FIZZled Out

The world can change. Fast. Or at least perception can.

At hand is a confession. Or rather, a reflection.

The game of investing is hard. Very hard. A mere 18 months ago I was fairly convinced LaCroix was a true brand. The kind that could stand the test of time. The kind that a young Buffett and Munger would dream of. At the time I saw (and to some extent still see) a low wallet share, frequently purchased, habit forming product that didn’t suffer from taste attrition. The taste attrition attribute was absolutely key to my thesis because it’s the quality that makes Coke so desirable. And, more importantly, keeps customers returning. See the clip below (starting at ~44:28 for why I thought that was so key).

Below are screenshots of when I made my meaningful purchase and sell decisions on National Beverage Corporation (“National Beverage” or “FIZZ”), the owner of LaCroix. I am sharing because I think it’s important to be transparent. In that same spirit I have to admit I bet too little at the time. I wasn’t fully comfortable running a portfolio back then so my strategy was to bet small and ensure survival.

Below is a chart of what happened during my “investment.” I put investment in quotes because it is never my intention to hold a position for under a year. In my view, holding a security under a year is closer to speculation than investing.

Ultimately, I got nervous about how quickly the position increased. I just couldn’t get myself to hold on to an entity priced at ~2.5% current cash flow yield (~$100mm of trailing 12 month free cash flow and a $4.0Bn enterprise value at time of sale). So I sold. The hardest part of selling is I was certain the business would continue to grow. So, I felt pretty horrible as I watched the stock increase another 20% within 10 weeks.

Fast forward to today…I tweeted at @alderlaneeggs (hereafter “Mr. Cohodes”) asking why he was short the company. I was poking around because the stock has fallen substantially since I exited.

Mr. Cohodes is known for shorting frauds. It was odd to see him short this company because, while I agree there are substantial corporate governance issues, I don’t believe fraud is a major risk. While he didn’t give me a direct answer, he did mention competition and his Twitter feed has pictures showing Costco discounting LaCroix Curate (an extension of the LaCroix brand). Therefore, I believe Mr. Cohodes is short because of capital cycle theory (more assets/competition chasing the market) resulting in LaCroix discounting to drive sales. Discounting is not only a sign of organic demand declining, but also results in lower margins.

I didn’t realize I’d find out whether he was right so quickly. Tonight FIZZ released its 10-Q. It contained the following:

Source: http://ir.nationalbeverage.com/static-files/6b551c4f-17d8-40e9-82c9-a7faf2302bec

In layman’s terms the 10-Q said “We’re selling less LaCroix because of a lawsuit ( https://www.usatoday.com/story/money/nation-now/2018/10/05/lacroix-lawsuit-claims-sparkling-water-ingredients-cockroach-insecticide/1532241002/ ). Consequently, our manufacturing margins declined because we processed fewer units and costs stayed fairly constant.” I’m skeptical the lawsuit is the real driver of the volume decline. Therefore, as of today, it looks like Mr. Cohodes is right.

Alternatively, it is possible the lawsuit against LaCroix really has hurt volumes and customers are waiting for the outcome. I suspect the headline of the lawsuit reads worse than the facts ultimately prove. If that is truly the case, I’d bet LaCroix will recover (see Chipotle for an example of a food company rebounding from negative health publicity).

Nevertheless, look at the reaction to the 10-Q:

Which brings me to my takeaways from this post:

  • Beware that facts can change pretty quickly- Just last quarter FIZZ disclosed 16% growth in the Power+ (mostly LaCroix) brands. What a difference a quarter makes.
  • Don’t be afraid to sell when you think you are getting above fair value- I exited when the cash flow yield felt egregious. The short term pain of exiting and watching the stock run up is worth not being in the stock today.
  • Be mindful that things you know may not be so- I was certain LaCroix would grow and grow. This is now two consecutive quarters of free cash flow erosion. Pay attention to facts as they develop and don’t get anchored to an opinion/conclusion.
  • Seek out smart people with divergent opinions- I wasn’t prepared to purchase the stock today. I didn’t have enough data. But, tweeting at Mr. Cohodes (and his response) reframed how I view the situation.
  • The only thing worse than a value trap is a busted growth story.
  • Remain humble.
  • Never anchor to a narrative.

