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Good day, ladies and gentlemen, and welcome to the Quarter Two 2018 Boston Beer Company Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time.
I would now like to turn the conference over to Founder and Chairman, Jim Koch. Sir, you may begin.
Thank you. Good afternoon and welcome to everybody. This is Jim Koch, Founder and Chairman, and I'm pleased to be here to kick off the 2018 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 highlights of our results. Then hand over the microphone to Dave, who'll provide an overview of our business. Dave will then turn the call over to Frank, who'll focus on the financial details for the second quarter, as well as a review of our outlook for 2018. Immediately following Frank's comments, we'll open the line up for questions.
We achieved depletions growth of 12% in the second quarter, an increase from depletions growth of 8% in the first quarter. I'm tremendously proud of the efforts of our people in achieving double-digit growth and record total depletions, while maintaining a focus on quality and innovation. I believe that our depletions growth is attributable to our key innovations, to our quality and strong brands, as well as sales execution and support from our distributors.
While our total growth is a testament to our strategy of a diversified brand portfolio, our Sam Adams volume has continued to decline despite the early success of our launches of Sam '76 and Samuel Adams New England IPA.
We continue to work very hard on our Sam Adams brand messaging, particularly around Sam Adams Boston Lager and Seasonals with the goal of significantly improving these trends and returning Samuel Adams back to growth.
We were delighted to learn that the eighth year out of the last 10, distributors ranked us as the number one beer supplier in the industry, in the annual poll of beer distributors conducted by Tamarron Consulting, a consulting firm specializing in the alcoholic beverage distribution industry. This is due to the efforts of all Boston Beer Company people to service and support our distributors' business and to the relationships we've built with them. Overall, our brand portfolio is very healthy and we remain positive about the future of craft beer.
I will now pass it over to Dave for a more detailed overview of our business.
Thanks, Jim. Good afternoon, everyone. Before I jump into our business results, I'd like to start with the usual disclaimer. As we stated in our earnings release, some of the information we discuss and that may come up on this call reflect 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 these forward-looking statements.
Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the company's most recent 10-K. The company does not publicly update forward-looking statements whether as a result of new information, future events or otherwise.
Okay. Now, that the disclaimer is out of the way, let me share a deeper look at our business results for Q2. Our depletions growth in the second quarter was the result of increases in our Truly Spiked & Sparkling, Twisted Tea and Angry Orchard brands that were only partially offset by decreases in our Samuel Adams brand.
We're excited that Truly is well-positioned as a leader in the emerging segment of hard sparkling water. Twisted Tea also continues to generate much consumer pull and grow distribution. We're very pleased by the reaction to our current Angry Orchard campaign and the early success of the Angry Orchard Rosé cider launch, which we believe is attracting new drinkers to the category from wine and spirits. Both Sam '76 and New England IPA show strong promise, and we'll continue to support them aggressively as we head into the second half of the year.
During the quarter, our operating expenses increased significantly, primarily due to the timing of our planned brand investments. Brand investment increases for the remainder of the year will moderate as we maintain our annual spend guidance. Based on our first half results, we've increased our expectations for full year depletions growth, reflecting our view of the most recent trends.
We'll continue to invest in capacity increases in our brewing and packaging capabilities to support our product innovation and our brand growth. These improvements include our new can line in our Pennsylvania Brewery that began production this quarter.
I'd like to recognize the significant efforts of our brewery employees in supporting this start-up and reacting to the heightened demand. We've been operating at capacity during peak weeks and have increased our usage of third-party breweries during the quarter in response to the accelerated depletions growth.
The growth has been challenging operationally, which has resulted in higher supply chain costs. The new can line will help relieve these pressures as it ramps up during the third quarter. Further, based on our rapid growth and to address current capacity bottlenecks, we're accelerating capacity and efficiency improvements at our breweries and accordingly are raising our capital spend expectations for the balance of the year.
I'm pleased that the business has shown great momentum and depletion improvements during the first half of the year. The company has great people, a great culture and a tremendous innovation capability. I believe the Sam Adams brand has much latent brand equity, which we'll leverage in our efforts to return the brand to growth.
