Boston Beer Co Inc Q3 FY2021 Earnings Call

Greetings, and welcome to The Boston Beer Company Third Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now turn the conference over to your host, Mike Andrews, Associate General Counsel and Corporate Secretary. Thank you. You may begin.

Thank you. Good afternoon and welcome. This is Mike Andrews, Associate General Counsel and Corporate Secretary of The Boston Beer Company. I'm pleased to kick off the 2021 third quarter earnings call for The Boston Beer Company. Joining the call from Boston Beer are Jim Koch, Founder and Chairman; Dave Burwick, our CEO; and Frank Smalla, our CFO. Before we discuss our business, I'll start with our disclaimer. As we state in our earnings release, some of the information we discuss and that may come up on this call reflect the company's or management's expectations or predictions of the future. Such predictions are forward-looking statements. It's important to note that the company's actual results could differ materially from those projected in these forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the company's most recent 10-Q and 10-K. The company does not undertake to publicly update the forward-looking statements whether as a result of new information, future events or otherwise. I will now pass it over to Jim for some introductory comments.

Thanks Mike. Our intent today is to provide some additional context around our third quarter earnings, discuss our views on trends we see driving results at Boston Beer and in our industry and talk about how we see performance going forward. After I discuss a few highlights from the third quarter, I'll hand it over to Dave who will provide an overview of our business. Frank will then provide details of the third quarter financial results and how these results have been impacted by slower than anticipated hard seltzer growth, as well as our outlook for the remainder of 2021 and 2022. Then I will share with you our longer term view of the business. Finally we'll open the line up for questions. I'll begin with some context in measured off-premise channels year-to-date through October 10th where our brand portfolio represents only 4.4% of the total industry volume. We've delivered more than 41% of the total industry volume growth, the highest by far of all brewers. Four of our five major brands are growing depletions and gaining share in off-premise measured channels over the last 13 weeks. We have a broad portfolio of healthy brands which we will further build in 2022 to continue driving our growth. Our success has been recognized by our most important customers, our distributors who recently voted us the top beer supplier in 2021 in the latest Tamarron survey. This is the 10th time in the last 12 years that our most important customers have recognized us as the top supplier in our industry. We are thankful to our outstanding co-workers, distributors, and retailers whose continued support is helping grow our business to achieve our 14th consecutive quarter of double-digit growth. But despite these ongoing strengths, we experienced very large unanticipated costs as a result of the sudden unexpected slowing of growth in hard seltzer. Based on our growth projections, we moved aggressively to build inventory to try to avoid the out of stocks that we experienced in 2019 and in 2020 and to secure capacity both short-term and long-term to be ready for growth through 2023. Dave will share our perspective on the decisions that led to these unanticipated costs and Frank will share a fuller accounting of them. I'll now pass it over to Dave for a more detailed overview of our business.

