The waiting game continues for Craft Brew Alliance (NASDAQ:BREW). Back in 2016, the company negotiated a revised distribution agreement with Anheuser-Busch InBev (BUD). The deal provided several benefits to CBA, including an end to distribution fees, increased contract brewing, and a $20 million incentive payment for international distribution, payable this year.
It also included an escalating minimum buyout price, one of several incentives apparently designed for A-B to purchase CBA by August 24th of this year. By that date, A-B either has to offer at least $24.50 per share to buy out CBA, of which it already owns 31% - or Craft Brew Alliance keeps all those benefits (including the $20 million) while regaining the right to sell itself to whomever it would like.
The rapidly approaching deadline - now a little over three months out - makes BREW a fascinating special situation stock. Theoretically, the fair value for the stock at the moment should be equal to the valuation of the underlying business plus the optionality of an A-B buyout offer. That optionality is material: at Friday's close of $15.53, an agreement almost certainly would lead to a minimum of 50% upside in relatively short order. Even a modest chance of such a buyout significantly impacts present fair value.
What makes the stock even more interesting is that reasonable investors can disagree - and vehemently so - over both the likelihood of a buyout and the valuation of BREW as a standalone. A mixed Q1 earnings report from CBA this week, along with Thursday's news of the merger between Boston Beer (SAM), both can be seen as positives or negatives for BREW.
I've argued in recent months, with BREW shares at levels similar to Friday's close, that the stock likely is too cheap. I still believe that's the case. But this is a potentially tricky situation, one with real downside risk - and I'll admit that reasonable investors might see BREW quite differently than I do.
There are reasons to be skeptical of, if not outright bearish toward, BREW:
More broadly, CBA at this point "is what it is". Revenue growth and margin expansion opportunities look incremental at best. Yet, based on 2019 guidance, the stock is trading at ~20x EV/EBITDA and 30x+ free cash flow. (Both mutliples exclude the $4.7 million accrual in Q1 for the resolution of a class-action lawsuit.) It's not difficult to imagine more reasonable - and still somewhat aggressive multiples - of ~15x and 20x, both of which suggest a stock price closer to $10.
Adherents to the bear/skeptical case here likely saw the Q1 report as supporting their view - and from here, the quarter does look modestly negative for BREW. CBA trumpeted a 10% increase in shipments for Kona, and a 13% combined rise for the three newly acquired brands. But depletion figures - which measure the change at wholesalers, more accurately reflecting end customer demand - are much more concerning. For Kona, depletions rose just 1.4% in the quarter - and that against a soft 3% year-prior compare.
Some of the weakness, per the Q1 call, came from a disappointing and surprising decline in international markets, with CEO Andy Thomas calling out the UK and Australian markets, and speculating that political upheaval may have played a role. Still, given Kona's importance to this story - the brand accounted for 63% of barrels shipped last year, per figures from the 10-K - any weakness is at least a modest concern.
The news elsewhere wasn't much better. Omission shipments fell 11.7%, and depletions dropped 10%, per the 10-Q. That follows reasonably stable performance the last two years - and is a concern given the company is launching Omission-branded seltzers later this year in a bid to expand beyond its current gluten-free branding. Thomas said almost in passing that the 99-calorie, low-carb Ultimate Light "has some work to do" - not a great sign roughly two years after the product was introduced.
Widmer and Redhook continue to fall, and the newer brands grew depletions 7% in the quarter - decent, but hardly spectacular, and a growth rate notably slower than the 13% shipment figure. At less than 7% of shipments, single-digit depletion growth means those newer brands aren't going to move the needle much, if at all, against the declines in the older products. (Widmer and Redhook shipments in the quarter more than doubled those of Cisco, Appalachian, and Wynwood.)
To be fair, CBA did call out strength in April. Kona depletions rose a sizzling 16% for this month. But this, too, could support the bear case. CBA ramped marketing spend behind the product with a national campaign during March Madness - spending some $4.6 million, per the Q1 release.
In the second quarter of 2018, CBA revenue was a bit over $65 million. Kona likely generated roughly two-thirds of that, or ~$44 million. (The product accounted for 64% of shipments, per that quarter's 10-Q.) CBA spent over 10% of that figure - and generated 16% depletion growth in a single month.
Obviously, there are long-term potential benefits from the spend in terms of acquiring new customers and expanding distribution. But the long-running worry here, again, is that CBA continually has spent beyond its means, and has been unable to generate consistent profit or free cash flow:
source: author from CBA filings and press releases. 2019 figures author estimate based on company guidance
The spike in marketing spend and the resulting modest acceleration in April depletions doesn't negate that fear. 2019 EPS expectations already came down after Q4, and may have to do so again given a $0.19 loss in Q1. That all goes to the idea that BREW, particularly from a profitability/valuation standpoint, has been a "next year" story for years now - and still might be.
