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Friday, December 7, 2018

The Uncertain Fate of the Craft Brew Alliance

I last discussed the Craft Brew Alliance roughly a year ago, just after they shut down the Gasthaus pub and turned it into a taproom for their small batch beers. That move was designed, at least partially, to make the CBA a juicier buyout target for Anheuser-Busch. But nothing has happened. What gives?

To understand why many assumed a buyout was imminent, you have to go back to the contract AB and the CBA signed in August 2016. That was a different time in craft beer, predating the market saturation and instability we see now. The document, which was a renewal and expansion of a prior contract, heavily favored the CBA and effectively established a framework for a slow moving buyout.

Giveaways in the contract involved domestic distribution costs, contract brewing opportunities, international distribution rights and more. They are covered thoroughly in the piece I wrote back in 2016. Rather than repeat those details, you can find them here if you're so inclined.

The reason many assumed a buyout was coming is the contract set escalating "qualifying offer" prices. By August 2017, a qualifying offer to buy the CBA had to be at least $22 per share. By August 2018, the number rose to $23.25 per share. By August 2019, a qualifying offer is set at $24.50 per share. There was incentive for AB to act sooner than later.

The allure of easy money attracted speculators. Soon after the new contract was announced in 2016, the CBA's stock price, which had been hovering around $14 per share, jumped to above $20. It hasn't yet worked out for the speculators that jumped aboard. The stock price has bounced around a bit, but shown life in July and August in each of the last two years, as speculators positioned themselves to cash in. It closed at $15.80 on Friday.

Given the structure of the contract, it's fair to wonder why the expected buyout hasn't happened. We all understand it's a different craft beer climate these days. Some of the big shots at AB have said they're comfortable with the High End portfolio as it is. They say they're focused on paying down debt acquired in the SABMiller merger/acquisition. Right.

The reality, though, is that Anheuser-Busch could not have gone through with a buyout in the wake of the SABMiller deal. It had to wait for the Department of Justice to complete its review. The "consent decree" was only recently issued, which means it's open season again, subject to certain limitations. One condition is that AB must give 30 days notice of any acquisition.

Opinions on whether a deal will happen on the 2019 timeline are mixed. Some believe the market is too unstable and that AB will stay focused on the craft assets it has and delay future acquisitions until the dust settles. That's not necessarily a bad argument.

However, there are sound reasons to believe a buyout may happen. Foremost is Kona, which continues strong growth despite the funk descending on the industry as a whole. Kona drove 64 percent of the CBA's total shipments during the first nine months of 2018 and its international potential is virtually untapped.

On the flip side, the CBA's legacy brands, Widmer and Redhook, are in decline and have no value to AB. They wouldn't be a stumbling block given the appeal of Kona, but they would likely be spun off in a buyout. It's ironic, for sure, given the history, but that's the way it is.

Should Anheuser-Busch fail to make a qualifying offer by August 2019, the contract stipulates that it pay the CBA a $20 million "international volume development incentive" fee. Those fees were $3 million in 2016 and $5 million in 2017. The $20 million balloon payment was put in the contract to leverage the imperative of a buyout.

It's entirely possible that AB moves forward in coming months. Since it already owns 31.4 percent of the CBA, it would spend only about $330 million (at $24.50 per share) to gain full ownership. That isn't a huge financial hit in a company so focused on reducing debt that it recently cut dividends to the tune of $4 billion a year. The spin for shareholders would be that the acquisition saves and makes the company money.

The fly in the ointment is the state of the industry. There are a lot of nervous folks out there. Some fear we are looking at a repeat of what happened in the late 1990s, which in our present context would mean dozens, if not hundreds, of brewery closures, and a depressed market for several years, at least. It's a serious and realistic concern.

On the other hand, there's Kona, seemingly impervious to market conditions. Even in a shrinking beer market and with overall craft sales flat or barely growing, Kona continues to surge. It's been dragging the CBA forward for several years and has the kind of brand appeal that a lot of companies covet. Kona may be one of the few gems left and AB already owns a piece. Why not own it all?

With all that in mind, I rate the chances of a buyout before the end of August 2019 at less than 50 percent. The incentives for AB to own Kona outright are significant. One thing that would certainly scuttle a deal is a sudden slowdown in Kona's growth trajectory, a scenario that would also cripple the CBA.

Anheuser-Busch may very well let the buyout timeline expire in 2019. When the contract was renewed in 2016, the parties didn't anticipate the slowdown we're seeing. They foresaw continued rapid growth in the craft segment. The qualifying offer minimums were set to protect both parties, but it turns out the numbers were set too high and are now an obstacle.

Should the August 2019 deadline pass without a deal, the CBA will receive the $20 million international development payment. It will also continue to benefit from all other aspects of the contract, including distribution, contract brewing, etc. The CBA would, of course, be open to offers from other suitors, though it's difficult to imagine who might be in the market.

The CBA's stock price will likely level off at around $14-$16 in that scenario, only slightly higher than it was before the contract renewal and buyout provisions artificially boosted it. If Kona falters, the stock price could take a significant hit, possibly into single digits.

It seems entirely plausible that AB plays a waiting game that extends beyond the 2019 deadline. Unless they want to be really generous with their CBA friends, they'll watch what happens with Kona and the overall market. If Kona continues to look strong, they'll likely proceed with a buyout for something less than the current $24.50/share price.

Crapshoot on.

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