Stock Strategist

Boston Beer's Valuation Is Too Frothy

Sonia Vora

 Boston Beer’s (SAM) shares have rallied over the past year, up 72% versus a 16% decline for the brewers under our coverage and a 15% increase in the S&P 500 index. We attribute this recent strength to a recovery in the company’s volume, with the first quarter of 2018 marking a return to depletion growth for the first time since the third quarter of 2015, thanks to the success of recent innovations like Sam '76, Angry Orchard Rosé Cider, and Truly Spiked & Sparkling.

While we agree that Boston Beer’s near-term prospects appear more favorable, as evidenced by improving volume trends in the first half of the year (depletions were up 11% versus down 7% in the prior-year period), we don’t expect this level of growth to persist, particularly given the lighter comparisons the company is lapping this year. While we’ve ticked up our forecast for 2018 sales growth to more than 9% from the low single digits and maintained our expectation for low teens operating margin, we’ve held the line on our longer-term outlook for around 4% sales growth toward the end of our 10-year forecast and average operating margin around 17% (versus a five-year historical average around 15%).

The market has valued the shares at an increasingly high multiple to earnings, hovering around 34 times roughly 30 times at the beginning of the year and a three-year historical average in the high 20s. However, we don’t view this expansion as sustainable; we think the market is underappreciating the extent to which a maturing craft beer market will heighten the competition Boston Beer faces from both niche players and the largest beer producers. Although we think the company will be able to leverage its brand intangible assets, including the brand equity of its flagship Sam Adams brand and resulting entrenchment in wholesalers’ supply chains, to stabilize its share and maintain its presence on retailers’ shelves amid a potential craft shakeout, we expect volume growth to decelerate alongside the craft category.

Consequently, our outlook for 6.6% average top-line growth over the next three years remains about 190 basis points below consensus. Still, while we don’t expect Boston Beer’s margins to close the gap with its wide-moat brewing peers, we’re more optimistic than consensus about its bottom-line strength as it continues to extract costs from its operations and as headwinds from deleveraged volume subside. Moreover, we expect these savings will provide the company with greater resources to invest behind its brands, whether through product innovation or advertising and promotional spending, ensuring a sustainable trajectory of growth.

Higher-End Offerings Remain a Pocket of Growth
U.S. beer volume has stagnated over the past decade, as consumers have increasingly opted for alternatives like wine and spirits. While beer still accounts for the largest portion of the domestic alcoholic beverage market, consumers are increasingly drinking across the beer, wine, and spirits categories. According to Constellation Brands, consumers who drink across all three categories hold upward of 50% share of total alcoholic beverage dollars and on average spend 6 times as much as consumers of just one category and more than twice as much as consumers of two categories.

Despite roughly flat sales growth for the overall beer category, premiumization trends in the category have lifted volume of higher-end offerings, while more mainstream and discount price points have ceded share. This aligns with our view that consumers across the global alcohol category are likely to trade up to more expensive categories or brands over time, as alcoholic beverages are often a more affordable luxury than other goods. This especially holds true for beer, where the price gaps commanded by premium fare tend to be modest on a dollar basis: While a six-pack of a craft offering may be priced 40% above a more conventional brand, the difference between $6 and $10 is much less striking in absolute terms. Premium and above-premium offerings now account for nearly 40% of domestic beer volume versus roughly one fourth a decade ago. Over the same time frame, we estimate the proportion of discount-priced beer has fallen from around 23% of total volume to the high teens.

Craft beer has been a beneficiary of this premiumization trend, with volume averaging low-double-digit growth over the past decade, according to the Brewers Association, which applies the “craft” definition to breweries that produce no more than 6 million barrels of beer annually, are less than 25% owned or controlled by a noncraft player, and derive the majority of their total volume from beers made “from traditional or innovative brewing ingredients and their fermentation” (that is, excluding flavored malt beverages).

We estimate craft beer now holds a nearly 13% volume share of the U.S. beer market versus around 3% in 2005. Imported beers have also performed well, gaining around 4 percentage points of share over the past decade to contribute 18% of beer volume in 2017. In aggregate, these categories accounted for 30% of volume in 2017. When craft and imported variants are excluded from volume, the weak performance of the mainstream beer category is even more pronounced, with domestic noncraft beer declining by a low-single-digit clip on average over the past decade.

