##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (MARK ONE) [X]
    
    QUARTERLY REPORT UNDER SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004OR[  ]
    
    TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934for the transition period from  to
 COMMISSION FILE NUMBER
0-26542  REDHOOK ALE BREWERY, INCORPORATED  Washington
    
    91-1141254(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)14300 NE 145th Street, Suite 210Woodinville, Washington
    
    98072-9045(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (425) 483-3232 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X] The number of shares of the registrants Common Stock outstanding as of
October 31, 2004 was 8,185,599. Page 1 of 28 sequentially numbered pages




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REDHOOK ALE BREWERY, INCORPORATED FORM 10-Q For The Quarterly Period Ended September 30, 2004 TABLE OF CONTENTS PagePART I. Financial InformationITEM 1. Financial StatementsBalance Sheets as of September 30, 2004 and December 31, 2003
    
    
    3Statements of Operations for the Three Months Ended September 30, 2004 and
2003 and the Nine Months Ended September 30, 2004 and 2003
    
    
    4Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003
    
    
    5Notes to Financial Statements
    
    
    6ITEM 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    11ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    27ITEM 4. Controls and Procedures
    
    
    27PART II. Other InformationITEM 6. Exhibits
    
    
    27EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. 
 ITEM 1. Financial Statements REDHOOK ALE BREWERY, INCORPORATED 
 BALANCE SHEETS September 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent Assets:Cash and Cash Equivalents
    
    $
    7,112,782
    
    
    $
    6,123,349Accounts Receivable
    
    
    2,188,331
    
    
    
    1,686,735Inventories
    
    
    3,167,538
    
    
    
    3,342,006Other
    
    
    581,788
    
    
    
    247,038Note Receivable
    
    
    150,000
    
    
    
    Total Current Assets
    
    
    13,200,439
    
    
    
    11,399,128Fixed Assets, Net
    
    
    63,572,947
    
    
    
    65,699,658Investment in Craft Brands Alliance
LLC
    
    
    298,664
    
    
    
    Other Assets
    
    
    27,097
    
    
    
    32,256Total Assets
    
    $
    77,099,147
    
    
    $
    77,131,042LIABILITIES, PREFERRED STOCK
AND COMMON STOCKHOLDERS EQUITYCurrent Liabilities:Accounts Payable
    
    $
    1,640,439
    
    
    $
    1,983,377Accrued Salaries, Wages and Payroll Taxes
    
    
    1,258,276
    
    
    
    1,561,526Refundable Deposits
    
    
    2,788,673
    
    
    
    2,272,328Payable to Anheuser-Busch
    
    
    2,000,000
    
    
    
    Trade Payable to Craft Brands Alliance
    
    
    393,538
    
    
    
    Other Accrued Expenses
    
    
    669,741
    
    
    
    621,185Current Portion of Long-Term Debt
    
    
    450,000
    
    
    
    450,000Total Current Liabilities
    
    
    9,200,667
    
    
    
    6,888,416Long-Term Debt, Net of Current Portion
    
    
    5,287,500
    
    
    
    5,625,000Deferred Income Taxes, Net
    
    
    468,798
    
    
    
    468,798Other Liabilities
    
    
    48,677
    
    
    
    CommitmentsConvertible Redeemable Preferred Stock
    
    
    
    
    
    
    16,232,655Common Stockholders Equity:Common Stock, Par Value $0.005 per Share, Authorized, 50,000,000
Shares; Issued and Outstanding, 8,184,879 Shares in 2004 and
6,226,306 Shares in 2003
    
    
    40,925
    
    
    
    31,132Additional Paid-In Capital
    
    
    68,755,421
    
    
    
    54,250,059Retained Earnings (Deficit)
    
    
    (6,702,841
    )
    
    
    (6,365,018
    )Total Common Stockholders Equity
    
    
    62,093,505
    
    
    
    47,916,173Total Liabilities, Preferred Stock and
Common Stockholders Equity
    
    $
    77,099,147
    
    
    $
    77,131,042
 See Accompanying Notes to Financial Statements 3




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REDHOOK ALE BREWERY, INCORPORATED 
 STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Sales
    
    $
    8,789,773
    
    
    $
    11,110,622
    
    
    $
    29,623,658
    
    
    $
    32,113,402Less Excise Taxes
    
    
    878,253
    
    
    
    868,381
    
    
    
    2,601,464
    
    
    
    2,669,775Net Sales
    
    
    7,911,520
    
    
    
    10,242,241
    
    
    
    27,022,194
    
    
    
    29,443,627Cost of Sales
    
    
    6,950,722
    
    
    
    7,178,361
    
    
    
    21,004,133
    
    
    
    21,288,966Gross Profit
    
    
    960,798
    
    
    
    3,063,880
    
    
    
    6,018,061
    
    
    
    8,154,661Selling, General and Administrative Expenses
    
    
    1,310,395
    
    
    
    3,236,106
    
    
    
    6,384,759
    
    
    
    9,005,919Income from Equity Investment in Craft Brands
    
    
    657,705
    
    
    
    
    
    
    
    657,705
    
    
    
    Craft Brands Alliance Shared Formation Expenses
    
    
    (2,947
    )
    
    
    
    
    
    
    534,628
    
    
    
    Operating Income (Loss)
    
    
    311,055
    
    
    
    (172,226
    )
    
    
    (243,621
    )
    
    
    (851,258
    )Interest Expense
    
    
    48,332
    
    
    
    45,743
    
    
    
    134,732
    
    
    
    146,488Other Income (Expense)  Net
    
    
    58,990
    
    
    
    6,965
    
    
    
    82,730
    
    
    
    40,393Income (Loss) before Income Taxes
    
    
    321,713
    
    
    
    (211,004
    )
    
    
    (295,623
    )
    
    
    (957,353
    )Income Tax Provision (Benefit)
    
    
    10,000
    
    
    
    
    
    
    
    20,000
    
    
    
    Net Income (Loss)
    
    $
    311,713
    
    
    $
    (211,004
    )
    
    $
    (315,623
    )
    
    $
    (957,353
    )Basic Earnings (Loss) per Share
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )Diluted Earnings (Loss) per Share
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )
 See Accompanying Notes to Financial Statements 4




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REDHOOK ALE BREWERY, INCORPORATED 
 STATEMENTS OF CASH FLOWS (Unaudited) Nine Months Ended September 30,2004
    
    2003Operating ActivitiesNet Income (Loss)
    
    $
    (315,623
    )
    
    $
    (957,353
    )Adjustments to Reconcile Net Income (Loss) to Net Cash
Provided by Operating Activities:Depreciation and Amortization
    
    
    2,212,611
    
    
    
    2,286,637Deferred Income Taxes, Net
    
    
    
    
    
    
    (22,005
    )Net Change in Operating Assets and Liabilities
    
    
    (300,950
    )
    
    
    (333,504
    )Net Cash Provided by Operating Activities
    
    
    1,596,038
    
    
    
    973,775Investing ActivitiesExpenditures for Fixed Assets
    
    
    (76,991
    )
    
    
    (830,939
    )Investment in Craft Brands Alliance LLC
    
    
    (298,664
    )
    
    
    Note Receivable from Craft Brands Alliance LLC
    
    
    (150,000
    )
    
    
    Other, Net
    
    
    (3,750
    )
    
    
    Net Cash Used in Investing Activities
    
    
    (529,405
    )
    
    
    (830,939
    )Financing ActivitiesPrincipal Payments on Debt
    
    
    (337,500
    )
    
    
    (337,500
    )Repurchase of Common Stock
    
    
    
    
    
    
    (230,667
    )Issuance of Common Stock
    
    
    260,300
    
    
    
    Net Cash Used in Financing Activities
    
    
    (77,200
    )
    
    
    (568,167
    )Increase (Decrease) in Cash and Cash Equivalents
    
    
    989,433
    
    
    
    (425,331
    )Cash and Cash Equivalents:Beginning of Period
    
    
    6,123,349
    
    
    
    7,007,351End of Period
    
    $
    7,112,782
    
    
    $
    6,582,020Supplemental Disclosures of Cash Flow Information:Noncash Disposal of Fixed Assets
and Related Deposit Liability
    
    $
    
    
    
    $
    431,337Issuance of 1,808,243 Shares of Common Stock to A-B
and $2,000,000 payable to A-B in Exchange for
1,289,872 Shares of Series B Preferred Stock Held by A-B
    
    $
    16,232,655
    
    
    $
    
 See Accompanying Notes to Financial Statements 5




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REDHOOK ALE BREWERY, INCORPORATED 
 NOTES TO FINANCIAL STATEMENTS
(Unaudited) 1. Basis of Presentation The accompanying financial statements and related notes of Redhook Ale
Brewery, Incorporated (the Company) should be read in conjunction with the
financial statements and notes thereto included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2003. These financial statements
have been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission. Accordingly, certain information and footnote disclosures
normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States have been
condensed or omitted pursuant to such rules and regulations. These financial
statements are unaudited but, in the opinion of management, reflect all
material adjustments necessary to present fairly the financial position,
results of operations and cash flows of the Company for the periods presented.
All such adjustments were of a normal, recurring nature. The results of
operations for such interim periods are not necessarily indicative of the
results of operations for the full year. 2. Inventories Inventories consist of the following: September 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    1,043,988
    
    
    $
    1,184,733Work in process
    
    
    942,105
    
    
    
    900,388Finished goods
    
    
    572,759
    
    
    
    408,561Promotional merchandise
    
    
    453,222
    
    
    
    631,147Packaging materials
    
    
    155,464
    
    
    
    217,177$
    3,167,538
    
    
    $
    3,342,006
 Work in process is beer held in fermentation tanks prior to the filtration
and packaging process. 6




