Earnings Call Transcript - SAM Q2 2020

Operator, Operator

Greetings, and welcome to the Boston Beer Company Second Quarter 2020 Earnings Call. At this time, all participants will be in listen-only mode. A question-and-answer session will follow the formal presentation. Please note that this conference is being recorded. At this time, we’ll turn the conference over to Mr. Jim Koch. Mr. Koch, you may begin.

Jim Koch, Founder and Chairman

Thank you. Good afternoon, and welcome. This is Jim Koch, Founder and Chairman, and I'm pleased to kick off the 2020 second quarter earnings call for the Boston Beer Company. Joining the call from Boston Beer are Dave Burwick, our CEO, and Frank Smalla, our CFO. I'll begin my remarks this afternoon with a few introductory comments, including some discussion on the COVID-19 pandemic and the highlights of our result, and then hand over to Dave who will provide an overview of our business. Dave will then turn the call over to Frank, who will focus on the financial details of our second quarter results, as well as a review of our outlook for 2020. Immediately following Frank's comments, we'll open the line up for questions. As our world continues to grapple with this COVID-19 pandemic, our primary focus at Boston Beer Company continues to be on operating our breweries and our overall business safely and supporting our partners in the beer industry. Supporting the communities in which we work and live is one of our core values, and we're very happy that our Samuel Adams Restaurant Strong Fund has raised over $5.4 million so far to support bar and restaurant workers who are experiencing hardship in the wake of COVID-19. Working with the Greg Hill Foundation, this fund is committed to distributing 100% of its proceeds to grants to bar and restaurant workers across the country. While doing this, we also achieved depletions growth of 46% in the second quarter, of which 42% is from Boston Beer legacy brands and 4% is from the addition of the Dogfish Head brands. I am tremendously thankful for the effort of our coworkers in achieving our ninth consecutive quarter of double-digit growth, while maintaining a focus on quality and innovation. We are also thankful to our outstanding distributors and retailers for their focus during COVID-19. Our business in the second quarter was strong, but uncertainties due to COVID-19 do remain. These uncertainties include our ability to continue to operate our breweries at a level of safety that meets our standards, the continued ability to distribute to off-premise retail locations, and the timing of the reopening of on-premise retail locations. We will continue to work hard through the COVID-19 pandemic and prioritize safety above all else. I am proud of the passion, creativity, and commitment to community that our company and coworkers have demonstrated during this pandemic. We remain positive about the future growth of our brands and are happy that our diversified brand portfolio continues to fuel double-digit growth. I will now pass over to Dave for a more detailed overview of our business.

Dave Burwick, CEO

Okay. So, thanks, Jim, and hello everyone. Before I review our business results, I'll start with the usual disclaimer. As we've stated in our earnings release, some of the information we discussed and that may come up on this call looks like 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 the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those of 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 forward-looking statements whether as a result of new information, future events, or otherwise. Okay, now let me share a deeper look at our business performance. Our depletions growth in the second quarter was a result of increases in our Truly Hard Seltzer and Twisted Tea brands, and the addition of the Dogfish Head brands that were only partially offset by decreases in our Samuel Adams and Angry Orchard brands. The growth of the Truly brand, led by Truly Hard Lemonade, has accelerated and continues to grow beyond our expectations. Since early January, Truly has significantly grown its velocity and has sequentially grown its market share, while many other hard seltzer brands have entered the category. Truly is the only hard seltzer not introduced earlier this year to grow its share during 2020, and we will continue to invest heavily in the Truly brand and further improve our position in the hard seltzer category as competition continues to increase. We're excited about our new Truly advertising campaign that showcases colors, variety, and joy to hard seltzer drinkers through four different ads. Because we delayed the premiere of this campaign to June, given the consumer environment surrounding COVID-19, it's too early to know if it will resonate with drinkers. Twisted Tea continues to generate double-digit volume growth rates that are well above full year 2019 trends. We expect to increase our brand investments in the second half compared to the first half, and see significant distribution and volume growth opportunities for our Truly, Twisted Tea, and Dogfish Head brands. Samuel Adams and Angry Orchard’s volumes continue to decline as they are more deeply impacted by the effect of COVID-19 on on-premise retailers. We're encouraged, however, that Samuel Adams Boston Lager and Angry Orchard Crisp Apple both have experienced double-digit growth in the measured off-premise channels during the quarter. We continue to work on returning these brands to growth, but don't expect them to grow during 2020 because of on-premise closures. I'm pleased that overall business has shown great momentum and depletion improvements during the first half of the year. Given our trends for the first half and our current view of the remainder of the year, we've adjusted our expectations for higher 2020 full-year earnings, depletions, and shipment growth, which is primarily driven by the strong performance of our Truly and Twisted Tea brands. We've adjusted our business to the COVID-19 environment and continue to work to control what we can control, with our primary focus being the safety of our coworkers, distributors, retailers, and drinkers. We have deployed many safety protocols across our business and at our breweries, including entrance screening and temperature checks, face mask requirements, reorganized work spacing to increase physical distancing between and among shifts, and adding more cleaning and sanitation time to each shift. We are slowly reopening our hospitality locations, which were closed since March, with a focus on outdoor service and takeout. Our accelerated depletions growth has been challenging operationally. We have been experiencing out-of-stocks, and we expect wholesaler inventories to remain very tight for the rest of the summer. We’ve been operating at capacity for many months and have further increased our usage of third-party breweries in response to the growth. In particular, the additional Truly volumes have come at a higher incremental cost due to an increased usage of third-party breweries, which is negatively impacting our gross margin expectation for the year. We’re investing significantly in our supply chain but do not expect these pressures to be relieved in the second half of the year. We’ll continue to invest to increase capacity as appropriate to meet the needs of our business and take full advantage of the fast-growing hard seltzer category. We're in a very competitive business, but we are optimistic for continued growth of our current brand portfolio. We remain prepared to forsake short-term earnings as we invest to sustain long-term profitable growth in line with the opportunities that we see. Based on information in hand, year-to-date depletions reported to the company through the 28 weeks ended July 11, 2020, are estimated to have increased approximately 42% from the comparable weeks in 2019, excluding the Dogfish Head impact, depletions increased 37%. Now I'm going to head over to Frank who will provide the financial details.

