I have always been enthralled by the fickleness by which investors in the stock market can fall in love with a stock one minute, and hate that stock in the next minute. The rise and fall of some stocks can be a spectacular sight to behold. These "go-go" stocks can rise sharply on the unrealistic expectations of fundamental investors who erroneously believe the company can sustain above-average growth indefinitely. These stocks continue to appreciate when momentum investors blindly buy into the "story" and the shares, unconcerned by fundamentals or reasonable valuation metrics. Who can forget the rise and fall of fad stocks like Krispy Kreme Doughnuts (KKD) or Crocs (CROX)? Like Icarus, these stocks flew too high and too close to the sun, but eventually crashed to Earth.
I have been following one such stock since its initial public offering in March 2012 that I believe is headed for the same fate as other fad stocks. The company is Annie's Inc. (BNNY), a natural and organic food company with a widely recognized brand in a number of packaged food categories. BNNY has the #1 natural and organic market position in four product lines: macaroni and cheese, snack crackers, fruit snacks and graham crackers. In the fiscal year ended March 31, 2012, BNNY generated net sales of $141.3 million and Adjusted EBITDA of $21.3 million (15.1% margin).
Although BNNY operates in a high growth food category (natural and organic foods) and the company is expected to generate sales growth of roughly 20% per year for the next several years, there are a number of factors that investors should consider when evaluating the stock. After extensive analysis of Annie's and its industry segment, I believe the company is significantly overvalued and, further, believe the intrinsic value for the stock is roughly half of its current trading value of $47 per share. As such, I have established positions (put options) that will benefit when BNNY's stock eventually falls to its intrinsic value ($24-26 per share, in my opinion). Here are 5 of the key factors behind my analysis.
1. Lack of Tangible Assets and Limited Liquidity = Weak Balance Sheet
Many companies are "built to last" (meaning built for long-term success and profit maximization), as described by Stanford University Graduate School of Business professors James Collins and Jerry Porras in their book of the same name, where they study 18 truly exceptional and long-lasting companies. Annie's is definitively not "built to last." One primary example is the fact that BNNY has not invested in any of its own manufacturing operations. According to the S-1 filed with the SEC at the time of its IPO, the company outsources the manufacturing of its products to contract manufacturers in the U.S. Two contract manufacturing vendors accounted for roughly 50% of its business. BNNY is a "virtual" company that designs and markets products but doesn't manufacture anything.
A quick review of its balance sheet shows how fragile the company is. Because BNNY doesn't own or operate any manufacturing operations, its Property, Plant & Equipment (a long-term asset known as "PP&E") totals less than $5 million. More strikingly, BNNY has over $30 million of goodwill, which accounts for more than 40% of the company's total assets. Goodwill is an intangible asset that is created when a company acquires another business and pays more than the value of its tangible assets (for things like brands or other intellectual property that are notoriously difficult to value). Goodwill is subject to periodic tests to determine whether the book value is justified from an accounting standpoint, and companies may be required to write-down goodwill value if the value is determined to be too high. In general, a company with a higher percentage of tangible assets (assets like cash, inventory and PP&E) are considered more stable and stronger than companies with mostly intangible assets (companies in the technology or biotech space are exceptions to this rule).
Another factor to consider is BNNY's low financial resources and limited liquidity position. According to the press release for its latest quarter, BNNY had only $5.1 million of cash on its balance sheet, a low amount for a business on track to deliver more than $160 million of sales this year.
2. Initial Stocking Masks Weak Underlying Performance
Annie's is benefiting from the rapid growth of natural retailers as well as new product introductions in a way that the market is interpreting as "high growth." Meaning, when Annie's gains additional "doors" with retailers (or introduces a new product) there's an initial product stocking that takes place. This is a one-time sales boost. Afterwards, sales to that store are "replacement" sales driven by consumer demand (meaning a package of mac & cheese is purchased by the retailer to "replace" a package is removed from the shelf by the consumer). Overall company sales growth looks high because of that initial stocking, but it can mask under-performance and weakness elsewhere. We're currently seeing this sales boost in Annie's numbers because of the rapid growth of natural retailers (more "doors") as well as the company's rollout of its pizza product line. I believe investors should analyze net sales growth excluding the impact of new product introductions to get a more accurate picture of year-over-year performance from products that have been in the marketplace for more than one year.