In our view, craft beer’s rapid growth reflects consumers’ thirst for more flavorful beer and a greater variety of products. We think smaller brewers’ nimble product innovation cycles have helped them create high-quality products that resonate with evolving consumer preferences, allowing their offerings to maintain a price premium over mainstream fare. Craft share gains are even more striking from a dollar perspective. Craft beer’s value share has expanded by nearly 4 times over the past decade, amounting to 23% of the U.S. beer market. This suggests that consumers are willing to pay up on the basis of taste or product innovation and that there is modest runway for pricing growth even at the high end of the beer market.

While we expect craft beer volume to outpace that of the overall beer category longer term, signs of a slowing market are emerging. In 2016 and 2017, craft volume growth slowed to the midsingle digits, according to data provided by the Brewers Association. While this was well above the roughly flat growth of the beer category in aggregate, it represents a material step down from the 15% averaged over 2011-15. We forecast decelerating craft volume growth as the industry matures, averaging roughly 4% over the next five years. We also expect broader beer volume to stabilize over the next few years but don’t foresee a return to growth.

In our view, this reflects increasingly challenging comparisons following a lengthy period of outperformance (with craft volume averaging above 12% annual growth between 2006 and 2015), rather than a sign that consumers’ desire for more premium, flavorful beer has cooled, given that craft has continued to take incremental share from mainstream beer over this time frame. We also note that the Brewers Association’s definition of craft beer (and consequently its growth figures) excludes breweries in which the largest beer producers hold a 25% or more economic interest; consolidation by large beer producers has ticked up since 2011. Even so, we would still view slowing volume growth by “independent craft” producers to be a telling indicator of category health, given that smaller players have historically driven growth. As evidence, the Brewers Association estimates that microbreweries (that is, breweries that produce less than 15,000 barrels of beer per year and sell at least 75% of their beer offsite) contributed nearly 60% of 2017 craft volume expansion.

Even as the craft market cools, we don’t expect competitive intensity to subside, as entrenched players and newer entrants continue to vie for volume gains in a lower-growth environment. These competitive pressures may be compounded by relatively low brand loyalty within the craft segment, given its consumers’ propensity toward trying new products. According to Nielsen, craft beer consumers make their purchasing decision at the shelf roughly 70% of the time (versus slightly below 60% for fast-moving consumer goods overall), and 60% of weekly craft beer drinkers look at beer style before they consider brand. Further, given the relatively low costs associated with trying a new variety of beer, we see minimal barriers to switching among brands.

Of the brewers we cover, we believe narrow-moat Boston Beer, Heineken (HEINY), and Constellation Brands (STZ) are best poised to benefit from ongoing U.S. premiumization trends, as their exposure to the beer category is exclusively in the faster-growing premium and superpremium price points. However, we think heightened competition in this space is likely as volume growth in the mainstream beer segment remains elusive. We expect larger players like wide-moat Anheuser-Busch InBev (BUD) and narrow-moat Molson Coors (TAP) will continue to look for opportunities to build out their presence in the high end, including through acquisitions or equity investments. We view craft consolidation as likely, given more than 6,000 craft breweries, a slowing volume environment, and the limited scale and resources of many craft breweries, which may impair their ability to appropriately support or expand their brands.

Strong Distribution Relationships Help Brands Maintain Visibility
We maintain that Boston Beer’s competitive edge should help it sustain its recovering volume trends and defend its share in the face of competitive pressures. We estimate the company holds a roughly 2% volume share of the domestic beer and cider market, including a 60% share of cider (though this contributes just 1% of the overall category) and a low-double-digit share of craft beer. We think the company’s position as one of the oldest and largest craft brewers in the United States has allowed it to amass an intangible asset in the form of entrenched relationships with wholesalers and retailers. These intangible assets underscore our narrow moat rating. The company’s robust returns on invested capital, which have averaged 30% over the past decade (well above our 9% cost of capital estimate), support our view that Boston Beer has been able to leverage these intangible assets to generate economic profits.

We view distributor relationships as a key source of competitive advantage in the beverage space; this is especially pertinent to craft beer producers, given the three-tier distribution system that characterizes the U.S. alcoholic beverage landscape. This system, which has been in place since the repeal of Prohibition in 1933, mandates that alcoholic beverage producers must sell their products through an intermediary (the distributor/wholesaler), which in turn sells products to the retailer (which encompasses both off- and on-premises establishments). While the delineation of these tiers can vary from state to state--for example, many states permit certain breweries, often smaller entities, to self-distribute beer through brewpubs--this layer of complexity makes the relationships between producers and distributors a decisive factor.

