Published in Manufacturing

‘Realistic expectations’ urged as craft beer industry matures, competition rises

BY Saturday, May 26, 2018 03:04pm

The meteoric rise of Michigan’s craft brewing industry has spawned the creation of hundreds of new companies in communities all over the state. 

From 2007 to 2017, the number of Michigan breweries more than quadrupled. As a result, the majority of breweries operating today in the state’s $2.09 billion industry have opened their doors in the last four years, spurred on by a good economy, available financing and strong demand for locally-made beers.

But the craft brewing industry’s latest wave of entrants, which also makes up the largest segment of the sector nationally, are challenging the more established craft breweries in new ways. That includes making bets on future growth at a time when the industry’s rapid expansion has decelerated to a more mature 5-percent growth rate.

As well, these new breweries have only operated during a strong economy with readily available capital and cheap debt, meaning many of them lack firsthand experience of going through an economic dip or a market correction.

That’s become an emerging industry concern, as research shows the newest breweries also are growing the fastest of any segment. Nationally last year, craft brewers grew sales by 5 percent, or 1.2 million barrels of beer, but the bulk of that growth — 916,000 barrels — came from breweries that opened since 2014, according to the Brewers Association. While the newer breweries grew at a rate of 52.6 percent, their older counterparts that were founded in 2013 or earlier only grew by 1.3 percent.

The rapid growth among the industry’s youngest companies drew a word of caution from Dr. Bart Watson, economist for the Brewers Association, who encouraged owners to set “realistic expectations” for the next few years, especially as overall growth in craft beer continues to level off.

“While you’re growing fast now, don’t expect that you’re going to beat the odds when so many older, more experienced breweries are not able to,” Watson said during the Craft Brewers Conference this month in Nashville.

One factor inherent in the recent industrywide growth spurt is that a majority of breweries have known nothing but growth and a good economy. Although the industry claims to be resilient to economic downturns, breweries are not immune from the whims of the market, particularly from lenders if signs of trouble emerge from the hyper-competitive craft beer segment.

Some distressed situations have already started to appear. Brewery closings ticked up to 165 last year, according to Brewers Association data, the highest since the dawn of the craft brewing industry.

“(The industry) should prepare themselves for closing rates that are at this rate if not higher in the coming years,” Watson said.

A handful of those closures occurred in West Michigan, including Dutch Girl Brewing Co. in Spring Lake, Millgrove Brewing Co. in Allegan, Arcadia Brewing Co.’s original location in Battle Creek and Cultivate Brewing Co. in Berrien Springs.

One of the prominent distressed examples nationally came when San Diego-based Green Flash Brewing Co. was forced to downsize its distribution footprint, close a satellite brewery in Virginia Beach, Va. and sell to a new investor group after its lender, Comerica Bank, foreclosed on its loans.

WATCH LEVERAGE

Ryan Buckley, a Muskegon native and partner in the Chicago office of Livingstone Partners LLC, represented the buyers in the transaction.

“If you look back at the distressed situations that have occurred, I think Green Flash is obviously the most widely followed issue of just overextending both nationally and also with the amount of debt that was taken on to build an East Coast brewery,” he told MiBiz. “This is still an industry that has strong margins and has strong growth and still has a tremendous amount of tailwind behind it.

“It’s just there’s maybe this prevailing thought that you’ve got to grow so rapidly and this is an industry that has step-function growth. That’s what happened at Green Flash: a desire to grow far too quickly as opposed to taking a measured step-by-step growth here.”

According to Cedar Springs Brewing Co. founder David Ringler, a former investment manager, breweries that get caught in the cycle of constantly releveraging to support growth could be in a tough position if additional growth fails to materialize.

That could result in more breweries getting upside down on their loan-to-value covenants, leading banks to step in and liquidate the assets, similar to what happened with Green Flash, sources said.

“When you have to sell 5,000 barrels, that’s tough and it’s expensive,” Ringler said. “That is woefully underestimated by many, in my opinion. They build these capacities and then they can’t fill them. Suddenly, they still have to pay that note and they’re not filling it. Now we have a problem.”

While acknowledging that Cedar Springs Brewing took on debt to open, Ringler remains confident his conservative growth strategy — letting the market decide whether the brewery needs to add capacity or not — will position the company for a sustainable future.

“The ones that aren’t leveraged are the ones that are going to survive,” Ringler said. “Cash is king. Everybody struggles with cash from time to time but … debt load is what kills most. The notes get called, and you can’t make the payments. It’s true in any business. It’s harder to weather the storm when you’ve got debt load.”

OVERCAPACITY CONCERNS

Buckley at Livingstone Partners also said craft brewers should think long and hard before investing in large expansions, particularly given the overcapacity in the market.

For example, craft brewers meeting the Brewers Association’s definition produced 25.3 million barrels of beer last year, but they only used about 56 percent of their production capacity.

If craft beer continues to grow at an annual rate of 5 percent, “it would take the industry 12 years before we would use up all of the existing capacity that’s out there right now,” Watson said.