As we go forward, growth is at the core of our mission and we remain committed to growing the Sam Adams brand through continued innovation, promotion and brand communication initiatives. We've done a lot of consumer work over the past few months and believe we have some new insights and ideas to reverse Sam Adams' trends.
Meanwhile, we see a clear path to maintain Angry Orchard's and Twisted Tea's momentum and ensure Truly's position as a leader in the hard sparkling water category. We'll continue to focus on cost savings and efficiency projects to fund the investments needed to grow our brands and to build our organization's ability to deliver against our goals.
Based on our visibility to opportunities in 2018 and 2019, we're maintaining our previously stated goal of increasing our gross margins by an average of about 1 percentage point per year over the three-year period ending in 2019, before any mix or volume impacts, while preserving our quality and improving our service levels.
We remain committed to investing in short and long-term product innovation, where we continue to tap into consumer trends and explore beverage areas compatible with our business model. And as we've proven and has been acknowledged by the Tamarron survey, which Jim just referenced, we believe we're the best in the business at executing at store level in partnership with our distributors.
Based on information in hand, year-to-date depletions reported to the company through the 29 weeks ended July 21, 2018, are estimated to have increased approximately 12% from the comparable period in 2017.
Now, I'm going to hand it off to Frank, who will provide the financial details.
Thank you, Jim and Dave. Good afternoon, everyone. For the second quarter, we reported net income of $23.5 million or $1.98 per diluted share, representing a decrease of $5.6 million or $0.37 per diluted share from the same period last year. This decrease was primarily due to increased advertising, promotional and selling expenses and lower gross margins that were partially offset by increases in net revenue and lower income taxes.
Shipment volume was approximately 1.2 million barrels, a 9% increase compared to the second quarter of 2017. We believe distributor inventory as of June 30, 2018, was lower than planned due to higher demand. Inventory at distributors participating in the Freshest Beer Program as of June 30, 2018, decreased slightly in terms of days of inventory on hand when compared to July 1, 2017. Approximately 79% of all volume is on the Freshest Beer Program.
Our second quarter 2018 gross margin of 52% decreased from the 54.1% margin realized in the second quarter of last year, primarily as a result of higher processing costs, mainly due to increased production at third-party breweries as well as higher packaging costs, partially offset by price increases, cost saving initiatives at our breweries, and lower excise taxes.
Second quarter advertising, promotional and selling expenses increased $18.7 million compared to the second quarter of 2017, primarily due to increased planned investments in media advertising, local marketing, salaries and benefits costs, and increased freight to distributors due to higher rates and volumes, and less efficient utilization.
General and administrative expenses increased by $4.5 million from the second quarter of 2017, primarily due to increases in salaries and benefits and stock compensation costs.
During the second quarter, we recorded a net income tax expense of $7.6 million, which consists of income tax expense of $8.7 million, partially offset by $1.1 million tax benefit related to stock option exercises in accordance with the accounting standard Employee Share-Based Payment Accounting, also known as ASU 2016-09.
The effective tax rate for the second quarter, excluding the impact of ASU 2016-09, decreased to 28% from 36% in the second quarter of 2017 mainly due to the favorable impact of the Tax Cuts and Jobs Act of 2017.
Based on information of which we're currently aware, we continue to target full-year 2008 earnings per diluted share of between $6.30 and $7.30. But actual results could vary significantly from this target. This projection excludes the impact of ASU 2016-09.
Full-year 2018 depletions growth is now estimated to be between 7% and 12%, an increase from the previously communicated estimate of between zero and plus 6%. We continue to project increases in revenue per barrel of between zero and 2%.
Full-year 2018 gross margins are expected to be between 51% and 53%, a decrease from the previously communicated estimate of between 52% and 54%. This decrease is primarily due to incremental costs related to the higher production volumes at third-party breweries, as well as higher ingredient and packaging material costs.
We plan to increase investments in advertising, promotional and selling expenses of between $15 million and $25 million for the full-year 2018, not including any increases in freight costs for the shipment of product to our distributors.
We plan to increase general and administrative expenses of between $10 million and $20 million for the full year of 2018. We estimate our full-year 2018 non-GAAP effective tax rate to be approximately 28%, which excludes the impact of ASU 2016-09.