Frank Smalla, CFO

Thank you, Jim and Dave. Good afternoon, everyone. For the second quarter, we reported net income of $60.1 million, an increase of $32.3 million or 116% from the second quarter of 2019. Earnings per diluted share was $4.88, an increase of $2.52 per diluted share from the second quarter of 2019. This increase was primarily due to increased revenue, driven by shipment growth of 39.8%, partially offset by lower gross margins and higher operating expenses. We began seeing the impact of the COVID-19 pandemic on our business in early March. Today, the direct financial impact of the pandemic has primarily shown and significantly reduced demand from the on-premise panel and higher labor and safety-related costs at our breweries. In the first half of 2020, we recorded COVID-19 pre-tax related reductions in net revenue and increases in other costs totaling $14.1 million, of which $10 million was recorded in the first quarter and $4.1 million was recorded in the second quarter. The total amount consists of a $5.8 million reduction in net revenue for our estimated keg returns from distributor to retailers and $8.3 million of other COVID-19 related direct costs, of which $5.6 million are recorded in cost of goods sold and $2.7 million are recorded in operating expenses. In addition to these direct financial impacts, COVID-19 related safety measures resulted in a reduction of brewery productivity. This has shifted more volume to third-party breweries, which increased production costs and negatively impacted gross margins. In April 2020, we withdrew full year fiscal 2020 financial guidance due to uncertainties around COVID-19. Despite the continued uncertainties related to the COVID-19 pandemic, we've seen that our business outlook has stabilized and that it is now appropriate to give full year fiscal 2020 financial guidance. We will continue to assess and manage this situation and will provide a further update in our third quarter earnings release, to the extent that the effect of the COVID-19 pandemic is then known more clearly. Shipment volume was approximately 1.9 million barrels, a 39.8% increase from the second quarter of 2019. Excluding the addition of the Dogfish Head brand beginning July 3, 2019, shipments increased 35.3%. We believe distributor inventory as of June 27, 2020, averaged approximately 2.5 weeks on hand and was lower than prior year levels due to supply chain capacity constraints. We expect wholesaler inventory levels in terms of weeks on hand to remain lower than prior year levels for the remainder of the year. Our second quarter 2020 gross margin of 46.4% decreased from the 49.9% margin realized in the second quarter of 2019, primarily as a result of higher processing costs due to increased production at third-party breweries, partially offset by price increases and cost-saving initiatives at company-owned breweries. Second quarter advertising, promotional, and selling expenses increased by $6.3 million from the second quarter of 2019, primarily due to increases in salaries and benefits costs, increased brand investments in media and production, the addition of Dogfish Head brand-related expenses beginning July 3, 2019, and increased freight to distributors due to higher volumes, partially offset by decreased investments in local marketing and national promotions due to timing of these costs compared to the prior year. General and administrative expenses increased by $2.9 million from the second quarter of 2019, primarily due to increases in salaries and benefits costs and the addition of Dogfish Head general and administrative expenses beginning July 3, 2019, partially offset by the non-recurrence of $1.5 million in Dogfish Head transaction-related fees incurred in the second quarter of 2019. Based on information on which we're currently aware, we are now targeting full year 2020 earnings per diluted share between $11.70 and $12.70. However, actual results could vary significantly from this target. This prediction excludes the impact of ASU 2016-09. Full year 2020 depletions growth, including Dogfish Head, is now estimated to be between 27% and 35%, of which between 1% and 2% is due to the addition of the Dogfish Head brand. We project increases in revenue per barrel of between 1% and 2%. Full year 2020 gross margins are expected to be between 46% and 48%. We plan to increase investments in advertising, promotion, and selling expenses of between $70 million and $80 million for the full year 2020. This does not include any increases in freight costs for the shipment of products to our distributors. We estimate our full year 2020 non-GAAP effective tax rate to be approximately 26%, which excludes the impact of ASU 2016-09. We're continuing to value 2020 capital expenditures and currently estimate investments of between $180 million and $200 million. The capital will be spent mostly on continued investments in our breweries, and it could be higher if deemed necessary to meet future growth. We expect that our cash balance of $86.7 million as of June 27, 2020, along with our future operating cash flow and unused line of credit of $150 million will be sufficient to fund future cash requirements. We will now open up the call for questions. Before we do that though, I would like to remind everybody that we're still in different locations due to COVID-19. Hence, Dave will act as an emcee again, when we address any questions similar to how we did it in our last earnings call in April.

