The King Has Strong Bishops

Stalking The King continues.  The topic at hand is AB InBev’s craft beer strategy.  Throughout this post I will reference information found in the book Barrel Aged Stout and Selling Out by Josh Noel; beer writer for the Chicago Tribune.  It’s a great business book and a must read for beer enthusiasts.  Josh Noel, if you read this, thank you for writing the book.  

AB InBev’s Regional Approach To Quality Acquisitions

AB InBev probably should have entered the craft beer market earlier. However, management suffered from a classic Innovator’s Dilemma because their core brands were so much bigger than any up and coming segment.  Further, they were focused on debt repayment rather than product innovation.  Consequently, they’ve pivoted to an acquisition based craft beer strategy.  Below is a timeline of key acquisitions:

Source: Barrel Aged Stout and Selling Out at 335

As I said in my previous post, I believe craft beer is a regional game.  The map below shows how AB InBev’s strategy is consistent with my interpretation of the marketplace.  

Note: AB InBev originally targeted acquiring 10 craft breweries.  This map has some gaps in it.  Therefore, I expect the total number to settle somewhere between 15-20. EDIT: Further acquisitons may be difficult as the DOJ will have to review virtually every acquisition from this point forward. 

The result is a regional portfolio of quality brands, almost all of which are located near a major city.  AB InBev created a formidable beast.  “With eight or ten or twelve of the kinds of breweries it could never create itself, Anheuser-Busch [can] scale up beers from them all—just as it [has] done with Goose Island—and shoot them into national distribution at affordable Big Beer prices. Its distributors [can] walk into any bar, chain restaurant, supermarket, or convenience store as a one-stop shop: A low-alcohol IPA from Los Angeles! A robust IPA from Seattle! A vanilla porter from Colorado! A stout aged in bourbon barrels from Chicago! An easy-drinking lager from Virginia!…No one ever had to [know] that much of the beer was brewed in the same tanks.” Barrel Aged Stout and Selling Out at 307.  

Strategically, this makes sense.  AB InBev was never going to be able to out innovate the small craft breweries.  The institutional imperative precludes such thinking.  Therefore, it makes more sense for an incumbent like AB InBev to acquire talent.  Furthermore, its distributors, and their customers, can offer a “diverse” beer selection even though many of the beers trace back to common tanks (which results in efficiencies of scale).  

Why Would Craft Brewers Choose To Partner with AB InBev? 

There are basically three choices craft breweries have: (1) remain independent, (2) sell to private equity, or (3) sell to Big Beer (AB InBev, MillerCoors, Heineken, etc).  Remaining independent, while noble, basically relegates companies to a small geography.  Scaling requires a fair amount of capital investment and large scale distribution relationships are very hard to develop.  AB InBev, for example, has restricted (and may still restrict) the product portfolio its distributors are allowed to carry (distributors can only carry small craft breweries’ products).  Few distributors will choose to upset Big Beer in favor of smaller craft breweries.  Thus, local craft breweries are somewhat limited to local bar and liquor store distribution.  

Selling to private equity is a decent option if a brewery owner wants to get paid.  But, private equity isn’t buying for the long haul.  By definition there are fund lives and decisions are made with an exit plan in mind.  Furthermore, private equity, while well capitalized, can’t compete with Big Beer on product procurement, cost, or production quality/consistency.  Therefore, if a brewery owner (a) wants to scale his/her brand and (b) cares about the long term vision of his/her company, private equity probably isn’t the best exit plan.   

Big Beer, as odd as it may sound, actually provides a fairly good long term exit plan.  Why?  Because a growing brewery must invest in beers that appeal to the masses.  Those products require reliable access to quality hops (raw material), additional capital investment (brewing equipment), and allocation of resources towards the growing products (as opposed to projects of love).  Big Beer offers a solution to these problems as well as distribution relationships to ignite growth.  Therefore, Big Beer can offer premium exit multiples while still creating a win-win. 

Yes, there are downsides to selling a local brewery to Big Beer.  People will threaten to boycott the brand.  Some employees will leave.  Some local craft bar owners will drop the beer from their taps.  But it seems as though the benefits outweigh the costs.  Especially since now AB InBev understands that supporting the “craft” part of the craft beer industry is extremely important.

Goose Island’s Decision to Sell to AB InBev 

Goose Island’s owner, John Hall, was a business man.  He wanted to make money.  But he also loved creating craft beer.  In order to get his brewery to the next level he was going to have to invest substantial time and resources to scale a new beer’s production.  That beer was 312 (the area code for Chicago). 

The 312 ramp up required new equipment, space, inventory investment, hiring resources, etc.  Moreover, every square foot Goose Island dedicated to 312 production took Goose Island’s brewers away from the premium beers they made (like Bourbon County Brand Stout, Sofie, Matilda, Lolita, etc).  John found himself tight on capital, time, and making less of what he loved. 