Hey, thanks Jim. Good afternoon everybody. Let me start by addressing where we are strategically, how we're viewing the future of the hard seltzer category and how we plan to grow our portfolio going forward even without high double-digit hard seltzer category growth. There's no question that hard seltzers have generated tremendous growth for the beer category over the last five years and will remain a very important beer industry segment in the future. Hard seltzers are 11% of total beer dollars year-to-date, up from 9% during the same period in 2020. Consumer metrics remain favorable. Social media sentiment continues to trend positively and household penetration frequency and buy rate all are increasing over the past 13 weeks. Volume growth has slowed this year, but we continue to believe that hard seltzers can reach 15% to 20% of total beer dollars in the next five years. We believe the ability to create alcoholic beverages from a beer base with a range and variety of flavors, previously only available to mixed drinks, coupled with the convenience and affordability of beer and beer's tax and distribution levels will be a platform for long-term growth for Boston Beer. We've been playing to win and we've reaped many benefits. So far this year, Truly has achieved the second highest household penetration in all of beer behind only Bud Light beer and ahead of all its other hard seltzer and beer industry competitors. Truly has generated 54% of all hard seltzer category growth so far in 2021, 2.3 times the next highest brand. We've gained 23 share points against the category leader since January 2020. We've led the category in innovation and brand building and have outgrown the category for 13 straight months. We also believe that Truly is blazing its own path and not following the category like so many other entries. Thus, we believe we are well positioned to succeed in the future when it will be much harder for new entrants to gain share. We've created a $1 billion brand in only five years and we're confident we'll continue to grow it going forward. Slowing hard seltzer category growth has certainly impacted our business. Earlier in the year, we had expected the category to grow at over 70% and Truly to gain share. The Truly brand did gain share but the category did not grow as we had expected. Now we expect Truly, thanks to its share gains to finish the year up between 20% and 25% in volume. Because of our higher demand projections earlier in the year and our commitment to avoid the out of stocks that we experienced during the summers of 2019 and 2020, we added significant capacity and pre-built inventories of cans and finished goods to levels that ended up exceeding actual needs as the category slowed down. As a result, we are currently faced with significant temporary costs as we adjust to the new category trends. These cost impacts are reflected in our third quarter financials. Building our capacity and inventory levels was an essential part of Playing to Win. In that strategic context, we believe the risk of undersupply was bigger than that of oversupply. So we resourced against a high-growth scenario, securing supply constrained materials and capacity to gain market share in a highly competitive and fast-growing category. Having said this, we've updated and evolved our own category growth model and believe the category could be flat to plus 10% growth in our most likely 2022 scenarios. Clarity will probably not increase until we start to lap June and July 2021 when the category started to decelerate rapidly especially in the two-year volume stack, which we look at closely. Regardless of which scenarios prove most accurate, we fully intend to extend our streak of outgrowing the category throughout the year, driven by innovation, continued brand building and superior retail execution and distributor support. As Jim mentioned, we have a balanced portfolio of healthy well-positioned brands. As we look towards 2022 and beyond, our aim is to continue double-digit depletions growth on the foundation of this portfolio, especially as consumers drink more Beyond Beer products. We are the number two player in Beyond Beer with a 26% share driven by the number one FMB in Twisted Tea, the strong number two hard seltzer in Truly and the number one hard cider in Angry Orchard. Twisted Tea has overcome this past summer supply chain issues and out of stocks and has grown 22% in the last 13 weeks in measured off-premise channels. Twisted Tea is the second fastest-growing brand year-to-date among the top 25 in beer while Truly remains number one in percentage and absolute volume growth. We will have industry-leading innovation again with Truly starting with a Holiday Party Pack next month and followed by the January 2022 launch of Truly Margarita Style, which has received a terrific response in initial discussions with our distributor partners and retailers. As Twisted Tea expands its consumer base, we're launching a new Twisted Tea Light with only 109 calories. But our innovations go beyond Truly and Twisted Tea. For 2022, we're introducing new brands, the Bevy Long Drink, Sauza Agave Cocktails and HARD MTN DEW. We're also expanding our lineup of award-winning Dogfish Head Canned Cocktails with new vodka and gin crush styles and we're launching a new tropical fruit extension for Angry Orchard, in addition to adding Angry Orchard HardCore and 8% ABV products. Meanwhile, our Sam Adams Your Cousin from Boston campaign is paying dividends, as Sam Adams grew double-digits in the third quarter, fueled by both on-premise and off-premise gains while also gaining share of crafts in the off-premise. Now I'll hand it over to Frank to discuss our third quarter financials as well as our outlook for 2021 and our initial thoughts on 2022.