Operator, Operator

Thank you. Our first question is from the line of Bonnie Herzog with Goldman Sachs.

Bonnie Herzog, Analyst

I wanted to drill down on the impressive growth that we're seeing for this category, which has been unbelievable. So I kind of would like to hear a little bit more from all of you about what gives you the confidence that this can really continue, especially as more bars and restaurants open. How do you think about that? And then it may help all of us understand how you guys are thinking about the barriers to entry for the category, since it seems like the category is obviously attracting a lot of new entrants. I just want to hear your thoughts on how big of a risk you see this as more and more companies and/or brands enter, especially maybe from non-beer companies. Thoughts on that? Thanks.

Dave Burwick, CEO

I will begin and then open it up for others to contribute. We are very confident, and Bonnie, I assume you are mainly referring to the hard seltzer category. This year, we anticipate growth around 150%, which would account for about 8% of total beer volume, a small portion of the beer market. We believe there are several reasons for our confidence, starting with consumer trends that we've previously discussed. We identify three significant trends in the broader beer market that directly impact seltzers: health and wellness, the demand for diverse flavors, and the exploration of new flavor brands along with premiumization. These trends are quite strong. Regarding sourcing, over half of the volume still comes from wine and spirits, and recently about 50% is sourced from there. This category is more accessible than beer for consumers. We also recognize there is considerable potential for growth in shelf space, as hard seltzers remain significantly underrepresented across various channels. There are additional opportunities in convenience stores, gas stations, and on-premise locations where we can further develop our brands. According to Nielsen, approximately 90% of hard seltzer drinkers view it as distinct from beer, seeing it as a unique beverage. This is advantageous for brands that are not exactly positioned as beer but are tailored for this category. Previously, we noted that the top two players in this space hold about 70% to 80% of the market share, and we compared this to the energy drink sector to illustrate potential consolidation due to well-marketed legacy brands that innovate effectively and invest in brand retention. With our recent reformulation efforts and heightened advertising for Truly Hard Lemonade, we have gained 5 market share points, moving from 28 to a closer position of 21 points, reducing the gap to 15 points. This solid progress contributes to our confidence.

Bonnie Herzog, Analyst

And just to clarify something that you just mentioned in terms of innovation, because obviously a lot of that has been driving the growth of the category. Should we assume there’s more to come from you this year in terms of your pipeline of innovation, is that what's contributing to some of the conviction that you have for the category growth continuing or your business continuing?

Dave Burwick, CEO

If I look at the next two or three years, we see innovation coming in a continuous stream. I mean, we’ll determine how we space it out. So I think it's really important not to, when you innovate, sometimes there’s an assumption that just innovating and putting a brand out there means you're building a brand, but innovation and brand strength are not necessarily the same thing. We want to make sure we're building something that’s strong that can last. We think the lemonade has been terrific for us and the repeat purchase rates are actually very high, which are 50% higher than all the other new products that were launched this year. The velocity is also very high, and we think it is providing a differentiated experience within the category. So whilst we’re going to keep supporting that aggressively, there will be other ideas for innovation that will come behind that, that we think also can kind of spark interest and excitement in the category.