There are two recent signs of trouble in Annie's product offering that investors may be overlooking because of the Company's seemingly robust sales growth. The first is its cereal product line, which BNNY recently discontinued due to its inability to compete with the big cereal makers. The second sign of trouble is in the Company's dressings and condiments business (17% of FY2012 net sales) where growth has stagnated. It's a bad sign when a company's more established products fail and it needs to market new products with uncertain track records to "fill the void" left by dying or stagnating product lines.
An examination of BNNY's latest 10-Q for the period ended June 30, 2012 (Q1 of FY2013) shows another sign of concern. While the company generated net sales growth of 20% year-over-year, adjusted EBITDA grew a mere 9.3% from $3.7 million in Q1 2012 to $4.1 million in Q1 2013 (considerably lower than sales growth). Adjusted EBITDA margin declined 110 basis points year-over-year from 13.0% to 11.1%, due to margin compression from higher commodity costs and higher SG&A expenses. Most companies experience margin expansion when sales are growing (called operating leverage), but Annie's seems to be experiencing lower profitability as sales grow - quite a troubling sign.
3. Lofty and Unsustainable Valuation
When Annie's went public in March 2012, the investment banking underwriters - JPMorgan (JPM) and Credit Suisse (CS) - priced its shares at $19.00. Underwriters typically price a company's common stock at a slight discount to intrinsic value to encourage institutional and retail investors to buy the shares, with an expectation of slight appreciation when the shares begin to trade publicly. Based on reasonable valuation statistics of comparable "natural and organic" comparable companies, there is every indication that the underwriters appropriately valued BNNY's stock at the time of the IPO.
The only way to say whether Annie's current valuation is justified is to analyze (on a relative value basis) BNNY's valuation statistics with those of "comparable" companies operating in the natural and organic food industry. Unfortunately there are no perfect "comparable" companies from a size, profitability, growth and product perspective. I believe investors are looking at natural and organic food companies and retailers such as Hain Celestial (HAIN), Inventure Foods (SNAK), Lifeway Foods (LWAY), The Fresh Market (TFM), United Natural Foods (UNFI) and Whole Foods Market (WFM).
Based on last Friday's closing stock price ($46.64 per share), Annie's has a fully-diluted equity value (aka market capitalization) of $821 million and an enterprise value of $816 million (enterprise value = market capitalization + debt - cash). This equates to 5.6x sales, 38x Adjusted EBITDA, and 84x net income based on last twelve month ("LTM") financial metrics, levels that are astronomical for a company that makes packaged food (these levels might be acceptable for a highly profitable tech company growing at 100% per year, but not a company that sells mac & cheese).
Some will argue that LTM valuation statistics are less relevant for a company like BNNY which is growing its top-line by 20% per year and its EBITDA and net income by more than 20% per year. These people will argue that analyzing Annie's forward (or projected) financial metrics to the current equity and enterprise values is more appropriate. Based on the consensus of Wall Street research, analysts estimate BNNY will generated $169 million of net sales, $26 million of adjusted EBITDA, and $15 million of net income in the fiscal year ending March 31, 2013. BNNY is trading at 4.8x sales, 32x adjusted EBITDA, and 56x net income based on FY2013 forward estimates. In FY2014, BNNY is estimated to generate $33 million of adjusted EBITDA, and therefore is trading at 25x 2-year forward adjusted EBITDA. This is quite simply an unsustainable valuation level, and completely out of line with comparable companies or any rationale intrinsic valuation.