Thanks, Dave. Good afternoon, everyone. Before I get into the financial review of our third quarter results and financial outlook, I'd like to provide more detail on the third quarter charges and other costs related to the hard seltzer slowdown. As Dave explained, we strategically resourced against the high side of our internal category growth and market share projections to ensure we would not be constrained in our efforts to build our share position in the hyper-growth hard seltzer category. Resourcing against our high side scenario included adding internal and external capacity, pre-building distributor and internal inventory ahead of the peak summer season and securing tight supply materials, such as cans and flavors. This strategy enabled us to gain share in 2020 and 2021 in a supply-constrained environment. Following the rapid slowdown this summer, actual hard seltzer category growth fell below our internal low side projections and resulted in excess capacity and higher-than-planned inventory levels of input materials and finished goods. As a result, we have taken a $102.4 million third quarter charge related to direct costs of the hard seltzer slowdown, consisting of inventory obsolescence and destruction – and related destruction costs of $54.3 million; contract termination costs primarily for excess third-party contract production of $35.4 million; and equipment impairment of $12.7 million. In addition, the third quarter results include indirect costs resulting from the slowing hard seltzer category growth of $30.6 million. These costs include negative absorption impacts at company-owned breweries and downtime charges at third-party breweries of $11.4 million, increased raw material, sourcing, and warehousing costs of $11.8 million and distributor return provisions for out of code or damaged products of $5.4 million and other costs of $2 million. The negative absorption impacts are the result of shipments lagging depletions to reduce distributor inventories to target levels and production lagging shipments to reduce internal inventory levels. With this background and the third quarter financial impact of the slowdown in hard seltzer, I will now turn to our overall third quarter results and our current outlook for the full year 2021 and 2022. For the third quarter, we reported a net loss of $58.4 million, a decrease of $139.2 million from the third quarter of 2020. Loss per diluted share was $4.76, a decrease of $11.27 per diluted share from the third quarter of 2020. This decrease was due to the combined direct and indirect costs related to slowing hard seltzer category growth of $133 million or $7.73 per diluted share net of the related tax benefit and higher operating expenses partially offset by increased net revenue. Depletions for the quarter increased 11% from the prior year reflecting increases in our Twisted Tea Truly Hard Seltzer, Samuel Adams, and Dogfish Head brands, partially offset by decreases in our Angry Orchard brand. Shipment volume for the quarter was approximately 2.3 million barrels, an 11.2% increase from the prior year, reflecting increase in our Twisted Tea, Samuel Adams and Angry Orchard brands partially offset by decreases in our Truly Hard Seltzer and Dogfish Head brands. We believe distributor inventory as of September 25, 2021 averaged approximately six weeks on hand and was at an appropriate level for each of our brands except for Truly, which has significantly higher-than-planned distributor inventory levels for certain styles and packages. To address the slowing demand, and continued volatility of future volume projections for Truly we are working closely with our distributors to reduce Truly distributor inventory levels. We adjusted production and shipments during the third quarter and expect to continue to do so during the remainder of the year. Our third quarter gross margin of 30.7% decreased from the 48.8% margin realized in the third quarter of 2020, primarily due to the $84.9 million direct and indirect volume adjustment costs as a result of slowing hard seltzer growth described above and higher material costs partially offset by price increases. Advertising promotional and selling expenses increased by $58.8 million or 54.4% from the third quarter of 2020, primarily due to increased brand investments of $37.6 million, mainly driven by higher media, production and local marketing costs and increased freight to distributors of $21.2 million that was primarily due to higher rates and volumes. Based on information of which we are currently aware, we are now targeting full-year 2021 earnings per diluted share of between $2 and $6. However, actual results could vary significantly from this target. This projection excludes the impact of ASU 2016-09 and is highly sensitive to changes in volume projections particularly related to the hard seltzer category. Full-year 2021 depletions growth is now estimated to be between 18% and 22%. We project increases in revenue per barrel of between 2% and 3%. Full-year 2021 gross margins are expected to be between 40% and 42%. The gross margin impact related to the combined full-year direct and indirect cost of the hard seltzer slowdown is estimated at $132.6 million of, which $95.8 million have been incurred in the first nine months and the remainder of $36.8 million are estimated to be incurred in the fourth quarter. Our full year 2021 investments in advertising promotion and selling expenses are expected to increase between $80 million and $100 million. This does not include any increases in freight costs for the shipment of products to our distributors. I will now turn to 2022. We're in the process of completing our 2022 plan and we'll provide further guidance when we present our full-year 2021 results. Based on information of which we are currently aware, we are using the following preliminary assumptions and targets for our 2022 fiscal year, which are highly sensitive to changes in volume projections particularly related to the hard seltzer category. We're targeting depletions and shipments percentage increases of between mid-single digits and low double digits. We project increases in revenue per barrel of between 3% and 6%. Full-year 2022 gross margins are expected to be between 45% and 48%. We plan increased investments in advertising promotion and selling expenses of between $10 million and $30 million for the full-year 2022 not including any changes in freight costs, for the shipment of products to our distributors. We expect that our cash balance of $86.5 million as of September 25, 2021 along with our future operating cash flow, and unused line of credit of $150 million, will be sufficient to fund future cash requirements. Now I'll hand it back to Jim for some closing remarks.

Thanks, Frank. Before we open it up for questions, I'd like to share some perspective from someone who's been at Boston Beer Company since the beginning, and remind us all we have a tremendous track record of growth at Boston Beer Company. For the past 20 years, we've grown our revenue at over a 12% compounded annual growth rate and have increased total shareholder returns at a 20% compounded annual growth rate. That growth doesn't always come in a straight line. The numbers are a beautiful thing but the actual results sometimes aren't pretty. But it has come over 20 years compounded because we've demonstrated the ability to, consistently innovate and grow great brands in our niche the high end of the beer and beyond category. That brings us to where we are today. Truly is the number two hard seltzer and closing the gap this year with the current category leader. Twisted Tea is number one in hard tea and now the number one FMB and is continuing to gain share. The Sam Adams brand is gaining share for the first time in several years and Angry Orchard is number one in hard cider and maintaining close to a 50% market share. We intend to grow these four brands and Dogfish Head as well in 2022 through brand, building and executing at retail the things that we've been doing for decades. We believe we have the best brewers, the best high-end brands, with potential yet to be fully tapped, the best sales force and the best innovation again for 2022. We're fixing our capacity and supply chain issues. Our marketing is hitting its stride and we have the best distributor network behind us. That's why we've been the fastest-growing company in all of alcohol for the last few years. We have a company and culture that not only delivers double-digit growth, but also demonstrates resilience and agility when faced with challenges. As Dave mentioned, we've been playing to win in the hard seltzer category. We will continue to play to win, to nourish our brands, to exploit their untapped growth potential, as we're seeing with our 20-plus-year-old Twisted Tea brand, and to innovate with new ones in the months ahead. Today, we hope to put the turbulence of the hard seltzer category slowdown behind us, and continue to prove our ability to outgrow the beer category for many years to come. Now, let's open it up for your questions.

