Don’t cry over spilt beer

“You’ll never go broke selling beer in Australia!”, or so the saying goes.

The Australian love of the amber liquid is almost legendary, and you could be forgiven for thinking that owning a brewery is like having a license to print money… Especially these days with the surge in demand for ‘craft’ beer as Aussies shift their (or should I say, our) preference to the more boutique end of the market.

Those looking to share in the spoils would do well to consider WA-based craft brewer Gage Roads (ASX:GRB), though investors should be mindful that it ain’t all beer and skittles. Well, at least not skittles.

A (pint) glass half empty

Let’s be frank; the brewing business is a tough one, especially if you’re not one of the two major — and very dominant — players.

There are high fixed costs, the industry is dominated by some very large and deep pocketed incumbents and there are meaningful barriers to entry — particularly when it comes to gaining access to the limited tap lines in pubs.

Further, though the craft beer market is experiencing very strong tailwinds, consumer preferences are extraordinarily fickle and there is a veritable flood of new entrants. Quality matters, a lot, but making a tasty brew will not guarantee success on its own; the industry standard is extraordinarily high and doing well is just as much about gaining scale and establishing distribution channels.

A (pint) glass half full

Despite the challenges of the industry, Gage Roads has a lot of advantages. Principally, scale, diversity and a strong likelihood for increased volume.

Brewing beer at scale involves relatively high fixed costs. Profit is only made once you cover these, and though the gross margins are typically quite attractive (around 50% for Gage), you still need to sell a lot of beer before you break-even.

Gage’s operations in Fremantle have a capacity of 3 million cases per year, which makes them one of the largest, if not the largest, independent craft brewer in the country (competitors like Little Creatures having long since been acquired by large multinationals).

In the most recent full year, the business pumped out the equivalent of around 1.7 million cases of beer, leaving a lot of headroom for growth. While that was a 20% improvement on the previous year, it was still insufficient to turn a profit.

Nevertheless, the loss was modest, and once (or if) Gage surpasses the point of break even, roughly half of what they sell will drop straight to the bottom line. Because they are growing profit from such a small (or in essence, non-existent) base, once the company passes this point of inflection, profit growth should be substantial.

Thus, what ultimately matters is volume. Fortunately, there are good reasons to expect volumes will indeed rise, and strongly.

More Beer!

Part of the reason to expect greater volume is the diversity angle, hinted at earlier. Roughly speaking, one third of production is for Gage’s own brands; the remainder is beer produced under contract, and this is the most appealing part of the business.

The beauty of brewing facilities is that you can produce an extremely wide variety of beers with the same equipment — only the ingredients change as well as some tweaks to process (brewing times, temperatures and the like).  Unlike most manufacturers, you don’t need to ‘re-tool’ your production line to make something new.

Contract brewing is an appealing avenue for other brands, as they can essentially outsource the production once they have developed a recipe and a brand. Gage’s facility, with its relatively substantial scale, is very attractive for those looking for a low risk entry into the market.

Half of the beer that is brewed under contract is done so on behalf of Woolworths (ASX: WOW), which contracts Gage to produce its private label range of craft beer. Woolworths also owns 25% of Gage and has a director on the board.

With Woolworths liquor operations continuing to expand and the attractiveness and priority of the private label strategy (which has been pursued to great success in its supermarket operations), it is reasonable to expect a good surge in beer volumes in the coming years.

Foolish takeaway

Gage suffered from a spoilt batch of beer, which significantly knocked down last year's earnings. As a consequence, the share price took a substantial dive and has yet to recover.

For those able to look farther ahead, this was a legitimate 'one-off' with little to no bearing on the prospects for the business. Great beer, a strong strategic partner and operational leverage? I'll drink to that!

For those able to look farther ahead, this was a legitimate 'one-off' with little to no bearing on the prospects for the business. Great beer, a strong strategic partner and operational leverage? I'll drink to that!

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Andrew Page is a Motley Fool analyst. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. 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.

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