Boston Beer's Valuation Too Foamy

U.S. consumers' appetite for craft beer has been insatiable over the past decade. Despite overall industry headwinds, the volume of craft beer sold in the United States has grown at a 12% compound annual growth rate, mitigating a 1.3% annual fall in noncraft liters. The biggest losers in this craft revolution have been the major domestic brewers, particularly Anheuser-Busch InBev (BUD) and MillerCoors (SBMRY)/(TAP), which have seen sales of traditional mainstream and light beers fall precipitously (nearly 1.7% annually over the past decade) as consumer preferences have dramatically shifted.

Conversely,  Boston Beer (SAM)--maker of the largest craft beer, Samuel Adams--has enjoyed a 12.5% volume CAGR over the same period and an even stronger 15.3% revenue CAGR as a result of consumers' willingness to pay up for nonmainstream brands, both in beer and alternative flavors (such as the company's 2011 relaunch into the fast-growing hard cider business with Angry Orchard). Shareholders have benefited as well; Boston Beer's stock has increased at a nearly 30% rate annually since early 2004, compared with a 6.5% yearly gain in the S&P 500.

But we're starting to see chinks in Sam Adams' armor, and we expect slowing category growth, falling market share, and increased marketing needs could drive slower earnings growth for its parent. While we believe Boston has built a solid suite of brand intangible assets that will continue to support its narrow economic moat, we believe the stock looks overvalued at its current price.

Craft Beer's Share Still Has Room to Expand, but Growth Rate Will Slow
In the U.S., beer consumption per capita (of those over the age of 20) has steadily declined over the past decade, and we don't anticipate this trend reversing in the near to medium term, given the continued trend toward increased wine and spirits consumption and penetration (which has climbed to 52% of total alcohol consumption, from about 49% five years ago) and an aging population. In the U.S., the population aged 50 and up has increased at a rapid clip over the past five years (a 2.3% CAGR) and now represents 46% of those over 20 years old, up from 43.4% in 2009. This aging looks to continue; the U.S. Census Bureau expects the total drinking-age population to grow at about 0.8%, in line with trends over the past five years, but sees those older than 70 representing 15.2% of the group over 20 years of age in 2020, up from 13.1% today. Studies, such as those by Britain's Institute of Alcohol Studies, have shown that alcoholic consumption tails off as people age, suggesting further total beer per capita declines will continue at their recent rate (roughly 2% annually),

However, drilling deeper into these declines shows that the fall has stemmed entirely from mainstream, noncraft brands such as Bud Light and Coors; conversely, craft beer has seen volume grow and its share of the U.S. beer market rise to 11% of volume in 2014, according to estimates by the Brewers Association, from less than 6% in 2010. The industry has also seen a spike in the number of craft breweries over this time frame, roughly doubling over the past five years to more than 3,000 after remaining relatively constant in the five years prior. We attribute this shift largely to the advent of the millennial generation, which has shown a much higher willingness to try new, fuller-flavored beers, pay higher prices, and shun national historical brands.

Per capita consumption of craft beer has climbed at an impressive rate in recent years (averaging 15% since 2010), driving down noncraft consumption an average of 3% annually over the past three years--an acceleration from the 1.3% decline we've seen over the past decade.

Beyond our key expectation that total beer consumption per capita will continue to decline at roughly a 2% annual rate, we also assume that we'll see continued shift away from mainstream beer, driven by more millennials and the generation behind them making up a larger portion of total consumption as older drinkers reduce their intake rates; we expect noncraft beer declines to continue, as we believe many of the drinkers in this older cohort represent these beers' target consumers.

But the question remains: How much share can craft beer take under these circumstances? To address this, we anticipate the absolute annual change in craft beer consumption per capita will remain relatively constant through 2020, on average, at an additional 13 barrels per 1,000 drinking consumers added each year. We think this projection is reasonable; when combined with our assumption that mainstream beer per capita volume continues to decline at roughly 4% annually (similar to the rate of decline in 2013 and 2014), the implied total aggregate beer consumption falls at roughly a 1% annual rate, in line with recent years. This growth in craft beer suggests that the segment climbs to 23% of total beer volume by 2020, slightly ahead of the Brewers Association's own 20% target.

However, while we expect absolute volume gains to remain constant for craft beer, the resulting growth rates slow over the coming years because of the increasing base. Moreover, we calculate that barrels produced per craft brewery have trended downward at a 6.6% annual rate since 2010, and we don't expect this trend to change in the near term. As a result, we expect the industry will need to continue to open new breweries to support further growth, driving increased competition for Boston Beer and other current players already operating in the craft market.

