The deadline for Anheuser-Busch InBev (BUD 0.03%) to make a qualifying offer to Craft Brew Alliance (BREW) is fast approaching, but Midwood Capital Management says it's time the craft brewer starts planning to sell itself regardless.

The activist investor says the market is discounting the possibility the megabrewer will actually make an offer, but the acquisition of Dogfish Head Craft Brewery by Boston Beer shows that Craft Brew Alliance has a lot of value that can be realized through a sale.

Bottles of Kona beer

Kona, Craft Brew Alliance's flagship brand. Image source: Kona Brewing.

Close ties

In 2016, Anheuser-Busch looked like it was in the midst of trying to roll up the craft beer industry under its very large umbrella as it made almost a dozen acquisitions of small labels.

During this period, it also struck a new, enhanced contract with Craft Brew Alliance, in which A-B has about a one-third ownership stake. The two brewers agreed to give Craft Brew Alliance access to A-B's breweries for up to 300,000 barrels of beer to improve the operational efficiency of both, while also having A-B support the international distribution of Craft Brew's portfolio of beers.

Craft Brew had recently launched its flagship Kona Brewing brand in Brazil and Mexico, and the deal let Craft Brew remain an independent brewer while also allowing it to be part of A-B's vast wholesaler distribution network. A-B was looking to profit from the growth that both companies envisioned would result from making Craft Brew's beer more widely available.

And a unique clause in the contracts also gave A-B the right to buy out the company. Although there were several possible buy-in points along the way that increased the price A-B would have to pay, there was a drop-dead date of Aug. 23, 2019, where A-B has to either put up or shut up. It has to make a qualifying offer of $24.50 per share by then, or pay Craft Brew Alliance $20 million and still allow the brewer to participate in the distribution deal until 2026.

Premium potential

Midwood Capital saw the growth of Craft Brew's Kona beer, the portfolio of interesting lesser beers, and access to A-B's breweries and wholesaler network as a special situation to invest in. The private investment fund owns approximately 2% of Craft Brew's outstanding stock, making it the seventh largest investor in the brewer, exclusive of A-B's ownership stake.

While there was massive potential for the investment, it didn't quite work out as planned. Although Kona continues to be the star of the portfolio as part of its Kona+ strategy -- which focuses most of its attention on promoting the Kona brand, while lending minimal support to its other labels -- the legacy Redhook and Widmer Brothers brands continue to drag performance lower.

As Midwood outlines in its letter calling for Craft Brew Alliance to put itself up for sale, revenue has only grown 1% annually despite Kona's impressive gains, because of the volume declines suffered by Redhook and Widmer. And even if management is successful in its efforts to hit the high end of its guidance, the company's stock will still be trading at sky-high valuations.

But for all that, the market isn't giving Craft Brew Alliance much credence for its efforts. Midwood's evaluation shows the Kona brand alone is worth the $24.50 A-B would pay. And should it make the qualifying offer, the firm urges management to snatch it up since it represents a 60% premium to where the stock trades today. Yet it also says the market is discounting the probability the megabrewer will make the offer.

Where Boston Beer just bought Dogfish Head Brewery for $300 million, or about $1,000 a barrel and 2.6 times sales, the market values Craft Brew Alliance at $435 a barrel and 1.5 times sales, which Midwood terms "a monumental discount."

If A-B doesn't make the offer, Midwood believes there is significant downside potential to Craft Brew's stock, and it calls on the brewer to begin making plans to sell itself right away, whether it's to A-B or someone else.

Prepare for the worst

Of course, even if Anheuser-Busch does make an offer, it would have to be approved by the Justice Department. When the megabrewer bought SABMiller, it agreed to allow trade regulators to pre-approve any smaller acquisitions it made to ensure it wasn't killing competition in the craft beer industry. It's not a sure thing the government will approve a deal.

The Brewers Association says Craft Brew Alliance is the 12th largest brewer in the U.S. by sales volume, but the only breweries really showing growth today are microbreweries producing around 1,350 cases on average. It remains a highly fragmented industry with 7,450 breweries in operation at the end of 2018, but Anheuser-Busch alone controls over 40% of the U.S. beer market.

While Craft Brew Alliance's Kona+ strategy may have some good growth prospects now, Midwood says it's going to cost too much money with no assurance of success. It believes a better choice to maximize shareholder value would be to put itself up for sale and sell to the highest bidder, whether that turns out to be Anheuser-Busch or someone else.