Our first question comes from Nik Modi with RBC Capital Markets. Please state your question.

Thanks. Good evening, everyone. Dave I was hoping maybe you can provide some context on some of your 2022 preliminary guidance that you provided, just in terms of the buckets of shelf space allocation innovation kind of core category growth. I know, the range of the outcome for category growth is pretty wide. But maybe you could just give some context around kind of how you guys came to that conclusion?

Okay. Nik, thanks for the call. I think without getting into specifics about what we're thinking about each brand, there's a range of growth we see for each brand. We definitely expect all five of these brands to grow next year. And as Jim mentioned, we're building momentum as we head into next year. Innovation will definitely play a role. And depending on how you count innovation it's probably – it could be a-third or more of the growth. But we're placing a lot of bets as you heard across the board both in just investing in our brands to sustain the growth, whether it be for Twisted Tea or Sam Adams, adding line extensions, where it's appropriate certainly for Truly and Twisted Tea. We added Twisted Tea Light as I mentioned. Sam Adams Wicked Hazy is on a roll. And also, we actually have three new brands next year that we'll put into the marketplace with Beam Suntory, Sauza and obviously HARD MTN DEW with PepsiCo, et cetera. So it's going to be a balanced approach to all of those brands. By the way, we do expect Truly to grow. And as I mentioned, it's the category – we kind of came out with – a lot of folks on this phone came out on the category growth on hard seltzer. And we think that, we'll get growth with Truly next year as well.

And then just well a final question on Truly, and the marketing now that the Dua Lipa campaign has been out, you have some time under your belt, any perspective on consumer engagement scores brand equity scores?

Yeah. I mean, I think the best – the thing that we look at most actually for Truly is social media engagement and response, because to be fair we – initially several years ago we weren't that competitive in that space. And we made a lot of progress. So our share of voice in social media is about 50 index to the leader. Right now, however 91% of all of our – all the comments are positive. So we're seeing a lot of positive momentum on social media. And for us right now that's the biggest – I'd say, the biggest litmus test for how we're reaching the right consumer in the right way.

Excellent. Thank you. I'll pass it on.

Thanks, Nik.

Our next question comes from Eric Serotta with Evercore.

Thanks, very much. First a clarification. In terms of the '22 preliminary look, is the range of scenarios that you're looking at, does that have Truly growing in excess of the category or gaining shelf space? Wasn't clear on that from your previous comments. And then, if you could talk a bit about shelf space more broadly. Clearly, shelf space gains have been a major driver of both your and the hard seltzer category growth over the past two years. With a lot of those brands, not really turning, how do you see the shelf space evolving as we get into next year? And is your guidance built on Truly holding shelf space, losing shelf space, gaining overall shelf space? Any color would be appreciated.

Thanks, Eric. Regarding your first question about Truly growth, our current projection for the category is between 0% and 10%, and we anticipate Truly will exceed this growth rate. So, if the category growth is at 0%, Truly will definitely grow, and if the category is at 10%, Truly will grow by more than 10%. Concerning shelf space, seltzers currently occupy about 10% of total shelf space, which is slightly below where they should be based on their market presence. We expect some adjustment in the long tail of brands, allowing the top two brands to capture more shelf space. Presently, Truly has a 24% share of shelf space. These figures are approximate, and we expect slight growth in this share next year. However, our growth for Truly won't solely depend on shelf space expansion. We believe that our successful strategies will take effect soon, particularly by next spring, which will lead to increased shelf space. Nonetheless, the growth we anticipate for Truly will extend beyond just shelf space considerations.

Great. I’ll pass it on and get back in the queue. Thank you.

Okay. Thanks, Eric. Diego, do we have more questions coming?

Diego, can you hear us?

For those who might be able to hear us, please stay tuned. We're working on resolving this issue and we hope to have it fixed shortly.

Apologies for the technical issue. Please stand by. Our next question comes from Laurent Grandet with Guggenheim. Please state your question.

Yes, good evening, everyone. To follow up on the previous question, Dave, you mentioned that next year the seltzer category is expected to grow by 0% to 10%. However, we have observed a decline in that category over the last three periods. What gives you confidence that the category will grow again? This is likely the key question on every investor's mind, and we would appreciate your insights on that.

