We believe Boston Beer Co. Inc. (NYSE:SAM) is substantially overvalued at current prices, and is set to implode in the second half of the year.

Opportunity

In the 10Q for the quarter ending 31 March 2012, SAM guided 6-9% depletions growth. The most recent Nielsen data, as of June 9, indicates SAM’s beer volumes are down 6.5% in AOC data (which covers approximately 50% of volume and includes grocery, drug, and mass market channels). In order for SAM to meet guidance, growth through remaining channels (bar/restaurant, convenience stores) will need to be close to 20%. We do not think those growth rates are achievable. SAM may reduce guidance, catalyzing a fall in the share price. (Sources: 3,6)

Company Description and Valuation

SAM engages in the production and sale of alcohol beverages primarily in North America. The company sells approximately 60 beverages under the Sam Adams, Twisted Tea, Angry Orchard and HardCore brand names. SAM was founded in 1984 and is based in Boston, Massachusetts.

Valuation at $114.81

(Source: 1, as of 19 July 2012)

Market Cap (Class A and B common stock): $1,480.1M

TEV: $1,442.0M

2012 Consensus Sales: $560.49M

2012 Consensus EBITDA: $111.37M

2012 Consensus EPS: $4.20

Management Guidance: $3.80 to $4.20 (Sources: 15))

TEV/2012 Consensus Sales: 2.5x

TEV/2012 Consensus EBITDA: 12.5x

2012 P/E Consensus: 26.5x

The stock has moved up 26% in the last twelve months (as of 19 July 2012). SAM is good but not special. Would you pay 26.5x earnings for a company with 6% volume growth, assuming management can meet its target? The only way to support the current valuation from a fundamentals perspective is to believe that the craft beer segment will become thirty percent or more of the total US beer market and that SAM can maintain its position as the largest craft brewer by a significant margin. Let’s examine the beer industry first.

Beer Industry

The domestic beer market is $95.5B/year. Volume growth has been slow or negative over the last ten years, and a growing US population has masked a steady decline in beer consumption per capita. The major brewers are still losing share with ABI volume share down 40bp and MillerCoors down 80bp in 2011 on volume changes of -3.0% and -3.2%, respectively. The bright spot has been the craft beer segment, which has growing steadily since 2005, including 13.2% volume growth and 14.7% sales growth in 2011. Craft beer’s market share by volume was 5.7% in 2011 and 9.1% by sales. (Sources: 1,11)

SAM is the largest craft brewer. It is also losing share faster than its peer crafts. (See table below)

Craft Beer Competition

Competition in the craft beer space has increased dramatically and will continue to do so. The number of breweries in the US fell steadily from a high of 1,751 in 1900 to less than 100 in the 1980s, but has rebounded over the last two decades, climbing to over 2,000 in 1Q2012. There were an additional 915 applications for brewing licenses in 2011, which will lead to even more players entering a space which we believe is becoming saturated. One newcomer, Revolution Brewing, is expanding in Chicago with a new brewery in 2012 that has initial capacity of 25,000 barrels/year and eventual capacity of 100,000 barrels/year. (Sources: 7,11)

While the little guys are bringing competitive pressure from the bottom, the big players are pushing their own faux craft beers, bringing pressure from the top.  MillerCoors’ Blue Moon label is the single biggest craft beer in the country. ABI is looking to replicate Blue Moon’s success with its recent acquisition of Goose Island. In the alternative space, Blue Moon is rolling out a caramel apple spiced ale this summer. (Sources: 8,12)

On top of the pressure from the start-ups and the giants, the established craft brewers are ramping up competition for each other’s market share. Western craft brewers are pushing east into SAM’s home market. California-based Sierra Nevada is building a 300,000 barrel brewery in Asheville, CA. Colorado-based New Belgium is building a 400,000 barrel brewery, also in Asheville, NC. At the same time, Yeungling, a lower price regional brewer that is dominant in Pennsylvania with 2.5M barrel/year production, has moved into Ohio with plans for further expansion. Portland-based Craft Brew Alliance has targeted Chicago for its expansion. In the middle of this competitive field, SAM is betting on expansion westward out of New England to find its own growth. (Sources: 5, 9,11)

Warning Signs

Insiders have been selling recently.