We are not able to provide forward guidance on the impact that ASU 2016-09 will have on our 2018 earnings per diluted share and full-year effective tax rate, as this will mainly depend upon unpredictable future events including the timing and value realized upon exercise of stock options versus the fair value when those options are granted.
We're continuing to evaluate 2018 capital expenditures and currently estimate investments of between $65 million and $75 million, an increase from the previously communicated estimate of between $55 million and $65 million. The capital will be mostly spent on continued investments in all breweries and taprooms and could be higher, if deemed necessary, to meet future growth.
We expect that our cash balance of $76.2 million as of June 30, 2018, along with future operating cash flow and our unused line of credit of $150 million, will be sufficient to fund future cash requirements.
During the 26-week period ended June 30, 2018, and the period from July 1, 2018 through July 20, 2018, the company repurchased approximately 222,000 shares of its Class A Common Stock for an aggregate purchase price of approximately $50.5 million. We have approximately $128.1 million remaining on the $931 million share buyback expenditure limit set by the board of directors.
We will now open up the call questions.
Thank you. And our first question comes from Judy Hong from Goldman Sachs. Your line is now open.
Thank you. Hi, everyone.
Hi, Judy.
Hi. So I guess the first question is on the gross margin line because it seems like that's come in a little bit softer and the guidance has also come down. So maybe if you can elaborate a little bit in terms of the mix of your products that are going through the third-party production. Is it mostly Twisted Tea or Truly where it's growing pretty strongly? And as you think about kind of bringing some of that production in-house, how quickly can you see gross margin headwinds abate? And then maybe along with that, talk a little bit more also about the packaging costs because it seems like the slim cans are also going up from a packaging cost perspective.
Yeah. Hi, Judy. This is Frank. I'll take that question. On the gross margin, there are two main impacts here. One is the costs that are coming to market and that I think you will see across the industry that increased packaging costs and then some freight which ends up in ingredients being delivered. So that's one piece. The other one in the gross margin, which is the bigger impact, is incremental costs related to primarily third-party production, but also internally higher costs as our new can line that we have installed is below the efficiencies that we had expected. So that's pushing volume out to third-party production. And that is coupled – but is really happening in a pretty tight freight environment. So those are incremental costs that are really specific to our situation where the volume is significantly higher than what we had expected.
To your question like what it is, it's primarily related to the non-Sam products, primarily in cans. The portfolio is shifting dramatically. We have an increase in cans and we have an increase in variety packs. Those are packages that are a little bit more expensive to produce if you're not prepared for it. We are really prepared to meet all the volume requirements. We are going to incur the incremental costs.
As we have alluded in our prepared remarks, we are investing into capacity. So we expect that this will address that in the next year. Some of the costs will remain. We hope we're going to see some improvement as we as we move through the year, but the new capacity for, like, the can line and variety packs, that will come on stream next year.
Can you give us a quantification of that? What portion of that non-beer goes to a third-party at this point?
I can give you absolute numbers, but I will tell you that – so we always had some portion at third parties because we always see where the products are taking us, and then we install the capacity once we're sure we have the volume. But our volume this year will be more than doubling at third parties versus what we had before.
Okay, got it. And then I guess the SG&A also went up more in second quarter. Some of that seems to be timing of the advertising investments and maybe also you can break-out the increase between the advertising investments going up versus freight?
Yeah, absolutely. So clearly, I mean, that's a big impact which is also hitting the EPS for the quarter. There are two impacts. One is primarily the investment into selling into AP&S and then you have freight. So of the $18.7 million increase for the total, 80% is in advertising, promotion and selling, 20% is related to the freight. And the reason for the selling is really different phasing. If you recall last year, we didn't spend very much in the first three quarters and we had a significant increase in the fourth quarter. This year, while we felt we had better campaigns, we had better products, we invested more in the first half of the year.
So, clearly, the phasing was significantly higher in the first half of the year. And so, we'll stick with the guidance. It's purely phasing within the year. And last year, we were below 50% in the first half, and this year we are quite a bit above the 50%.