Certainly, Laurent. Let me clarify how we arrived at that growth estimate and our confidence in it. We have gained a deeper understanding of the market dynamics through additional time. Our model analyzes factors like household penetration rates, purchase frequency, buy rates, and repeat rates, focusing specifically on the last 13 weeks compared to the entire year, as conditions have evolved. Extensive work has been done with the model, including consultations with wholesalers and retailers to gather their insights. We also factored in data from others in the industry, many of whom are present on this call, and the projected growth range of 0% to 10% aligns with these findings. Moreover, new consumer insights reinforce our confidence in the category's growth. For instance, data from IRI shows that the two-year performance trend has stabilized around 100% to 110% since Labor Day. From a consumer standpoint, we see that household penetration has risen by approximately 4% in the latest 13-week period, with a buy rate increase of about 1.5 points. Social media metrics also reveal that 38% of comments regarding our products are positive, while 17% are negative, resulting in a widening gap favoring positive sentiment compared to a year ago. We have recently conducted a consumer study involving 4,000 alcohol drinkers aged 21 to 55, revealing that about one-third of current hard seltzer consumers are eager to increase their consumption. Additionally, around 75% of non-users or lapsed drinkers expressed openness to trying hard seltzer in the coming year, and only about 6% of consumers are complete rejectors, similar to last year's figures. Other research, including work done by Wendy at Citi, supports these findings. Overall, consumer data combined with our quantitative models indicates sustained interest in the category. Another important observation is the increasing penetration rate. However, when examining new buyers compared to those who are lapsed or casual, we find that fewer new buyers are entering the market and they tend to spend less, contributing to some downward pressure. Conversely, there is a notable increase in "heavier repeat buyers" who are purchasing more, which reflects a normalization within the category. Although this is a complex situation that we've all been analyzing diligently, our model and the ongoing consumer research corroborate the potential for growth in the category. To achieve our maximum projected growth rate of 10%, we anticipate a household penetration increase of about 2 percentage points and a 6.5% increase in buy rates. Given that household penetration has risen by 8% year-to-date, which diverges from the recent trend, we believe this outlook is reasonable. Together, all of these insights suggest a category poised for growth, reinforcing our belief in its potential.

Thank you, Dave. Very comprehensive. So I pass it on and redo the queue. Okay. Thanks.

Thank you.

Thank you. Our next question comes from Nadine Sarwat with Bernstein. Please state your question.

Hi. Thank you for taking my question. One for me, please. So if volumes continue at this new normal that you are forecasting, are you liable to incur any additional expenses such as shortfall fees in the coming years? Thank you.

Yes. This is Frank. Let me take that. So when we looked at the capacity, the way it contracted with our external manufacturers, some of that we canceled and that is reflected in the charge that we communicated. With the co-manufacturers or the third-party brewers that we still are working with, we have thresholds. And if we fall below those thresholds, we're still liable to shortfall fees. So the contracts that are still in place, we still have that. But it's going to be a much leaner network and much more integrated.

If I could just follow up on that. Could you then explain how the contracts that you have existing that are left compare to your volume forecast that you've expressed for 2022? Is there a gap in there? What could a worst-case scenario be essentially?

We have enough capacity in our entire network for the first time in a while, so we do not need to prebuild inventory for the peak as we have done in previous years. We can meet the demand with our current capacity. If there are risks to consider, particularly concerning shortfall fees, they should not impact our gross margin by more than 0.5 percentage points and are expected to remain below that threshold.

Got it. Thanks very much.

Thank you. Our next question comes from Bonnie Herzog with Goldman Sachs. Please state your question.

Hi, everyone.

Hi, Bonnie.

Hi, Bonnie.

Hi. I had a question on your incremental spend. I guess first, I'm surprised your incremental investment spend remains pretty elevated this year, but then you do have plans to step it down pretty considerably next year. So could you guys talk about the strategy behind this, especially in context of your strategy of playing to win? And then I guess thinking about a step-down next year, does this suggest your pipeline of innovation will be a lot slower and you don't think the hard seltzer category specifically warrants additional spend? And I guess, finally, what's the risk in your mind that a pullback on incremental spend next year could result in share losses for you in a category that is decelerating, I guess with the possibility for growth to turn negative next year? Thanks.

So Bonnie, let me start off and then I'll hand it over to Dave. When we look at 2021, we were clearly aiming for higher growth than what we ended up achieving. In 2020 and again in 2021, we invested early in the year to get ahead of the peak period and maximize our opportunities. Unfortunately, the volume did not meet our expectations, meaning we spent more compared to the volume we anticipated. While we will increase our spending next year, it won't be to the same level, as we need to consider that growth isn't as strong as we had hoped. However, I believe 2021 may not serve as a good benchmark due to the unprecedented circumstances. Looking at the projected AP&S spending, for 2022, it will be nearly 30% above 2020 levels and close to 80% above 2019 levels. We have significantly invested in this category to secure our market share in a growing segment, which differs from a stabilizing category where gaining market share is much more challenging. The dynamics are shifting, and we are confident that we can allocate our spending effectively to achieve the best returns.

