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Two years ago, City Brewing poured money into new production facilities to feed booming demand for hard seltzer. Now, the company has had to seek a covenant waiver from its revolver lenders to avoid its liquidity running dry.

The excitement around drinks like White Claw has gone flat, reducing demand for City Brewing’s contract beverage manufacturing services and hurting its earnings.

The company was acquired in March 2021, by a consortium of investors including Charlesbank Capital Partners and Oaktree Capital Management. It then announced it would spend $630m to buy a brewing facility in California, to expand its offerings beyond beer.

At the time, the move made a lot of sense. Beer sales were falling, but hard seltzer was having its time in the sun. Sales grew by 160% between 2019 and 2020, as hard seltzer became a cultural phenomenon and spawned the phrase “ain’t no laws when you’re drinking Claws”.

But consumer tastes change fast. Today, hard seltzer is significantly more crowded and demand is softening. Sales declined by 5.5% year-over-year last August, and in December 2022 alone they fell by 10.4%.

One of City Brewing’s customers is The Boston Beer Company, which owns the Truly Seltzer brand. Last year the company warned it had overestimated the growth in seltzer — in the four weeks leading up to 4 January 2023, sales of Truly dropped by 19.5%, according to a report.

None of this is good news for City Brewing.

By the end of the first quarter of 2023, the company's earnings had declined enough to breach a springing covenant on its $122m revolver due 2026, which is set at 7.15x and triggered if more than 30% of the facility is drawn.

Net leverage was around 8.95x at the end of the quarter, at which time City Brewing had just $45m of capacity on the revolver and $14.1m of cash on hand, according to 9fin sources said;

The company’s revolver lenders agreed to waive the covenant through the fourth quarter of 2023, the sources said.

This provides some much-needed breathing room, and has boosted trading in City’s debt. Its $850m term loan due 2028 was quoted at 60 today; that’s up from 42.5 at the end of May (before the covenant waiver was was announced) but down from 88.75 this time last year.

Covenant drama aside, the company’s latest earnings show some promise. City reported $23m of EBITDA for the quarter, up from $18m in Q1 22, according to two sources. Revenue also ticked up a modest 2% year-over-year, to $111m.

According to sources, company executives told investors they were confident that earnings would recover enough by the end of the year that they would not need to extend the covenant waiver.

“Earnings were a little better than feared, and with the covenant waiver their liquidity is okay, but it’s still a dicey situation,” one of the sources said.

City Brewing's minority investor Blue Ribbon Ventures (a joint venture between Pabst Blue Ribbon chairperson Eugene Kashper and TPG Consumer Partners) is in the process of moving all of its beer manufacturing over to City Brewing by the end of 2024.

While this potential increase in volumes certainly helps the outlook, one of the sources cautioned that margins from beer are significantly lower than hard seltzer.

Another source following City Brewing said their best-case scenario was that this year the company would match the $190m of EBITDA it generated in 2022.

Anything less, and it’s possible that free cash flow would turn negative, the source added. That is based on estimated capex needs of between $20m and $100m, which would depend on how many new customers the company gains.

Free cash flow is further stressed by rising interest rates. The company’s term loan debt is unhedged, according to S&P.

“The core issue is the operating leverage of the entity,” the source said. “When seltzer exploded in 2021, they were well positioned. But now it has collapsed, they're having a hard time with the operational aspects because they're not running their facilities at the right throughput.”

The trend has also impacted beverage canning companies such as Ball Corp. After boosting production capacity during the pandemic to meet demand, Ball announced plans to close two canning plants in August last year in light of slowing sales.

“All of the big publicly traded can manufacturers were head-faked into capacity expansions that have proven unnecessary,” said an analyst familiar with the space. “The demand fell off a cliff once Covid restrictions were lifted. People just went back to bars.”

According to S&P, City Brewing has alleviated liquidity pressure by executing equipment sale and leasebacks totaling $133m at two of its brewing facilities over the past year. It used proceeds to pay down revolver borrowings and support growth capex needs.

But this move has not been hugely popular with lenders, who view the strategy as collateral-stripping.

“This is one reason why the value of their term loan is dipping,” the first source said. “They only have four facilities, and now they don’t have all the real estate assets at two of them, so it’s a lot of collateral leaking out.”

In addition to its Irwindale facility, City Brewing also operates manufacturing plants in Pennsylvania, Tennessee and its home state of Wisconsin, where it bottles alcoholic drinks and other beverages such as iced tea and energy drinks.

The prospect of additional sale-leasebacks to boost liquidity is a major concern for lenders, with some sources saying lenders would likely be willing to lend money on a pari-passu or super-senior basis to avoid it.

“If they came to lenders and said they need $100m in liquidity, people would do it,” said one source. “As lenders, the goal is to make sure they don't get primed by sale leasebacks. The best defense is good offense.”

Another troubling (albeit hypothetical) possibility is that City Brewing could generate liquidity by carving out facilities as separate entities and borrowing against them, potentially giving new lenders priority over existing debt holders.

“They could designate facilities that are guarantors of the first-lien as non-restricted, which would raise debt there and make its superior to the first lien,” the first analyst said. “It’s just a possibility, but this is why the market is pricing the debt low.”

City Brewing is rated Caa2/CCC at the corporate and facility level, following downgrades from Moody's and S&P in December and January. Both agencies have their ratings on negative outlook.

Oaktree declined to comment. City Brewing, Charlesbank and Blue Ribbon did not return requests for comment.

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