ROIC And Returns

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.

FB, AAPL, GOOG – SHAME

The spirit of Henry Singleton cried a little this earnings season. If you don’t know who he is see https://25iq.com/2014/11/08/a-dozen-things-ive-learned-from-henry-singleton-about-value-investing-venture-capital/. In short, he was one of the best capital allocators of all time. He issued shares when Mr. Market loved his company and bought them back when Mr. Market didn’t like his company. Dr. Singleton didn’t care about Mr. Market’s opinion. He used Mr. Market to his advantage.

Today, corporate share buybacks are all over the news. On December 21, 2018 Barron’s ran an article about corporate buybacks setting a record in 2018. https://www.barrons.com/articles/2018-record-stock-buybacks-51545361596. This excerpt was particularly exciting for long term oriented investors:

Why? Because in December there was carnage in the market. Everyone was selling everything indiscriminately. The selling offered up some very interesting opportunities in certain companies. That’s when management teams should pounce.

So what did Facebook, Apple, and Google all do with their cash hoards at that time? Nothing. At least nothing meaningful. And that is a disgraceful outcome given the amount of talent that is at these companies. In retrospect, it’s pretty clear that December was not a fundamentally driven sell off. It was fear based (though Apple actually had a meaningful slowdown in China).

Moreover, these companies had internal data that showed they were healthy. The CFOs knew the businesses were not deteriorating like the stock price. That is the exact time a corporate finance department should increase their buying activity. Especially in a cash generative company! Instead, they sat on their hands.

And that lack of action demonstrates why corporations, in aggregate, are not very good at share repurchases. On average, corporate buybacks do decrease share count and shares historically tend to increase in price. So, for the long term investor buybacks are better than nothing. But, buybacks have immense potential power and even today’s best companies don’t understand how (or are too scared) to use them properly.

In the interest of disclosure, SCG reduced its cash position from 33% in October to just under 20% by the end of December. This isn’t a promotional statement. In fact, it’s way too early to determine whether that was the right long term decision. But, why in the world were the best companies not meaningfully deploying capital when SCG was? The answer lies in the institutional imperative. And that is a sad realization considering who those companies supposedly employ.

CPG and Capital Theory

The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.

One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:

  • High returns on capital lead to competition entering an industry.
  • The new competition increases the amount of assets chasing the same dollars of profit.
  • More assets fighting over the same profit dollars reduces margins.
  • Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
  • Repeat

Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…

A lot of traditional consumer brands discuss disruption. Why? Historically, traditional large brands leaned on retail distribution channels, dominated shelf space everywhere, scaled production and distribution to enhance margins, and pushed their messages out via advertising. See https://www.forbes.com/sites/antoinegara/2018/04/30/jorge-paulo-lemann-says-era-of-disruption-in-consumer-brands-caught-3g-capital-by-surprise/#2607284d1f9b. Today, the internet eliminated traditional advertising and distribution barriers. Therefore, it is easier to have launch a new brand.

Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.

Regardless, barriers to entry are clearly lower than they used to be.
The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:

Source: Bloomberg

I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.

But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.

BUD Investment Summary

SCG recently acquired a minority interest in AB InBev and presented the idea to MOI Global, a group of investment managers. In the future, I will share the presentation in order to show the investment thought process. In the meantime, below is a summary of my thoughts. NOTE – This is not investment advice, all information should be confirmed, much of this is opinion, and AB InBev carries substantial risk.

Volume and Price Trends

Large beer companies’ biggest brands in developed markets are losing volume. Therefore, they’ve driven growth (if any) by increasing prices. In the U.S., growth in the beer category is attributable to craft and imports. While AB InBev has an impressive import portfolio, it needs a brand that resonates with Hispanic consumers (the company owns the rights to Corona and Modelo globally but had to sell the U.S. brand rights because of antitrust concerns).

