Craft BrewAlliance (BREW) makes and markets beers under the brand-names Widmer Brothers, Redhook, Kona and Omission. Like a number of other brewers, their business has been growing over the last few years. However, we think the potential for growth hasn’t been fully priced in and see a great entry point for bulls following the soft reaction to their last earnings report on November 6.

In general, small cap stocks have been lagging recently as investors buy blue-chips and fret about the long-term impact of third quarter disruptions. We would attribute BREW’s recent underperformance to systemic issues rather than anything intrinsic in the company’s fundamentals. In fact, BREW’s fundamentals look great and we will try to show that growth has been underestimated.

Margins vs. Growth

BREW’s margins dipped this year as they remodeled properties and distribution expenses increased. This is always a concern but in this case it appears to be a temporary issue. They also continue to lose sales in their legacy Widmer Brothers brand. That is the bad news. The good news is that growth with their distribution partners — including Buffalo Wild Wings  (BWLD) — has a lot of upside.

BWLD also released earnings recently and surprised to the upside. As part of that release the CEO, Sally Smith, made this comment:

“Game Changer, a craft beer brewed by Redhook, also launched in our restaurants on July 15. This beer was developed with guests’ feedback and was made to perfectly pair with wings and sports. The launch of Game Changer exceeded our estimates, and it was in the top 5 selling draft beers in the third quarter in our company-owned restaurants.”

BREW acknowledged that Game Changer was responsible for 25% of the growth in the Redhook brand but still only represented 6% of Redhook volume. While we can’t suggest that BWLD’s growth will drive BREW all by itself, it seems likely that BREW’s recent lag behind BWLD’s breakout will reverse in the short term. You can see a comparison of the two stocks in the next chart.

If BWLD expands to the 1,700 units they are targeting, we have to assume that BREW will be able to capitalize on that growth as they distribute the new beer in and out of the BWLD distribution channel. If nothing else, this is a good excuse to pick up something a little different to enjoy while watching this week’s games.

BREW’s management claims that the decline in margins is temporary but that growth isn’t. However, they didn’t raise their outlook, which is another likely reason for the recent lag. But why wouldn’t management want to capitalize on the good news and push guidance (and their stock) higher following the earnings release? The CEO, Terry Michaelson, had this to say:

“We actually had a lengthy discussion internally as a management group on how to handle guidance going forward. And as you know, we’re still a young company and new with this, and want to make sure that as we go forward, we don’t change guidance up or down in a way that may confuse analysts. You’re right, as you look at some of the areas like STR growth, keeping the low end of the guidance doesn’t make a lot of sense at this point. So what I can tell you is, there’s absolutely no concern at all that we’ll get anywhere near the low end.”

So, was that an upgrade to guidance or not? This is a good example of a little prudent “sandbagging” to keep volatility down. We can’t argue with the strategy but it seems likely that many investors didn’t investigate beyond the headline to see that there really was an informal guidance increase.

The Technicals Point to Additional Upside

All stocks draw down periodically, which presents new entries for bulls. BREW started to pull back with the Russell 2000 on October 30, which was expected. The stock then found trendline support following their earnings report this month. Based on the prior trend we expect an initial short term target following a bounce at the stock’s recent-highs near $18 per share. If momentum continues, we expect prices to hit $20.50, which is the Fibonacci projection level based on the depth of the draw down.

Conclusion

Like any trading opportunity, BREW is not a perfect company. We remain concerned with the erosion of sales in one of its marquee brands and the assumption that margins will improve again isn’t a given. However, we feel that BREW is undervalued due to a temporary disinterest in small-cap stocks. When buyers return, they will be looking for growth and the stock should accelerate to the upside.

Recommendation: Buy BREW at current levels with an initial $18 target and a secondary $20.50 target, but set a stop under trendline support.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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