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REDHOOK ALE BREWERY, INCORPORATED NOTES TO FINANCIAL STATEMENTS (Continued)
(Unaudited) 3. Craft Brands Alliance LLC On
July 1, 2004,
the Company announced that it had entered into definitive agreements with Widmer Brothers
Brewing Company (Widmer) with respect to the operation of Craft Brands Alliance LLC
(Craft Brands). The Company and Widmer separately entered into a supply, distribution
and licensing agreement with Craft Brands pursuant to which Craft Brands purchases products
from the Company and Widmer and advertises, markets, sells and distributes these products
in the western United States. The Company and Widmer also entered into a restated operating
agreement with Craft Brands (the Operating Agreement) that governs the operations of Craft
Brands and the obligations of its members. The Operating Agreement
requires the Company to make certain capital contributions. Contemporaneous with the execution
of the Operating Agreement, the Company was obligated to make a 2004 sales and marketing
capital contribution in the amount of $250,000. The agreement designated this sales and marketing
capital contribution to be used by Craft Brands for expenses related to the marketing,
advertising, and promotion of Redhook products (2004 Special Marketing Expense). The
Operating Agreement also requires an additional sales and marketing contribution in 2008
if the volume of sales of Redhook products in 2007 in the Craft Brands territory is less
than 92% of the volume of sales of Redhook products in 2003 in the Craft Brands territory.
The 2008 contribution, if one is required, cannot exceed $750,000 and will be required to
be paid by the Company in no more than three equal installments made
on or before February 1,
2008, April 1, 2008, and July 1, 2008. Widmer has an identical obligation under the Operating
Agreement with respect to the 2008 sales and marketing capital contribution and sales of its
product. The Operating Agreement also obligates the Company and Widmer to make other additional
capital contributions only upon the request and consent of the Craft Brands board. To the extent
cash flow from operations and borrowings from financial institutions is not sufficient
for Craft Brands to meet its obligations, the Company and Widmer are obligated to lend
to Craft Brands the funds the president of Craft Brands deems necessary to meet such
obligations. The Operating
Agreement additionally addresses the allocation of profits and losses of Craft Brands.
After giving effect to the allocation of the 2004 Special Marketing Expense, which
is allocated 100% to Redhook up to the $250,000 sales and marketing capital contribution,
the remaining profits and losses of Craft Brands are allocated between the Company and
Widmer based on the cash flow percentages of 42% and 58%, respectively. Net cash flow,
if any, will generally be distributed monthly to the Company and Widmer based upon the
cash flow percentages. No distribution will be made to the Company or Widmer unless,
after the distribution is made, the assets of Craft Brands will be in excess of its
liabilities, with the exception of liabilities to members, and Craft Brands will be
able to pay its debts as they become due in the ordinary course of business. On
July 1, 2004,
the Company made the required 2004 sales and marketing capital contribution to Craft
Brands in an amount equal to $250,000. For the three months ended
September 30, 2004,
the Companys share of Craft Brands' net income totaled $658,000. This share of Craft
Brands profit was net of $78,000 of the 2004 Special Marketing Expense that had been
incurred by Craft Brands during the same period and was fully allocated to the Company.
In July 2004, the Company also made a member loan of $150,000 to Craft Brands. The loan
remained outstanding as of September 30, 2004 and is classified as a current note
receivable on the Companys balance sheet. In conjunction with the sale of Redhook
product to Craft Brands, the Companys balance sheet as of
September 30, 2004 reflects
a trade payable due to Craft Brands for approximately $394,000. During the formation of Craft Brands, both the Company and Widmer incurred
certain start-up expenses, including severance expenses and legal fees. The
Companys operating loss for the nine months ended September 30, 2004 reflects
$535,000 attributable to the Companys share of these start-up expenses.
Additionally, during the period March 15, 2004 through June 30, 2004, while the
companies sought the regulatory approval required for Craft Brands to become
fully operational, the Company and Widmer agreed to share certain sales-related
costs, primarily salaries and overhead. The Companys share of those costs
totaled $554,000 for the nine months ended September 30, 2004, and are
reflected in the Companys statement of operations as selling, general and
administrative expenses. In
December 2003, the Financial Accounting Standards
Board (FASB) issued FASB Interpretation No. 46R (FIN 46R),
Consolidation of Variable Interest Entities,a revision to Interpretation No.
46 (FIN 46). FIN 46R clarifies the application of consolidation accounting
for certain entities that do not have sufficient equity at risk for the entity
to finance its activities without additional subordinated financial support
from other parties or in which equity investors do not have the characteristics
of a controlling financial interest; these entities are referred to as
variable interest 7




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REDHOOK ALE BREWERY,
INCORPORATED

NOTES TO FINANCIAL STATEMENTS (Continued)
(Unaudited) entities. Variable interest entities within the scope of FIN 46R are
required to be consolidated by their primary beneficiary. The primary
beneficiary of a variable interest entity is determined to be the party that
absorbs a majority of the entitys expected losses, receives a majority of its
expected returns, or both. FIN 46R also requires disclosure of significant
variable interests in variable interest entities for which a company is not the
primary beneficiary. The Company has assessed Craft Brands under the provisions
of FIN 46R and has concluded that it meets the definition of a variable
interest entity but that the Company is not the primary beneficiary.
Accordingly, the Company has accounted for its investment in Craft Brands under
the equity method, as outlined by Accounting Principles Board Opinion No. 18
(APB 18), The Equity Method of Accounting for Investments in Common Stock.
The Company will periodically review its investment in Craft Brands to insure
that it complies with the guidelines prescribed by FIN 46R. 4. Relationship with Anheuser-Busch On July 1, 2004, the Company completed the restructuring of its ongoing
relationship with Anheuser-Busch, Inc. (A-B). The terms of the agreement,
which closed on July 1, 2004, provided that the Company issue 1,808,243 shares
of Common Stock to A-B in exchange for 1,289,872 shares of Series B Preferred
Stock held by A-B. The Series B Preferred Stock was cancelled. A-B was also
granted certain contractual registration rights with respect to the shares of
Common Stock held by A-B. In connection with the exchange, the Company agreed
to pay $2.0 million to A-B prior to December 1, 2004. The impact of this
exchange and recapitalization on the balance sheet as of September 30, 2004 was
to reduce convertible preferred stock by $16.3 million, increase common stock
by $9,000, increase additional paid-in capital by $14.2 million and record a
current liability to A-B for $2.0 million. As of September 30, 2004, A-B held
33.7% of the Companys outstanding shares of Common Stock. On July 1, 2004, the Company also entered into a new distribution
agreement with Anheuser-Busch which will expire on December 31, 2014, subject
to automatic renewal for an additional ten-year period unless A-B provides
written notice of non-renewal to the Company on or prior to June 30, 2014. The
A-B Distribution Agreement is also subject to early termination upon the
occurrence of certain events. The new distribution agreement provides for the
distribution of the Companys products in the Midwest and eastern United States
and includes an increase in certain fees the Company pays to A-B in connection
with sales through the distribution alliance. 5. Common Stock Activity In conjunction with the exercise of stock options granted under the
Companys stock option plans, the Company issued 150,300 shares
of the Companys common stock (Common Stock) totaling $260,000 during the nine months ended September 30, 2004, including
14,800 shares of Common Stock totaling $26,000 issued during the three months
ended September 30, 2004. No Common Stock was issued during the nine months
ended September 30, 2003. From May 2000 through May 2003, the Company repurchased its Common Stock
in conjunction with a repurchase plan authorized by the Board of Directors. The
plan allowed for the repurchase of 1.5 million outstanding shares of Common
Stock for a total maximum repurchase of $2,750,000. In May 2003, at which time
a total of 1,463,100 shares of Common Stock had been purchased in the open
market for an aggregate expenditure of $2,750,000, the Company ended the
repurchase plan. During the nine-month period ended September 30, 2003, 101,400
shares of Common Stock were purchased for $231,000. No shares of Common Stock
were repurchased in 2004. 8




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REDHOOK ALE BREWERY, INCORPORATED NOTES TO FINANCIAL STATEMENTS (Continued)
(Unaudited) 6. Earnings (Loss) per Share The
Company follows FASB Statement of Financial Accounting Standard (SFAS) No. 128, Earnings per
Share. Basic earnings (loss) per share is calculated using the weighted average
number of shares of the Companys Common Stock outstanding.
The calculation of adjusted weighted average shares outstanding for purposes of
computing diluted earnings per share includes the dilutive effect of all
outstanding convertible redeemable preferred stock and outstanding stock
options for periods when the Company reports net income. The outstanding
convertible preferred stock and outstanding stock options have been excluded
from the calculation of diluted loss per share for the three months ended
September 30, 2003 and the nine months ended September 30, 2004 and 2003
because their effect is antidilutive. The calculation uses the treasury stock
method and the as if converted method in determining the resulting incremental
average equivalent shares outstanding as applicable. The following table sets forth the computation of basic and diluted
earnings (loss) per common share: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Basic earnings (loss) per share computation:Numerator:Net income (loss)
    
    $
    311,713
    
    
    $
    (211,004
    )
    
    $
    (315,623
    )
    
    $
    (957,353
    )Preferred stock accretion
    
    
    
    
    
    
    (11,100
    )
    
    
    (22,200
    )
    
    
    (33,300
    )Numerator  income (loss) available
to common stockholders
    
    $
    311,713
    
    
    $
    (222,104
    )
    
    $
    (337,823
    )
    
    $
    (990,653
    )Denominator:Weighted average common shares
    
    
    8,181,966
    
    
    
    6,224,706
    
    
    
    6,906,812
    
    
    
    6,249,437Basic earnings (loss) per share
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )Diluted earnings (loss) per share computation:Numerator:Net income (loss)
    
    $
    311,713
    
    
    $
    (211,004
    )
    
    $
    (315,623
    )
    
    $
    (957,353
    )Preferred stock accretion
    
    
    
    
    
    
    (11,100
    )
    
    
    (22,200
    )
    
    
    (33,300
    )Numerator  income (loss) available
to common stockholders
    
    $
    311,713
    
    
    $
    (222,104
    )
    
    $
    (337,823
    )
    
    $
    (990,653
    )Denominator:Weighted average common shares
    
    
    8,181,966
    
    
    
    6,224,706
    
    
    
    6,906,812
    
    
    
    6,249,437Effect of dilutive securities:Series B convertible preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Stock options, net
    
    
    292,456
    
    
    
    
    
    
    
    
    
    
    
    Denominator for diluted earnings (loss)
per share
    
    
    8,474,422
    
    
    
    6,224,706
    
    
    
    6,906,812
    
    
    
    6,249,437Diluted earnings (loss) per share
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )
 9