Got it. Okay. And then my last question just on your top line. So I mean, clearly the depletion has improved driven by the innovations. I guess your depletion guidance, which has gone up from beginning of the year, still does imply that back half of the year you do see some slowdown or even a decline if you kind of take the high end out. So I guess I'm just wondering at this point how do you feel about kind of the repeat rates on new innovations, like there was a cider. How much of the growth can you continue to see from Truly, particularly if there is a little bit of a tight supply in the marketplace? And then it sounds like Twisted Tea continues to kind of grow as well. But just thinking about the back half and how some of those drivers sort of build up to your guidance for the back half the year.
I'll take that, Judy. In terms of repeat rates, we're very pleased with all of the innovations. And repeat rates are at the higher end of the range, indicating successful products with legs. They are not a – I try it once and I don't have a second six pack as we saw a couple of years ago with hard root beer. But the repeat rates are very encouraging at least for the next 6 to 12 months. They don't really reflect year three or even year two. But for a year out, they look sticky, they look like quite viable products. All four of the major innovations, which would be the Truly Berry Variety pack and Sam '76 and the Truly 6-pack and New England IPA and Angry Orchard Rosé.
So we're very encouraged about those. I think we're also quite happy with both Truly and Angry Orchard Rosé in their ability to both not cannibalize the rest of our product line. And maybe, more importantly, a big chunk of the incremental volume is coming from wine and spirits. So something from the data we're seeing, 30% to 40% is coming from the wine and spirit world. So it's truly incremental to the entire beer category.
I think that some of the conservatism you see in Frank's numbers for the back half of the year relate to the seasonality of Twisted Tea and of Truly and to some extent of Angry Orchard. And so, based on last year, for Truly it was quite seasonal. What we don't know is whether that seasonality will be less this year. And years ago, when we started developing Twisted Tea and rolled it out, year-over-year, the seasonality reduced for it. So we're being a little conservative and assuming we're going to get same kind of seasonality we got last year. And our experience has been maybe that seasonality diminishes as the category and the brand get entrenched in consumers' consideration set.
Got it. Okay. Thank you.
And our next question comes from Nik Modi from RBC Capital Markets. Your line is now open.
Yeah, thanks. Good afternoon, everyone. So the question is, you indicated there's some new insights that you've seen on Sam Adams Lager and just curious if maybe you can give us some broader perspective on what exactly you saw, what you are implying?
And then the second question is, given the success of all the new innovation you had, how should we think about the innovation pipeline over the next 12 months? I mean are we going to be seeing more white space type expansion in terms of new category subsets? Any perspective around there would be very helpful.
Okay. This is Dave. I'll take that one. Regarding Sam, I can't share a lot of details right now, but I will tell you that I stepped in about four months ago and that's been my number one priority working closely with Jim and the rest of the team to kind of figure that one out. And we've made a lot of progress.
We do have some insights. We have a new campaign that will be ready relatively soon. It's already been shot in fact. So we've moved sort of at rapid speed to understand sort of what's working, what's not working with the Fill Your Glass campaign. Fill Your Glass is going away, that campaign. It was fine, but it didn't deliver what we needed it to. And we just believe that the brand has unique characteristics versus other lagers. And we'll be highlighting those differences in only ways that we can do it.
And so, we're going to come back with a fresh approach in a way that's authentic and true to Sam. Based on the consumer work we've done, it really seems to resonate well with consumers. And I'll just kind of stop there because I don't want to get into too much detail yet until we actually start to show it. But we do feel really confident that we're in a better place, a better line of thinking and have a better plan of action for Boston Lager. And that is as absolutely critical for us. And we've taken a lot of time in a short amount of time to get it right.
In terms of innovation for next year, like, we're going to innovate based on wherever we see opportunities. So you'll see innovation sort of in the non-Sam in the non-beer area, you'll also see it in beer as well. And you'll see maybe new brands and maybe line extensions. So we have a lot of good ideas. We have to really narrow it down.
I think what's really important to mention though is that, as Jim just said, we have some potential winners out there that we launched this year. It's really important that we support those brands aggressively, not only in the back half of 2018, but into 2019. So Sam '76, New England IPA and Rosé, Truly, you'll see continued support behind those brands. But we're also going to bring some new stuff to the table as well. We're just going to be choiceful in how we sequence and how we do it.
