The Danger of Betting Against This Beer Company

It's difficult to call Craft Brew Alliance (NASDAQ: BREW  ) cheap. Not only is the stock up 162% in the past 12 months alone, but its P/E ratio is at nosebleed heights compared with rivals such as Anheuser-Busch InBev (NYSE: BUD  ) , Molson Coors (NYSE: TAP  ) , and Boston Beer (NYSE: SAM  ) . Despite appearing to be a risky investment to be long on, betting against Craft Brew Alliance or going short on it could prove to be even more dangerous.

Craft Brew Alliance's earnings
Last quarter, Craft Brew Alliance reported diluted earnings per share of $0.10, double its figure last year. Sales were up a more modest 10.7%, but the company is seeing record growth and believes it has many new markets to expand into. According to the company, the No. 1 bottleneck for Craft Brew Alliance has been production constraints, rather than demand, for which it is ramping up and expects to alleviate.

CEO Terry Michaelson is confident about the future. He stated, "As we look ahead, we remain committed to continue driving strong sales and profit growth." Certainly this means that the $0.10 in EPS should be expected to grow, and it could potentially grow significantly. Analysts are calling for $0.27 in EPS for 2014, or 80% growth over 2013 expectations. Still, with a stock price over $16 that puts the P/E near 60. It's hard to call that cheap, even with 80% growth behind it.

Comparison with other brewers
Based on analyst estimates, Anheuser-Busch InBev has a forward P/E under 19. Molson Coors has a forward P/E of around 13. Even Boston Beer with its hyper growth only has a forward P/E in the mid-30's, still nearly half that of Craft Brew Alliance. Boston Beer, just like Craft Brew Alliance, is more constrained by production as it is seeing unprecedented demand.

Investors in Boston Beer don't have to invest just based on speculation. The company has trailing 12-month earnings of $5.21 per share which puts the trailing P/E in the mid-40's. Even if you annualize Craft Brew Alliance's record results last quarter during a seasonally advantageous period for the beer industry, you're still looking at a trailing P/E in line with Boston Beer. Meanwhile, analysts expect EPS for the current quarter to drop to $0.05, down from the $0.10 reported last quarter.

So why is it dangerous to bet against Craft Brew Alliance?
The danger comes from the risk of a buyout. Craft Brew Alliance may be overvalued as a stand-alone company, but it may very well be undervalued if bought and owned by one of its larger rivals. Based on analyst expectations for next year, Craft Brew Alliance only trades at 1.5 times sales.

First, compare that ratio to Anheuser-Busch InBev, which trades at 4 times 2014 sales. Part of the reason for that is the higher margin of the company. A higher margin, at least in large part, comes from much larger production and distribution networks that can absorb costs more easily. If Anheuser-Busch InBev were to own Craft Brew Alliance, it's conceivable that it could increase both its sales and profit margin through a higher volume of sales in its distribution network, as well as by consolidating brewing operations. Also, some if not most of the overhead at Craft Brew Alliance could be reduced or eliminated. Some costs are only necessary for a stand-alone company (such as the cost of being publicly traded).

The same holds true for Molson Coors and Boston Beer. While both companies and Anheuser-Busch InBev have higher gross profit margins than Craft Brew Alliance does, the profit margin for the smaller company has been steadily rising as production volume increases. It stands to reason that the margin would continue to expand if it was owned by a larger competitor. Molson Coors trades at around 2.5 times next year's sales. Boston Beer trades at around 3.5 times sales. Any one of these companies could potentially swallow Craft Brew Alliance at a premium to its market cap using shares of their own stock.

Foolish final thoughts
Based on P/E ratio alone Craft Brew Alliance is a risky investment. Plenty of speculation is already priced into the stock, and in order to fundamentally justify a higher valuation the company has to be extremely successful in terms of production, profit margin, and sales. However, those who bet against Craft Brew Alliance may be playing the financial version of Russian roulette and risking a larger rival pulling the trigger and acquiring the company. Cautious Fools should consider sitting this one out as a bearish bet.

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