And Bonnie, I want to expand on what Frank mentioned. I would like to emphasize that we are very confident in the strength of our creative work. We have dedicated significant time to developing our own model to assess the impact and effectiveness of our creative strategies across our brands, including Twisted Tea, Sam Adams, Angry Orchard, and Truly. We believe that we will achieve more value from each dollar spent due to the changes we've implemented and the evolution of our campaigns. The Sam Adams campaign serves as an excellent example; Your Cousin from Boston is connecting well with younger audiences that we hadn't reached before. Additionally, there’s a substantial public relations angle generated by good promotional efforts which adds considerable value. For instance, we had several PR initiatives linked to our advertising investments this year for Sam Adams, including a Super Bowl spot featuring the Clydesdales, a COVID vaccine advertisement, a Say It with Sam wedding vows contest, and a recent collaboration with the Inspiration4 space mission to create a spacecraft beer. Collectively, these initiatives produced hundreds of millions to billions of impressions, illustrating how we can maximize our efforts. Therefore, it’s not that straightforward to assess total spending and claim that we cannot support our entire portfolio; we believe we can. Lastly, I want to add that if we observe a positive response, we will increase our spending. We won’t reduce our investment simply because we’ve provided some directional insights for 2022. If we sense momentum, we will commit fully. We will always invest in our brands when we believe we can achieve a good return.

Okay. Yes, that's definitely helpful because I guess I was kind of thinking about it in the context of you really have been the driver of the growth in the category. And if there is any pullback then I'm just thinking about what that suggests for the outlook for the category. So, that's good to hear. If you see something you'll push harder. And if I could just squeeze in a second quick question as it relates to the stronger price growth that I guess you're guiding to next year of 3% to 6%. I guess I'm also curious. What gives you guys the confidence that you have that kind of pricing power, especially given what we're talking about the deceleration of the category and maybe the eventual shakeout of the category which could happen early next year? And then I think about that in the context of pricing pressure as that shakeout happens. So, just any thoughts there would be helpful. Thank you.

Yes. I'm going to start and pass it over to Dave. Our pricing this year and next year is significantly influenced by the rising input costs that everyone is encountering. We aim to reflect that in our pricing. Our confidence remains fairly strong because, even with the slowing growth in the category, price has not truly impacted purchasing decisions. What we've observed is that brand strength and the quality of the beverage itself are what really matter. We’ve noticed attempts across the category to reduce prices in order to gain market share, but this approach hasn’t proven effective, even for our own brands. Therefore, we believe that pricing will not be a decisive factor at this point.

I don't have much more to add to that other than if a shakeout occurs in hard seltzer, fewer brands would actually support the ability to take higher prices. This entire ecosystem, from retailer to wholesaler to brewer, is affected by all the input costs, as you know. I think it's in everyone's best interest to try to recoup those costs. Lastly, we're not the only ones experiencing excess raw materials that need to be disposed of. No one in this category has resorted to lowering prices to move product because they believe in maintaining the integrity of pricing, which is especially important given the current economy.

Yes, understood. Thank you again.

Diego, are you there?

Our next question comes from Kaumil Gajrawala with Credit Suisse. Please state your question.

Hi everybody. Thank you, Diego. Can we talk about inflation maybe in a little bit more detail as you're thinking about next year? Obviously, you've given us some rough guidance, but you can give us an idea of kind of what you're seeing, where you're hedged, if you're not hedged, or at least what some of the assumptions are and some of what you've provided us so far? And obviously not limiting to gross margins. Also maybe including freight if you can.

Yes, Kaumil. The key categories we are observing this year include a notable increase in aluminum, which is reflected in can pricing with double-digit increases. Freight costs have risen significantly, around 30%, affecting the entire economy due to a driver shortage. We expect these elevated levels to continue, with plans for a further single-digit increase for 2022. Additionally, we're seeing increases in paperboard, linerboard, and sweeteners. Inflation for our input materials is projected to reach about 5% to 6% next year, depending on the mix of categories. When I refer to inflation, I mean the underlying commodity and cost, excluding any productivity savings or volume tiers—just the base commodity costs. Regarding hedging, we do not hedge. Although hedging can provide temporary relief, it does not change the fundamental market realities, especially during major trends. Thus, we navigate these challenges without any hedge positions.

Okay. Got it. Thank you.

Thank you. Our next question comes from Sean King with UBS. Please state your question.

Hey, guys. Thinking about gross margins and just given some of like the rightsizing of the production expectations. Do you see I guess a pathway on gross margins getting back above 50% like as it's been historically sort of excluding some of the inflationary headwinds, or is there something going on with sort of the beyond beer kind of mix of the portfolio that's going to be a structural headwind longer-term?