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REDHOOK ALE BREWERY, INCORPORATED NOTES TO FINANCIAL STATEMENTS (Continued)
(Unaudited) 7. Stock-Based Compensation The Company accounts for its employee stock-based compensation plans using
the intrinsic value method, as prescribed by APB 25, Accounting for Stock Issued to Employees. Under APB 25, because
the Companys employee stock options are granted at an exercise price equal to
the fair market value of the underlying Common Stock on the date of the grant,
no compensation expense is recognized. As permitted, the Company has elected to
adopt the disclosure only provisions of SFAS No. 148, Accounting for
Stock-Based Compensation. The following table illustrates the effect on net income (loss) and
earnings (loss) per share for the three and nine months ended September 30,
2004 and 2003 had compensation cost for the Companys stock options been
recognized based upon the estimated fair value on the grant date under the fair
value methodology. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    311,713
    
    
    $
    (211,004
    )
    
    $
    (315,623
    )
    
    $
    (957,353
    )Add: Stock-based employee
compensation expense as
reported under APB 25
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Less: Stock-based employee
compensation expense
determined under fair value
based method for all options,
net of related tax effects
    
    
    (44,883
    )
    
    
    (62,745
    )
    
    
    (153,383
    )
    
    
    (195,369
    )Pro forma net income (loss)
    
    $
    266,830
    
    
    $
    (273,749
    )
    
    $
    (469,006
    )
    
    $
    (1,152,722
    )Earnings (loss) per share:Basic  as reported
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )Basic  pro forma
    
    $
    0.03
    
    
    $
    (0.05
    )
    
    $
    (0.07
    )
    
    $
    (0.19
    )Diluted  as reported
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    (0.05
    )
    
    $
    (0.16
    )Diluted  pro forma
    
    $
    0.03
    
    
    $
    (0.05
    )
    
    $
    (0.07
    )
    
    $
    (0.19
    )
 10




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##### Table of Contents



ITEM 2.Managements Discussion and Analysis of Financial Condition and
Results of Operations The following discussion and analysis should be read in conjunction with
the Financial Statements and Notes thereto of Redhook Ale Brewery, Incorporated
(the Company or Redhook) included herein. The discussion and analysis
includes period-to-period comparisons of the Companys financial results.
Although period-to-period comparisons may be helpful in understanding the
Companys financial results, the Company believes that they should not be
relied upon as an accurate indicator of future performance. Overview Since its
formation, the Company has focused its business activities on the brewing, marketing
and selling of craft beers in the United States. The Company produces its specialty
bottled and draft products in two Company-owned breweries, one in the Seattle suburb
of Woodinville, Washington (the Washington Brewery) and the other in Portsmouth,
New Hampshire (the New Hampshire Brewery). Prior to
July 1, 2004, the Companys sales
consisted predominantly of sales of beer to third-party distributors and Anheuser-Busch,
Inc. (A-B) through the Companys distribution alliance with A-B
(the Alliance or the
Distribution Alliance). On July 1, 2004, the Company entered into
definitive agreements
with Widmer Brothers Brewing Company (Widmer) with respect to the operation of a joint
venture, Craft Brands Alliance LLC (Craft Brands). Pursuant to these agreements, the
Company manufactures and sells its product to Craft Brands at a price substantially below
wholesale pricing levels; Craft Brands, in turn, advertises, markets, sells and distributes
the product to wholesale outlets in the western United States through a distribution agreement
between Craft Brands and A-B. Profits and losses of Craft Brands are generally shared between
the Company and Widmer based on the cash flow percentages of 42% and 58%, respectively. On
July 1, 2004, the Company also entered into a new distribution agreement with A-B (the A-B
Distribution Agreement) pursuant to which the Company continues to sell its product in the
Midwest and eastern United States through sales to A-B. For additional information regarding
Craft Brands and the A-B Distribution Agreement, see Managements Discussion and Analysis of
Financial Condition and Results of Operations  Formation of Craft Brands
Alliance and Restructuring of Relationship with Anheuser-Busch, Incorporated.
In addition to sales of beer, the Company derives other revenues from sources
including the sale of beer, food, apparel and other retail items in its two brewery pubs. The Companys
gross sales and net loss for the nine months ended September 30, 2004 totaled $29,624,000
and $316,000, respectively, compared to gross sales and a net loss of $32,113,000 and
$957,000, respectively, for the same period in 2003. The Companys sales volume (shipments)
decreased 2.9% to 169,200 barrels for the nine months ended
September 30, 2004 as compared
to 174,300 barrels for the same 2003 period. Comparability of the Companys current
quarter and current year operating results relative to the results for the same periods in 2003
is significantly impacted by the July 1, 2004 formation of Craft
Brands and the July 1,
2004 A-B Distribution Agreement. Sales in the
craft beer industry generally reflect a degree of seasonality, with the first and
fourth quarters historically being the slowest and the rest of the year typically
demonstrating stronger sales. The Company has historically operated with little or
no backlog and, therefore, its ability to predict sales for future periods is limited. The Companys
sales are affected by several factors, including consumer demand, price discounting
and competitive considerations. The Company competes in the craft brewing market
as well as in the much larger specialty beer market, which encompasses producers
of import beers, major national brewers that produce fuller-flavored products,
and large spirit companies and national brewers that produce flavored alcohol
beverages. Beyond the beer market, craft brewers also face competition from producers
of wines and spirits. The craft beer segment is highly competitive due to the
proliferation of small craft brewers, including contract brewers, and the large
number of products offered by such brewers. Imported products from foreign
brewers have enjoyed a resurgence in demand since the mid-1990s. Certain
national domestic brewers have also sought to appeal to this growing demand
for craft beers by producing their own fuller-flavored products. In 2001 and
2002, the specialty segment saw the introduction of flavored alcohol beverages,
the consumers of 11




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##### Table of Contents



which, industry sources generally believe, correlate closely with the
consumers of the import and craft beer products. While sales of flavored
alcohol beverages were initially very strong, these growth rates slowed in 2003
and 2004. The wine and spirits market has experienced a surge in the past
several years, attributable to competitive pricing, increased merchandising,
and increased consumer interest in spirits. Because the number of participants
and number of different products offered in this segment have increased
significantly in the past ten years, the competition for bottled product
placements and especially for draft beer placements has intensified. In January 2003, the Company entered into a licensing agreement with
Widmer to produce and sell the Widmer Hefeweizenbrand in states east of the
Mississippi River. Brewing of this product, which began in February 2003, is
conducted at the Companys New Hampshire Brewery under the supervision and
assistance of Widmers brewing staff to insure their brands quality and
matching taste profile. The term of this agreement is for five years, with
automatic renewal for additional consecutive one-year periods unless either
party elects to terminate the arrangement. The agreement may be terminated by
either party at any time without cause pursuant to 150 days notice. The
agreement may be terminated for cause by either party under certain conditions.
During the term of this agreement, the Company will not brew, advertise,
market, or distribute any product that is labeled or advertised as a
Hefeweizen or any similar product in the agreed upon eastern territory.
Brewing and selling of Redhooks Hefe-weizen was discontinued in conjunction
with this agreement. This agreement, for the eastern United States only, is
expected to increase capacity utilization and has strengthened the Companys
product portfolio. The Company is required to pay federal excise taxes on sales of its beer.
The excise tax burden on beer sales increases from $7 to $18 per barrel on
annual sales over 60,000 barrels and thus, if sales volume increases, federal
excise taxes would increase as a percentage of sales. Many states also collect
an excise tax on the sale of beer. Under normal circumstances, the Company operates its brewing facilities up
to six days per week with multiple shifts per day. Under ideal brewing
conditions (which would include, among other factors, production of a single
brand in a single package), the current production capacity is approximately
250,000 barrels per year at the Washington Brewery and 125,000 barrels per year
at the New Hampshire Brewery. Because of various factors, including the
following two, the Company does not believe that it is likely that actual
production volume will approximate current production capacity: (1) the
Companys brewing process, which management believes is similar to its
competitors brewing process, inherently results in some level of beer loss
attributable to filtering, bottling, and keg filling; and (2) the Company
routinely brews and packages various brands and package sizes during the year. During the peak sales volume periods of 2002, production capacity at the
New Hampshire Brewery was nearly fully utilized. In order to accommodate volume
growth in the markets served by the New Hampshire Brewery, including
anticipated growth resulting from sales of Widmer Hefeweizen, the Company
expanded fermentation capacity during the first half of 2003. This expansion
brought the production capacity from approximately 110,000 barrels per year at
the end of December 2002 to the current capacity of approximately 125,000
barrels per year. Production capacity at the New Hampshire Brewery can be added
in phases until the facility reaches its maximum designed production capacity
of approximately 250,000 barrels per year, under ideal brewing conditions. Such
an increase would require additional capital expenditures, primarily for
fermentation equipment, and production personnel. The decision to add capacity
is affected by the availability of capital, construction constraints and
anticipated sales in new and existing markets. The Companys capacity utilization has a significant impact on gross
profit. Generally, when facilities are operating at or near their maximum
designed production capacities, profitability is favorably affected because
fixed and semi-variable operating costs, such as depreciation and production
salaries, are spread over a larger sales base. Because current period
production levels have been below the Companys current production capacity,
gross margins have been negatively impacted. This negative impact could be
reduced as actual production increases. In addition to capacity utilization, other factors that could affect cost
of sales and gross margin include changes in freight charges, the availability
and price of raw materials and packaging materials, the mix between 12