Bonnie Herzog, Analyst

If I can squeeze one more in. I really want to talk to you guys also about the industry-wide can shortages that have been going on right now. I just want to get from you how big of an issue or concern it's been and really how material it's been. I guess my assumption is that your main competitor has been more negatively impacted by the out-of-stock situation. Is that helping to contribute to some of the recent share gains that you've been experiencing, and how sustainable is that? Thanks.

Frank Smalla, CFO

Yes, Bonnie, this is Frank. I mean, it's pretty clear and well-known in the industry that there's a real can shortage in the U.S., which is spanning basically all beverage suppliers and manufacturers. So far, we've been working well with our suppliers. I think we've also benefited from the fact that we had pre-built can inventory for Truly and for Tea, as you know. But we've also pre-built can inventory, because we wanted to be prepared for the volume growth. We're running out of that now. Going forward, we believe the impact will not be that dramatic, but it's hard to say because of all the COVID impact that’s coming on top of the explosive growth that you see across the different categories; it’s really hard to predict. So far, we might have some tightness, but we hope that with everything that we have pre-built, we can manage through that.

Dave Burwick, CEO

And just to add to the last part of your question, Bonnie, about the share gains. I think there's a number of things that play into that. One is complete reformulation. If you look at our velocity, it’s from the timing of reformulating and went from growing 30% to 40%, sales per point, to over 100% for the last four months. So that's part of it. Lemonade certainly has been a great performer for us. To be fair and honest, I think we've been a bit more fortunate to have fewer out-of-stocks, and I think that’s part of what we've also seen happen as well.

Operator, Operator

Our next question is from the line of Vivien Azer with Cowen. Please proceed with your question.

Vivien Azer, Analyst

I was hoping to dive a little bit deeper into your thinking around A&P spend please. Clearly, it came down a lot in the quarter and not at the expense of your top-line. While you’ve noted select incremental investment spending, your overall guidance seems to come down a little bit relative to your pre-COVID guidance. You've also called out some timing changes, reducing ad spend in June. Frank, I think you noted as well in your prepared remarks. So I’m just trying to understand if we think about the outlook for A&P, like how much of what we saw in the second quarter was just the timing that you've alluded to specifically versus some structural changes that really reflect the benefit of some brand mix shift in your portfolio? Thank you.

Frank Smalla, CFO

We're not really changing much of the spend as we indicated when we first gave you guidance in February. What has happened is the phasing is very different from last year. When we came out, we had a significant increase in the first quarter because we wanted to start the year strong. We knew there were new competitive entrants, and we wanted to ensure that we were out there at the beginning. So if you look at Q1, there was quite a bit of an increase. Q2 is a combination, we were flat essentially, a slight increase but largely flat. This is a combination of planned adjustments but also partly reduced due to the events surrounding COVID and the social discussions that were happening in the country. So we adjusted our spend a little bit on that. We will definitely spend more in the second half of the quarter. Within that, you should expect the higher increase in the fourth quarter, because we also have to manage our product supply. So if you look at the growth rate in A&P spend, the second half of the year the growth rate will be twice as high as the growth rate that we have in the first half of the year.

Vivien Azer, Analyst

If I can just follow-up. You’re clearly referencing A&P dollars and that makes a ton of sense, particularly given the pre-commitments that you have to make around that kind of spend. But when I think about SAM historically, your A&P as a percentage of sales has been considerably higher than your peer group. The 22% change that you recorded this quarter is the lowest that I can recall in many years I’ve been covering the company. So just to put the question back to you, do you think that dollars is the right way to think about it now? It seems to have been tracking as a percentage of sales. But again, because Truly is so much more important and maybe you get more halo, in particular because both lemonade and the base business complement each other on a spend basis. Has there been a philosophical change? Thanks for indulging that, that’s a lot...

Dave Burwick, CEO

There hasn't been a philosophical change. When you look at that kind of revenue at the end of the day, we spend what we feel is the right thing to spend. And when you go back, I think you see quite a variability in spending in absolute terms, but also in terms of net revenue. The way we think about it is if you have something in our hands that we really want to push it, we look for the long term. We will build the brand for the long term and we're not trying to optimize the quarter, we’re trying to optimize the year. We feel fairly comfortable with the significant increase in spend that we have this year. It has to be effective, and that's important to us. We don't just want to spend to hit a certain ratio. We want to spend the money and get something back. We feel fairly confident that we do that, and that's also what we’re increasing in the back half of the year. We have strong growth with not a significant increase this year. So far that was slightly planned differently, as I've explained before. But again, it's more guided by the needs of the business and hitting a particular ratio.

