Sadly, the voluntary recall by Annie's (NYSE:BNNY) on their branded frozen pizzas is likely going to be a target of short-selling activities in the near-term. Net income in the previous two quarters (as compared to similar prior year periods) was bolstered by robust growth in meals (+34.4%) and snacks (+15.5%).
Of the growth in meals, revenues were benefited by the company's organic pizza lines.
The short thesis is now glaringly obvious given the inconvenience of the recall and what some investors considered to be a lofty valuation in place since last fall. Other concerns to support this vulnerability are the "micro" nature of BNNY $666 million market-cap and pint-sized $74 million in equity as of the latest quarter.
We recognize the explosive growth in organic foods and the overall theme appears intact across the sector. However, BNNY is particularly vulnerable to supply-chain and product source capabilities. The recall issue illustrates this dilemma as the pizza-products in question are being linked to a third party source provider. According to Exhibit 10.3 in BNNY's latest 10-Q filing, the exclusive manufacturer for BNNY organic pizzas is Illinois-based Little Lady Foods, Inc.
Although the top-line growth story for Annie's has been impressive thus far, competition for shelf-space and presence in mainstream grocery channels is fierce. It is also dependent on volume, pricing and distribution capabilities.
Over the years, we have seen too many potentially wonderful small-cap growth stories fall flat on their face when faced with disruption to supply and/or capacity limitations. This is amplified considerably for liquidity constrained companies experiencing rapid growth.
While many investors find the lofty P/E (TTM is 112 x earnings) and price-to-sales metrics (4.26 x revenues) of BNNY to be reasonable evidence of an "extended" valuation (absent the recall event and forward analyst expectations), an examination of the balance sheet is more convincing in our view.
More to the point, when examining small-cap situations, experience has taught us to pay close attention to how companies report earnings and the cash-flow constituents used to support them. Understanding the "quality" of an earnings report helps us to identify whether the valuation being assigned now (i.e. stock price) is reasonable or fair to the future expectations being priced in advance. Our dual cash-flow, accruals and capital productivity screen is quite effective at determining this.
Our analysis of BNNY indicates that even without the recall event, the stock is priced to perfection. The company has little wiggle-room for error in its execution going forward. The aforementioned "valuation" link (above) also offers ample analysis to support present/future valuation discrepancies.
Analysis of the financial statements appears to validate this bearish sentiment. The first clue can be seen in the dual cash-flow ratio signals. BNNY is flashing a "Recent" and "Confirmed" Bearish signal.
This indicates that despite growth in sales and earnings, the cash-flow generated from operating activities are not contributing any meaningful support to the earnings construction. Further, the bearish signals also suggest that non-cash contributions to earnings remain substantial to the earnings composition.
To be fair, these trends are not unusual for small-cap growth stories, but it does indicate that for future valuations to be justified (growth), cash-flows generated from actual operations will need to play a bigger role in the earnings picture.
The premise being, if a stock price is expected to reflect anticipated growth (assuming that equity prices are a forward-looking indicator), actual cash-flow should be growing also. Green Mountain Coffee (NASDAQ:GMCR) provides an excellent case-study of where rapid-growth and a lack of liquidity can be a catalyst to share price implosion. The only difference is GMCR has yet to be faced with similar events "beyond their control".
In the case of BNNY, this recall presents a host of complications which are likely to de-rail share price momentum for several quarters. We will spare the obfuscation of "well the future might be bright, but near-term risks cloud the picture". There is nothing more irritating than an analyst or journalist who flip-flops on their opinion of a stock. We view this recall as a major blow to the company's earnings and sales potential going forward.
Estimated Fair-Value: Our model suggests an estimated fair-value of $30.92 for BNNY shares. This is based on our analysis of the previous five quarterly periods. Despite the -6% sell-off following the recall announcement, the shares remain 18% overvalued.
We would submit that shares of BNNY are a legitimate short candidate. Who would have thought a flour products recall might be so detrimental to a company's share price, but with BNNY our recommendation is to head for the hills. If the stock pulls back anywhere near the $32 area (or under) we might consider revisiting the story as a long.
In addition to top line and margin growth risks, potential asset impairment and/or write downs associated with the recall could negatively impact shareholder equity. Examples of such risks might be inventory charges, impact of non-cancellable purchase commitments, changes in operating asset and liability accounts, etc. Other potential equity dilutive events would be a secondary common stock offering.
It should also be noted that Goodwill both as a percent of assets and equity were 35.6% and 41.5% respectively in the period ending September 30, 2012.
Additional disclosure: Data used in this article provided by: merriamreport.com, Annie's Inc. investor services and Seeking Alpha