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##### Table of Contents



draft and bottled product sales, the sales mix of various bottled product
packages, and fees related to the Distribution Alliance with A-B. See Managements Discussion and Analysis of Financial Condition and
Results of Operations  Certain Considerations: Issues and Uncertainties. Critical Accounting Policies and Estimates The Companys financial statements are based upon the selection and
application of significant accounting policies that require management to make
significant estimates and assumptions. Management believes that the following
are some of the more critical judgment areas in the application of the
Companys accounting policies that currently affect its financial condition and
results of operations. Judgments and uncertainties affecting the application of
these policies may result in materially different amounts being reported under
different conditions or using different assumptions. Income Taxes.The Company records federal and state income taxes in
accordance with Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standard (SFAS) No. 109, Accounting for Income Taxes.
Deferred income taxes or tax benefits reflect the tax effect of temporary
differences between the amounts of assets and liabilities for financial
reporting purposes and amounts as measured for tax purposes. The Company will
establish a valuation allowance if it is more likely than not that these items
will either expire before the Company is able to realize their benefits or that
future deductibility is uncertain. The valuation allowance is reviewed and
adjusted on a quarterly basis based on managements assessment of the
realizability of the deferred tax assets. As of December 31, 2003, the Company
had approximately $11.8 million of deferred tax assets, comprised principally
of federal net operating loss carryforwards (NOLs) that expire from 2012
through 2023 and state NOLs that expire through 2018. The recognition of these
assets is dependent upon estimates of future taxable income resulting from
future reversals of existing taxable temporary differences, which have been
recorded as deferred tax liabilities and exceed the deferred tax assets. As of
December 31, 2003, the Company also had a valuation allowance of $738,000,
reflected as a reduction of the Companys deferred tax assets on its balance
sheet. During the nine months ended September 30, 2004, the Company increased
its valuation allowance by $47,000 thereby reducing the estimated deferred
income tax benefit recorded in its statement of operations to $0. The valuation
allowance covers a portion of the Companys deferred tax assets, specifically
certain federal and state NOL carryforwards, that may expire before the Company
is able to utilize the tax benefit. Realization of the benefit is dependent on
the Companys ability to generate future U.S. taxable income. To the extent
that the Company is unable to generate adequate taxable income in the future,
the Company may not be able to recognize additional tax benefits and may be
required to record a greater valuation allowance covering expiring NOLs. Long-Lived Assets.The Company evaluates potential impairment of
long-lived assets in accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 establishes
procedures for review of recoverability and measurement of impairment, if
necessary, of long-lived assets, goodwill and certain identifiable intangibles.
When facts and circumstances indicate that the carrying values of long-lived
assets may be impaired, an evaluation of recoverability is performed by
comparing the carrying value of the assets to projected future undiscounted
cash flows in addition to other quantitative and qualitative analyses. Upon
indication that the carrying value of such assets may not be recoverable, the
Company recognizes an impairment loss by a charge against current operations.
Fixed assets are grouped at the lowest level for which there are identifiable
cash flows when assessing impairment. During 2003, the Company performed an
analysis of its brewery assets to determine if an impairment might exist. The
Companys estimate of future undiscounted cash flows indicated that such
carrying values were expected to be recovered. Nonetheless, it is possible that
the estimate of future undiscounted cash flows may change in the future,
resulting in the need to write down those assets to their fair value. 13




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##### Table of Contents



Results of Operations The following table sets forth, for the periods indicated, certain items
from the Companys Statements of Operations expressed as a percentage of net
sales. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Sales
    
    
    111.1
    %
    
    
    108.5
    %
    
    
    109.6
    %
    
    
    109.1
    %Less Excise Taxes
    
    
    11.1
    
    
    
    8.5
    
    
    
    9.6
    
    
    
    9.1Net Sales
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Cost of Sales
    
    
    87.9
    
    
    
    70.1
    
    
    
    77.7
    
    
    
    72.3Gross Profit
    
    
    12.1
    
    
    
    29.9
    
    
    
    22.3
    
    
    
    27.7Selling, General and Administrative Expenses
    
    
    16.5
    
    
    
    31.6
    
    
    
    23.6
    
    
    
    30.6Income from Equity Investment
in Craft Brands Alliance
    
    
    8.3
    
    
    
    
    
    
    
    2.4
    
    
    
    Craft Brands Alliance Shared Formation Expenses
    
    
    
    
    
    
    
    
    
    
    2.0
    
    
    
    Operating Income (Loss)
    
    
    3.9
    
    
    
    (1.7
    )
    
    
    (0.9
    )
    
    
    (2.9
    )Interest Expense
    
    
    0.6
    
    
    
    0.4
    
    
    
    0.5
    
    
    
    0.5Other Income (Expense)  Net
    
    
    0.8
    
    
    
    
    
    
    
    0.3
    
    
    
    0.1Income (Loss) before Income Taxes
    
    
    4.1
    
    
    
    (2.1
    )
    
    
    (1.1
    )
    
    
    (3.3
    )Income Tax Provision (Benefit)
    
    
    0.2
    
    
    
    
    
    
    
    0.1
    
    
    
    Net Income (Loss)
    
    
    3.9
    %
    
    
    (2.1
    )%
    
    
    (1.2
    )%
    
    
    (3.3
    )%
 Three Months Ended September 30, 2004 Compared to Three Months Ended
September 30, 2003 The following table sets, for the periods indicated, a comparison of
certain items from the Companys Statements of Operations: Three Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    ChangeSales
    
    $
    8,789,773
    
    
    $
    11,110,622
    
    
    $
    (2,320,849
    )
    
    
    (20.9
    )%Less Excise Taxes
    
    
    878,253
    
    
    
    868,381
    
    
    
    9,872
    
    
    
    1.1Net Sales
    
    
    7,911,520
    
    
    
    10,242,241
    
    
    
    (2,330,721
    )
    
    
    (22.8
    )Cost of Sales
    
    
    6,950,722
    
    
    
    7,178,361
    
    
    
    (227,639
    )
    
    
    (3.2
    )Gross Profit
    
    
    960,798
    
    
    
    3,063,880
    
    
    
    (2,103,082
    )
    
    
    (68.6
    )Selling, General and Administrative Expenses
    
    
    1,310,395
    
    
    
    3,236,106
    
    
    
    (1,925,711
    )
    
    
    (59.5
    )Income from Equity Investment in Craft Brands Alliance
    
    
    657,705
    
    
    
    
    
    
    
    657,705
    
    
    
    100.0Craft Brands Alliance Shared Formation Expenses
    
    
    (2,947
    )
    
    
    
    
    
    
    (2,947
    )
    
    
    (100.0
    )Operating Income (Loss)
    
    
    311,055
    
    
    
    (172,226
    )
    
    
    483,281
    
    
    
    280.6Interest Expense
    
    
    48,332
    
    
    
    45,743
    
    
    
    2,589
    
    
    
    5.7Other Income (Expense)  Net
    
    
    58,990
    
    
    
    6,965
    
    
    
    52,025
    
    
    
    746.9Income (Loss) before Income Taxes
    
    
    321,713
    
    
    
    (211,004
    )
    
    
    532,717
    
    
    
    252.5Provision for Income Taxes
    
    
    10,000
    
    
    
    
    
    
    
    10,000
    
    
    
    100.0Net Income (Loss)
    
    $
    311,713
    
    
    $
    (211,004
    )
    
    $
    522,717
    
    
    
    247.7
    %Beer Shipped (in barrels)
    
    
    57,100
    
    
    
    58,700
    
    
    
    (1,600
    )
    
    
    (2.7
    )%
 14




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##### Table of Contents



Sales.The following factors played a role in the $2,321,000 decline in
total sales in the third quarter of 2004: Sales to Craft Brands Alliance. Significantly impacting the
comparability of the current quarters sales are those sales of Redhook
product to Craft Brands in the third quarter of 2004. Approximately 60% of
the 2004 third quarter total shipments were sold to Craft Brands at a price
substantially below wholesale pricing levels. Redhook manufactures and sells
its product to Craft Brands at a fixed transfer price; Craft Brands, in
turn, advertises, markets, sells and distributes the product to wholesale
outlets in the western United States through a distribution agreement
between Craft Brands and A-B. Shipments. Total Company shipments declined 2.7%. Total sales volume
for the third quarter of 2004 decreased to 57,100 barrels from 58,700
barrels for the same period in 2003, the result of a 5.4% decrease in
shipments of its packaged products and a 2.0% increase in shipments of the
Companys draft products. The migration toward increasing package sales
reversed slightly, with 61.8% of total shipments in the third quarter 2004
being package shipments versus 63.5% in the same 2003 quarter. An 8.9%
decline in West Coast sales volume, including a 9.7% decrease in shipments
in Washington State, the Companys largest market, contributed to the
overall quarterly sales volume decrease. Shipments in the Midwest and
eastern United States increased modestly. Pricing and Fees. Average wholesale revenue per barrel on sales in the
Midwest and eastern United States showed modest improvement while fees that
the Company paid to A-B on sales in the regions increased pursuant to the
July 1, 2004 Distribution Agreement with A-B. Retail Operations. Sales in the Companys retail operations remained
flat at $1,508,000 and $1,514,000 for the three months ended September 30,
2004 and 2003. Excise Taxes. Excise taxes remained relatively unchanged at $878,000 in
the 2004 third quarter compared to $868,000 in the same 2003 period. The
Company continues to be responsible for federal and state excise taxes for all
shipments, including those to Craft Brands. The comparability of excise taxes
as a percentage of net sales is impacted most significantly by the sale of
Redhook product to Craft Brands at a price substantially below wholesale
pricing levels, but also by average revenue per barrel, the proportion of pub
sales to total sales, and the estimated annual average federal and state excise
tax rates. Cost of Sales.Comparing the 2004 third quarter to the 2003 third
quarter, cost of sales decreased 3.2%, or $228,000, and on a per barrel basis.
The decline is largely attributable to lower freight costs, offset by an
increase in some direct materials and indirect costs. Freight costs declined by
more than half as the cost of shipping Redhook product in the western United
States is now borne by Craft Brands, and the Companys effort at streamlining
its shipping relationships in the Midwest and eastern United States has yielded
some savings. Improvement in the Companys malted barley cost in 2004 was
offset by increases in other direct and indirect costs, including utilities,
depreciation and production wages. Depreciation and production wages increased
following the 2003 expansion of brewing capacity in the Companys New Hampshire
brewery. Based upon the breweries combined current production capacity of
93,750 barrels for the quarters ended September 30, 2004 and 2003, the
utilization rates were 60.9% and 62.6%, respectively. Selling, General and Administrative Expenses. Selling, general and
administrative expenses decreased $1,926,000 to $1,310,000 from 2003 third
quarter expenses of $3,236,000, significantly impacted by the formation of
Craft Brands as well as Company efforts to re-focus its sales and marketing
spending in its primary markets in the Midwest and eastern United States. All
advertising, marketing and selling costs in the western United States became
the responsibility of Craft Brands on July 1, 2004. Income from Equity Investment in Craft Brands Alliance.On July 1, 2004,
the Company and Widmer entered into a restated operating agreement with Craft
Brands (the Operating Agreement) that governs the operations of Craft Brands
and the obligations of its members. In accordance with the Operating Agreement,
the Company also made a $250,000 sales and marketing capital contribution,
which was to be used by Craft Brands for expenses related to the marketing,
advertising, and promotion of Redhook products (Special Marketing Expense).
After giving effect to the allocation of the Special Marketing Expense, which
is allocated 100% to Redhook, the Operating Agreement dictates that remaining
profits and losses of Craft Brands are 15