Operator, Operator

Thank you. The next question comes from the line of Kevin Grundy with Jefferies.

Kevin Grundy, Analyst

A question perhaps for David, just on the guidance. Depletions, obviously outstanding in the first half of the year, north of 40%, including some contribution from Dogfish Head. The guidance implies a deceleration down to 15% to 30% in the back half of the year. Understanding the comps get tougher, and understanding there’s some contribution from Dogfish in the first half of the year. Can you just kind of box in for us a little bit some of the assumptions around the high end and the low end of guidance? I think I heard you say, I could be mistaken, 150% sales or category growth, that's kind of down the fairway. Is that what you're expecting to finish this year, assuming Truly holds the line on market share perspective from here? So just some commentary on the guidance? And then I have a follow-up. Thanks.

Dave Burwick, CEO

On 150, that's our best guess for the category, and actually, we’ll hold growth and continue to grow share. I'll let Frank answer how we get to that range and what the assumptions were.

Frank Smalla, CFO

One thing is if you look at year-to-date and you see the depletions at plus 40%, and then the guidance is lower, it's clear. One is the high end of guidance we're not concerned about the demand, the demand is there. The constraint is around the capacity. The category has grown much stronger than we expected. Again, it has outpaced the capacity that we've put in, and we keep on running out of capacity. If you don't have any capacity constraints, we will end up at the upper end of the range. It's hard to say what's going to happen to the supply chain and when I say supply chain, I mean to broader supply chain that we depend on. We have a pretty good handle on our supply chain, but we don’t know what's going to happen there. They have different states. There’s like supply constraints potentially on our suppliers. We talked about cans, but that's pretty much true for our materials. You might not have structural tightness, but if COVID hits the supply chain and things become tight. If we hit that, then we’re going to get to the low end of the range. The other thing is Dogfish Head clearly contributed in the first half of the year whereas in the second half of the year we are comparing to the six months that had Dogfish Head included last year, and there is a certain impact. Additionally, we pre-built inventory for Truly and for Twisted Tea in the first half to get through the season and normally, that inventory piece last into the third quarter, but we don't have the same question anymore. We're pretty much hand to mouth at the moment as we speak, and the other key factors contribute to the range that we have.

Kevin Grundy, Analyst

I wanted to maybe for Jim and Dave on the on-premise channel, talk a little bit about what you've seen and then from a demand perspective, how that progressed as you move through the quarter and maybe even currently what you're seeing in July. And then just to follow up on-premise related question, Bonnie mentioned earlier, the unique dynamic of course with sell-through really doesn’t have any presence to speak of in the on-premise channel. Is there any rethink to that? Do you see that changing? This is true for both you and for Mark Anthony brands as well, which really haven't been a push. Is there any rethink to that as the channel recovers? Do you think you will see some demand impact on seltzers as consumers return to that channel, just given the lack of availability and presence, if you will, of hard seltzers at this point? Thanks for all that.

Jim Koch, Founder and Chairman

We've seen an evolution of the on-premise. In March and through April it basically just disappeared. During that period, we took back as much beer as we sold. Essentially, it was kind of zero. It has recovered somewhat, but not even half of what it used to be, and it's just faltering as you've seen the new shutdowns, and even when bars and restaurants are open, people aren't going to them. So, the on-premise remains very weak for us and we anticipate that may not change in the next few months. After that, we'll just have to see. In terms of the second part of your question, we see a much bigger opportunity for hard seltzer on-premise than has been realized yet. We were expecting this summer to be a time when there would be a lot of penetration that we didn't have last summer into the on-premise due to the natural trend of people consuming on patios and outside. But even with the places that have opened their outdoor seating, it's still distanced and it's a fraction of what it used to be, and putting a new product in is not high on their list. So, I think it's going to be the summer of 2021 when we see significant penetration of hard seltzer. I expect it will get to the point where you walk into a bar or a restaurant and type of expect them to have some hard seltzer, probably either Truly or White Claw. So I do think there's decent upside for seltzers on-premise but probably not in the next six to nine months.

Operator, Operator

The next question is from the line of Eric Serotta with Evercore.

Eric Serotta, Analyst

I’m hoping you could delve in a little bit more into the shelf space opportunity. Our understanding is that the spring shelf resets didn't occur as would be expected due to COVID. Just wondering how you see the shelf resets playing out in the fall or whether you think it's more of a 2021 event? Then I’ll have a quick follow-up for you.

