, the deal created increasing "qualifying offers" - a minimum price A-B would have to pay to buy out CBA.

That qualifying offer now sits at $24.50 per share - 61% above the current price. An A-B has until August 24th to make an offer at that price - or else CBA gets a $20 million payment (for international sales), plus the right to put itself up for sale. (BREW can't do so before then. Please note that my reading of the agreement suggests only that an offer be made, not that a deal has to be closed. That is categorically not legal or financial advice.) If no offer comes by August 24th, CBA keeps the $20 million - plus all the incentives for the duration of the agreement (through the end of 2026). In theory, then, A-B could be brewing Kona beer at its facility for, say, Molson Coors (TAP), assuming CBA sold itself to another giant.

It appears the market isn't expecting an offer, and there are reasons to expect that A-B won't make one. Most obviously, the beer giant halved its dividend last year in a bid to pay down a substantial debt load. It may not be a good look for A-B to then turn around and pay ~$520 million (including the assumption of CBA's debt) at what is likely a ~26x multiple to 2019 EBITDA.

Still, the possibility can't be completely discounted. A-B already owns over 30% of the company, cutting its cash contribution by roughly $150 million. A-B would save $20 million of that ~$370 million in cash right off the top, since it wouldn't have to make the incentive payment to an independent CBA. BUD stock has rebounded nicely in 2019, assuaging shareholder worries at least a little bit. Institutional owners - the ones who presumably matter - likely would understand the logic behind the move, even if it seemed incongruous with the newfound emphasis on deleveraging.

And, again, the upside for BREW from current levels is enormous, even at the $24.50 figure (which, again, is the minimum). Even a small possibility of a deal suggests a reasonable chunk of current valuation and makes much more reasonable the valuation applied to the business on a go-forward basis:

Odds of Buyout Standalone Share Price Standalone EV/EBITDA
10% $14.18 15.2x
20% $12.89 14.0x
30% $11.23 12.3x

Source: author calculations. Assumes $20 million in 2019 EBITDA; 2018 year-end net debt of $46.3 million; $20 million A-B payment due to the lack of a qualifying offer; 19.6 million fully diluted shares

In other words, investors at the moment who see a 20% possibility of a buyout are paying 14x EBITDA for the business - with the remainder going to what essentially is an option on an A-B buyout.

As an aside, taking that viewpoint opens an interesting potential trade here. The August 15 put is asked at $1.40, capping downside at 9.7%. Upside after the put premium in the event of a buyout at $24.50 (assuming the cost basis of $16.61, including the premium) would be 40%+, given that BREW won't instantly rise to that buyout price. Through this trade, an investor can get ~4.5 to 1 betting on a buyout - with additional upside possible if BREW doesn't get a buyout but still moves higher (something possible in theory, although I believe it's unlikely to actually occur).

Options market aside, the point here is that BREW's go-forward valuation isn't quite as high as headline figures suggest. First, there's value in the possibility of an A-B buyout, whatever that might be. Secondly, the forward multiple has to come down by a turn or so since CBA is receiving $20 million this year if a qualifying offer doesn't arrive. From that standpoint, the valuation here on an EV/EBITDA basis - and even, to some extent, in terms of P/E, given low net margins - isn't as ridiculous as it appears.

A Standalone CBA

Still, a buyout from here looks something close to unlikely. It's purely a 'feel' argument, but there's a sense that A-B would have moved by now, particularly now that its consent decree pertaining to the SABMiller acquisition has been finalized. A-B has made a couple of acquisitions of late - but in spirits (San Diego's Cuthound) and wine (a stake in California's Swish Beverages). There doesn't appear to be a lot of appetite for more beer M&A, with industry weakness certainly not helping on that front. (As I've written in the past, the head of A-B's craft acquisition division said back in September 2017 that "our plate's full" when it comes to M&A.)

So, the question becomes: what is BREW worth if A-B passes? It, too, is a difficult question to answer. Even with the relatively high multiples assigned the space (not just SAM, but Constellation Brands (STZ) (STZ.B), even with its recent pullback), 17x 2019 EBITDA seems awfully high.

But EBITDA - and even net income - aren't the only metrics to use here. CBA unquestionably has had its struggles of late. But the bull case long has been based at least in part on the idea that the value of the company's Kona brand is understated by broad profit metrics. Other brands - most notably Redhook and Widmer Brothers - are declining sharply, which obscures the impressive performance, and the value, of Kona.

And Kona continues to be an exceptional performer. Against what was a flat craft market (and one with more suppliers), depletions rose 8% in 2018, and shipments 7.5%, according to the 10-K. While this long has been a Kona story from a valuation standpoint, it's now becoming a Kona story from a business perspective as well. The brand drove 63% of CBA's total shipments in 2018 - against just 35% five years earlier.

That's important for two reasons. First, the long-running headwind from declines at Widmer Brothers and Redhook will moderate simply because those brands are a much smaller part of the story. They drove just 24% of 2018 shipments - and Thomas said on the Q4 call that the figure likely would be closer to 20% in 2019.