So, Sean, this is Frank. We don't really see an impact from the mix. We have encountered some issues this year with charges and costs, as well as adjustment costs and absorption impacts. However, the fundamentals haven't really changed in the medium to long term. As we have mentioned before, the key drivers for margin improvement come from building a more integrated and balanced production network. At the beginning of this year, we added several production locations with co-manufacturers, focusing on quickly adding capacity rather than integration or minimizing costs, as that strategy has worked for us in the past. Once things stabilize, we plan to integrate these locations. We are building a network with four anchor breweries, and importantly, there are significant facilities on the West Coast that will provide support. This will lead to substantial freight savings on two fronts: one for outbound freight, as we won't need to ship products from the East Coast to the West Coast anymore, and the second, related to variety pack costs due to the substantial growth of hard seltzers, which introduced a new packaging format. Producing these at scale takes time, but we have developed that capability internally and identified that our external costs have been very high. By increasing our internal production percentage, which we are achieving by reducing co-manufacturing, and by working with co-manufacturers who have technology that can closely match our internal capabilities, we're improving in this area. Additionally, our supply chain transformation efforts are helping us better integrate and become more efficient, which supports the four anchor brewery concept, reduces waste, and lowers inventories. This also decreases waste since we won't need to prebuild as much. In summary, we have three key drivers that remain in place. You have seen the margin guidance indicating improvement, and we aim to reach margins similar to those in 2020 or even better. We have already started seeing some benefits this year, though they are somewhat obscured by other factors, and we expect to see more benefits next year and eventually in 2023.

Okay. Thank you very much.

Thank you. Our next question comes from Kevin Grundy with Jefferies. Please state your question.

Good morning, everyone. Frank, I have two questions if you don't mind. First, I’d like some clarification on gross margin. Is it reasonable to expect this to become a mid-50% gross margin business? I remember you mentioning something along those lines in the past year. If that’s the case, what is a realistic timeline to achieve it? How crucial is this goal for the company in relation to broader growth initiatives? For Jim and Dave regarding the HARD MTN DEW deal with PepsiCo, it would be useful to understand how that agreement came about. If you can share, what kind of contribution are you anticipating this year, and how do you see that brand fitting into the wider RTD market? Jim, I’m also interested in your thoughts on PepsiCo’s decision to establish a separate entity for distribution. I think that’s notable. How do you think this could impact the industry moving forward? Thank you for your insights.

Let me begin by discussing our gross margin. It's an important focus for us, and that hasn’t changed. We have always stated that during this period of rapid growth, particularly in the hard seltzer segment where we are establishing a new category, our top priority is growth and gaining market share. Once this growth starts to stabilize, we'll shift our attention more towards improving gross margin. That strategy remains unchanged. We’re aiming for margins above 50%. While I can't commit to a specific figure at this time, we see clear potential for improvement, which is crucial since higher margins will impact all the volume we produce, boosting profit and earnings per share. We’ve initiated projects to enhance this, and we've seen advancement this year, with more expected next year. We should achieve significant progress by the end of 2022 or 2023 at the latest. However, this is contingent on growth trends. If new opportunities arise that require us to prioritize growth, our focus may shift. But enhancing our margins remains a top priority for us.

Okay. It looks like there's one for each of us, Kevin. So I'll address the second one. Regarding the conversations with PepsiCo, I spent 20 years there, so we still keep in touch. Over time, we've communicated about various matters. As you know, the category we're referring to as beyond beer is emerging, with consumers' preferences evolving as they seek new experiences. We've quickly found ourselves competing not just with other beer companies but also with wine, spirits, non-alcoholic beverages, and more. The discussions may have started in different areas but ultimately focused on the idea of HARD MTN DEW. We pursued this path because we believe we can meet consumer needs with our brand lineup and continue to innovate, as Jim highlighted, successfully over time. Given the various directions that the beyond beer segment is taking, we may need partners for certain initiatives, like Beam Suntory. Ultimately, this led us to HARD MTN DEW. Our initial preference is always to keep it within our system. However, they have different priorities, which is understandable for them, so we needed to reach a compromise. From there, I’ll hand it over to Jim, who can provide more insight into what this means for us.

