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Letter from Midwood Capital Management to the Independent Directors of Craft Brew Alliance, Inc.
[May 15, 2019]

Letter from Midwood Capital Management to the Independent Directors of Craft Brew Alliance, Inc.


Midwood Capital Management LLC ("Midwood"), a highly engaged shareholder of Craft Brew Alliance, Inc. ("CBA" or the "Company") (NASDAQ: BREW), announced today that it has delivered a letter to the Independent Directors of the Company's Board highlighting the substantial gap between the Company's public market trading price and its intrinsic value. Midwood encouraged the Board to recognize the difficulties CBA faces to sustainably create shareholder value as an independent company and to ultimately pursue a sale of the Company either to its strategic partner and largest shareholder Anheuser-Busch InBev, or to a third party.

Boston-based Midwood Capital Management is a private investment fund founded by David Cohen. Midwood manages investment funds which focuses on undervalued, niche-leading companies in the small-cap equity market in the U.S.

The full text of the letter is below.

The Independent Members of the Board of Directors
c/o Audit Committee Chair
Craft Brew Alliance, Inc.
929 N. Russell Street
Portland, OR 97227
Attn: contains shareholder communications

To the Independent Directors of Craft Brew Alliance,

I am writing to introduce my firm, Midwood Capital Management LLC, as a significant and increasingly concerned shareholder of Craft Brew Alliance ("CBA"). Funds managed by Midwood currently own approximately 2.0% of the company's outstanding primary shares.1 This position makes us the company's seventh largest shareholder (exclusive of Anheuser-Busch InBev).2 We have owned shares in CBA since mid-January 2017, and it has been a top five position for our firm for the past two-plus years. Our interest in the company is simple and consistent with that of all outside owners of the company: to see shareholder value maximized.

At the outset of our investment back in January 2017, CBA represented a special situation with several intriguing attributes, including:

  • A longstanding distribution alliance with the world's largest brewer ABI
  • An uncommon situation whereby ABI was not only a commercial partner but also owned nearly one-third of the company and held two seats on the board of directors
  • A largely untapped international expansion opportunity
  • Ownership of the Kona brand whose compelling growth in an increasingly challenging beer market was being masked by flagging brands within the CBA portfolio
  • A set of then-recently signed (as of 8/23/2016) contracts between CBA and ABI that extended and expanded their commercial relationship and, most interestingly, established a framework under which ABI, if it so desired, could make a "Qualifying Offer" to acquire control of CBA

As an investment firm that seeks idiosyncratic situations whose value realization would not necessarily be tied to moves in the broader market, CBA was very exciting to us.

CBA also had - and continues to have - its challenges. Specifically, the company's consolidated revenue growth was poor3 as two major brands - Widmer Brothers and Redhook - experienced significant volume declines. Additionally, the company faced (and continues to face) structural challenges in terms of its profitability due to its scale (as well as business mix with the Pub segment) with gross and EBITDA margins well below peers.

We can fast forward two years and take stock of the situation today. Revenue growth has remained muted, growing at an average annual rate of less than 1% over the past two years. Kona's growth has remained impressive, but Widmer and Redhook continue to drag on total revenue given their volume declines. And operating income in 2018 was essentially the same as operating income in 2014.

Management has entered 2019 with a new level of optimism regarding CBA's near-term growth potential with guidance for an increase in depletions and shipments ranging from +5% to +8% for the year. To no one's surprise, this growth requires investment, and management has guided to an increase in adjusted SG&A of approximately $10 million at the midpoint or 15%.4 While we appreciate the company's willingness to invest behind higher growth, these investments are material and the bottom line is that there is no assurance that the company's profitability will grow in 2019. The table below incorporates management's 2019 guidance to arrive at our EPS estimate for the year. Even the high end of the guidance range, while yielding attractive EPS growth on a percentage basis, would leave the company's stock trading at a very high P/E multiple in the mid-40's. It's also worth noting that the consensus among sell-side analysts is that CBA's EPS will actually decrease in 2019.5





           
  Implied FY 2019     FY 2018  
Low       Mid       High Actual
Net Revenue 218.6 222.7 226.8 206.2
Gross Profit 75.4 79.1 82.8 68.3
- SG&A 70.0 72.0 74.0 62.6
= Operating Income 5.4 7.1 8.8 5.8
- Net Interest Expense 0.4 0.4 0.4 0.4
= Income Before Taxes 5.0 6.7 8.4 5.4
- Taxes 1.3 1.7 2.1 1.2
= Net Income (Loss) 3.8 5.0 6.3 4.2
/Shares Outstanding 19.6 19.6 19.6 19.6
= Diluted EPS (Midwood Est.) $0.19 $0.26 $0.32 $0.21
 

