Gage Roads: Something brewing in Fremantle?

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Gage Roads Brewing Co Limited (ASX: GRB) could be brewing up a ripper result for 2012. After posting a maiden profit of $0.12m in 2011, Gage Roads has now announced sales volumes jumped by 100% in the three months to December 2011.

Much of the growth was attributed to demand from Woolworths Limited (ASX: WOW) and an increase in demand for several new products, such as apple and pear cider. Sales volumes of proprietary brands also jumped 97%.

Despite this companies potential, the shares are down 22% since January 2011, compared to the S&P/ASX200 index down 12%. Gage Roads has a micro-market cap of $21m, and is currently trading at around 6 cents.

The company
Gage Roads Brewing makes and sells craft brewed beer, cider and other beverages. Gage Roads has two segments, proprietary brand brewing and contract brewing. Its product range includes Wahoo Premium Ale, Gage Premium Lager, Gage Pils – Midstrength, Sleeping Giant india pale ale (IPA), Blue Angel Cider and Atomic Pale Ale.

Woolworths is Gage Roads major customer and shareholder, owning own 76m shares or 23 per cent. Gage Roads sells into the Woolworth's national distribution network as well as to other national and international outlets.

Its contract brewing segment brews beers, ciders, and other alcoholic beverages and non-alcoholic beverages. Gage Roads is now one of Australia's largest independent breweries, with a production capacity of over 1.2million cases per year. It plans to expand production to 3 million cases by 2015.

Financials and Valuation
The company is still fairly young, its first product hit shelves in 2005. The key factors to watch for are its profit margins and its capital expenditure. When dealing with the Woolworths gorilla, margins are all important. It's too early to judge the company's performance by its 2011 full year results, and very difficult to allocate a valuation to the shares.

Sales have increased nicely with $15.8m in sales in 2011, compared to $5.8m in 2010 (an increase of 171%). As previously mentioned, 2011 was its maiden full year profit of $0.12m (2010 was technically a profitable year, but included $3.7m in tax benefits).

Its capital expenditure is large compared to its current earnings, but this is normal for a young company. The company is planning to spend $9.6m over four years to expand production capacity from 1.2 million cases to 2015 target of 3 million cases.

Comparison with Little World Beverages
Gage Roads can't really be compared with Little World Beverages (ASX: LWB), the brewing company that produces Little Creatures beer and cider products. Little World Beverages produces and markets its own products for sale in retail bottle shops, and doesn't do contract brewing. Therefore, it is not at the mercy of the likes of Woolworths, whereas Gage Roads is. Gage Roads' strategy has been to move from a niche brewer to a contract brewer, so the company will be more dependent on Woolworths in future years.

Woolworths as a major investor in the company is both good and bad news. Woolworths can provide capital if required, and provides a very large customer wanting to expand its private label products, so there's plenty of scope for Gage Roads to increase sales.

The down side is that Woolworths holds the upper hand in the relationship and can force Gage Roads to sell its products cheaply thereby reducing Gage Roads margins and profits (as the dairy farmers recently found out, with Woolworths selling very cheap milk, and slashing the farmers' profit margins).

The other risk is that company's shares are very illiquid. The dangers of illiquidity are that large purchases of stock push the price up dramatically, and when trying to sell the stock, there may be very few buyers.

The foolish bottom line
I'd like to see 2012 full year financial results before considering whether to buy a round of shares in the company. My main concern is the power Woolworths holds in its relationship with Gage Roads, and the effect that has on Gage Roads' margins and profit.

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Motley Fool contributor Mike King does not own shares in Gage Roads. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.

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