Yes. And Kevin you mentioned, this much larger theme of convergence and I would add consolidation and blurring of lines. And I see that as a long-term trend. It's not going to change the world tomorrow but it is something that will be relevant in our future. 10 years from now it's going to look different. In 20 years different still. A lot of it is driven by just – well by the raw economics of the distribution channel. I mean basically, your gross margin dollars per stop is the biggest driver of profitability in the distribution channel. And the retailers are encouraging that too. If you're a 7-Eleven, you don't want to see three distributor trucks out in your parking lot one delivering Bud, one delivering Pepsi and another one maybe from a liquor distributor for your wines. They prefer fewer trucks, fewer salespeople calling on them if you worry invoices. So there is an underlying pressure from that. And then at the manufacturer level, everybody is exploring growth beyond their traditional lanes. The consumers are very supportive of that. There is a new consumer who is alcohol agnostic. I mean people don't ask, where does the alcohol and Truly come from. It's just not that relevant to them. And that's creating this sort of overlapping category. People are calling it beyond beer but it's also beyond wine, because you're getting wine in the juice box, canned wine, wine in the form of a margarita and things like Rancho Gloria. And it's in some ways beyond spirits. It's coming in a beer can. But it happens to say Crown Royal on the outside of it. So I guess, I see those things as fundamental drivers in our business and we have moved to build relationships with really strong players in terms of Beam Suntory and Pepsi. I mean we're a 4%, 5% share of beer, yet we've been able to build relationships with super high-quality companies with great brands. And I'm not sure where all that's going to go but I want to – I think Boston Beer should be better positioned than our other players in the beer industry, if we want to win in this converged and consolidated future. It will happen, as I said, slowly. And alcohol is different. So I think our friends at Pepsi are interested. They're putting their toe in the water. Do they – will they like it? Yet to be determined. They certainly have great capabilities and make great products. But alcohol is its own different animal. There's no slotting fees. There's all these state-by-state laws. It's a much more complicated equation. But a solid capable company wants to get into alcohol. They will just like beer distributors are exploring non-alc and seeing what they can do with energy brands and sports brands and new non-alc brands. So I see this convergence and consolidation not going away and we want to be well positioned to prosper from it.

That’s great. Thank you, guys for all the color. I appreciate it.

Thank you. Our next question comes from Steve Powers with Deutsche Bank. Please state your question.

Thank you. I appreciate it. I want to clarify something you mentioned about freight. If I understood you correctly, you indicated that you're anticipating a few points of inflation going forward. Are you referring to a sequential increase from this point, or is this your expectation for 2022, suggesting a slight inflation for the year-over-year comparison? Considering the appreciation we've seen throughout 2021, I would expect a more significant year-over-year impact, although that may be balanced out by the West Coast expansion and the efficiencies you've discussed. Could you provide a bit more clarity on what your base case rough rate looks like?

Yes. I think if you look at our freight, I think we broke freight out separately our freight on a rate basis is up higher than inflation. It's roughly 40%. And two-thirds of that is really rate inflation that's line haul that we're experiencing but then there's a mix impact that we're having as well. And the mix impact is because we're shipping way more to the West Coast. So, what I was trying to say is, there's like a significant 25%, 30% increase that we see really in line haul rates that we see this year. We don't see that going down. We see incremental single-digit increases, mid-single-digits, mid to high-single-digits for 2022 incrementally to 2021.

Okay. But then that's partially offset by the fact that you should have less of that long haul dynamic in 2022 versus 2021?

Exactly. Exactly. That's why I said before, what I'm giving you is like just pure rates and pure commodities.

Yes.

We have other productivity initiatives, which represent significant savings for us.

I wanted to revisit the pricing discussion in relation to the volume conversation we had earlier. It seemed like there were two separate discussions, suggesting that you are not seeing any impacts from elasticity. The volume aspect focused on household penetration and consumer feedback, while the pricing aspect centered on rising costs leading to price increases. Considering that consumers will face significant price increases across various categories next year, and taking into account the convergence we discussed, how do you view elasticity? Did I understand correctly that you believe elasticity is not a factor and that you feel confident in your pricing power, indicating relative inelasticity? Or is this factor included in your volume outlook for 2022?

We're considering that while we will be raising our prices, in real terms, we may be going down. We won't fully recover the 5.5% inflation present in the broader economy, but we believe consumers will likely be able to manage that. Their earnings and disposable income should increase a bit faster than 3% or 4%, although it won't be much slower than that. In our segments, we compete at the high-quality end. Consumers have already decided to spend more on our brands, which are priced significantly above the average in the beer category, and they haven't typically been very price sensitive. For instance, considering Truly in the hard seltzer market, there’s a much lower share product, but it hasn’t attracted many consumers. The same applies to other categories; craft beer consumers understand they will pay a premium, and low-priced alternatives from larger brands haven’t been successful. Cider has also become more expensive due to its production challenges and ingredient costs. Even with lower-priced ready-to-drink beverages entering the market, Twisted Tea maintains a substantial market share in its category. Overall, while our consumers and brands are not completely immune to price changes, we don't anticipate a significant volume impact from passing on some of our costs. We are not increasing our prices as much as our costs, and we believe this will not hinder volume growth; it will remain reasonable, and when considering everything else, our price increases will be less than the CPI.

Okay. Thank you very much.

Thank you. There are no further questions at this time. I'll turn it back to Mr. Koch, for some closing remarks.

I just want to say thanks everyone and we will speak next year.

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.