© Scott Eells/Bloomberg A six-pack of Boston Beer Co. Sam Adams Boston Lager sits displayed on a table during a Bloomberg Television interview in New York, U.S., on Thursday, April 3, 2014. Armed with a family recipe and a flair for…
Shares of narrow-moat Boston Beer (SAM) now trade at a substantial discount to our $175 fair value estimate, owing to recent market share challenges in the firm's craft beer and cider portfolio and deleveraged costs that have harmed profitability.
Admittedly, we agree that Boston's Sam Adams and Angry Orchard beer and cider brands will continue to grow more slowly than the overall craft industry, owing to competition from both small local brewers and mega beer conglomerates.
But we believe the market is missing the firm's longer-term opportunity to reduce bloated costs, improve brewery efficiency, and reinvest in product and marketing initiatives that should help to drive improved results versus a challenging 2016.
The firm's volume has fallen 5% in the year to date, but we believe the worst is likely behind Sam Adams because of strong end-market growth, planned marketing and brand investment, and easier comparisons going forward. We also remain confident of the long-term potential for the cider category, given its low penetration in the United States relative to other developed countries, and are encouraged that Angry Orchard has held market share.
Altogether, we expect craft beer and cider to continue climbing as a percentage of the overall U.S. beer market (to about 23% and 2%, respectively, by 2020, from an estimated 13% and 1% in 2015) as consumers continue to flock to these products, providing a solid backdrop for Boston Beer to increase volumes. Although we expect volumes to decline about 3% for full-year 2016, we forecast positive mid-single-digit volume gains past this year as the firm's products outpace the larger beer market.
Boston Beer has separated itself as the pre-eminent U.S. craft brewer, and we think the firm has carved a narrow economic moat based on its brand intangible assets. Craft beer has grown at an impressive rate over the past two decades at the expense of traditional value and premium offerings, with Boston Beer's above-premium Sam Adams brand a key driver.
We believe the company has an opportunity to further expand its national distribution, but the category's success has drawn more competition, which could limit pricing power and share position in the longer term. Nonetheless, we expect Boston Beer to enjoy mid-single-digit growth over the next five years, with benefits of scale and cost savings also improving the bottom line.
The craft beer, cider, and flavored malt beverage market in the U.S. (96% of Boston's revenue) is highly fragmented, with more than 4,000 breweries (both distribution-based and brewpub models), but we expect Boston Beer's leading position and strong brands to help the firm maintain wider distribution and better cost leverage than the vast majority of smaller peers.
However, Boston remains a much smaller brewer than major producers such as SABMiller and AB Inbev BUD (Boston brewed 5 million total hectoliters in 2015, compared with 245 million for SABMiller SBMRY and 457 million for AB Inbev globally). Although we believe Boston Beer can be more nimble in its flavor offerings--the company's Angry Orchard is the top-selling cider in dollars in the United States, for instance--the company also generates slimmer profitability than these behemoths given lower economies of scale.
We still believe that Boston Beer has a substantial margin-improvement opportunity over the longer term. While the firm's volume declines have caused fixed-cost and administrative expense deleveraging in the year to date, the firm estimates that the cost savings it is implementing now could drive nearly 300 basis points of comparable gross margin improvement when volumes rebound to 2015 levels, which we view as encouraging. We don't expect this gross margin improvement to immediately drop to the bottom line, however, as increased advertising and marketing needs will probably take precedent in the near term; nonetheless, we forecast operating margins climbing to the low 20% range from about 16% in 2015.
Given this, combined with lower capital expenditure needs, we project free cash flow climbing at a midteen rate past this year, justifying the name's relatively high multiple (our fair value estimate implies a P/E multiple of roughly 24.6 times our estimated 2017 EPS) and supporting the firm's continued share-repurchase activity. We also remain confident in the firm's narrow moat, which stems from the company's strong brand, better distribution network, and better negotiating power than other craft brewers.
However, increased competition has dented results, and further challenges seem inevitable. Larger players have added to their own craft-style offerings (such as MillerCoors' Blue Moon and AB InBev's Goose Island), while the number of craft breweries has increased at a double-digit annual clip over the past decade. Although pricing has remained rational and at a premium to mainstream beers (Boston Beer's average price per hectoliter was roughly $192 in 2015, compared with $109 for MillerCoors), the industry may see pressure if craft beer demand wanes from its recent torrid pace.
We've recently lowered our fair value estimate for Boston Beer to $175 per share as the firm faces stronger near-term headwinds to both the top line and profitability than we anticipated. That said, our long-term operating assumptions are largely unchanged. While short-term market share losses and resulting reduced profitability harm our near-term earnings estimates, we still see rebounding volumes and profitability over the long run. Our valuation implies a multiple of 26.8 times our updated estimated 2016 EPS and an enterprise value/EBITDA multiple of 13.4 times.
Boston Beer has enjoyed solid top-line growth in the past three years, including a 22% gain in 2014, but slowing results recently (revenue grew about 6% in 2015), as the firm has seen its share of the craft beer category slip and headwinds in the cider business. We assume that craft beer and cider will continue to climb as a percentage of the overall U.S. beer market (to about 23% and 2%, respectively, from an estimated 13% and 1% in 2015) as consumers continue to flock to these products (the products' respective shares have risen from 6% and 0.2% in 2010).
However, we also assume that Boston's Sam Adams and Angry Orchard beer and cider brands grow more slowly, owing to competition from both small local brewers and mega beer conglomerates. In our view, Boston Beer has carved a narrow economic moat, stemming from the company's strong brand, better distribution network, and better negotiating power versus other craft brewers. While the U.S. beer market has seen declining volumes in recent years, the above-premium (craft) portfolio has been one of the few areas of growth.
Given Boston Beer's continued declines to date, we've slightly lowered our outlook for 2016 volume and revenue about 100 basis points, to declines of 3% and 2%, respectively. Similarly, while we expect renewed brand and marketing efforts to drive improved results, we've lowered our 2017 top-line forecast to account for the timing of these investments. While we expect pricing to remain relatively rational (contributing about 2% annually), we now project revenue will grow at about 4.5% annually over the next five years versus 16% over the past five years.
The resulting earnings deleverage also looks to be a bit more than we previously assumed; we now expect operating margins of roughly 14.5% for the full year, versus 15% previously. Over the longer term, however, we continue to expect profitability gains as the firm leverages renewed volume increases across its expenses and drives efficiency improvements. We expect the firm to reinvest most of its gross-margin savings into marketing and other brand-development efforts, but still anticipate operating margins climbing to 23% by the end of our explicit 10-year forecast period, versus 16.3% in 2015.
Boston Beer is in great financial health. At the end of second-quarter 2016, the firm had minimal debt and $28 million of cash on its balance sheet, or about $2 per share. The firm generates strong operating cash flows, which gives it the flexibility to either take on leverage or continue its share repurchase activity. We would expect that in the coming decade, Boston Beer could aim to continue adding brewing capacity, though recent additions (which have hampered free cash flow) should prove sufficient for the near term.
By Adam Fleck
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