Boston Beer Likely to See Further Volume Share Loss in Craft
The lauded Samuel Adams Boston Lager and its many flavor extensions have helped drive Boston Beer to the top position in U.S. craft beer, and we expect continued support of this label (both on-premise--at bars and restaurants--and at-home consumption) will lead to continued volume growth over the coming years. That said, Sam Adams has lost significant share in craft beer recently, owing to the increase in smaller, local brands as well as increased craftlike consumer options from larger brewers, such as MillerCoors' Blue Moon and ABI's Goose Island. In all, we calculate that Boston Beer's volume share of the total market (excluding cider and flavored malt beverages) has slid to about 14% in 2014 from 20% in 2009.

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We don't think the company's share has yet found its bottom. On the basis of management commentary on continued strong competitive pressure, explicitly stated volume growth goals from larger, better-capitalized brewers, and our own analysis that suggests a likelihood that many more brewers will emerge, our projections suggest that Boston can maintain roughly 10% of the craft beer market by 2020. This puts the company's share of the total beer market at about 2.3% versus about 1.5% today--similar to the firm's absolute share gain of overall beer seen in the prior six years. Combined with the slowing growth rates we see in the overall craft beer space, our analysis suggests the beer portion of Boston Beer's portfolio will grow at roughly a high-single-digit clip through the remainder of the decade.

Angry Orchard Hard Cider Will Mitigate Beer Slowing
Outside of craft beer, one of Boston Beer's major successes over the past three years has been Angry Orchard, its hard cider brand that has taken the top spot in a small but rapidly growing market. Although the company doesn't explicitly break out its product lines, we estimate that Angry Orchard made up nearly 20% of total volume in 2014--a substantial rise since launching in late 2011 (that year Boston retired its original Hardcore cider brand, which had failed to garner substantial traction).

Over the past three years, hard cider has climbed to represent nearly 1% of the beer market, from less than 0.2% in 2011. Certainly, new product launches have helped to spur this growth; in 2011, for instance, 70% of the market was controlled by two companies--Green Mountain Beverage (Woodchuck and Cider Jack) and E.&J. Gallo (George Hornsby's)--but Angry Orchard's rapid rise has propelled it to nearly 60% of domestic market share now. Moreover, like craft beer's share grab from traditional full-flavored brews, we believe substitution from traditional light beers (particularly given cider's gluten-free properties) probably plays a part in cider's gains. We expect strong gains here can continue. Although the eye-popping growth seen in recent years (100% in 2013 and 60% in 2014) is likely to slide as the total market increases, we believe cider can double its penetration through 2020, driving high teens annual volume gains.

Still, as the top player in a hot space, Angry Orchard was bound to attract competition, and Boston Beer has noted in recent quarters that new offerings from both national brewers (MillerCoors' Smith & Forge and ABI's Johnny Appleseed, both launched in 2014) and smaller players are likely to encroach upon the brand. We think the Angry Orchard label can continue to lead the category, but we think it's reasonable to expect sliding share--we assume 45% volume share in 2020 versus about 60% currently. However, this projection suggests Angry Orchard will remain Boston Beer's fastest-growing product, driving total contribution to nearly 30% of volume from 20% today.

Profitability Expansion Has Flatlined, but Should Improve
The mix toward cider has had a negative impact on profitability, given higher ingredient costs and lower economies of scale. As such, Boston Beer's operating income per barrel (the sum of beer, cider, and other products such as the Twisted Tea flavored malt beverage) has remained relatively constant since 2010, despite total volume climbing 81% and revenue per barrel rising nearly 8%.

Further breaking down this flat operating profit per barrel performance confirms that the main driver has been increasing cost of goods sold per barrel, which has climbed at a 4% annual clip, outpacing a 2% yearly price/mix benefit. Similarly, freight and other costs have increased roughly 5% annually, while general and administrative expenses have proved relatively benign. We expect these last two line items to remain flat for the foreseeable future, given continued driver shortages in the U.S. and Boston's reliance on third-party distributors propping up freight expenses, offset by continued solid cost control on G&A spending.

This analysis also shows that the company has offset higher COGS by leveraging advertising and marketing expenses. On one hand, this leverage is a positive; total A&M expenses have still risen more than 50% over the period, and at about $24.50 in spending per barrel, we calculate Boston Beer's spending as nearly on par with that of ABI's $21.00 in North America. However, we think it's possible the firm has cut advertising too much, with recent share losses providing evidence of this theory. Also, although Boston's per-barrel A&M spending has been nearing ABI's, we note that the smaller company is now largely a national player, and its $100 million in marketing spending in 2014 pales in comparison with InBev's $2.1 billion in North America alone.