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##### Table of Contents



allocated between the Company and Widmer based on the cash flow
percentages of 42% and 58%, respectively. For the three months ended September
30, 2004, the Companys share of Craft Brands net income totaled $658,000.
This share of Craft Brands profit was net of $78,000 of the Special Marketing
Expense that had been incurred by Craft Brands during the same period and was
fully allocated to the Company. Interest Expense.Despite a declining term loan balance, higher average
interest rates during the third quarter of 2004 led to an increase in interest
expense over the third quarter of 2003. Other Income (Expense) Net. Other income (expense)  net increased to
income of $59,000 in the 2004 third quarter from income of $7,000 in the 2003
third quarter. Interest income increased modestly as a result of a higher
average balance of interest-bearing deposits and slightly higher average
interest rates. Income Taxes. The Companys effective income tax rate was a 3.1% current
state tax provision for the third quarter of 2004 and 0.0% for the third
quarter of 2003. In the third quarter of 2004 and 2003, the Company increased
the valuation allowance to fully cover net tax operating loss carryforwards and
other net deferred tax assets that were generated during the quarter. The
valuation allowance covers a portion of the Companys deferred tax assets,
specifically certain federal and state NOLs that may expire before the Company
is able to utilize the tax benefit. Realization of the benefit is dependent on
the Companys ability to generate future U.S. taxable income. To the extent
that the Company continues to be unable to generate adequate taxable income in
future periods, the Company will not be able to recognize additional tax
benefits and may be required to record a greater valuation allowance covering
potentially expiring NOLs. Nine Months Ended September 30, 2004 Compared to Nine Months Ended
September 30, 2003 The following table sets, for the periods indicated, a comparison of
certain items from the Companys Statements of Operations: Nine Months EndedSeptember 30,
    
    Increase/
    
    %2004
    
    2003
    
    (Decrease)
    
    ChangeSales
    
    $
    29,623,658
    
    
    $
    32,113,402
    
    
    $
    (2,489,744
    )
    
    
    (7.8
    )%Less Excise Taxes
    
    
    2,601,464
    
    
    
    2,669,775
    
    
    
    (68,311
    )
    
    
    (2.6
    )Net Sales
    
    
    27,022,194
    
    
    
    29,443,627
    
    
    
    (2,421,433
    )
    
    
    (8.2
    )Cost of Sales
    
    
    21,004,133
    
    
    
    21,288,966
    
    
    
    (284,833
    )
    
    
    (1.3
    )Gross Profit
    
    
    6,018,061
    
    
    
    8,154,661
    
    
    
    (2,136,600
    )
    
    
    (26.2
    )Selling, General and Administrative Expenses
    
    
    6,384,759
    
    
    
    9,005,919
    
    
    
    (2,621,160
    )
    
    
    (29.1
    )Income from Equity Investment in Craft Brands Alliance
    
    
    657,705
    
    
    
    
    
    
    
    657,705
    
    
    
    100.0Craft Brands Alliance Shared Formation Expenses
    
    
    534,628
    
    
    
    
    
    
    
    534,628
    
    
    
    100.0Operating Income (Loss)
    
    
    (243,621
    )
    
    
    (851,258
    )
    
    
    607,637
    
    
    
    71.4Interest Expense
    
    
    134,732
    
    
    
    146,488
    
    
    
    (11,756
    )
    
    
    (8.0
    )Other Income (Expense)  Net
    
    
    82,730
    
    
    
    40,393
    
    
    
    42,337
    
    
    
    104.8Income (Loss) before Income Taxes
    
    
    (295,623
    )
    
    
    (957,353
    )
    
    
    661,730
    
    
    
    69.1Provision for Income Taxes
    
    
    20,000
    
    
    
    
    
    
    
    20,000
    
    
    
    100.0Net Income (Loss)
    
    $
    (315,623
    )
    
    $
    (957,353
    )
    
    $
    641,730
    
    
    
    67.0
    %Beer Shipped (in barrels)
    
    
    169,200
    
    
    
    174,300
    
    
    
    (5,100
    )
    
    
    (2.9
    )%
 Sales.The following factors played a role in the $2,490,000 decline in
total sales in the first nine months of 2004: Sales to Craft Brands Alliance. Significantly impacting the
comparability of the current years sales are those sales of Redhook product
to Craft Brands in the third quarter of 2004. Approximately 20% of the 2004
year-to-date total shipments were sold to Craft Brands at a price
substantially below wholesale pricing levels. Redhook manufactures and sells its product to Craft
Brands at a fixed transfer price; Craft 16




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##### Table of Contents



Brands, in turn, advertises,
markets, sells and distributes the product to wholesale outlets in the
western United States through a distribution agreement between Craft Brands
and Anheuser-Busch. Shipments. Total Company shipments declined 2.9%. Total sales volume
for the nine months of 2004 decreased to 169,200 barrels from 174,300
barrels for the same period in 2003, the result of a 6.4% decrease in
shipments of its packaged products and a 3.4% increase in shipments of the
Companys draft products. The migration toward increasing package sales
reversed slightly, with 61.9% of total shipments in the nine months of 2004
being package shipments versus 64.2% in the same nine months of 2003. A 3.6%
decline in West Coast sales volume, including a 6.8% decrease in shipments
in Washington State, the Companys largest market, contributed to the
overall sales volume decrease. Shipments in the Midwest and eastern United
States increased modestly. Pricing and Fees. Average wholesale revenue per barrel on sales in the
Midwest and eastern United States showed modest improvement while fees that
the Company paid to A-B on sales in the regions increased pursuant to the
July 1, 2004 Distribution Agreement with A-B. Improvement in average
wholesale revenue per barrel was driven by strength in pricing in many of
the Companys markets, although the nine-month periods average revenue per
barrel did experience some downward pressure as a result of a contract
brewing arrangement, sold at a significantly lower revenue per barrel during
the second quarter of 2004, with Widmer Brothers Brewing Company. Retail Operations. Sales in the Companys retail operations increased
$210,000 to $3,753,000 from $3,543,000 for the nine months ended September
30, 2004 and 2003. Excise Taxes. Excise taxes decreased $68,000 to $2,601,000 for the first
nine months of 2004 compared to $2,670,000 in the same 2003 period. The Company
continues to be responsible for federal and state excise taxes for all
shipments, including those to Craft Brands. The comparability of excise taxes
as a percentage of net sales is impacted most significantly by the sale of
Redhook product to Craft Brands at a price substantially below wholesale
pricing levels, but also by average revenue per barrel, the proportion of pub
sales to total sales, and the estimated annual average federal and state excise
tax rates. Cost of Sales.Comparing the 2004 nine-month period to the 2003
nine-month period, cost of sales decreased 1.3%, or $285,000, but increased on
a per barrel basis. A significant decrease in freight in the third quarter of
2004 and an improvement in some of the Companys direct costs were offset by
increases in some indirect costs, including depreciation and production wages,
following the 2003 expansion of brewing capacity in the Companys New Hampshire
brewery. Based upon the breweries combined current production capacity of
281,250 barrels for the nine months ended September 30, 2004 and 277,500
barrels for the same 2003 period, the utilization rates were 60.2% and 62.8%,
respectively. Selling, General and Administrative Expenses. Selling, general and
administrative expenses decreased $2,621,000 to $6,385,000 from expenses of
$9,006,000 for the first nine months of 2003, significantly impacted by the
formation of Craft Brands as well as Company efforts to re-focus its sales and
marketing spending in its primary markets. All advertising, marketing and
selling costs in the western United States became the responsibility of Craft
Brands on July 1, 2004. While the Company and Widmer sought the regulatory
approval required for Craft Brands to become fully operational, they agreed to
share certain sales-related costs, primarily salaries and overhead. The
Companys share of those costs totaled $554,000 for the nine months ended
September 30, 2004 and is reflected in the Companys statement of operations as
selling, general and administrative expenses. Income from Equity Investment in Craft Brands Alliance.For the nine
months ended September 30, 2004, the Companys share of Craft Brands net
income totaled $658,000. This share of Craft Brands profit was net of $78,000
of the Special Marketing Expense that had been incurred by Craft Brands during
the same period and was fully allocated to the Company. Craft Brands Alliance Shared Formation Expenses.In conjunction with the
formation of Craft Brands, both the Company and Widmer incurred certain
start-up expenses, including severance expenses and legal fees. The Companys operating income (loss) for the nine months ended September
30, 2004 reflects $535,000 attributable to the Companys share of these
expenses. 17