People often say 3G doesn’t know how to drive organic growth. Is that true?

Yes, that data is stale. But, that chart doesn’t suggest 3G can’t grow organically. Instead, it says the biggest brands within AB InBev’s U.S. portfolio are losing share. But so are the categories those brands compete in. Stella, Michelob, and Rolling Rock are all growing nicely. Moreover, Corona and Modelo, which benefit from 3G’s international marketing are also growing nicely. I’d argue the trends against AB InBev’s larger brands are so strong that volume losses aren’t really management’s fault.

The beer industry responded to the volume trends above by increasing prices:

How far can they push price? That’s to be determined. In the meantime it’s important to look at how coordinated the price increases are. The beer industry benefits from a consolidated market with rational competitors. Craft is taking share and may put a ceiling on future price increases, but the image above shows an extremely desirable competitive industry dynamic. See http://ec.europa.eu/competition/mergers/cases/decisions/m7881_3286_3.pdf and https://www.justice.gov/atr/case/us-v-anheuser-busch-inbev-sanv-and-sabmiller-plc for interesting discussions about the industry.

Global Consolidation

AB InBev primarily competes in consolidated end markets. Moreover, the company has dominant market share in many end markets:

“Market share is often conflated with a competitive advantage, which it’s not…Generally speaking you will have much better economics when you have a relative scale advantage.” Pat Dorsey to Patrick OShaughnessy on the Invest Like the Best podcast, 2/20/2018 @ 30:25-31:34. The chart above is strong evidence of AB InBev’s relative scale advantage. That scale advantage, combined with consolidated end markets is highly desirable and results in eye popping gross and EBIT margins.

Leverage

The biggest risk in this investment is the leverage. While the headline leverage number is very high, it’s important to note that the leverage was incurred to make transformative acquisitions. It’s reasonable to criticize 3G for paying too much for SAB Miller. That said, the acquisition combined the number 1 and 2 players in the market, solidified AB InBev’s relative scale advantage, and gave AB Inbev exposure to growing end markets. Carlos Brito, AB InBev’s CEO, discussed the strategic importance of SAB Miller’s India assets saying:

The Groupo Modelo transaction was also strategically important. Groupo Modelo’s strategy involved gaining market share by keeping price constant. That strategy hurt Big Beer’s ability to raise prices without losing volume. When AB InBev acquired Groupo Modelo the U.S. beer market became more rational and the company acquired fantastic global beer brands. See https://www.justice.gov/atr/case/us-v-anheuser-busch-inbev-sanv-and-grupo-modelo-sab-de-cv for details.

Finally, 3G structured AB InBev’s debt incredibly efficiently. The debt has a weighted average cost below 4.5%, no covenants, and an incredible maturity profile. Recently, they improved the maturity profile even more but did have to issue slightly higher cost debt. See https://www.sec.gov/Archives/edgar/data/310569/000119312519007051/d691727d424b5.htm for prospectus.

Conclusion

There’s a lot of risk in this investment. People have said there’s no Alpha and AB InBev just offers Beta risk. That is a reasonable argument. But, it’s reasonable Beta risk to take because the company has such a strong competitive position and frequently sells a drug to a diversified consumer base.

The market doesn’t like management right now. But, the market is fickle. At these equity prices the investment can work without heroic assumptions. Below is a back of the envelope model.

In my view, the projected return is reasonable and the model is conservative. While I’d prefer returns far higher than 9%, this entity is an extremely strong competitor with a great management team competing in a consolidated, rational industry. Morever, the entity isn’t likely subject to technological disruption. 9% is reasonable given those facts.

Bears will disagree. That’s what makes markets.

The Merits of Writing

First and foremost, SCG is not an investment advisor and does not recommend buying shares in AB InBev.  The investment discussed below has substantial risk and should only be considered after lengthy due diligence.  That said, I recently purchased shares of AB InBev @ $68.37/sh.  Therefore, readers should presume I am promoting my own position when I am talking about AB InBev going forward. 