And I would just add to that. This was a really good year for innovation. We have three of the top six innovations in the sort of the greater beer space. So that's not something that we can do every year. This was a very, very successful year for our innovations. We'd love to duplicate it next year, but unlikely.
However, we think there is just a lot of running room in distribution upside and consumer upside for this year's innovations. Historically, it's taken us two or three years to really capture the front end or the potential for something like Angry Orchard or Twisted Tea, and now we're seeing it with Truly. So the second year, we anticipate being strong as well.
Great. Thanks so much, guys.
And our next question comes from Vivien Azer from Cowen. Your line is now open.
Hi. Good afternoon.
Hey, Vivien.
Hey, Vivien.
Hey.
So first question is on A&P, please. I'm just curious on, obviously, like big spending increase in the fourth quarter and the first quarter. Was the second quarter increase like always part of the plan? Or did you pull that forward after like you started to see some good early momentum in 1Q?
No, that was largely the plan. Again as I said, like if you look at the increase, you look at the phasing last year, we didn't see last year that we have the programs to spend big. This year, the phasing was very different. So I think there are two things here. One is media spend, we felt better with our campaign. So we wanted to front-load it. We didn't want to wait until the end of the year because you want to get the volume going at the beginning. This is number one.
Number two is, we also had the product launches. And if you have product launches, you want to clearly support that. So we had events like the Kentucky Derby, for example. We had quite a few more experiential events, and that's what's flowing into that launch parties. Those are more kind of one-time costs in nature as you launch that. But then, in general, we've gone more into experiential. We're the sponsors of the Boston Red Sox. And so, you see that partly as well.
Thank you. That's helpful. So then dovetailing that into your top line outlook, so clearly that better marketing is working. So can you can you just talk about your decision not to actually raise you A&P to kind of ensure that this top line recovery is a little bit more durable? Thanks.
I mean we're increasing it $15 million to $25 million. So there's quite a significant increase that we're looking at this year. We feel we have good and healthy support. Again, there's a bit of phasing and there's more one-time type costs when you launch products and when you launch innovations. And as Jim pointed out, we had three successful ones, but we feel quite comfortable that we have good support also for the rest of the year. If you recall, we had a significant increase last year in Q4. We will not repeat that in Q4, but spread it more evenly throughout the month and the year to go.
Okay. That's helpful. And just last one for me. Any comment on the search for a new CMO? Thanks.
Yeah. So I think it's aggressively underway. And, fortunately, my background is in that world, so we know a lot of people who are terrifically talented who would be interested in joining this group here. So it gets going very quickly.
And in the interim – this is Dave speaking, by the way – I'm taking now Frank. I'm handling the CMO duties and it's actually been a good experience for me just to jump in with the team. But we plan to have somebody permanently in the seat fairly soon, so we're very optimistic about that.
That's great to hear. Thank you so much.
And our next question comes from Kevin Grundy from Jefferies LLC. Your line is now open.
Thanks. Good evening, guys.
Hey, Kevin.
Hi, Kevin.
Hey, Frank, can we just start on the guidance? I guess, Jim alluded to a moment ago some conservatism perhaps on the depletions guidance in the back half of the year. I think you guys are doing an outstanding job here with innovation. The top line is strong. And I think perhaps the margins and the outlook there may be met with some disappointment.
So I was hoping maybe you could just – maybe is there an element of conservatism in the company's outlook? The scanner data looks outstanding. The most recent period through July was up north of 20%. So is that a fair characterization that the guidance is a bit conservative and maybe even from an EPS perspective you're thinking toward the higher end of the range? I don't want to put words in your mouth. Is that accurate?
No. So let me start. The top line guidance is a relatively wide range. And the high end of the range depends pretty much on what the innovations are doing, what the seasonality is on Truly. So last year, like the first year that we launched Truly, there was extreme seasonality. It improved slightly last year. So if the seasonality in Truly extends, yes, then we get to the higher end range. And if it goes beyond what we expect, then, yes, there might be – you never know, it can go outside.
Having said that, when you look at last year, the first half was weak compared to the second half. So we gradually improved throughout the year. We had a very weak start in Q1 where depletions were down 15%. That was one of the reasons why Q1 looked pretty good.