The bull case is that the quarter is good enough - and certainly some investors saw it that way. Perhaps fittingly, BREW dropped just 0.4% on Thursday after reporting earnings on Wednesday after the close.
Kona's depletion numbers might not be great - but it's worth remembering that Q1 is a lighter quarter from a seasonal standpoint. International weakness will reverse, as the UK and Australian markets normalize and the company's efforts in Brazil bear fruit. Local production for the flagship Big Wave Golden Ale is starting in Rio de Janeiro this quarter, setting up an enormous opportunity backed by Anheuser-Busch.
From a broad standpoint, the bull case for BREW comes down to Kona. There may be over 7,000 breweries in the U.S. at the moment. Few have products like Big Wave and Longboard that have proven their attractiveness to a wide swath of customers; Kona was the #10 craft brand nationally last year, per the Q4 call. As long as it's growing domestically, CBA essentially will be fine.
Even the craft industry weakness can be spun as a positive: at some point, some of those competitors for shelf space are going to fade away. Thomas noted in the Q&A of the Q1 call, when asked about potential pressure, that Kona isn't like one of the "14 IPAs (India pale ales) fighting for shelf space and the same consumer". It's those smaller breweries with potentially narrower customer bases (as popular as IPAs are in some markets) that could get drawn into the pricing wars long forecast by observers within the beer industry and without. Kona's broader reach and wider distribution would seem to position itself well for the craft bubble bursting - even if there is some level of short- to mid-term disruption.
As far as Q1 goes, depletion numbers likely aren't what bulls hoped. But the marketing campaign is showing early signs of success. International expansion should remain on track. As for falling depletions in the rest of the portfolio, their importance is relatively immaterial. Redhook and Widmer have been declining for years, leading the company to pull back on distribution. Omission is a small part of revenue. Few investors should have expected much from those products to begin with.
The newer products, meanwhile, are still growing. Cisco and Appalachian are seeing success in their home markets (New England and North Carolina/Tennessee, respectively). Meanwhile, Wynwood's La Rubia blonde ale is showing early signs of being another hit. CBA launched the product in Puerto Rico and is looking at further expansion, with an eye on targeting the Hispanic market. It's probably too much to ask for a second Kona in the portfolio, but national reach for La Rubia could materially change the story here, either as a standalone or an acquisition target down the line.
Spending is a modest concern, but BREW is finally hitting its gross margin target. SG&A increases should moderate once marketing spend behind Kona returns to normal - or will stay elevated if the March/April campaign proves to have generated sufficient return on investment. Either outcome drives long-term optimism. And valuation, particularly relative to sales and shipments, remains reasonable, with the ability to make a case that the non-Kona assets are available for free, or close.
Bulls, like bears, probably see Q1 results as confirming their thesis heading into the report. But there was another big piece of news the following day.
Is the Sam Adams-Dogfish deal good news for BREW? Initial reactions certainly were positive. BREW shares gained 4.8% on Friday, with a spike in volume in call options as well.
The optimism makes some sense. Notably, it's the first major craft beer in some time. Anheuser-Busch paused its M&A strategy back in 2017, laying off a large number of employees in its craft division. That company's recent acquisitions have been outside of beer, in spirits and wine. Corona owner Constellation Brands (STZ) (STZ.B) went into cannabis with its investment in Canopy Growth (OTC:CGC). Molson Coors (TAP) bought a kombucha maker. Boston Beer itself launched alcoholic sparkling water Truly last year.
The sense for the last two years or so has been that beer companies were trying to move beyond beer - which quite obviously undercut hopes that CBA would be taken out, either by A-B or one of its competitors. In that context, it hardly seems a coincidence that BREW touched a two-year low last month.
So at the very least, Boston Beer's move suggests that there's at least someone out there who doesn't see craft beer as dead. That alone has to be seen as a positive in the context of the last 24 months for the industry. Meanwhile, the valuation assigned Dogfish Head looks rather favorable for BREW. SAM is paying right about $1,000 a barrel, a metric in line with 2015-2016 valuations. (That per-barrel number is based on the SAM stock price at the time the deal was negotiated, which created a total value right around $300 million.) That figure, given guidance suggests Kona should ship roughly 500,000 barrels this year, values Kona alone at $23 per BREW share. A 2.6x revenue multiple, using only CBA's beer sales (excluding pub revenue, which appears to generate minimal if any profit) values BREW at $22.