Secondly, there's a case that Kona, in an acquisition scenario, still supports a reasonable amount of the value here. Whether that acquirer is A-B or someone else, margins are much less important than growth. Kona is headed toward over 500,000 barrels in 2019, based on guidance for a double-digit increase next year, thanks in part to an A-B-backed entrance into Brazil. All of CBA has an enterprise value of $325 million (pro forma for the $20 million payment from A-B) - which means if Kona is valued at $600 a barrel or so, the rest of the assets are available basically for free.

Even though craft bubble deals were made at $1,000 a barrel or so, $600 isn't a terrible valuation for a brand that has a runway to years of growth. Kona seems to have proven itself at this point as a brand that is here to stay. Per the Q4 call, it finished the year as the #10 craft brand nationally. There's still room for broader penetration geographically, and the first national media buy behind the brand is on the way during the upcoming NCAA college basketball tournament.

Admittedly, I'm not quite ready to value Kona at $300 million-plus. And, there's an obvious issue: who, exactly, is doing the buying, if it's not A-B? Constellation seems to have its focus elsewhere (most notably through its large stake in Canopy Growth (OTC:CGC)). Molson Coors doesn't seem hugely interested in M&A. Boston Beer historically hasn't been an acquisitive brand.

Still, there's a case that Kona should get a premium valuation of some kind. And given that it's headed toward being two-thirds of 2019 shipments, that in turns suggests that CBA as a whole shouldn't be cheap.

Beyond that argument, there's some good news coming on the fundamental front as well. Capex should finally come down - suggesting CBA might be able to at last start generating consistent free cash flow. CBA is finishing a new brewery in Hawaii and making some ERP upgrades this year. After that, as Thomas put it, "you'll see our capex levels drop down to levels that you have never seen".

Interest expense should spike this year, owing to debt backing the late 2018 acquisitions of small partner brands Cisco, Appalachian Mountain Brewery, and Florida's Wynwood Brewing. But the $46.3 million in debt will come down sharply as the $20 million A-B payment is applied to pay it down. Back of the envelope calculations suggest potentially $10 million+ in free cash flow: $20 million in EBITDA, $1 million in interest, minimal cash taxes (owing to D&A), and $6-8 million in capex going forward (3-4% of revenue). That gets the P/FCF multiple down under 30x - not exactly deep value by any means, but at least reasonable.

It's reasonable because this is a business that should be able to start growing again - at least on the top line. The benefits from the A-B deal will be realized pretty much in full this year, which raises margin questions. But Kona still is growing. Gluten-free Omission is growing, and the three acquired brands combined were "plus 17" in 2018, per the Q4 call. (It's not clear if that's sales, volume, or depletions.) Widmer and Redhook are going to keep shrinking; as Thomas put it in the Q&A, "You're not going to see a positive number in front of those brands. I can say that unequivocally." But at 20% of volume, that headwind should become less important over time. And that in turn means that, at the moment, it seems like CBA should start generating material cash flow in 2020 - and grow from there.

Valuation and the 'Feel' Argument

Whether there's enough in the business to support $15 as a standalone is up for debate. My sense is that it's probably not quite to that level, yet. And if A-B doesn't come through, there's likely to be some volatility in the stock over the rest of 2019. The news itself, when it comes, likely is going to drive a big move.

But I do think it's close - and potentially close enough to take a flyer on A-B coming through. With Kona established as a key brand - long the biggest risk here, no matter what happens - and its depletion growth accelerating as 2018 went on (+1% in Q1, +11% in Q4), there's real value in the business despite the high headline multiples.

The other source of potential volatility could come from the craft business itself. It's becoming clear - as CBA's own research shows - that marijuana legalization (whether recreational or medical) has an impact on beer consumption levels and patterns. As Thomas pointed out, CBA has a heavy presence in California, Oregon, and Washington - where the impacts from cannabis are likely to be higher. That narrative could impact BREW stock, and the fundamental effect could impact the craft beer space as a whole.

Indeed, BREW's Q4 numbers and the results of its research seem to strengthen the argument that craft beer as a whole is headed for trouble. The U.S. market is going to clear 7,000 breweries this year, more than twice as many as there were five years earlier. Supply is escalating rapidly, from breweries where incremental (and decremental) margins are exceedingly high. Demand is flat.

There's going to be a shakeout at some point (which industry insiders have been predicting for years). Near term, that may be a bad thing for CBA revenue. Long term, however, it may provide opportunities for share growth.

All told, between the buyout, the industry, and Kona, this is one of the more interesting stories in the market. And, again, it's a stock where reasonable investors can have very different perspectives. But I still think a buyout is possible, if not likely. Meanwhile, on its own, BREW can support upside from $15, even it may require some patience and riding out some volatility. This story still can play out, and how, exactly, it does will be fascinating to watch.

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.