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Interest Expense.Interest expense was $135,000 for the first nine months
of 2004, down from $146,000 for the comparable 2003 period. Lower average
interest rates during the first half of 2004 and a declining term loan balance
resulted in a year-to-date decline in interest expense. Other Income (Expense) Net. Other income (expense)  net increased to
income of $83,000 in the first nine months of 2004 compared to income of
$40,000 in the first nine months of 2003. Income Taxes. The Companys effective income tax rate was a 6.8% current
state tax provision for the first nine months of 2004 and 0.0% for the
comparable 2003 period. In the first nine months of 2004 and 2003, the Company
increased the valuation allowance to fully cover net tax operating loss
carryforwards and other net deferred tax assets that were generated during the
period. The valuation allowance covers a portion of the Companys deferred tax
assets, specifically certain federal and state NOLs that may expire before the
Company is able to utilize the tax benefit. Realization of the benefit is
dependent on the Companys ability to generate future U.S. taxable income. To
the extent that the Company continues to be unable to generate adequate taxable
income in future periods, the Company will not be able to recognize additional
tax benefits and may be required to record a greater valuation allowance
covering potentially expiring NOLs. Liquidity and Capital Resources The Company has required capital principally for the construction and
development of its production facilities. To date, the Company has financed its
capital requirements through cash flow from operations, bank borrowings and the
sale of common and preferred stock. The Company expects to meet its future
financing needs and working capital and capital expenditure requirements
through cash on hand, operating cash flow and, to the extent required and
available, bank borrowings and offerings of debt or equity securities. The Company had $7,113,000 and $6,123,000 of cash and cash equivalents at
September 30, 2004 and December 31, 2003, respectively. At September 30, 2004,
the Company had working capital of $4,000,000. The Companys long-term debt as
a percentage of total capitalization (long-term debt, convertible redeemable
preferred stock and common stockholders equity) was 8.5% at September 30, 2004
compared to 8.7% at December 31, 2003. Cash provided by operating activities
totaled $1,596,000 for the nine months ended September 30, 2004, an improvement
over cash provided by operating activities of $974,000 for the comparable 2003
period. The improvement was primarily attributable to improved operating
results in 2004. During the nine months ended September 30, 2004, the Companys capital
expenditures totaled $77,000. Capital expenditures for fiscal year 2004 are
expected to total approximately $125,000. The Company has a credit agreement with a bank under which a term loan
(the Term Loan) is provided. The Term Loan, which originated in June 1997
upon the conversion of a $9 million secured credit facility, matures on June 5,
2007 and has a 20 year amortization schedule. The credit agreement also
provided for a $2 million revolving credit facility; however, the Company did
not renew the revolving facility upon the July 1, 2004 expiration of the
commitment period. There were no borrowings outstanding under the revolving
facility at the time of its expiration. The Term Loan is secured by substantially all of the Companys assets.
Through June 4, 2002, interest on the Term Loan accrued at a variable rate
based on the London Inter Bank Offered Rate (LIBOR) plus 1.25%. Since June 5,
2002, interest on the Term Loan has accrued at LIBOR plus 1.75%. The Company
has the option to fix the applicable interest rate for up to twelve months by
selecting LIBOR for one- to twelve- month periods as a base. As of September
30, 2004, there was $5.738 million outstanding on the Term Loan, and the
Companys one-month LIBOR-based borrowing rate was 3.63%. The termination of
the A-B Distribution Agreement for any reason would constitute an event of
default under the credit agreement and the bank may declare the entire
outstanding loan balance immediately due and payable. See  Certain
Considerations: Issues and Uncertainties below. If this were to occur, the
Company could seek to refinance its Term Loan with one or more banks or obtain
additional equity capital; however, there can be no assurance the Company would
be able to access additional capital to meet its needs or that such
additional capital would be at commercially reasonable terms. 18




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The terms of the credit agreement require the Company to meet certain
financial covenants. In December 2001, March 2003, February 2004 and October
2004, the credit agreement was amended to modify several financial covenants.
These revisions have reduced the likelihood that a violation of the covenants
by the Company will occur; however, if the Company were to report a significant
net loss for one or more quarters within a time period covered by the financial
covenants, one or more of the covenants would be negatively impacted and could
cause a violation. Failure to meet the covenants required by the credit
agreement is an event of default and, at its option, the bank could deny a
request for a waiver and declare the entire outstanding loan balance
immediately due and payable. In such a case, the Company would seek to
refinance the loan with one or more banks, potentially at less desirable terms.
However, there can be no guarantee that additional financing would be available
at commercially reasonable terms, if at all. The Company was in compliance with
all covenants for the quarter ended September 30, 2004. From May 2000 through May 2003, the Company repurchased its Common Stock
in conjunction with a repurchase plan authorized by the Board of Directors. The
plan allowed for the repurchase of 1.5 million outstanding
shares of Common Stock for a
total maximum repurchase of $2,750,000. In May 2003, at which time a total of
1,463,100 shares of Common Stock had been purchased in the open market for an
aggregate expenditure of $2,750,000, the Company ended the repurchase plan.
During the nine-month period ended September 30, 2003, 101,400
shares of Common Stock were
purchased for $231,000. No shares of Common Stock were repurchased in 2004. Formation of Craft Brands Alliance and Restructuring of Relationship with
Anheuser-Busch, Incorporated Overview of Product Distribution The Companys products are available for sale directly to consumers in
draft and bottles at restaurants, bars and liquor stores, as well as in bottles
at supermarkets, warehouse clubs and convenience stores. Like substantially all
craft brewers, the Companys products are delivered to these retail outlets
through a network of local distributors whose principal business is the
distribution of beer and, in some cases, other alcoholic beverages, and who
traditionally have local distribution relationships with one or more national
beer brands. The Company also offers its products directly to consumers at the
Companys two on-premise retail establishments, the Forecasters Public House in
Woodinville, Washington and the Cataqua Public House in Portsmouth, New
Hampshire. In October 1994, the Company entered into a distribution agreement with
A-B pursuant to which the Company began distributing its products, for any new
markets entered, exclusively through the Distribution Alliance. During 2003,
the Companys products were distributed in 48 states through 527 Alliance
distribution points, accounting for approximately 72% of the Companys sales
volume. In addition, sales through wholesalers that are part of the A-B
distribution network but that are not part of the Distribution Alliance
accounted for an additional 23% of the Companys sales volume in 2003. Craft Brands Alliance On July 1, 2004, the Company entered into definitive agreements with
Widmer with respect to the operation of Craft Brands. Craft Brands
purchases products from the Company and Widmer and markets,
advertises, sells and
distributes these products in the Western Territory pursuant to a distribution
agreement with A-B (the CBA Distribution Agreement). The Western Territory
includes the following western states: Alaska, Arizona, California, Colorado,
Hawaii, Idaho, Montana, New Mexico, Nevada, Oregon, Washington and Wyoming. The
Company and Widmer are each a 50% member of Craft Brands and each has the right
to designate two directors to its six member board. A-B is entitled to
designate the remaining two directors. The Company and Widmer have entered into a restated operating agreement
with Craft Brands (the Operating Agreement) that governs the operations
of Craft Brands and the obligations of its members.
The Operating Agreement requires the Company to make certain capital
contributions and loans to Craft Brands to assist Craft Brands in conducting
its operations and meeting its obligations. In July 2004, the 19




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Company made a
2004 sales and marketing capital contribution to Craft Brands in an amount
equal to $250,000 and a member loan of $150,000. The sales and marketing
contribution is to be used by Craft Brands for expenses related to the
marketing, advertising, and promotion of Redhook products. The Operating
Agreement also requires an additional sales and marketing contribution in 2008
if the volume of sales of Redhook products in 2007 in the Western Territory is
less than 92% of the volume of sales of Redhook products in 2003 in the Western
Territory (other than sales made by the Company at its on-premise retail
establishments and from dock sales). The 2008 contribution, if one is required,
cannot exceed $750,000 and will be required to be paid by the Company in no
more than three equal installments made on or before February 1, 2008, April 1,
2008, and July 1, 2008. Widmer has an identical obligation under the Operating
Agreement with respect to sales of its product. Other additional capital
contributions will be made only upon the request and consent of the Craft
Brands board. Additionally, to the extent cash flow from operations and borrowings from
financial institutions are not sufficient for Craft Brands to meet its
obligations, the Company and Widmer are obligated to lend to Craft Brands the
funds the president of Craft Brands deems necessary to meet such obligations. Under the Operating Agreement, profits and losses will generally be
allocated between the Company and Widmer based on the cash flow percentages of
42% and 58%, respectively (the Cash Flow Percentages). Net cash flow, if any,
will generally be distributed monthly to the Company and Widmer based upon the
Cash Flow Percentages. No distribution will be made to the Company or Widmer
unless, after the distribution is made, the assets of Craft Brands will be in
excess of its liabilities, with the exception of liabilities to members, and
Craft Brands will be able to pay its debts as they become due in the ordinary
course of business. The Company has also entered into a supply, distribution and licensing
agreement with Craft Brands (the Supply and Distribution Agreement). Under
the Supply and Distribution Agreement, Craft Brands sells, markets, and
distributes the Companys products in the Western Territory. The
Company manufactures and sells its product directly to Craft Brands (except in states
where laws require sales to be made directly from Redhook to wholesalers) and
Craft Brands advertises, markets and distributes the products to retail
outlets in the Western Territory through the CBA Distribution Agreement. The
Company has granted Craft Brands a license to use Redhook intellectual property
in connection with these efforts to advertise, market, sell and distribute the
Companys products in the Western Territory. The Supply and Distribution
Agreement also gives the Company the right to manufacture certain products of
Widmer for sale to Craft Brands if Widmer is unable to manufacture the quantity
ordered by Craft Brands. In addition, if sales of the Companys products
decrease as compared to previous year sales, the Company will have an option to
manufacture Widmer products in an amount equal to the lower of (i) the
Companys product decrease or (ii) the Widmer product increase. Widmer has also
entered into a supply, distribution and licensing agreement with Craft Brands
upon substantially similar terms. The Supply and Distribution Agreement has an indefinite term, subject to
early termination upon the occurrence of certain events. The Supply and
Distribution Agreement may be terminated immediately, by either party, upon the
occurrence of any one or more of the following events:  (a)
    
    the other party fails to timely make any payment required under the
Supply and Distribution Agreement for a period of 60 days following
written notice thereof by the nonbreaching party;(b)
    
    the other party fails to perform any other material obligation under
the Supply and Distribution Agreement and such failure remains uncured
for a period of 60 days following written notice thereof by the
nonbreaching party;(c)
    
    the other party becomes the subject of insolvency or bankruptcy
proceedings, ceases doing business, makes an assignment of assets for
the benefit of creditors, dissolves, or has a trustee appointed for all
or a substantial portion of such partys assets;(d)
    
    any government authority makes a final decision invalidating a
substantial portion of the Supply and Distribution Agreement;(e)
    
    either party finds that complying with any law or regulation relating
to fulfilling its obligations under the Supply and Distribution
Agreement would be commercially unreasonable and failure to comply 20