Dave Burwick, CEO

I think you're right, a lot of innovation didn't get out there this spring for obvious reasons. We're hearing feedback that for the most part, the shelf resets are going to occur in 2021. A whole generation of innovation may have been put on hold because of this. Within the category, there is still a lot of opportunity for hard seltzer; as you know, it's under-spaced across channels and we're expecting more space being allocated to hard seltzer in 2021.

Eric Serotta, Analyst

And then Jim and Dave, a follow-up for you. Last year in the fourth quarter, towards the end of the year, you started to communicate what was a very deliberate plan, which played out very well for you guys to manage through and that came out on top of the hard seltzer competitive onslaught that happened earlier this year. I'm wondering if there is a similar type of plan as you look to the first half of '21 or even second half of this year as White Claw ramps up its capacity? Just wondering sort of how you're thinking about the next 12 months and if there's anything you could share with us today or if we should stay tuned for the fall or if this is more of a, we'll be talking about this this time next year?

Dave Burwick, CEO

I think the way I look at it is we're still for your last question, Eric. We still haven't fully realized the potential, for example, Truly Lemonade didn't get to our shelves because of COVID. We're seeing a lot of progress there in terms of Q2 versus Q1; we're seeing penetration growth actually more than double. The repeat has also increased to about a third, but there's still a long way to go there. Also, because we've just reformulated our flavors for the base Truly brand. There’s still lots of opportunity and we feel good about the trajectory but we don't have anything to share today; maybe in our next call we'll be able to share more information.

Operator, Operator

The next question is from the line of Nik Modi with RBC Capital Markets. Please proceed with your question.

Nik Modi, Analyst

Two questions from my end. One is just on innovation. I know the retail landscape has been changing and what they take onto the shelf has been changing. So, I just wanted to get your state of the union on what you're seeing from retailer behavior in terms of accepting new products. That's the first point. And then the second one is, I guess, the million-dollar question, or I don't know, maybe it's more than a million dollars, I'm sure it's more than a million dollars, is when gross margins are going to start growing or expanding again. I mean it's clear this category surprised everyone but I think at this point, maybe it's not so much of a surprise on what potential could be. So, maybe you could give us your longer-term vision on how you think about the category growth rate, capital spending, and when maybe we can expect gross margins to start expanding again?

Dave Burwick, CEO

I'll take the first part of that and I'll hand the gross margin part over to Frank. I think looking out for the fall, very little innovation is going to get into the marketplace across the board. Retailers are focusing on fewer new things. They like our current lineup, which is basically fewer SKUs being more productive. It's going to be an important time to continue to strengthen core brands. A lot of legacy brands have seen penetration and repeat growth; it's been an interesting trend. So it is to be determined, and we’re preparing for any alternative. We have lots of innovation for next year, but we haven't determined what we’re going to launch. For now, we’re focused on maintaining balance.

Frank Smalla, CFO

So Nik, clearly, if you look at gross margin, it's not where we wanted to be very clearly. We wanted it much higher. I'm not particularly happy about it, but I'm not concerned because the reasons are known. The key reasons are that we have significantly higher growth than what we had expected. We are servicing the demand as best as we can at any cost to build the brand and category. The additional cases that we produce, they're external production, they come at a higher cost, but we're happy to do that because it stabilizes what we get to a better cost structure. The second point is that we're impacted by COVID too. A large chunk of our costs due to COVID is reflected in the gross margin line, and if you look at Q1 versus Q2, we see some slight improvement, and we expect the guidance will improve as well. Our expectation is that when we get a better handle on growth and can plan better, the margins should improve over time. We have clear plans on how to address that and will seek improvements as we go.

Operator, Operator

The next question is from the line of Laurent Grandet with Guggenheim. Please proceed with your questions.

Laurent Grandet, Analyst

Jim, even in your best dreams three or four years ago, you couldn't think of a quarter where depletion numbers could approach 40%. Okay, getting a bit more into the innovation. One of the reasons for Truly's success this year can be attributed to the Lemonade line extension. What have you learned, Dave, from this line extension that can help you further develop the Truly franchise going forward specifically around differentiation? And what about the tests you are doing in New York? I think these are Truly with a higher ABV.