Adding to the complexity of these distribution networks, craft beer consumers’ demand for a variety of offerings, coupled with rapid category growth, has led the average number of stock-keeping units carried by distributors to more than double over the past decade. The average wholesaler carried north of 1,000 SKUs in 2016, versus just 200 in 2003.

However, we don’t view this trend to be sustainable, and we expect distributors to pare the number of SKUs they carry as the craft beer category matures. From the distributor’s perspective, it is preferable to carry brands with proven customer appeal, which are likely to have faster inventory turnover, thereby allowing them to shorten their cash-conversion cycle. Quick inventory turns are doubly important for beer distributors because, owing to the finite shelf life of craft beer (for optimal flavor), carrying too many SKUs can also lead to inferior or even unusable product.

While we don’t expect distributors to shy away from craft, given that its growth prospects and margin profile remain more attractive than the overall category, we find it likely that they will increasingly prioritize leading brands for the aforementioned reasons. And although Boston Beer’s share of the overall beer market remains shy of 2%, its position as the largest independent craft brewer (by our estimates, producing roughly twice as much volume as its second-largest independent competitor, Sierra Nevada) and long-standing relationships should ensure healthy distribution, supporting its brand intangible asset.

Further, more-established beer producers can leverage their deep industry knowledge to enhance their distributor relationships. Given the increasing complexity of distributors’ portfolios due to SKU proliferation, we expect that a craft brewer’s ability to differentiate itself by supporting its brands and helping distributors communicate their value to retailers will become increasingly important.

We also contend that Boston Beer’s consistent position on retailers’ shelves reflects the durability of its retail relationships, and we don’t expect ongoing SKU rationalization at the retailer level to alter our outlook for the company. Over the past several years, retailers have increased the allocation of shelf space to craft brands at the expense of more mainstream offerings; during a 2012 presentation, Boston Beer’s management claimed that craft space was growing faster than craft volume. However, by 2014, management noted that these increases in shelf space were slowing, due to “a limited amount of space that can be taken out of the mass domestic beers before they start running into out-of-stocks,” as well as a finite amount of cooler space. By 2016, the trends of increasing fragmentation in the craft category, an increasing proportion of shelf space allocated to craft beer, and SKU proliferation had waned.

As further evidence, MillerCoors’ Behind the Beer blog estimates that the average retailer added six beer, cider, or malt beverage items a year between 2013 and 2016, including four craft beer items. In contrast, retailers removed four items on average across these categories from their shelves in 2017.

We infer that Boston Beer’s position on shelves held steady during the craft boom (evidence of the strong relationships it has maintained with retailers) but posit that its share of the shelf decreased as the total space dedicated to craft increased. As such, we expect SKU rationalization to have a neutral to positive impact on the company as this headwind subsides. We expect retailers will continue to favor SKUs of leading brands for many of the same reasons (including faster inventory turns and promotional support) as those discussed at the distributor level, as well as a lower likelihood of out-of-stocks.

These strong relationships at both the wholesale and retail levels should allow Boston Beer to maintain its products’ visibility even as the craft market slows. Further, we think these relationships have helped the company secure shelf space for new offerings, which should support its volume recovery.

We Expect Increasing Consolidation in Craft Beer
We don’t expect the outlook for brewers that lack the aforementioned competitive advantages to be as rosy, and we view a shakeout in the craft segment as likely. The craft beer landscape has become increasingly fragmented, as the number of breweries has expanded at a faster clip than industrywide volume. We estimate the number of craft breweries has increased more than 20% over the past five years on 12% craft volume growth, leading the average number of barrels produced by a craft brewer to decline at a mid-single-digit clip over this time horizon. This gap widened in 2016 and 2017 as the number of craft breweries grew 19% (versus 6% volume growth) and 16% (5% volume growth), respectively, implying a double-digit decline in average barrels per brewer each year. While we expect craft beer to continue to gain share, we think these gains will come at a slowing rate that may not be sufficient to support the current number of breweries, many of which are likely to face lower-than-projected volume as growth wanes. Therefore, we expect the number of craft breweries to decline longer term.

As overall craft growth slows, we expect further stratification in craft brewer performance, with brands that fail to resonate with consumers losing out as distributors and retailers trim the SKUs they carry. When combined with declining average production volume, craft brewers that fail to meet their top-line projections are likely to face excess capacity and volume deleverage, hampering profitability. Even brewers that experience top-line growth may not have sufficient capital to expand capacity to meet demand. Lastly, overleveraged balance sheets or rising input costs (including rent, labor, and ingredients) could limit operational flexibility. An uptick in craft brewery closures as of late, amounting to 2.6% of breweries in 2017, or around 1% higher than the average rate over the prior five years, supports this stance.