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with the law or regulation would subject such party or any of its personnel
to a monetary or criminal penalty; or(f)
    
    the CBA Distribution Agreement with A-B terminates for any reason; or(g)
    
    the Operating Agreement terminates for any reason. Additionally, Craft Brands may, upon notice to Redhook, terminate the
Supply and Distribution Agreement if Redhook causes Craft Brands to be in
default in its obligations under the CBA Distribution Agreement and Redhook
either (a) fails to take all actions necessary to cause Craft Brands to cure
such default or (b) fails to pay on demand certain direct or indirect costs
arising out of or related to such default. Craft Brands may also terminate the
Supply and Distribution Agreement and cease advertising, marketing, or
distributing one or more of the Companys products if an event of default
occurs under the CBA Distribution Agreement that gives A-B the right to
terminate that agreement and Redhook caused such event of default. Relationship with Anheuser-Busch, Incorporated On July 1, 2004, the Company completed the restructuring of its ongoing
relationship with A-B. Pursuant to an exchange and recapitalization agreement
(the Exchange and Recapitalization Agreement), the Company issued 1,808,243
shares of common stock to A-B in exchange for 1,289,872 shares of Series B
Preferred Stock held by A-B. The Series B Preferred Stock, reflected in the
Companys July 1, 2004 balance sheet at approximately $16.3 million, was
cancelled. In connection with the exchange, the Company also agreed to pay $2.0
million to A-B prior to December 1, 2004. As of September 30, 2004, A-B owned
approximately 33.7% of the Companys common stock. A-B was also granted certain
contractual registration rights with respect to its shares of the Companys
common stock. Additionally, pursuant to the Exchange and Recapitalization Agreement, A-B
is entitled to designate two members of the board of directors of the Company.
A-B also generally has the contractual right to have one of its designees sit
on each committee of the board of directors of the Company. The Exchange and
Recapitalization Agreement contains limitations on, among other matters, the
Companys ability to issue equity securities or acquire or sell assets or
stock, amend its Articles of Incorporation or bylaws and adopt plans that may
have the effect of deterring a change in control of the Company and requires
the Company to refrain from voluntarily terminating its listing on the Nasdaq
Stock Market, without the prior consent of A-B. Further, if the new A-B
Distribution Agreement described below or the CBA Distribution Agreement is
terminated, or the distribution of Redhook products is terminated by Craft
Brands under the CBA Distribution Agreement, A-B has the right to solicit and
negotiate offers from third parties to purchase all or substantially all of the
assets or securities of the Company or to enter into a merger or consolidation
transaction with the Company and cause the board of directors of the Company to
consider any such offer. On July 1, 2004 the Company also entered into a new A-B Distribution
Agreement. The A-B Distribution Agreement provides for the distribution of the
Companys products in the Midwest and eastern United States (the Eastern
Territory), which represents those states not covered by the Supply and
Distribution Agreement. The structure of the new A-B Distribution Agreement is
substantially similar to the Companys prior arrangement with A-B. Under the
A-B Distribution Agreement, the Company is responsible for marketing its
products to A-Bs distributors in the Eastern Territory, as well as to
retailers and consumers. The A-B distributors then place orders with the
Company, through A-B, for Redhook products. The Company separately packages and
ships the orders in refrigerated trucks to the A-B distribution center nearest
to the distributor or, under certain circumstances, directly to the
distributor. Generally, the Company sells its products to A-B at the same list
prices the Company charges non-Alliance distributors in the respective markets,
but it must pay A-B certain fees in connection with sales to A-B. Such fees are
determined by a formula that effectively reduces the total gross profit margin
earned on sales to A-B. However, management believes that the benefits of the
distribution arrangement with A-B, particularly the potential for increased
sales volume and efficiencies in delivery, state reporting and licensing,
billing and collections, are significant to the Companys business. Under the A-B Distribution Agreement, the Company has granted A-B the
first right to distribute Redhook products, including future new products, in
the Eastern Territory. 21




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The new A-B Distribution Agreement has a term that expires on December 31,
2014, subject to automatic renewal for an additional ten-year period unless A-B
provides written notice of non-renewal to the Company on or prior to June 30,
2014. The A-B Distribution Agreement is also subject to early termination upon
the occurrence of certain events. The A-B Distribution Agreement may be
terminated immediately, by either party, upon the occurrence of any one or more
of the following events:  (a)
    
    a material default by the other party in the performance of any of
the provisions of the A-B Distribution Agreement or any other agreement
between the parties, which default is either:  (i)
    
    curable within 30 days, but is not cured within 30 days
following written notice of default; or(ii)
    
    not curable within 30 days and either:  (A)
    
    the defaulting party fails to take
reasonable steps to cure as soon as reasonably possible
following written notice of such default; or(B)
    
    such default is not cured within 90 days
following written notice of such default;  (b)
    
    default by the other party in the performance of any of the
provisions of the A-B Distribution Agreement or any other agreement
between the parties, which default is not described in (a) above and
which is not cured within 180 days following written notice of such
default;(c)
    
    the making by the other party of an assignment for the benefit of
creditors; or the commencement by the other party of a voluntary case or
proceeding or the other partys consent to or acquiescence in the entry
of an order for relief against such other party in an involuntary case
or proceeding under any bankruptcy, reorganization, insolvency or
similar law;(d)
    
    the appointment of a trustee or receiver or similar officer of any
court for the other party or for a substantial part of the property of
the other party, whether with or without the consent of the other party,
which is not terminated within 60 days from the date of appointment
thereof;(e)
    
    the institution of bankruptcy, reorganization, insolvency or
liquidation proceedings by or against the other party without such
proceedings being dismissed within 90 days from the date of the
institution thereof;(f)
    
    any representation or warranty made by the other party under or in
the course of performance of the A-B Distribution Agreement is false in
material respects; or(g)
    
    the CBA Distribution Agreement is terminated or the distribution
thereunder of the products of Redhook is terminated pursuant to its
terms. Additionally, the A-B Distribution Agreement may be terminated by A-B,
upon six months prior written notice to the Company, in the event:  (a)
    
    the Company engages in certain Incompatible Conduct (as defined in
the A-B Distribution Agreement) which is not curable or is not cured to
A-Bs satisfaction (in A-Bs sole opinion) within 30 days following
written notice;(b)
    
    any A-B competitor or affiliate thereof acquires 10% or more of the
outstanding equity securities of the Company, and one or more officers,
designees or agents of such person become a member of the board of
directors of the Company;(c)
    
    the current chief executive officer of the Company ceases to function
as chief executive officer and within six months of such cessation a
successor satisfactory in the sole, good faith discretion of A-B is not
appointed;(d)
    
    the Company is merged or consolidated into or with any other person
or any other person merges or consolidates into or with the Company; or(e)
    
    A-B or its corporate affiliates incur any liability or expense as a
result of any claim asserted against them by or in the name of the
Company or any shareholder of the Company as a result of the equity
ownership of A-B or its affiliates in the Company, or any equity
transaction or exchange between A-B 22




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or its affiliates and the Company,
and the Company does not reimburse and indemnify A-B and its corporate
affiliates on demand for the entire amount of such liability and
expense. If the A-B Distribution Agreement and/or the Supply and Distribution
Agreement were terminated early, as described above, it would be extremely
difficult for the Company to rebuild its distribution network without a severe
negative impact on the Companys sales and results of operations. It is likely
that the Company would need to raise additional funds to develop of a new
distribution network. There cannot be any guarantee that the Company would be
able to successfully rebuild all, or part, of its distribution network or that
any additional financing would be available when needed, or that any such
financing would be on commercially reasonable terms. The termination of the A-B Distribution Agreement for any reason would
also constitute an event of default under the Companys bank credit agreement.
Upon default, the bank may declare the entire outstanding term loan balance
immediately due and payable. The Company could seek to refinance its term loan
with one or more banks or obtain additional equity capital; however, there can
be no assurance the Company would be able to access additional capital to meet
its needs or that such additional capital would be on commercially reasonable
terms. Certain Considerations: Issues and Uncertainties The Company does not provide forecasts of future financial performance or
sales volume, although this Quarterly Report contains certain other types of
forward-looking statements that involve risks and uncertainties. The Company
may, in discussions of its future plans, objectives and expected performance in
periodic reports filed by the Company with the Securities and Exchange
Commission (or documents incorporated by reference therein) and in written and
oral presentations made by the Company, include forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, or
Section 21E of the Securities Exchange Act of 1934, as amended. Such
forward-looking statements are based on assumptions that the Company believes
are reasonable, but are by their nature inherently uncertain. In all cases,
there can be no assurance that such assumptions will prove correct or that
projected events will occur. Actual results could differ materially from those
projected depending on a variety of factors, including, but not limited to, the
successful execution of market development and other plans, the availability of
financing and the issues discussed below. While Company management is
optimistic about the Companys long-term prospects, the following issues and
uncertainties, among others, should be considered in evaluating its business
prospects and any forward-looking statements. Relationship with Anheuser-Busch, Incorporated and Craft Brands Alliance
LLC.All of the Companys future sales are expected to be made through the
Distribution Alliance with A-B and through sales to Craft Brands. Craft Brands
will distribute the Companys products through a separate distribution
arrangement with A-B. See Formation of Craft Brands Alliance and Restructuring
of Relationship with Anheuser-Busch, Incorporated above for a description of
the Companys restructured relationship with A-B and with Craft Brands. If the
relationship between A-B and the Company, between the Company and Craft Brands
or between A-B and Craft Brands were to deteriorate, distribution of the
Companys products would suffer significant disruption and such event would
have a long-term severe negative impact on the Companys sales and results of
operations, as it would be extremely difficult for the Company to rebuild its
own distribution network. While the Company believes that the benefits of the
Distribution Alliance and its relationship with A-B and Craft Brands, in
particular distribution and material cost efficiencies, offset the costs
associated with the relationship, there can be no assurance that these costs
will not have a negative impact on the Companys profit margins in the future. Craft Brands Alliance.On July 1, 2004, the Company entered into
definitive agreements with Widmer with respect to the operation of Craft
Brands. As discussed above, Craft Brands advertises, markets, sells and
distributes the Company and Widmers products in the western United States. The
Company believes that the combined sales and marketing organization will create synergies and
capitalize on both companies sales and marketing experience and complementary
product portfolios. The Company anticipates that the joint organization will
positively impact revenues and decrease the Companys selling, general and
administrative 23