I recently presented an investment in AB InBev to a group I belong to, The Manual of Ideas, as my “Best Idea of 2019.”  That was my first presentation to the group.  Thus, I took career/reputation risk discussing this investment.  Moreover, it’s an investment with a credible bear thesis so I have a reasonably high chance of looking “obviously foolish.” As if that weren’t emotionally taxing enough, yesterday I saw some numbers released that created some “fast thinking” panic.  Bud and Bud Light both apparently saw U.S. volume declines in excess of 6%.  See https://adage.com/article/special-report-super-bowl/ab-inbev-reveals-super-bowl-ad-plans/316173/?mod=djemCMOToday.

My first reaction to the story was “Great, it took exactly one day for my ‘Best Idea of 2019’ to blow up.” Then I started to do some math and write. 

To begin, I have a high degree of confidence the cited numbers relate to AB InBev’s U.S. business.  The U.S. market accounts for ~31% of sales attributable to AB InBev (AB InBev only owns ~62% of AmBev but consolidates 100% of the entity’s sales).  In 2016 Bud and Bud Light accounted for ~60% of AB InBev’s U.S. volumes.  Presumably this percentage declined as brands like Stella and Michelob grew their percentage share in AB InBev’s portfolio.  But, let’s assume 60% is the correct number and volume production equates to sales.

If 60% of 31% of sales are fading at 6.6% the result is a 1.2% decline in total sales.  That sales decline doesn’t account for the offset in growing brands such as Stella Artois and Michelob Ultra.  That’s actually not that bad. My projected returns rely on U.S. sales declining at 2% per year.  See below.

Do I wish Bud and Bud Light were growing in the U.S.?  Yes.  But I knew they weren’t.  The 6.6% number scared me emotionally.  But once I got rational and “thought slow” I realized I had accounted for that possibility via a conservative underwriting.  That said, rapid volume declines could put my margin assumptions under pressure but as of now I think those margin assumptions are reasonable.  Time will tell.

Without writing I probably couldn’t be so rational about the results because of how badly I want this idea to work.  The presentation induced emotion that otherwise might not have been there.  Thankfully, writing has me thinking slow.  This investment may not work.  But at least the investment’s success or failure won’t be caused by my emotional reaction.

What Should AB InBev Do About Bud and Bud Light?

The investment thesis in AB InBev is not a U.S. focused thesis. That said, the U.S. business is important for AB InBev’s debt repayment. Therefore, data points such as Bud and Bud Light falling 6+% y-o-y are concerning.

I’d like to see more resources diverted towards the craft beer portfolio, Stella Artois, and Michelob Ultra. Those brands are growing nicely. See https://www.bizjournals.com/birmingham/news/2018/10/01/here-are-the-top-20-best-selling-beer-brands-in.html. The recent repackaging in the “Taste of Belgium” 12 pack (Stella, Leffe, and Hoegarden in one 12 pack) is a good packaging innovation. While Bud Light remains important, I don’t believe marketing will solve the consumption trends in that brand; it’s more about milking the cow rather than driving growth.

Longer term, I’d like to see the company figure out how to activate the craft beer portfolio they’ve acquired. Perhaps they should borrow a page from Starbucks and create the beer equivalent of Starbucks Roasteries. A group of really awesome beer shrines in urban environments could be a decent way to remain corporate but also authentic to beer lovers.

Most importantly, AB InBev should focus on emerging markets. The relative scale advantages AB InBev enjoys matter immensely in those economies. Expanding the beer category and offering consumers a reasonably cheap alcoholic beverage solution offers true growth potential in EM. Furthermore, any and all potential distribution advantages should be solidified over the next 3-5 years. Those investments would generate solid ROIC for years to come.

After paying down debt and widening the emerging market moat AB InBev should probably diversify further away from beer. This would be natural as the company already bottles and distributes Pepsi and Gatorade in LatAm. Whether the diversification efforts lead to non drug related beverages or marijuana related beverages remains to be seen. For the near future, let’s work with the portfolio we have and pay down debt. Acquisitions can wait.

Disclosure: Long AB InBev

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.