Increasing Thirst for Craft Brews Should Drive Boston Beer's Earnings Growth

 Boston Beer (SAM) once again delivered excellent quarterly results, as depletions grew 26% versus the year-ago third quarter, and the company slightly raised its outlook for 2013 as well as giving a 2014 forecast that slightly outpaced our prior expectations. Although we have increased our fair value estimate to $160 per share from $150, we still view the stock as expensive. We believe the firm's narrow economic moat is fortified by its strong brands (Samuel Adams, Twisted Tea, and Angry Orchard), but longer-term increased competition from the craft beverages created by MillerCoors /(TAP) and Anheuser-Busch InBev (BUD), as well as thousands of smaller independent craft brewers, could impede Boston Beer's growth.

Growth in Craft Beer Has Benefits and Risks
While Boston Beer has benefited from nearly two decades of the craft beer category gaining share of stomach, this same growth is fueling some significant risks for the company. As Americans drink fewer premium light beers (such as Miller and Budweiser), the major beer companies have been promoting their own craft beers (such as Blue Moon and Leinenkugel) and hundreds of smaller craft breweries have been popping up, trying to become the next Samuel Adams. This increased competition could lead to irrational pricing. Nonetheless, we believe it is more likely than not that Boston Beer's market share could nearly double over the next decade as the category continues to gain share and the Sam Adams and Angry Orchard brands remain relevant to American drinkers.

The craft beer category is highly fragmented, with more than 2,000 breweries in the United States. Roughly 770 of these craft breweries ship their products to distributors (versus 420 in 2006), with the remainder selling on premises, primarily through brewpubs. Although only privately held Yuengling is close to Boston Beer's volume, other large craft brewers are ramping up their production capacities, and hundreds of new breweries are likely to pop up over the next five years. Sierra Nevada and New Belgium are planning to build new breweries in North Carolina, which should result in increased competition up and down the East Coast, which is a Boston Beer stronghold. The big brewers don't want to be left behind: MillerCoors, which owns Blue Moon and Leinenkugel, has been steadily expanding its craft beer volume for several years, and AB InBev's Shock Top and Goose Island brands enable the firm to have a presence alongside other craft beers. Boston Beer also faces competition from imported beers--primarily Heineken and Corona--as well as spirits and wine.

More Capacity Could Mean Irrational Pricing
The company's biggest risk is that increased competition--from larger brewers entering the craft market, hundreds of craft breweries, imports, and wine and spirits--causes pricing to become irrational. Should too much capacity be added in the United States, craft beer maker may opt to compete on price. This would probably impede Boston Beer's growth and margins. Additionally, profits could be negatively affected by higher input costs, increased taxation, or an economic slowdown that reduces consumers' willingness to pay up for better beer.

Strong Brands That Taste Good Make for a Narrow Moat
Boston Beer has a narrow economic moat, in our opinion. The firm offers differentiated products in categories with relatively strong brand recognition and is able to charge a premium to mass-produced mainstream beers because consumers are willing to pay up for superior taste. We believe Boston Beer will outearn its cost of capital in the coming decade by generating 25% returns on invested capital.

Relative to its craft brewer peers, Boston Beer has achieved large scale, selling nearly 2.7 million barrels in 2012. However, the U.S. beer market is still highly concentrated, with 80% of the volume held by AB InBev and MillerCoors. Privately held brewers like Yuengling, Sierra Nevada, and New Belgium are steadily expanding their distribution footprints and production capacities. While such ventures help build the entire better beer category, pricing could become more competitive, resulting in profitability headwinds.