AB InBev provided the solution when it offered to offload the: (a) burden of figuring out how to scale production, (b) investment requirements needed to scale production, (c) HR headaches of hiring people, (d) establishment of safety measures required for mass production, and (e) top notch raw material procurement.  AB InBev was able to offer this because it already had the processes, procurement strategies, and facilities to brew beer in massive quantities. 

As part of the deal, 312 production was diverted AB InBev’s existing facilities.  Moreover, AB InBev took a fairly “hands-off” approach to Goose Island’s local operations.  They did institute some rules and invest capital, but they allowed Goose Island to operate as its own entity.  To John Hall, and the other breweries that ultimately sold to AB InBev, that value proposition was a win-win.

AB InBev is Committed to Making Quality Product

It’s very important for AB InBev (or any acquirer) to maintain a brand’s reputation after closing an acquisition.  As stated above, an important part of AB InBev’s pitch to craft brewers is the acquisition enables the brewery to focus on craft items and get rid of the headache of mass production.  But can AB InBev ramp production without sacrificing quality?  312’s production increase provides a good case study. 

312 was AB InBev’s first attempt at mass craft beer production.  Predictably, ramping up production of 312 and satisfying Goose Island’s brewers was not easy.  But AB InBev committed to getting the formula right:

“‘[AB InBev] ended up dumping more beer than every frat house in America could have drunk in a single year when we started making 312…We dumped batch after batch after batch after batch after batch.’…Finally, St. Louis became worried. Where was this headed? They had dumped three thousand barrels of 312 Urban Wheat Ale—more beer than most US breweries made in a year.” Id. at 202; Emphasis added; Quotes attributed to Brett Porter. 

Eventually Goose Island and AB InBev got the formula correct.  312 was complete only after the Goose Island team approved the beer’s taste, texture, and appearance.  In my view, this is a crucial example of AB InBev deferring to Goose Island and following through on a commitment to maintain the brand.  AB InBev easily could have settled on a formula that was “close enough.”  Instead they took a long term outlook and developed the right product to maintain brand integrity and fulfill their commitment to John Hall.

But Does AB InBev Know How to Sell Craft Beer?

Despite correctly developing 312, AB InBev made a big mistake marketing Goose Island.  Goose Island’s team told AB InBev to build the Goose Island brand deliberately.  They argued that distributors needed to understand the merits of Goose Island’s beers and brand in order to successfully position the brand against Sierra Nevada and other craft beers. AB InBev thought that idea was quaint and figured they could push Goose Island’s beer through their distribution machine.  The 2014 national roll-out of Goose Island was a  massive failure.   

Source: Barrel Aged Stout and Selling Out at 234.

To its credit, AB InBev learned from that mistake.  They acknowledged the initial rollout was mishandled and pivoted when they released Goose Island “4 Star Pils.”  AB InBev marketed 4 Star Pils by taking a local approach to distribution. 4 star Pils, intially Blue Line, was available in Chicago, only on draft,  during the spring of 2015.  National production scaled only after Chicago embraced the beer and the product had momentum.  Id. at 328. 

In its most impressive sign of adaptation, AB InBev released 4 Star Pils even though it directly competed with Budweiser.  The old Anheuser-Busch would never release a beer that directly competed with Budweiser.  Id. at 328.  But, 3G learns and adapts to the market. That adaptability resulted in Goose Island growing sales as follows:

Source: Barrel Aged Stout and Selling Out at 325.

Important things to note about the chart above include: 

  • AB InBev grew Goose Island at a ~28% CAGR since it acquired a 100% ownership interest in Goose Island. 
  • Goose Island’s sales don’t even amount to a rounding error compared to AB InBev’s $15.6Bn of 2017 North American sales.  Therefore, Goose Island isn’t going to offset material erosion in AB Inbev’s core portfolio. 
  • Growth slowed in 2017.  Craft beer sales are based on “pull through” demand.  They aren’t easily pushed onto consumers. Therefore, it’s plausible that Goose Island will grow at a much slower rate going forward. 
  • Goose Island is only one of AB InBev’s craft beer portfolio companies.  Assuming all 10 achieve similar results they still won’t be material to AB InBev as it exists today.  But, they could be material to AB InBev’s future strategy and market position.   

Distribution Matters A Lot.  And AB InBev has it in Spades.

Through a series of smart strategic regional acquisitions, AB InBev has accumulated a product portfolio that is both geographically relevant and diverse.  “The big thing to me is, the craft beer industry was built on individuals and their stories…We’re not corporate. We are entrepreneurial and individual…It’s going to be harder and harder to get our voices heard at the wholesale level…It’s hard enough for craft beer in general to get meetings with big chain buyers. Now, AB can go in and pitch [their portfolio].” Id. at 281; Quoting Breckenridge Brewery’s founder, Todd Ursy.  Breckenridge later sold to AB InBev.