We expect brewers that are somewhere between the two ends of the spectrum--established, national craft brewers like Boston Beer and niche, local players--to bear the brunt of this turbulence, as they are the most likely to face excess capacity or fall flat in their efforts to expand geographically. Still, despite a potential shakeout, we expect Boston Beer will continue to face stiff competition from independent craft brewers (albeit a smaller number) longer term.

In addition to pressures Boston Beer has faced from the small, independent craft breweries that have fueled craft expansion, there’s the threat posed by the largest brewers, wide-moat Anheuser-Busch InBev and narrow-moat Molson Coors, which still control the lion’s share of the beer market and are probably thirsting for growth, given that each has been plagued by volume declines across their largest brands recently. We believe the largest brewers’ scale affords them stronger distribution relationships and, in the case of AB InBev, a more favorable cost structure than smaller players. These factors limit our confidence that Boston Beer will continue to outearn its cost of capital over the next 20 years, which underlies our view that its moat is narrow rather than wide.

Despite Boston Beer’s status as one of the largest craft players, its volume share of the broader U.S. beer and cider market pales in comparison with the largest brewers, amounting to less than 2%. We estimate AB InBev holds the largest share of the U.S. market with more than 40% of volume, followed by Molson Coors at 25%. Both companies have lost share over the past few years as volume of core brands like Bud Light (AB InBev) and Miller Lite and Coors Light (Molson Coors) has languished. We estimate that each of these brands has declined at a low-single-digit rate on average over the past five years as a result of the trend toward more premium, flavorful beer that has been a boon to the craft category. Nevertheless, these companies remain formidable opponents and still control nearly 70% of volume in aggregate.

These companies also benefit from vast distribution networks, with AB InBev maintaining a network of 440 wholesalers (17 of which are owned) and Molson Coors maintaining approximately 400 wholesalers (1 owned) in the U.S. as of 2017. According to Boston Beer chairman and founder Jim Koch, more than 90% of beer in most local markets is controlled by the distribution networks of these two companies. While Boston Beer’s significant distribution network (350 wholesalers) shows its ability to secure widespread national distribution, the company usually doesn’t control the primary brands in its distributors’ portfolios. Koch has often said that a company like AB InBev contributes the vast majority of volume for its wholesalers and can therefore more quickly scale distribution through its network than a company like Boston Beer, which often competes with other brands in a distributor’s portfolio.

In the event of a craft beer shakeout, we think these larger players could act as consolidators in the space. AB InBev spurred a wave of consolidation across the craft beer category in 2011, when it purchased Goose Island Brewery for $39 million. Since then, the company has scooped up nine more U.S. craft brewers in order to expand its presence in the higher end of the market. Molson Coors has also engaged in several tuck-in deals, taking a majority stake in four craft brewers since 2015.

Although the terms of these deals remain largely undisclosed, we wouldn’t be surprised to see increasingly high valuations across the space following Constellation Brands’ $1 billion acquisition of Ballast Point in 2015 (implying a multiple of 8-9 times sales, by our estimates). We recognize the appeal of this strategy, as craft brewers have been able to achieve substantially higher growth than mainstream brewers have been able to accomplish through organic means. Moreover, craft brewers can leverage a partnership with a large beer producer to secure more widespread distribution (from both a geographic and channel perspective) through their well-established wholesaler networks. As a result, many of the “craft” brands that can now tap into resources of larger brewers have been able to achieve tremendous volume growth over the past five years (which we primarily attribute to distribution gains), outpacing several more well-established independent craft brands. For example, we estimate Ballast Point has increased volume at a 75% rate on average over the past five years (including 60% in the two years since being acquired). Similarly, Founders Brewing (30% stake acquired by Mahou San Miguel, a leading Spanish brewer, in 2014), Lagunitas (50% stake acquired by Heineken in 2015, with the remaining stake acquired in 2017), and Goose Island have experienced 30%-50% volume growth over the past five years thanks to the enhanced capacity, distribution, and selling and marketing resources these partnerships afford.

While these dynamics aren’t new, we expect continued pressure from both ends of the beer market to constrain Boston Beer’s volume growth to the midsingle digits on average over our forecast. However, we expect the success of recent innovations like Sam '76, Angry Orchard Rosé Cider, and Truly Spiked & Sparkling to help the company recoup some of the share lost in recent years. In the longer term, we expect its volume to grow roughly in line with the overall craft beer market. This implies volume share stabilizing at around 10% of the domestic craft beer market and 2% of the overall beer and cider market.