So the year-to-date numbers that you're seeing, they have this recovery of the fairly weak Q1 looking at last year because of the spring seasonal miss that we had. So you take that into consideration, if you go across the different brands that we have, we are relatively balanced. But again, the wild card is like what's the true seasonality on Truly, and that could swing things.
Okay. That's helpful, Frank. And then just a broader sort of informational question. Can you frame the gross margin gap for us between your major lines or major brands just in terms of helping us think about some of the negative mix implications, given the sort of wide divergence in growth rates for the business, like beer versus flavored malt, beverages versus cider?
So there is not really a big mix impact. We are very close across all the products. That's kind of how we manage all business. So if one brand grows a little faster, that doesn't really have a big implication. The two implications really that you have is the coming to market commodity cost; and then below gross margin, the freight cost. That's what we need to address. And we will do that through pricing, which comes late in the year. That will not cover the full impact because it's in full year impact if you do pricing, and then some sort of savings. And then the other one is really related to the higher volume that we have.
We're putting in efforts to improve the efficiencies in our lines. We don't know exactly how quickly that is going to get traction this year, but we're also putting in incremental capacity. So we're pretty confident for next year that we have that issue addressed, and that's definitely the bigger issue of the margin gap.
So if you look on the downside, we have those two issues on the downside. On the upside, we are getting to the savings that we were planning, that we said we're going to get. So that's why not the full impact that we're having from those incremental costs is coming through in the gross margin line, and pricing is also coming through as expected.
Okay. Thanks, Frank. One last one for me, maybe for Jim and Dave. Just in terms of positioning in the Spiked/Sparkling category, number one, can you maybe speak to the competitive activity? There's been a lot of new entrants. And I guess maybe the worry would be around sort of the competitive moat of some of these brands that are out there. So that's sort of number one, maybe if you could touch on that?
And then related to that, number two, how do you attempt to differentiate longer term versus some of these other brands that are out there? Thank you.
Let's see. The category is now kind of into its second full year of being developing, getting pretty developed at this point. What you're seeing is two leaders emerging, both with brands focused on this category. That would be us and White Claw. And depending on geographies, one of us will be number one in a different geography. The other one will be number one, but fairly close. We have this neck-and-neck competition between the two of us who have not quite 80% of the category between the two of us.
And then, there is sort of a long way down to others. And if you go to something like Spiked/Sparkling which has more calories and is positioned somewhat differently, more sugar, different kind of taste. But at the core of it, you have us and White Claw with something like 75% of the category.
So, at this point, that seems to be the way it has shaken out. The differentiation, I guess, it's in the eye of the beholder. And some of it's flavor differentiation, some of it is a little bit different look and feel to it. I think everybody is working on going forward how do we create differentiators between us.
And I don't have an answer for that at this point. But I see it's the category shaking out the two leaders in the 100 calorie segment. And then Spiked & Sparkling kind of owning the higher calorie; I don't know what they are, 140, 160, something like that.
Okay. And just to add on to that, I would just say that, maybe a year ago it was questionable whether this was sustainable, was this a fad or a trend. And then if you look at, first of all, you look at where in year three, the category is almost tripling this year. But also if you just look at broader consumer trends around health and wellness, in the non-alcoholic space, the LaCroix, the Bubly's, all these other brands are real in there and they are reflection of consumers wanting to put this stuff in their bodies or not put bad stuff in. And I think we're seeing those trends carry over into the space. And I think the reason the two top players are White Claw and Truly are because we're actually delivering I think pretty well against that concern.
Okay. Thank you very much, guys. Good luck.
Thank you.
Thank you.
And our next question comes from Caroline Levy from Macquarie. Your line is now open.
Thank you. Good afternoon. I wonder if you could help us understand the difference between on-premise trends and the scanner data that we see where it looks like the F&Bs are about 75% of your volume in measured channels. How does that look on-premise and what have on-premise trends been like and is there uptake of Twisted and Angry and Truly in the on-premise channels?