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expenses. However, there can be no assurance that the Company
will see any anticipated benefits from the joint venture. In conjunction with the formation of Craft Brands, both the Company and
Widmer have incurred certain start-up expenses, including severance expenses
and legal fees. The Companys operating loss for the nine months ended
September 30, 2004 reflects $535,000 attributable to the Companys share of
these expenses. Additionally, during the period March 15, 2004 through June 30,
2004, while the companies sought the regulatory approval required for Craft
Brands to become fully operational, the Company and Widmer agreed to share
certain sales-related costs, primarily salaries and overhead. The Companys
share of those costs totaled $554,000 for the nine months ended September 30,
2004, and are reflected in the Companys statement of operations as selling,
general and administrative expenses. Dependence on Distributors.While all of the Companys future sales are
expected to be made through the Distribution Alliance with A-B and through
sales to Craft Brands, the Company relies heavily on distributors, most of
which are independent wholesalers, for the sale of its products to retailers.
The Companys most significant wholesaler, K&L Distributors, Inc., accounted
for approximately 13% of the Companys shipments in the first nine months of
2004. A disruption of the Companys, Craft Brands, the wholesalers or A-Bs
ability to distribute products efficiently due to any significant operational
problems, such as wide-spread labor union strikes, the loss of K&L Distributors
as a customer, or the termination of the Distribution Alliance or the Supply
and Distribution Agreement could have a material adverse impact on the
Companys sales and results of operations. Effect of Competition on Future Sales.The Company competes in the highly
competitive craft brewing market as well as in the much larger specialty beer
market, which encompasses producers of import beers, major national brewers
that have produced fuller-flavored products, and large spirit companies and
national brewers that produce flavored alcohol beverages. Beyond the beer
market, craft brewers also face competition from producers of wines and
spirits. Primarily as a result of increased competition, the Company
experienced declining sales volumes ranging from 2.3% to 5.7% for the years
1997 through 1999. And while the Companys sales volumes since 1999 have
increased when compared to the corresponding prior years volumes, competition
within the segment has, at times, negatively impacted pricing of the Companys
products. A further increase in competition could cause the Companys future
sales and results of operations to be adversely affected. The Company has
historically operated with little or no backlog and, therefore, its ability to
predict sales for future periods is limited. Sales Prices.Future prices the Company charges for its products may
decrease from historical levels, depending on competitive factors in the
Companys various markets. The Company has participated in price promotions
with its wholesalers and their retail customers in most of its markets. The
number of markets in which the Company participates in price promotions and the
frequency of such promotions may increase in the future. Variability of Gross Margin and Cost of Sales.The Company anticipates
that its future gross margins will fluctuate and may decline as a result of
many factors, including disproportionate depreciation and other fixed and
semi-variable operating costs, depending on the level of production at the
Companys breweries in relation to current production capacity. The Companys
high level of fixed and semi-variable operating costs causes gross margin to be
very sensitive to relatively small increases or decreases in sales volume. In
addition, other factors that could affect cost of sales include changes in
freight charges, the availability and prices of raw materials and packaging
materials, the mix between draft and bottled product sales, the sales mix of
various bottled product packages and federal or state excise taxes. Also, if
sales volume through the Distribution Alliance increases, the related fees will
increase. Advertising and Promotional Costs.The Company has participated in
advertising programs to varying degrees over the past five years. Prior to
1999, the Company engaged in very limited advertising to market its products.
In order to increase brand awareness and capture a larger share of the
fragmented craft beer market, the Company determined that a significant
increase in spending on advertising and promotion was necessary.
During 1999 and 2000, the Company primarily utilized radio, billboard and
print advertising in key markets, while also participating to a small degree in
a co-operative program with its distributors. In 2001, the Company allocated a
larger share of its advertising spending to this co-operative program whereby
the Companys 24




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spending is matched dollar for dollar by the distributor. In 2002
and 2003, the Company continued its co-operative advertising and promotion
program while reducing even further those advertising expenditures where the
Company funded the entire program. The Company believes that the financial
commitment as well as the distributors knowledge of the local market result in
an advertising and promotion program that is targeted in a manner that will
best promote Redhook. Expenditures for the co-op program and media advertising
program totaled $642,000 for the nine months ended September 30, 2004, and $1.6
million and $1.9 million for the years ended December 31, 2003 and 2002,
respectively. Upon the formation of Craft Brands, the program in the western
United States markets was suspended. The Company expects to continue to
participate in the co-op advertising and promotion program and limited media
advertising in select eastern United States markets through the remainder of
2004. Market and competitive considerations could require an increase in other
promotional costs associated with developing existing and new markets. Customer Acceptance, Consumer Trends and Public Attitudes.If consumers
were unwilling to accept the Companys products or if general consumer trends
caused a decrease in the demand for beer, including craft beer, it could
adversely impact the Companys sales and results of operations. If the flavored
alcohol beverage market, the wine market, or the spirits market continue to
grow, they could draw consumers away from the Companys products and have an
adverse effect on the Companys sales and results of operations. Further, the
alcoholic beverage industry has become the subject of considerable societal and
political attention in recent years due to increasing public concern over
alcohol-related social problems, including drunk driving, underage drinking and
health consequences from the misuse of alcohol. If beer consumption in general
were to come into disfavor among domestic consumers, or if the domestic beer
industry were subjected to significant additional governmental regulation, the
Companys sales and results of operations could be adversely affected. Effect of Sales Trends on Brewery Efficiency and Operations. The
Companys breweries have been operating at production levels substantially
below their current and maximum designed capacities. Operating breweries at low
capacity utilization rates negatively impacts gross margins and operating cash
flows generated by the production facilities. In 1998, after performing an
analysis of the Companys current and future production capacity requirements,
production at the Fremont Brewery in Seattle, Washington was permanently
curtailed and the assets were written down to an estimate of their net
realizable value. The Company will continue to evaluate whether it expects to
recover the costs of its two remaining production facilities over the course of
their useful lives. If facts and circumstances indicate that the carrying value
of these long-lived assets may be impaired, an evaluation of recoverability
will be performed in accordance with FASB Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, by comparing the carrying value of
the assets to projected future undiscounted cash flows in addition to other
quantitative and qualitative analyses. If management believes that the carrying
value of such assets may not be recoverable, the Company will recognize an
impairment loss by a charge against current operations. Income Tax Benefits.As of December 31, 2003, the Company had
approximately $11.8 million of deferred tax assets, comprised principally of
federal net operating loss carryforwards (NOLs) that expire from 2012 through
2023 and state NOLs that expire through 2018. Federal NOLs, generally permitted
to be carried forward no more than 20 years, and state NOLs, generally
permitted to be carried forward five to 15 years, can be used to offset regular
tax liabilities in future years. The recognition of these assets is dependent
upon estimates of future taxable income resulting from future reversals of
existing taxable temporary differences, which have been recorded as deferred
tax liabilities and exceed the deferred tax assets. As of December 31, 2003,
the Company also had a valuation allowance of $738,000, reflected as a
reduction of the Companys deferred tax assets on its balance sheet. During the
first nine months of 2004, the Company increased its valuation allowance by
$47,000 thereby reducing the estimated deferred income tax benefit recorded in
its statement of operations to $0. The valuation allowance covers a portion of
the Companys deferred tax assets, specifically certain federal and state NOL
carryforwards, that may expire before the Company is able to utilize the tax
benefit. Realization of the benefit is dependent on the Companys ability to
generate future U.S. taxable income. To the extent that the Company is unable
to generate adequate taxable income in the future, the Company may not be able
to recognize additional tax benefits and may be required to record a greater
valuation allowance covering expiring NOLs. 25




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Recent Accounting Pronouncements In December 2003, the Financial Accounting Standards Board (FASB) issued
FASB Interpretation No. 46R (FIN 46R), Consolidation of Variable Interest
Entities, a revision to Interpretation No. 46 (FIN 46). FIN 46R clarifies the
application of consolidation accounting for certain entities that do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties or in which equity
investors do not have the characteristics of a controlling financial interest;
these entities are referred to as variable interest entities. Variable
interest entities within the scope of FIN 46R are required to be consolidated
by their primary beneficiary. The primary beneficiary of a variable interest
entity is determined to be the party that absorbs a majority of the entitys
expected losses, receives a majority of its expected returns, or both. FIN 46R
also requires disclosure of significant variable interests in variable interest
entities for which a company is not the primary beneficiary. The Company has
assessed Craft Brands under the provisions of FIN 46R and has concluded that it
meets the definition of a variable interest entity but that the Company is not
the primary beneficiary. Accordingly, the Company has accounted for its
investment in Craft Brands under the equity method, as outlined by Accounting
Principles Board Opinion No. 18 (APB 18), The Equity Method of Accounting for
Investments in Common Stock. The Company will periodically review its
investment in Craft Brands to insure that it complies with the guidelines
prescribed by FIN 46R. 26




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ITEM 3.Quantitative and Qualitative Disclosures about Market Risk The Company has assessed its vulnerability to certain market risks,
including interest rate risk associated with financial instruments included in
cash and cash equivalents and long-term debt. Due to the nature of these
investments and the Companys investment policies, the Company believes that
the risk associated with interest rate fluctuations related to these financial
instruments does not pose a material risk. The Company did not have any derivative financial instruments as of
September 30, 2004. 
 ITEM 4.Controls and Procedures The Company has carried out an evaluation of the effectiveness of the
design and operation of the Companys disclosure controls and procedures (as
defined in Exchange Act Rule 13a-15(e) or 15d-15(e)) as of the end of the
period covered by this quarterly report on Form 10-Q. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Companys disclosure controls and procedures are effective. No changes in the Companys internal control over financial reporting were
identified in connection with the evaluation that has materially affected, or
is reasonably likely to materially affect, the Companys internal control over
financial reporting. 
 PART II. 
 ITEM 6.Exhibits (a) Exhibits The following exhibits are filed as part of this report. 31.1
    
    Certification of
Chief Executive
Officer of Redhook
Ale Brewery,
Incorporated
pursuant to
Exchange Act Rule
13a-14(a)31.2
    
    Certification of
Chief Financial
Officer of Redhook
Ale Brewery,
Incorporated
pursuant to Exchange
Act Rule 13a-14(a)32.1
    
    Certification of
Chief Executive
Officer of Redhook
Ale Brewery,
Incorporated
pursuant to Exchange
Act 13a-14(b) and 18
U.S.C. Section 135032.2
    
    Certification of
Chief Financial
Officer of Redhook
Ale Brewery,
Incorporated
pursuant to Exchange
Act 13a-14(b) and 18
U.S.C. Section 1350
 27




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. REDHOOK ALE BREWERY, INCORPORATEDNovember 12, 2004
    
    BY:
    
    /s/ David J. MickelsonDavid J. MickelsonExecutive Vice President,Chief Financial Officer and Chief Operating OfficerNovember 12, 2004
    
    BY:
    
    /s/ Anne M. MuellerAnne M. MuellerTreasurer,Principal Accounting Officer
 28