As such, we're not surprised that the company increased its total spending by 24% in 2014, and that management outlined a plan to increase advertising and marketing spending faster than revenue growth again in 2015 (roughly 25%-35%, versus low double-digit revenue gains), suggesting a rising per-barrel rate; we think these increases will continue for the next several years, given the increased level of competition we see in both craft beers and hard ciders. Nonetheless, we believe the company will be able to expand its gross margins, following several recent investment projects and continued better volume scale, which should help to improve input cost leverage and brewery production costs.

Buoying our thinking, management has noted several times over the past few quarters that its primary ambition is to serve customers and support its own growth opportunities, with minimal focus on the cost side of the P&L. Moreover, while recent heightened capital expenditures have harmed free cash flow (which has been negative for the past two years), we expect these projects should lead to efficiency improvement, given updated equipment and higher capacity. The company has already estimated that capex will fall to about $80 million-$110 million in 2015--a sharp decline from the $152 million spent in 2014--and we expect free cash flow to return to nearly 100% of net income over the long run, growing at a 38% annual clip through 2020, compared with our projected 2015 level.

We Think Consumers Are Willing to Pay More, and Boston's Moat Is Intact
Although we project Boston Beer will shed further volume share in its key markets, we expect it to enjoy continued positive pricing actions. The company has increased revenue per barrel at a 3.3% annual clip over the past five years, both from rate increases (meant to cover higher-cost products) and a positive mix shift toward bottles and cans (which typically represents consumption away from the retail location) versus kegs (mostly consumed on premise, such as in bars). The company's mix of bottles and cans has climbed to 77% of total shipments in 2014 from 71.5% in 2009.

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While price increases haven't completely offset rising costs, we think the increasing metric is evidence of Boston Beer's brand-driven intangible asset competitive advantage and ultimately supports its narrow economic moat; customers have proved their willingness to pay higher prices over time for the company's products and, importantly, have purchased them for at-home consumption.

We expect further average price increases in the low-single-digit range over the next five years, driven by continued positive mix shift (larger brewers sell roughly 10% in kegs) and additional rate increases. Importantly, while we expect the environment to remain competitive, we don't anticipate a sudden price war among craft brewers, at least in the medium term, as this niche provides positive price mix for larger brewers as well; we doubt the major national brewers would sacrifice price and profitability, given consumers' willingness to pay up for these brews. For instance, a six-pack of Sam Adams Boston Lager sells for roughly $8 and Angry Orchard for nearly $10. Similarly, ABI sells Johnny Appleseed for almost $9 per six pack, and MillerCoors' Blue Moon retails for about $8, all more than the average mainstream beer, which sells for about $5 per six-pack in the U.S.

Craft Beer Is Naturally a Narrow- Rather Than Wide-Moat Business
Although we expect Boston Beer and its craft beer cohorts to enjoy further price increases, we don't think the firm has carved a wide economic moat. One of our primary concerns lies in the industry's growth itself; given the rapid proliferation of new brands, flavors, and breweries, we have a hard time building the confidence to say that Boston Beer will enjoy excess economic profitability 20 years from today (the basis for our wide moat rating).

Moreover, while craft beer is higher priced than mainstream brews, on average, it also carries higher ingredient costs--particularly among full-flavored IPAs and other hoppier beers. As such, Boston Beer's gross margins trail those of larger, wide-moat brewers (which, in our opinion, also enjoy a cost advantage from their vast distribution scale), and although we expect improvement, we don't expect gross margin profitability to close this gap over the next five years.

Additionally, the firm could see increasing competition from nationwide craft brewers. Craft names like Lagunitas, which grew 84% in 2013, are expanding nationwide, which threatens Boston Beer's position as one of the few craft brews available nationally.

Larger competitors such as Molson Coors and ABI are also acquiring craft brands, These brands can keep a craftlike appeal to customers--especially since in many cases, the founder stays in charge of brewing--but benefit from the financial resources (often in the form of expanded capacity) and distribution cost advantages of a larger competitor. For example, before being acquired by ABI in 2011, craft brand Goose Island was struggling with capacity issues. After its acquisition, the brand expanded its capacity (by having some beer brewed in ABI's facilities in New York) and rolled out nationally. Several news reports suggest the Goose Island brand was able to increase sales and volume more than 50% in the few years following its acquisition.

