Redhook's Impending Hangover

Thanks to prior contracts on barley grain, Redhook Ale Brewery (Nasdaq: HOOK  ) has so far been able to avoid much of the recent escalation in barley prices. Since those contracts expired in the second quarter, however, the company's Q2 conference call suggests that investors should expect significantly higher costs in the third quarter and beyond.

Across the industry, barley prices have risen 48% from year-ago levels. Until now, Redhook benefited from existing contracts that locked in barley at lower costs. Through the first half of this fiscal year, that shrewd hedging helped Redhook pay only about 10% more for barley. Expect margins to suffer now that those contracts are history.

Unfortunately for Redhook, the company's margins are already under severe pressure. In the second quarter, gross margin declined 120 basis points, from 18.5% a year ago to the current 17.3%. A substantial increase in sales from lower-margin contract brewing, as opposed to Redhook-branded products, apparently triggered the slide.

Redhook's contract brewing, incidentally, is part of a joint venture with Widmer Brothers Brewing, a company with which Redhook is still mulling a potential merger. The joint venture, Craft Brands Alliance LLC, receives the product from Widmer and Redhook at prices substantially below wholesale, then distributes the product to wholesale on behalf of Anheuser-Busch (NYSE: BUD  ) . Not surprisingly, the home of Budweiser also has equity ownership in both Widmere and Redhook.

Management provided no indication if or when the merger would be completed. Given the complexities of its contract brewing deal, and the multiple parties involved, we can only imagine the various levels of discussion that must take place on a deal like this. We do know that the contract brewing is set to last until the end of the year. Over the next several months, Redhook shareholders can thus expect a double whammy upon the company's gross margins.

If and when the merger goes through, Redhook shareholders can tap a kegger of elation. Meanwhile, they'll most likely endure a hefty headache in the coming months.

Anheuser-Busch is a Motley Fool Inside Value recommendation. Discover more cool, refreshing Wall Street bargains with a free 30-day trial subscription.

Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool's disclosure policy always appoints a designated driver.

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