Midwood sees 2019 as a pivotal year. And presumably CBA's leadership also saw 2019 as a pivotal year when it crafted the multiple contracts signed with ABI in August 2016. With the clock ticking on the August 2019 deadline for ABI to make a Qualifying Offer under the 2016 framework, we have a stock whose price has declined 8% since the beginning of 2017.6

We acknowledge that CBA's management has taken many actions to further the objective of increasing shareholder value, and we applaud the team's efforts over the past several years. We have built a strong rapport with Andy Thomas and value highly his leadership of the company. However, as we think Andy would readily acknowledge, the craft beer segment faces momentous challenges in a rapidly changing social lubricant industry. In our opinion, despite Kona's virtues as a brand and its solid growth, the intrinsic value of this highly attractive asset will not be recognized by the public market with CBA as a stand-alone company.

CBA lacks the margin structure and scale of its peers to grow sales, profits, and cash flow consistently. Absent an ability to consistently deliver this fundamental financial performance, the gap between price and intrinsic value will not close in the public market. Shareholder value will then only be maximized through a transaction in which another entity determines what CBA is worth.

We would argue (based primarily on comparable industry transactions) that the intrinsic value of Kona alone - excluding all other CBA brands - should approach the current Qualifying Offer threshold of $24.50 per share as illustrated in the table below

     
Standalone Kona Valuation
Low       Mid       High
EV/Barrel $900 $1,000 $1,100
x 2019 Est. Barrels 505,000
= Enterprise Value 455 505 556
+ Cash 1Q'2019 1.6 1.6 1.6
- Total Debt 1Q'2019 49.7 49.7 49.7
+ 2019 FCF [Implied Guidance] 2.5 2.5 2.5
= Equity Value 409 459 510
/ Shares Outstanding 19.6 19.6 19.6
= Value Per Share $21 $23 $26
Premium to BREW Market Price 36% 53% 70%
 

In terms of estimating private market value, we have as of May 9th yet another relevant transaction in which The Boston Beer Company has acquired Dogfish Head Brewery. At the announced transaction price of $300 million, Boston Beer is paying $1,000 per barrel and 2.6x sales based on estimated 2019 volume. In comparison, the public market is valuing all of CBA at $435 per barrel and 1.5x forward sales - a monumental discount in our minds.

CBA's leadership expended a lot of time and energy in 2016 to codify the relationship with ABI and provide a constructive framework for a potential acquisition. With the current Qualifying Offer threshold of $24.50 per share, we would argue that it would be difficult to find a shareholder who would hold out for more than that price with the stock currently trading at a far lower price.

Arguably, the market is significantly discounting the probability that ABI will make an offer to buy the company. We know that CBA's leadership cannot control ABI's willingness to execute on a Qualifying Offer. And we also know that if such deliberations were occurring now, CBA would not comment on them. Nonetheless, we believe CBA must find a buyer for the company in any scenario. If not ABI, then someone else.

Looking at the company's alternatives, we would sum up by saying:

  1. If ABI wishes to make a Qualifying Offer, we believe CBA's board should absolutely accept it. And in our view the board should do whatever it can to facilitate ABI making an offer
  2. If ABI chooses not to make a Qualifying Offer, we believe there is considerable downside for the stock. In this event we believe the board should immediately announce a strategic alternatives process with a plan to sell the company. And while the board may be inclined to be reticent about such a path, we believe in this case that making an explicit announcement would be warranted

We have been engaged and committed shareholders in CBA for some time now. We knew in early 2017 that the company did not craft its agreements with ABI to only pursue a sale. However, with the combined effects of the trends in craft beer industry and CBA's inherent challenges to grow revenue, profitability and cash flow, we strongly believe that the company must seek a sale to maximize shareholder value.

Thank you very much for your consideration. We would be more than happy to speak with any representative of the board to share more of our perspective.

Sincerely,

David Cohen
Portfolio Manager and Managing Member
Midwood Capital Management LLC

1 Midwood share count as of 5/10/2019. Total CBA outstanding shares of 19,414,950 as of 5/02/2019 per the latest 10Q.
2 Source (News - Alert): Bloomberg LP.
3 Consolidated revenue grew 2.1% and -0.8% in 2015 and 2016, respectively.
4 Management guidance for 2019 updated as of 5/08/2019 including: depletions and shipments each ranging between an increase of 5% to an increase of 8%; average price increases of 1% to 2%; gross margin rate of 34.5% to 36.5%; Adjusted SG&A (excluding Kona settlement expense of $4.7 million) ranging from $70 million to $74 million; effective tax rate of 25%.
5 Per Bloomberg (News - Alert) as of 5/13/2019, 2019 EPS consensus among four sell-side analysts is $0.115
6 Based on stock price of $15.53 as of 5/10/2019.


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