The industry’s state of overcapacity and the drive to add more is cause for concern for many brewery owners, including Michael Brower, a cofounder of Pigeon Hill Brewing Co. that is undertaking an expansion of its own in Muskegon.

Pigeon Hill’s $2.5 million three-phase expansion plan includes building an off-site production facility on a parking lot in the city and turning its present production space into a new taproom as its lease runs out for its original space.

The company continues “full-steam ahead” with its own plans, which are based on a “very conservative” growth estimate to make the project sustainable, Brower said.

“We’re building with the assumption that we can’t count on the same level of growth that we’ve been experiencing,” Brower said. “At the end of the day, we’re comfortable with it. We’re still small enough (that) we’re not at the level of what really seems to be the plateau for most breweries. There is certainly still a lot of room for growth, it may just take more time and more effort.”

THINK BEFORE EXPANDING

Brower acknowledges that had Pigeon Hill not expanded with an off-site production facility in 2015, the company would likely be in a different position today to focus on taproom sales instead of distribution, given how much more competitive the retail market has become. Taproom sales have better margin for the brewers, afford them the most control over the product and remain a growing part of the industry, he added.

According to the Brewers Association, craft brewers nationally sold 2.7 million barrels of beer directly to consumers last year.

“I worry about some of my friends that are trying to take a big leap right now just because the taproom is safe and I think it always will be safe,” Brower said. “Unfortunately, I think that where this massive growth creates room for a lot of people to really seize their dreams and to live the dream, it also created an environment where people didn’t necessarily have to worry about the business side of their operations. And, I hate to say it, but sometimes bad beer was OK.

“Now that we’re seeing the change, and with the maturation of the industry … I think that those folks who have just been ballooned along with the crazy growth of the industry may start to face a little bit different reality. They’ll either need to improve the product, or learn business — and learn the ins and outs of running a tight ship — or face the alternative.”

That’s a sentiment echoed by Scott Newman- Bale, partner at Bellaire-based Short’s Brewing Co., who urged other brewers to “think heavily before you add too much capacity.”

ADOPTING BEST PRACTICES

In 2016, Short’s implemented a $1.8 million inventory-reduction plan that shifted the company more to a just-in-time model that prioritized getting fresh beer to customers. The net result was a sales decline for the brewery in Michigan that year, which a highly-leveraged company would have struggled to survive, Newman-Bale said.

Companies need to be realistic in setting their expectations for growth, especially given the volume of new entrants in the last few years, he said.

“We had a year of zero growth and for a lot of companies, if they had that year of zero growth, it would bankrupt them — and we’re seeing that,” Newman-Bale said. “We’re seeing a lot of good companies right now struggle not because they didn’t grow, it’s because they didn’t grow at 20 percent.”

According to Brandon Finnie, managing director and partner at Grand Rapids-based Hungerford Valuation, brewery owners should be strategic about their investments given the market competition. Finnie, who works with a range of clients in the alcoholic beverage industry, advises breweries that do intend to grow to implement systems and processes to run as efficiently as possible.

“Keep overhead at a manageable level and really try to make as much money as you can now,” he said.

As well, Finnie is seeing more craft beverage producers begin to clean up their capitalization tables by buying out some of their initial minority investors. It’s a move owners are making based on the relative strength of their companies to try to gain more control over their future.

Although not every minority owner is pleased with the timing of the buyout, they’re often able to realize good returns, Finnie said.

“They’re seeing strong returns on their initial investments. In a lot of these cases, they put in very little money and they’re getting a nice buyout,” he said.

CHANGES COME QUICKLY

At Short’s Brewing, the new business model didn’t alleviate overall capacity constraints and the prospects of beer shortages. To finance more growth, Short’s in July sold a 20-percent equity stake to Petaluma, Calif.-based Lagunitas Brewing Co., a wholly-owned subsidiary of Dutch brewer Heineken International.

With a project to add fermentation capacity nearing completion, the company again finds itself running at 100-percent capacity, largely based on the “insane” sales of its new Soft Parade Shandy brand and 60-percent growth for its recently rebranded flagship Local’s Light, an American lager.

Calling the launch of Soft Parade Shandy “the most successful release we’ve ever done by far,” Newman-Bale said the company “already sold more in five weeks than we intended to sell for the whole summer, or about four months.”

“You have to add capacity, you can’t plateau. If you are seeing growth, it’s dangerous to run out of beer, but at the same time it changes quickly, especially when you’re dealing with one or two products or for newer breweries,” Newman-Bale said. “Shandy boomed at the end of last summer and we’re seeing it continue right now, but at the same time, I’m a realist and it could totally change next year.”

For Newman-Bale, success will come down to companies navigating a “confused” industry by making calculated risks in an era of high volatility, particularly if the economy dips or more prominent breweries come under financial scrutiny.

“I think what is going to be different this time is when the economy goes down, the banks are going to squeeze. … Someone’s going to go bankrupt, and they’re going to turn around and squeeze everyone else,” he said. “Then even people (with manageable debt) who could have totally survived get squeezed. They’re in trouble not because they did anything wrong, but someone else screwed over the bank and now they’re getting punished for it or their loans aren’t renewed or capital becomes harder to get.”

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