Thursday, January 7, 2016

Could mid-sized independent breweries start disappearing?

Will mid-sized independent breweries like 21st Amendment
find tougher going with industry consolidation? 
In this second part to last Tuesday's post on A-B InBev's business strategy, I'll take look at issues facing breweries in light of recent brewing industry developments. In brewing, the more beer you brew, the less the overall cost to brew it per unit volume, known as "economies of scale". Breweries get price breaks on malt and hops when they buy them in larger volumes and can justify purchasing expensive automated equipment like high speed bottling lines when brewing in large volumes are just two examples in the industry. With large breweries taking advantage of brewing's inherent economies of scale, mid-size breweries that still needing to sell in appreciable volume may really feel the pinch moving forward.

Large corporate breweries have always counted on economies of scale in the brewing process to increase profits and their strong distribution networks allowed them to sell the beer at high volumes to sustain their business. Smaller breweries are always at a cost disadvantage and often lacked distribution channels, but as consumers gravitated towards porters, pale ales, and IPA's and away from mass market lagers, customers were increasingly willing to pay more for craft beer, leading distributors to sign onto craft brands into their portfolios.

Recent investments by corporate breweries, whether Constellation Brands buying Ballast Point, MillerCoors acquiring Saint ArcherHeineken taking a 50% stake in Lagunitas, or A-B InBev amassing a war chest of craft beer brands are certainly motivated by extending these economies of scale to craft breweries that were unable to take these advantages on their own. There is a common perception that when big corporations take over craft breweries, they'll start cutting costs and inevitably water down the product, but there are counterexamples to this "conventional wisdom". For example, we're coming up on five years since A-B bought Goose Island, and even the harshest craft beer critics concede there's been no demonstrable decline in Goose Island's brews.

It's even possible these acquisitions will lead to more greater innovation and beers for unprecedented taste and quality, now these acquired breweries can rely on greater resources from their corporate parents. For example, 10 Barrel Brewing's Chris Cox praised A-B InBev for sourcing enough hops so that 10 Barrel's award winning Joe IPA could be widely distributed on the West Coast. Prior to the A-B InBev acquisition, the only way you could get your hands on a pint Joe IPA was at one of 10 Barrel's brewpubs in the Pacific Northwest. A-B InBev has been credited in providing the necessary resources to expand Goose Island's barrel-aging program. Several other brewers have cited access to corporate resources to improve and more widely distribute their beer as justification for selling their businesses to large corporate breweries. Of course, people always say nice things like this in press releases but this may actually turn out to be true. Beer consumers may very well be the big winners in this acquisition frenzy.

However, for the independent brewer, these developments are disturbing. Soulless corporate breweries churning out tasteless mass market lagers were pretty easy targets. Now, these same corporations are producing comparable beers at a potentially lower costs with plenty of corporate sales, marketing and distribution muscle behind them. While beer geeks might shun these beers as corporate sell-outs, the remaining 99% of the population is largely unaware of the ultimate ownership of these breweries and probably wouldn't care very much even if they knew. Corporate beer no longer means bad beer hyped with silly gimmicks like vortex bottles. It now means beer comparable to what you can find at your local brewery giving independent breweries plenty to be worried about.

One type of brewery that will still flourish is the local "nanobrewery", the small brewery which sells most of its beer onsite at a brewpub or tap room. These very small breweries exploit a little appreciated "reverse economy of scale" in the brewing industry not everyone is aware of. Since these small breweries sell most, if not all of their beer directly to their customers, they don't need to split the revenues with any distributor and make higher margins on beer sales as a result. Many small breweries I've talked to have decided to pull back distribution, or prioritize their production in favor of more profitable on-premise sales. Not only are these small breweries increasing their margins by staying small, they put themselves in position to satisfy their fiercely loyal local following. Many indulge in all sorts of fun, wild experimental beers adding to their allure which would be highly problematical to brew at even a modest scale of a few thousand barrels.

If you don't believe these small breweries are successful, try finding a seat in a tap room. Having visited tap rooms and brew pubs in Bend, OR, Fort Meyers, FL, Kansas City, MO, Los Cruces, NM as well as plenty all over Northern California in the past year, these business are clearly thriving. It's a force large corporations really have no answer for, and since these small breweries actually represent a very tiny fraction of beer sales in America, probably aren't worth their time bothering with.

So if you're a brewery aligned with a large corporate parent, you're in a good position. If you're a small neighborhood brewery with a tap room and loyal following, life is pretty good, too.  But if your a mid-size independent brewery, things might start getting difficult.  Already, A-B InBev is making moves stifle competition through an incentive program which rewards distributors if 98% of their sales are A-B InBev products. It's a pretty safe bet Heineken, MillerCoors, and Constellation Brands will make similar moves.

What will the unaligned mid-size breweries do moving forward? Some of them are large enough like Sierra Nevada, Stone Brewing, or Deschutes that they should be able to keep chugging away. But will a 50,000 barrel a year brewery start to have trouble finding distributors? Will it become harder to secure hop contracts for specialty hops, now that big corporations are starting to buy these hops as well? Will smaller independent breweries have to swallow thinner margins or price their beer higher and be at a disadvantage on store shelves?

In the near term, I think most breweries should be fine and it' unlikely some catastrophic beer bubble will happen. Craft beer sales still continue to increase at a rate of 15% and can do so for a few more years, so there's still a lot of room for everyone. Of course, 15% growth is not sustainable forever and corporations are fighting back a lot more smartly to reclaim lost market share. We may see consolidation on a smaller level as well, with 50,000-100,000 barrel a year breweries merging together or forming strong business alliances. For example, in Northern California, it's entirely plausible to see something like Drakes and 21st Amendment joining together to form a larger brewery out of necessity to remain competitive.

There's one thing I'm sure of. There will always be plenty of breweries brewing great beer, and ultimately, beer drinkers will be the winners. We may not like it when corporations take over our favorite breweries. I have mixed feelings about this myself. However, this development has the potential lower beer prices while stimulating innovation in ways that previously weren't possible. This may be one of the most fascinating times in the history of brewing and I for one am watching it intently.

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