While it is possible that acquired craft brands will lose appeal with customers as they become "mainstream," the success of Goose Island, Blue Moon, and Leinenkugel suggest this is not the case. ABI and Molson Coors have acquired or taken a stake in five other small craft brewers in recent years, and Boston Beer could soon see increased competition from craft brands with low-cost national distribution and potentially preferential retail space at retailers as a result of the negotiating power of the new, larger parent companies. We don't believe Boston itself will substantially participate in consolidating the industry, given management's historical penchant for minimal balance sheet leverage and organic product extensions; we also don't believe the firm would enjoy the same synergies from acquiring a smaller brand as larger brewers, given its lesser ability to bring any target's brewing in-house or immediately offer the product on a national (or even international) distribution network.

Nonetheless, we see Boston's returns on invested capital remaining north of 30% over the next 10 years, well above our estimated 9% cost of capital, due to aforementioned margin improvement and minimal asset needs--while the firm doesn't control its own distribution, it is also not tasked with ownership of these assets.

International Expansion an Opportunity, but Too Small to Move the Needle
We see international growth as an opportunity for Boston Beer, as the craft export market is projected to grow faster than craft domestically, but we don't expect this channel to offset the slowing growth we see elsewhere for the firm. The company does not break out its international exposure, but the Brewers Association reported that 282.5 thousand barrels of U.S. craft beer were exported in 2013, up nearly 50% from 2012. Given Boston Beer's larger scale and financial resources compared with many small brewers, we believe it is reasonable to assume the firm has a greater share of the craft export market than the domestic market. If we assume that Boston Beer has captured 40% of the international market, exports would make up approximately 4% of its total beer volume. Export volume as a percentage of sales moves about a percentage point per a 10% change in our market share assumption (5% at 50% share, 3% at 30%, and so on).

According to estimates by IBISWorld, the craft export market will grow at a 34.8% compound annual growth rate through 2018. At this rate, total exports in 2018 would be approximately 1.25 million barrels. Even assuming Boston loses some share to constitute 25% of this market, international sales would grow at a compound annual growth rate of 23% and represent 7.6% of Boston Beer's total beer volume.

The largest market for U.S. craft exports is Canada (46.5% of volume), and it is logical to assume it is the largest export market for Boston Beer as well. Boston's beer exported to Canada is produced in the U.S. and distributed by Moosehead Breweries. Boston--specifically founder Jim Koch--prefers to make the freshest product available (as evidenced by its freshest beer initiative) and therefore has chosen to contract brew in other major markets as opposed to transporting beer a significant distance. For example, the United Kingdom is the third-largest craft export market (7.9% of craft export volume from the U.S. in 2013), and Kent-based Shepherd Neame brews Samuel Adams Boston Lager in the U.K. using Boston Beer's yeast strain.

While growth looks promising, there are challenges for Boston Beer in the craft export market. Local craft beer production is growing in Canada and the U.K., which is likely to increase competition in these markets. Additionally, the Brewers Association data does not include craftlike superpremium beers distributed internationally by major players, such as Molson Coors' Blue Moon. Larger players, which own brewers around the world, also have the ability to introduce or acquire local craftlike products in foreign markets, such Molson's Doom Bar or Carling Cider in the U.K. If competition were to drive Boston Beer's share of the craft export market toward 12%, which we forecast for the domestic market in 2018, it would lag domestic growth and come down to an estimated 3.6% of total volume, generating only 6% growth annually.

Boston Beer Is Set for Further Growth, but Currently Looks Expensive
We see Boston Beer's revenue growing at a 10% annual clip for the next five years, driven by high- single-digit volume growth and about 2% of pricing and mix gains on average. We expect the fastest growth early in this projection, with yearly gains slowing as a result of continued market share loss and a rising base; we see Angry Orchard growing the fastest over this period, climbing to roughly 30% of Boston Beer's volume from about 20% today.

A key part of our thesis is that Boston will leverage its operating costs and return to gross margin expansion as volume growth slows (due to better cost focus), which, along with stable G&A costs and higher revenue per barrel, should enable operating margin expansion. We also expect free cash flow to materially improve following recent investment in new equipment and various efficiency programs.

However, the market currently appears quite a bit more optimistic. To justify the present share price, we'd have to assume that Boston can hold on to double-digit volume gains, with stronger price increases than seen in the past several years (roughly 2.5% annually through 2019). We would also have to project operating margins climbing to 22% within the next five years, versus about 20% in our valuation.