Dave Burwick, CEO

As it relates to Lemonade, we learned that there's certain expectations of what a hard seltzer can be, generally 100 calories or fewer and limited sugar/carb content. It must taste good and refreshing. We’ve realized people want variety in flavor, and this was a key component of our strategy. People seem to appreciate diversity, and that helps create a connection not just with normal hard seltzer, but an extension as we've done with Lemonade. So this extension has hit on the flavor profile for the space, and it serves as a good indicator of what consumers are looking for. As for the higher ABV tests in New York, this is something we are exploring and will take a closer look at as that could be one way to differentiate ourselves further in this space.

Laurent Grandet, Analyst

I believe a bit of this is coming from the fact that you are unique in the Lemonade in that space. So, along that line, is the test you are doing in New York with higher ABV kind of the way to differentiate yourself from the space or what's the goal here?

Dave Burwick, CEO

One thing I mentioned is that the base level for hard seltzers is about 5% ABV; that’s somewhat standard. White Claw is also testing their product Surge; ours is called Edge, and we're looking at that as a possibility. The experience might be more about the flavor than the ABV, but everyone is currently exploring ways to create a differentiated experience in the hard seltzer space. I should point out that Truly Lemonade is performing very well, larger than Mike's now. It addresses the needs of hard seltzer drinkers right now. There's a lot of opportunity for further engagement with consumers looking for depth and variety in the seltzer market.

Laurent Grandet, Analyst

Thanks, Dave. One more for me if I may. At the beginning of the year, there was talk of having a more balanced male and female consumer base, attracting new male consumers into the franchise. Could you please update us on that progress and where should be the right balance for the brand?

Dave Burwick, CEO

We are making progress. If you look at it, we're still slightly more skewed female than, say, White Claw is, but not as much compared to before. We changed the pack design to be more balanced, and we actually have another one in market now that's aimed toward that balance. Volume-wise, over 50% of the volume is consumed by men because they drink more than women, but we have been able to close that gap significantly from when we started. Our focus has been to target women directly, but we continue to evolve to see more gender neutrality in our consumer base moving forward.

Operator, Operator

Next question is from the line of Wendy Nicholson with Citigroup.

Wendy Nicholson, Analyst

My two questions are, number one, have you developed any more plans about potential UK launch or expanding further into Europe? It just doesn't seem, to me, why that wouldn't be a priority, although I know you're doing the best you can to meet the demands in the U.S. But it still seems like Europe could be a great opportunity down the road. My second question, just going back to Lemonade, have you seen a different demographic for that specifically relative to core Truly, or do you think it's existing Truly consumers just switching over to the stronger flavor profile? Thanks.

Dave Burwick, CEO

Wendy, I'll do the second, and maybe Jim can do the first part of that question. On the second part, just on the Lemonade, we are seeing the difference. If you look across all the brands, the major brands in the category, Lemonade is indeed younger than any other brand in hard seltzer. It’s definitely younger than the base Truly business, younger than White Claw, younger than any other brand in hard seltzer, and it's bringing more new drinkers into the beer category, which is great to see. In terms of international, Jim's got a long-standing point of view about our global business level. I'll let Jim talk about that one.

Jim Koch, Founder and Chairman

Wendy, I would say that as a company, we are not particularly internationally focused. We are very focused on the United States. We've succeeded in many cases just by the strength of our sales force and our distributors, and that's challenging to duplicate globally. In the U.S., we have about 500 salespeople, so we're very grassroots intensive. We do have an importer in the EU, with a long-standing brewing relationship, but we have spent very little time or effort on international expansion. We are very focused on the United States because that’s what we know well, and that’s kind of what we're good at. We have had some success with Truly in Canada, having recently launched it there this year, and it's doing pretty well, so Canada is a comfortable market for us. Outside of that, we’re not prioritizing international expansion at this time.

Wendy Nicholson, Analyst

Well, you've got enough growth in the U.S., so that's fine by me. But if I can squeeze in one more, I remember last year, particularly last summer, part of what you were talking about vis-à-vis the gross margin pressure was the fact that so much of seltzer was sold in variety packs. That made a lot of sense 12, 18 months ago when people wanted to try the product, but I'm just wondering, as the business grows and people become more loyal and say, I really like this flavor but not so much that flavor, are you seeing a shift in the business to more of the single-flavor packs or cases? I would think that would alleviate some of the gross margin pressure, but maybe I'm off on that. Thanks.

Frank Smalla, CFO

I think still we see a large majority, call it 75% or so, of our business is through variety packs. Consumers still tell us they enjoy that. They like the experimentations among different flavors. It doesn't mean that that won't change over time, and we're sort of looking at that. There are all these players that have single-flavor options out there, as do we, but currently the consumers seem to prefer a variety pack. We have been convinced that this is a better way to go, but we could also adjust if the opportunity arises. Regarding the gross margin, it was an issue a year ago, but we have made progress and continue to work on our efficiency. Going forward, that margin challenge shouldn’t be as significant as it was before.