Furthermore, AB InBev’s scale enables it to offer kegs at prices no other brewer could reasonably offer.  For instance, when the company wanted to expand its Goose Island IPA product it was able to cut the price to $110/keg.  This compares to a standard-priced keg of Budweiser costing $106.  Therefore, AB InBev can offer bars a premium product at average prices.  That becomes an easy decision for the bar owner. 

AB InBev’s distributional and cost advantage enabled Goose Island IPA to to grow like this:  

Source: Barrel Aged Stout and Selling Out at 326

Importantly, AB InBev can offer a portfolio of craft beer styles and geographies.  While it may take time to establish different brands, the power of AB InBev’s competitive position is undeniable. 

Conclusions:

  • Ab InBev has a reasonable strategy that should enable the company to successfully navigate the craft beer trend in the United States.  This is evidenced by (a) the company’s regional acquisition strategy and (b) management’s willingness to learn from failure and pivot marketing strategies.  Furthermore, AB InBev increasingly relies on its acquired craft breweries to perform research and development. This should enable AB InBev to leverage core competencies and benefit from the talent it acquired.
  • 3G has an extraordinary management team.  These people know what they are doing.  They learn from mistakes but also flex their muscle when appropriate (like in distribution).  That’s probably why AB InBev is now the largest craft brewer in the US. https://www.foodandwine.com/news/ab-inbev-high-end-craft-beer-sales-2018
  • I still have a lot to learn about AB InBev’s international markets.  Reading Barrel Aged Stout and Selling Out made me realize how ignorant I was about some of AB InBev’s strategy.  There’s still a lot of work to do.

Remaining Concerns About The Investment Thesis:

The biggest risk to this investment thesis is AB InBev’s leverage.  I don’t believe there is a material chance of bankruptcy, but dilution is a real possibility.  My “model” shows AB InBev generating sufficient cash to meet its debt obligations.  However, that “model” is dependent on emerging market growth.  Emerging market fundamentals negatively impacted AB InBev’s results through this year.  Some emerging market risk can be mitigated via foreign exchange derivatives, but emerging market economic risks are an inherent part of this investment thesis.    

Thus far the debt market seems confident in AB InBev’s ability to satisfy its obligations.  That said, the cost of insuring debt repayment rose over the past year.  My general bias is to look to the credit markets for warning signs.  Thus, the cost of debt insurance increasing is a concern.  

Concerns About Putting Too Much Emphasis on One Book:

Question 1: Which biases might I suffer from while reading this book?

Goose Island was the first local beer I drank when I arrived in Chicago.  312 was my go to choice.  I left the brand when Goose Island sold to AB InBev and haven’t considered their products other than Bourbon Country Brand Stout and Matilda since.  So I had some biases about the brand and its development when I started reading the book. 

I find it difficult not to like the companies I am researching.  Endowment bias creeps in after devoting hours to an idea. Further, the sunken cost fallacy compounds the irrational devotion to an idea as time invested increases.  It’s important to remember that one book is not the end all cure for due diligence.  That said, this book was incredibly good at answering key questions about AB InBev’s craft beer strategy. 

Which brings up the final biases I am concerned with.  Availability, authority, and confirmation biases.  How did this book fall into my lap the week I began to research AB InBev?  How did it answer some of my major concerns about AB InBev’s strategy and management team?  Am I seeing something that doesn’t exist because my brain wants to?  I think I am being rational but I am not certain I’m not answering questions I’ve already predetermined the answers to.  Further, an industry expert wrote the words.  He can’t be wrong, right?  Right?! (Sarcasm font)

Question 2: Which biases might the author suffer from?

Josh Noel is a well known beer writer.  Could he write a hypercritical book about a local beer company and the biggest beer company in the world AND maintain his industry contacts?  I’m not sure. 

I’ve read some of his blog posts to get a sense his biases.  Generally, I think Josh Noel has more incentive to “call it like he sees it” rather than become an AB InBev shill.  After all, he has a pretty awesome job that depends on people trusting his beer knowledge.

That said, he interviewed a lot of people from AB InBev.  Those people are incredible sales people.  Otherwise AB InBev probably wouldn’t have them in jobs where Josh could interview them.  On the other hand, Josh went out of his way throughout the book to present the other side of almost every argument.  So, I suspect he consciously avoided taking one side or the other.  Again, I believe his incentive is to speak his version of truth.

Recommended Reading:

https://www.joshnoel.net/barrel-aged-stout-and-selling-out/

Note: The book is cheaper at Barnes and Noble than it is at Amazon. 

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