I'll take that. Let's see. There is some uptake. I think the strongest of those three brands by far, on-premise, is Angry Orchard. It has meaningful percent of its volume in draft. So it kind of looks in some ways like craft beer. And cider has always been pretty strong on-premise. Truly and Twisted Tea are primarily off-premise brands. There is single-digit levels of on-premise within both of those. We are trying to develop Truly a little more on-premise, but that's a long-term prospect. And, of course, Sam Adams is much – within our mix is our lead brand, both Lager and Seasonal in on-premise. And in Sam Adams, our draft trends are significantly stronger than our scanner trends.
So your beer business is much better on-premise than off?
Yes. Depending on how you want to define beer. But yes.
Can you help me define it?
Well, it's in the eye of the beholder. There is a statutory definition of it and Truly and Tea and Sam Adams would be defined and taxed as beer and cider is not. A non-alcoholic beer is not beer. So you can define it in lots of different ways. IRI does it one way. I'm just referring to the legal definition.
Right. So, Jim and David, how important is it to you guys that beer becomes a growth – I know, David, you've said it is important. But I mean is there a scenario whereby there's just so much fragmentation in craft that that may not be the main driver of Sam Adams Company going forward? Or what gives you confidence that you can really move the dial on beer long-term?
Well, I can – I'll just before Dave jumps in because he has more expertise in some of this. But I will say that Sam Adams is, it's the heart and soul of Boston Beer Company. So we are absolutely committed to returning it to growth, and everybody in the company feels that same commitment. And we also believe that it is possible to do that. And we've been through some ups and downs with Sam Adams over the years and always been able to bring it back to growth.
And we are seeing in craft beer the beginnings of a trend of returning to brands being a more important part of consumers' selection, the annual Nielsen survey of craft beer, highlighted that a few weeks ago. So we are committed and optimistic. And I'll let Dave address the rest of it.
Yeah. I think when you look at Boston Lager, it's said that consumers are looking for high-quality products, and Boston Lager delivers on that. It literally has the story, has the authenticity. It's got a lot of latent equity. So we talk to consumers that's there. Our challenge is how do we make it more relevant to the next generation of beer drinkers, and that's what we're on to.
So I think, to Jim's point, everything starts with Boston Lager and we need to get – it may not be the biggest growth contributor in the future, but it's going to contribute a lot more than it's contributing today. And that's our intent and that's our belief.
In addition, there's ways to take Seasonals and create some news and excitement around Seasonals. We dominate Seasonals historically. There's a lot more competition. But we also see ways to make Seasonals more relevant and more top of mind. So there's an effort there as well.
And I'd also say, you layer on top of that after Sam and Seasonals, there's a really good innovation that we can do to get to capture people's attention. I think, New England IPA, the most recent one, is a great example of a terrific liquid in a category that obviously we know is a big part of the category. And it's a very small part. It's 3% of the IPA category, but it's generating more than a third of the growth and we have a great brand there.
So I think it's a combination of getting the base business right, optimizing the upside potential that Sam Adams has which we truly believe is high. And then, from there, smartly innovating off of that to get that growth back. But this is what we think about. We love the non-Sam business. Obviously, as you can see the results. And we'll continue to innovate there. But at the end of the day, we come to work every day and think about how do we grow beer.
Thanks. I just had...
And within the craft space, they have other – to have a broader portfolio that is clearly providing company-level growth and providing gross profit and profit dollars that give us a lot more flexibility in what we need to do to support Sam Adams. So having a broader portfolio provide resources that we can commit to Sam Adams, and it will always be over-resourced because it is so essential to the spirit and heart of the company.
That's very helpful. I have one last sort of technical question for Frank, please, which is on depletions in the fourth quarter of last year were down 10% and I just don't know how much of that related to it being a week short. And if you could just help me understand what the sort of comparable will be for the fourth quarter this year.
Yeah. So I mean if you look at last year, of the 10%, about 7 points was related to the extra week. So roughly we're declining 3% which was, I believe, in line also broadly with Q3 and Q2. So that's the right comparable.
Thank you. And when you said on gross margin, I believe, you said that you're going to still get to your target of 1 percentage point improvement annually by 2019, which is a bit confusing because you've guided to kind of flattish for this year. Did you mean you'll make it all up in 2019?