Dave Burwick, CEO

I think the second part of the question is that we started the whole business; variety packs were something small but profitable. As volume has grown, we have significantly improved our volume capacity and efficiency on variety pack lines, and that part of our operation has automated. So, we are getting better at that, and we still have some runway left in terms of opportunities to enhance margins. A few changes we can implement should lead to better margins in the future.

Operator, Operator

Thank you. The next question is from the line of Steven Powers with Deutsche Bank.

Steven Powers, Analyst

I guess just given the challenges you've talked about of meeting existing demand, as well as the potential unlock of future gross margin, could you talk a bit more about the anticipated pacing of the new capacity you referred to coming online, particularly any of your own new capacity and Truly looking out over the next, say, 12, 18 months?

Jim Koch, Founder and Chairman

Right now, we're trying to get it up and running as quickly as we can. Since the last earnings call, we have added basically 1.5 can lines. Next month or in September, we'll add another half. That will help us in the back half of this year. We think that the current supply constraints and the basically retailer out of stocks will continue through the summer. But post-Labor Day, the hand-to-mouth existence, we'll be able to rebuild wholesaler's inventories and start building again a significant pre-build for 2021. We're adding a second can line in Cincinnati at the end of Q2, beginning of Q3 next year. We signed up additional contract capacity, aiming to double our capacity a year from now.

Steven Powers, Analyst

And I guess that alleviates any potential pressure on just your ability to introduce new flavors or pursue the on-premise opportunity next summer that you talked about. It sounds like you've got line of sight there.

Jim Koch, Founder and Chairman

We think so, though we desperately hope that we will oversell all that and have another hand-to-mouth summer next year with double the volume.

Steven Powers, Analyst

And I guess just one last question, if I could. You spoke a bit to A&P plans in response to Vivien's earlier question, but if we think about the scalability, maybe for Frank, of selling cost and of G&A, clearly a lot of leverage this quarter. I guess, as I look forward, how do you think about the scalability of those line items into the future versus the need to ramp those costs up to support a bigger business going forward?

Frank Smalla, CFO

So, Steve, I can’t give you exact numbers, but clearly from the high growth that we are experiencing, there are levers in the P&L, and we had that. If we continue to grow, we will see leverage. It’s hard to predict milestones because we are always focused on long-term value creation. So yes, you'll see leverage over time. You’ve seen it this quarter, and I think you'll see it for the full year. As we continue to grow, they will have leverage, but the extent really depends on our growth strategy and we will invest to support the business.

Dave Burwick, CEO

Philosophically, we've always prioritized growth over profitability, even recognizing that in the beer business, growth can be expensive. We see no reason to change that philosophy. We believe growth is an essential component of value, and when there are opportunities like this to grow 40%, we're going to spend to maintain the highest growth rates possible for as long as we can.

Operator, Operator

Thank you. The next question comes from Kevin Grundy with Jefferies.

Kevin Grundy, Analyst

Frank, I just wanted to follow up, building on Steve's question, the shape of the P&L and then Nik's question earlier on gross margin. Can you help us think about it structurally? If you go back a decade ago with a 55% gross margin business skewed largely to beer at that point, now beer becomes much less, cider becomes, flavored malt beverages increasingly higher. Where should this business be if you set aside some of the rapid growth and volatility it is seeing now? If I think about a four to five-year horizon, should this be a 55% gross margin business? Should it be closer to some of the targets more recently in the 51% to 53% range? Can you help us think about that a little bit even on a longer-term basis? I think that'd be helpful.

Dave Burwick, CEO

I was here 10 years ago, and clearly, I know the gross margins then were very different. It was a much simpler portfolio and we had a different balance between demand and capacity that we have now. We aim to stabilize and get our costs down and get back to at least the mid-50s percentages as we stabilize and grow. I don't have a target of being exactly 55%, but we definitely want to be in the 50s as we optimize our operations.

Operator, Operator

Thank you. At this time, I'll turn the floor back to Mr. Koch for closing remarks.

Jim Koch, Founder and Chairman

Thank you, and thanks to everybody for being on the call. It was certainly an exciting quarter with impressive growth alongside many changes to accommodate this pandemic. I'm grateful to the many people who helped us get through this with creativity and flexibility, from our coworkers to our wholesalers to retailers, and of course, to our can suppliers. We look forward to continuing our winning streak in a few months, and hopefully, we can talk to you then. Thank you.

Operator, Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.