Mark Meckler, Ph.D. - Crafting A Strategy

It's a Matter of Perspectives

The CEO of Molson Coors Brewing Company (TAP) recently commented that North American craft breweries are way overpriced [1]. What did he mean by that? For his perspective, click the link and read the article. For my perspective, read below and I will explain the rest of the story.

First, some props to Molson Coors. This is a great company – Molson’s brands are legendary in Eastern Canada and Northeastern United States. Many New York and New Englanders (like me) grew up with Molson Golden as our aspirational beer, not Heineken. Coors held status as well. It was hard to get. I remember stories from my older friends as they drove many miles to get their hands on this great beer from the Rocky Mountains and brought it back from trips across the country. Molson Coors is a company with a great history that knows what it is doing. So when the CEO speaks, it is certainly not out of ignorance.

Large breweries have a financial model that has developed over the years. In general, they expect much higher operating margins and they design beers and supply chains to help them achieve this. According to Yahoo! Finance, Molson Coors’ operating margin was 12.33% last year and AB/In-Bev’s was a whopping 32.2%. As a comparison, the average operating margin for small, independent craft breweries was 2% in 2013 [2]. Large, clear beer breweries achieve these margins through economies of scale – a term that suggests the more of a particular product you make, the lower the cost per unit gets. They achieve these economies through bulk purchasing, automated processes, large continuous batch production, heat pasteurization, and years of learning to perfect their processes and eliminate waste. At the same time they have large advertising and promotion budgets that help them keep prices up. They are very profitable operations. They are able to keep costs down and prices up.

Wall Street (the stock market) has come to expect these margins from these kinds of companies. If a large brewery – Molson Coors for example, were to report in a quarterly statement that margins were 10%, the share price would drop like a rock, and the major shareholders (mutual fund managers, investment banks, retirement funds) would scream for the CEO and the rest of the top management team to get things back on track immediately. These top managers are under constant, tremendous pressure to keep margins up and keep sales volumes up.

The vast majority of Craft breweries do not have the cost advantages that come with economies of scale or from using ingredients designed to control costs and increase shelf life. Craft breweries require high quality ingredients that enhance flavor, character and spirits; which mean the critical inputs are expensive. Furthermore, the fermentation processes change significantly with the style of beer being produced. A small batch of triple dry hopped IPA, hand bottled and labeled, and delivered in a Sprinter van does not meet the operating margin criteria for Molson Coors. This helps explain why craft breweries are able to keep the prices up, but they cannot keep the costs down like the large, clear beer firms.

Value is defined differently for Small, Independent Craft Breweries – So it should be measured differently, too

Everybody seems to know these critical differences between craft beers and the large, industrial beers produced by Molson Coors and others. However, no one seems to talk about how these fundamentally different products and very different business models affect company values. This leads to statements from the Molson Coors CEO that craft companies are overvalued --- compared to the clear beer business model, he’s right. Craft breweries cannot come close to the operating margins of Molson Coors, and until they do, their value should be measured on different metrics than those that Wall Street uses to value Molson Coors. Let’s look at one of the largest, most successful craft breweries as a comparison.

Craft Brew Alliance (BREW), a partnership of five different craft breweries had operating margins of 3.43% in 2013. Industry financial analysts trashed the low margins and they especially “blamed” Widmer Brewing, the most “craft beer style” brand in the CBA portfolio. They pointed out that Widmer’s beer had the lowest margins in the portfolio. So, the best microbrew of the bunch, with the most flavor and character has the lowest margins. Why, because the ingredients and the process are more expensive. It’s basic math, really. The Widmers are not complaining, nor are their customers. But because BREW is publicly traded, their numbers are trashed compared to Molson Coors despite the fact they have a fundamentally different product that is much more expensive to make and has a much shorter shelf life, which increases distribution costs.

How Does All Of This Explain Molson Coors CEO’s Comments?

If we assume Craft Brew Alliance is among the most efficient and large craft breweries in the world, then they ought to be able to achieve some economies of scale. If we take a smaller craft brewery, like Green Flash, Ninkasi, or even your favorite local brewery, why would Swinburn say they are overvalued? To a beer conglomerate CEO like Peter Swinburn, purchasing a brewery with only 3.43% margins (or less) and only a small local market is not a viable purchase unless: (a) it was compensated by huge added value of other assets of the brewery (like the brand, or some secret recipe) and (b) it was very cheap to buy. An attractive price is something low enough to justify owning a business that only achieved 3.43% operating margins with best hopes of bringing it up to 10%. That is why almost all craft breweries, even the successful ones, look overpriced to the big firms. No matter what, the purchase of a typical to good craft brewery by an established clear beer corporation would bring those average operating margins down. With Wall Street expectations putting constant pressure on CEOs like Swinburn, his comment that craft is overvalued can be expected. However, this type of thinking can be dangerous, even to the large, clear beer corporations…

Dr. Sam Holloway wrote a very intelligent blog about the large beverage distributors “fleeing up-market” giving away the lower margin accounts. The large established industry players almost always eschew less profitable, small market segments, leaving them like scraps for others to run. As Dr. Holloway pointed out, staying out of small and less profitable vertical markets is completely logical --- and at the same time sometimes leads to the demise of large incumbent firms. This is just what happened in the U.S steel industry when they ignored the mini-mills. Clayton Christensen [3] called this a disruptive innovation when a new business model of a small market segment catches on, and grows up to steal away the customers of the big established firms.

To those in the craft beer industry, 3.43% operating margins look pretty darn good. It’s a living, a darn good living. Especially when distribution costs are local and low, and advertising is by brand community and word of mouth. That keeps the net profit margins pretty reasonable. In some markets, despite the low operating margins of individual craft brewing firms, the overall market share is actually larger than for clear beers!!! [4] Little by little, operating margins are growing, which suggests that craft beer business are learning, gaining efficiencies, and may someday improve operating margins. However, for a craft brewery to approach the operating margins of AB/In-Bev, we don’t think this is reasonable in the near future. What is more likely is that the craft beer industry will reflect the wine industry. Perhaps someday in the distant future, specialty craft beer will account for 70% of the market and bulk clear beer only 30% of the market. Margins will grow as the breweries learn and grow, and those higher volumes will certainly make up for lower margins. That’s how the wine industry looks today[5] …That doesn’t look so bad to us…