Yeah. So just one additional comment to the previous question. So last year is actually a 52-week, so you have a good base for last year in terms of absolute volumes on the growth rate where we lost the week versus the 2016 year.
Coming back to the gross margin question, so last year we gave the target that we will grow on average 1 percentage point our margin before any volume and mix impact broadly. Last year, that was the first year we got ahead. We delivered about 1.5 points despite the fact that our volume was down and we had negative fixed cost absorption.
This year, we're looking for roughly 1 point as we gave in the guidance. The two impacts, I think the high input cost, but essentially the higher third-party volume is negating that a little bit. So we're being pushed back. In addition to like that you're paying the contract fee, you're also not getting the fixed cost absorption partly that you were planning for. So we clearly believe that over the three-year period, next year we're going to make that up.
Great. Thank you so much.
Okay.
And then our next question comes from Amit Sharma from BMO Capital Markets. Your line is now open.
Hi. Good afternoon, everyone.
Hey.
Frank, a quick clarification. So if we look at 20% of your APS inflation related to the freight, should we assume that trend continues and for the full year you have around $10 million, $15 million freight headwind below the gross profit line?
No. When I was referring to the 20%, that was like of the 18.7% for Q2. The guidance that we give on APS, the forward guidance, $15 million to $25 million, is excluding the freight impact. So the actual is always included. That's why I'm breaking it out. The guidance $15 million to $25 million is excluding freight. On the freight, the number that you said, it might be a little on the high side. But it's about like double digits. I'd say, but low-double digits.
All right. And then just talking about APS spending by itself you've put a lot of focus on innovation this year and perhaps next year as well, and you're trying to revive Sam. Is that level of inflation that you're seeing for $15 million-$25 million, is that a good run rate for 2019 as well? Hello? Hello?
Ladies and gentlemen, please stand by. Your conference will continue in just a moment. Please stand by.
[Technical Difficulty] (49:27-50:23).
Hello.
Hello. This is Amit.
Sorry, sorry, we lost you.
Apologies.
Okay. Sorry about that. So I don't know if the last question went in or not.
No, unfortunately, it did not.
Okay. I think, Frank, your answered the freight question. I was just asking whether given all the innovation and focus on bringing Sam back to growth as well, Sam Adams back to growth as well. Is this level of EPS spending increase, is that a good run rate for 2019 as well?
I think if you look at it as a percent of net revenue, I think it would be.
Got it. And then last one from me. I think you touched on the pricing equation a little bit. I mean, given the freight inflation, given packaging inflation which your other beer peers are facing as well, do you feel like there is more opportunity for pricing than the outlook you provided for 1% to 2%?
Yeah. So when we've provided the outlook and the original guidance which hasn't changed, we're looking at pricing between zero and 2%. After that, we saw significantly higher increases in commodity and freight costs. So we are clearly looking at pricing. Clearly, you're competing in different markets throughout the U.S. So it's not that you can go and price across the board. So we are really looking into – going for opportunities and will price in the second half of the year. We think, if everything goes well, we get to the high end of the range, but I would not look for breakout pricing.
And how long does it typically take for pricing to roll through the channels if you decide to take pricing or more pricing than was planned at the beginning of the year?
Well, I think if things go well, we will see about a quarter of a year of an impact this year, but that's kind of the best case. But you have to kind of start rolling through it get into the right level next year and to the right competitive level, quite frankly.
Got it. Thank you so much.
Typically, we've put in pricing at the beginning of the year. So it does take some time for cost decreases to roll through. I think we are seeing some pass-through of these common cost increases more so than we have seen in previous years. So there may be more upward pricing activity in the second half of this year than there historically has been in the category.
And the retailer seems – not to say they ever welcome price increase, but are they open to, given the commodity inflation?
I think they realize that at some point increased commodity costs have to be passed through to some extent. So to them it looks sensible. And, of course, they will push back. And this is a very competitive industry and we want to maintain our competitiveness. But we are starting to see, on a local basis, price increases coming through at a time when they wouldn't normally be reflected.
Got it. Thanks so much.
I'm showing no further questions over the phone lines.
All right. Well, thanks, everybody, for joining us today, and we'll get together again in a few months.
Thank you.
Thank you.
Cheers.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.