We don’t anticipate that international (4% of sales) or inorganic growth opportunities will meaningfully contribute to Boston Beer’s top line, as management has historically pursued a simple wholesaler footprint. Expansion abroad introduces material operational complexity, with management citing beer’s inability to travel well, complicated international distribution networks, and lower margins as reasons these markets are less compelling. Acquisitions can also complicate distribution, as franchise laws (which govern the relationships between producers and wholesalers in the U.S.) often limit brewers’ ability to terminate contracts with distributors without facing penalties. As a result, consolidation can lead to multiple distribution networks in a specific territory, which management has often referred to as a negative synergy. However, we wouldn’t rule out the possibility of tuck-in acquisitions in regions where Boston Beer can maintain a clean wholesaler footprint, as was the case with Angel City (2012) and Coney Island (2013). However, we expect the company to remain focused on revitalizing its core Sam Adams brand in the near term, particularly as craft valuations remain elevated.

No Cost Edge, but We See Margin Opportunities
We think the largest global brewers benefit from powerful economies of scale, allowing them to benefit from a cost advantage relative to their peer set. This scale affords these players the ability to make more substantial investments behind their brands, which further reinforces their entrenchment in wholesale and retail supply chains. As evidence of this, AB InBev’s selling and marketing expenses amounted to 15% of revenue, or more than $8 billion, in 2017. Boston Beer’s advertising, promotional, and selling expenses (excluding freight) stood around $200 million, which represented 25% of sales. AB InBev also benefits from a procurement advantage (for example, we estimate it buys 8% of the U.S. rice crop each year), which has helped it achieve best-in-class gross margins above 60%. While we project that Boston Beer’s smaller scale will prevent its profitability from closing the gap with a wide-moat peer like AB InBev, we see room for modest gross margin improvement as the company’s volume improves and efforts to extract costs from its supply chain continue.

Until 2015--when volume growth slowed to 6% versus 20%-plus over the prior two years--Boston Beer’s rapid growth required substantial increases in capacity, and management has suggested that the speed at which this capacity could be added took precedence over manufacturing efficiency. However, as volume has faltered in recent years (deleveraging fixed costs), the company has taken a more stringent approach to its cost structure. It has made substantial investments to increase the flexibility of its supply chain, which should help it adjust production in response to demand fluctuations, and improve brewery efficiency. According to management, these efforts helped reduce filler changeover times by 70%-80% and reduce beer losses by 60%-80%. These cost savings should free up resources for Boston Beer to bolster investment behind its brands, which we view as necessary to support top-line expansion. We expect the company’s advertising and promotion expenditures to average around 14% of sales over our forecast, about 2% higher than the level of spending over the past five years.

Shares Look Substantially Overvalued
We think the market has overreacted to Boston Beer’s improving volume trends and underestimates the extent to which a maturing craft industry, combined with competitive pressures from small craft producers as well as the largest brewers, will constrain volume growth longer term. Our $189 fair value estimate incorporates nearly 6% compound revenue growth over the next five years (below the 9% average of the prior five years), with growth slowing to 4% in the out years of our 10-year forecast. This includes average revenue per hectoliter growth of 1% over our forecast, which is consistent with the low-single-digit pricing growth we expect for players across the U.S. beer space. We expect the company’s efficiency initiatives should allow operating income to grow faster than sales, resulting in a 15% average operating margin over the next five years, which is 170 basis points above 2017 but comparable with the five-year historical average. We expect the company will shore up its advertising, promotional, and selling expenses (to a low teens percentage of sales versus a five-year historical average around 12%) as a means of supporting top-line growth.

Also, Boston Beer’s shares appear expensive on a relative basis, commanding a hefty premium over brewing peers. There is a staggering discrepancy between Boston Beer’s multiple, which stands close to 34 times, and the low 20s average of its peer set, including companies like AB InBev, which we view as having a stronger competitive edge, and Constellation Brands, which is similarly well positioned to benefit from domestic premiumization trends. This supports our contention that Boston Beer’s share price has strayed from the company’s intrinsic value.

We’d suggest investors seeking exposure to the beer space consider wide-moat Anheuser-Busch InBev or narrow-moat Molson Coors, both of which trade well below our fair value estimates.

Sonia Vora does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.