Should Kona and/or CBA as a whole be valued similarly to Dogfish Head? Here, too, reasonable investors might disagree. Boston Beer estimated "high single digit" shipment growth this year for Dogfish Head. CBA is projecting 5-8% growth on the same basis - but excluding Widmer and Redhook, its expectations likely are similar to those of Dogfish Head.
Dogfish Head has an excellent reputation among craft beer aficionados - but it doesn't have a product anything like Kona. In fact, Kona's shipments this year should be ~70% higher than those of Dogfish Head as a whole. Boston Beer's release called out Dogfish Head's IPAs and sour beers - categories which simply don't, and won't, have the same broad appeal of Big Wave and Longboard. For that reason, more ardent BREW bulls likely would argue that Kona should receive a premium to Dogfish Head on a per-barrel basis.
On the other hand, as Bloomberg's Tara Lachapelle pointed out, there may have been an 'acqui-hire' aspect to the deal. Fundamentally, Dogfish Head likely has higher margins, given higher pricing: figures from Boston Beer suggest Dogfish Head will generate about $400 in revenue per barrel this year, while CBA's guidance implies a figure closer to $290. And Dogfish Head has more room to expand distribution; Kona already is distributed in all 50 states, per the Q1 call, but Dogfish Head's reach appears to be more limited.
Net/net, some optimism seems merited. At this point, any deal in the space is good news for BREW. But one deal - and particularly this deal - doesn't mean the boom days of craft M&A are back, or that A-B is going to jump to match Boston Beer's acquisition. There are some extenuating circumstances, both in terms of why Boston Beer chose Dogfish Head and why it was willing to pay the price it did.
The ideal bull case for BREW would be that the underlying business was worth $15+, leaving the option of an A-B takeover available essentially for free. Personally, I can't quite get there. 16-17x EBITDA - a figure that incorporates the $20 million from A-B, but also is based on guidance that looks a bit shakier after Q1 - is a big multiple. ~$600 a barrel for Kona and ~$200 for the rest of the portfolio look a bit high for a mature company; the $800-$1000 valuations seen a few years back both came at a peak for craft M&A and for brands with much greater hopes/plans for distribution and margin expansion.
That said, I do see something in the $12-$14 range as reasonable. And it doesn't take much in terms of buyout odds to make BREW attractive at $15+:
Buyout Odds Priced In @ $15.53
|Standalone Value||Odds of Buyout Priced In|
But what's interesting about BREW at the moment is that the options market, at least, is pricing in even lower odds:
The August strikes perhaps run some risk of missing out on an absolute last-minute announcement - but that aside the 20 strike is offering something better than 8-to-1 odds on a buyout, assuming BREW would move to $24 in the event A-B made a move. (There likely would a modest discount to the offer price ahead of the close - but I'd also argue that A-B probably would offer a touch above $24.50, if only for appearance's sake.) And there's no shortage of liquidity: the August and November strikes combined have nearly 10,000 call contracts outstanding.
And so there are some interesting trades here - from both sides. Personally, I'm not yet convinced a buyout isn't coming. It does seem strange, perhaps, that A-B hasn't moved yet; why the wait? Well, A-B had to wait for its consent decree to be finalized (as it was in October). And it's possible that the company wants to wait as long as possible to confirm Kona's growth trajectory - or perhaps get a read on the efforts in Brazil. Calls here obviously are high-risk - I'd argue the odds of a buyout still are below 50% - but also high-reward.
The case for simply owning BREW at this point is that Kona simply is good enough. And so an outcome with no buyout, even if it leads BREW to see some selling over the next three months, still leaves Craft Brew Alliance in a reasonably strong position. Even if A-B doesn't buy the company by August, someone else might be interested. In fact, West Coast-heavy Kona might be an interesting second buy for Boston Beer - and a fine fit with Dogfish Head - if it's looking to further to diversify its portfolio. Boston Beer's balance sheet easily can fund a BREW buyout as well.
There's also a bearish trade here: go short BREW and hedge with the August 20 or November 20 call. (The August 20 straddle gets to roughly the same place, but liquidity on the put side is minimal.) The bet there is simply that BREW shares will decline without a buyout, as some investors buying the stock for that option depart. Looked at another way, it argues that BREW is overpriced as a standalone - and likely profits nicely if CBA stumbles at all in Q2.
I've owned BREW in the past, but haven't taken a position in the run-up to the A-B deadline. I suspect that will stay the case: I find the story fascinating, but neither side quite compelling enough at $15+. Net/net, I'd lean bullish: CBA is back on the right track and Kona has real value, likely enough to support the current ~$350 million valuation at some point. The more interesting - and more difficult - question is how BREW will get there, and where it will trade along the way.
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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.