Recent growth has been unhealthy. Twisted Tea and Seasonals accounted for 70% of SAM’s growth in 2011 (see table below). Recent SAM volume and sales growth has come from filling distribution channels for Twisted Tea and meeting temporary demand for the Alpine Spring seasonal.

In regards to Twisted Tea, distribution channels are filling, suggesting growth will slow in the near term. Even in the case that Twisted Tea achieves equal distribution to Mike’s Hard Lemonade and Smirnoff Ice, distribution growth would slow y/y. (Source: 14)

In regards to Seasonals, Alpine Spring was a new variety, while the remainder of the 2012 Seasonals (Summer Ale, Oktoberfest, Winter Ale) are unchanged, suggesting the boost in growth from a new spring Seasonal will not be realized for the remainder of the year. (Source: 14)

Summary

The overall beer industry has not been growing, and per capita beer consumption is in a structural decline. The craft beer space has been growing, and will grow for a while longer, but craft beer won’t go from 5.7% to 30% of all beer sold. Furthermore, increasing competition will mean SAM won’t maintain as dominant of a position. SAM’s strategy is to expand westward, but Colorado and other western states already have local craft beers that they are loyal to. The western craft beer companies are already eating into SAM’s market share in SAM’s home territory on the East Coast, while the majors push their own faux crafts, and Yeungling tries to go national. Additionally, with the flagship Boston Lager flat to down, a slowdown in Twisted Tea or Seasonals will significantly impact sales growth, driving down multiples.

Conclusion

The assumptions needed to justify SAM’s valuation are unreasonable. The craft beer competition is intensifying. SAM’s growth will be flat to negative, with appropriate multiples for that kind of growth near 13x. Assuming $4 in earnings, we have a target share price of $52.

Risks

Acquisition by a major is a risk. However, Goose Island was acquired in 2011 by Anheuser-Busch for $38.8M , or 11.8x earnings, significantly below SAMs current P/E multiple of 26.5x. Stock buyback by the company is also a risk, although it is mitigated by the fact that the company only has $18.8M remaining on their $275M repurchase authorization, as of 27 April 2012. A further mitigation to the buyback risk is that management did not do a significant amount of buyback at stock prices 15% below current. (Sources: 6,10)

Sources

1. CapitalIQ.com
2. http://www.brewersassociation.org/pages/media/press-releases/show?title=brewers-association-craft-brewing-volume-hops-13-percent
3. GSCO Equity Research. Americas: Beverages. 2 July 2012
4. http://www.beerinstitute.org/
5. BREW http://phx.corporate-ir.net/phoenix.zhtml?c=95666&p=irol-IRHome
6. SAM 1Q12 10Q
7. www.Brewersassociation.com
8. http://www.thedenverchannel.com/money/31194439/detail.html
9. http://www.newbelgium.com/Community/Blog/12-04-05/Really-Big-News-Asheville-we-re-coming-for-you.aspx and http://www.sierranevada.com/about/news.html
10. BREW 2Q11 10Q and FY11 10K
11. The New Brewer. May/June 2012.
12. MolsonCoors Investor Relations
13. http://beerpulse.com/2012/04/revolution-brewings-production-brewery-opening-with-25k-barrel-capacity/
14. UBS Equity Research. Boston Beer Co. 9 July 2012.

The author of this report is short SAM, and may buy or sell the securities of SAM without disclosure. This report was prepared for the Value Investors Club for use only be investment professionals. The information presented in this report should not be considered a recommendation to purchase or sell any particular security, and all statements and expressions are the sole opinion of the author and are subject to change without notice.  Although the author believes that the expectations expressed in this report are accurate and reasonable, actual results could differ materially from those projected, and are subject to inherent risks and uncertainties.  Neither author nor its affiliates guarantees the accuracy or completeness of the information.  Securities trading involves a high degree of risk, and should only be undertaken by accredited investors