Of all the comparable companies, I believe investors look to Whole Foods Market as the most applicable comp. Whole Foods is trading at 16x 2012 estimated EBITDA and 14x 2013 estimated EBITDA. Personally I believe it's extremely generous to say that Annie's is "comparable" to Whole Foods since Whole Foods is significantly bigger (over $11 billion in sales versus $150 million for BNNY), has a stronger balance sheet (over $5 billion in total assets including $1 billion of cash versus $75 million in total assets for BNNY), and a more dominant position in its markets with much higher barriers to entry.
Even if you apply Whole Foods' 2013 EBITDA multiple of 14x to Annie's FY2014 (ended 3/31/14) adjusted EBITDA estimate of $33 million, BNNY's implied enterprise value is $462 million, equating to a common stock price of $26.25 per share. Based on a reasonable comparison of "comparable" natural and organic food companies, the intrinsic value of BNNY's common stock is between $24-26 per share, or 44-48% below the current share price of $46.64.
4. Heavy Insider Selling Signals Overvaluation
Prior to its IPO in March 2012, Annie's was predominantly owned by New York-based private equity firm Solera Capital, which owned ~90% of the common stock. In the IPO, existing stockholders (primarily Solera) sold a whopping 4.8 million shares, or more than 83% of the 5.75 million total shares sold in the IPO. Solera's ownership dropped from ~90% to ~58% after the IPO. Of course, the cash raised from those 4.8 million shares went to Solera and other insiders, and did not benefit the Company in any way.
Less than 5 months later, with the stock trading in the high $30s to low $40s, BNNY pressured the investment bank underwriters to waive a 180-day lock-up restriction with respect to 3.6 million shares of the Company's common stock held by certain stockholders (again, Solera Capital). Lock-up restrictions are put in place by underwriters so that insiders don't flood the market with shares shortly after an IPO, driving down the price of a stock. The waiver of the lock-up restriction took effect on July 31, 2012, after which BNNY priced a secondary share offering where Solera Capital and other insiders sold another 3.2 million shares priced at $39.25 per share. Solera Capital's ownership stake dropped to ~40% after the secondary offering.
Between the IPO in March and the secondary offering in July, a total of 9.4 million shares were sold to retail and institutional investors. Solera Capital and other insiders sold approximately 8 million of those shares, or 85% of the total shares sold. While it is not unusual for an investment firm to begin exiting its investment after an IPO, the magnitude of Solera Capital's stock selling and the speed by which it is dumping shares is highly unusual. Insiders like Solera Capital (whose professionals serve on the company's board of directors) have unlimited access to management and the best position from which to evaluate the company's future prospects.
It also goes without saying that Solera's professionals are extremely savvy in their investment decisions (including when to buy, hold or sell an investment). Heavy selling by existing stockholders is a clear signal that a company's shares are overvalued. With BNNY, Solera Captial and other insiders are screaming SELL, SELL, SELL - is anyone listening?
5. Even Wall Street Doesn't Like It
Wall Street research analysts, who are perpetual purveyors of good news, are known for their considerable bias towards "buy" recommendations on stocks. It's seems that Wall Street rarely finds a stock that it dislikes enough to give a "hold" or "sell" recommendation. It's not surprise that most of Wall Street's recommendations are positive, as investment banks do not win business from corporations when they have a "hold" or "sell" recommendation on a company's stock (the conflicts of interest between Wall Street research and investment banking services is well-known). Although all of the Wall Street research analysts covering BNNY are bullish on the company's growth prospects, almost all of them find the company's current valuation unappealing. Most of the research analysts believe that BNNY should trade at a slight premium to other publicly-traded natural and organic food companies, but not a valuation nearly double its peer "comp" group. As such, most of the Wall Street research analysts rate the stock a "hold" due to concerns over valuation.
To be clear, I am not suggesting that BNNY is not a good company with good products. I believe it is a good company and I buy its products, but BNNY is not a great company. Maybe in 15-20 years it could be considered a great company, although I have my doubts as management isn't investing in infrastructure and products in a way that would lead to this (see my "built to last" comments above). I am also not suggesting that BNNY will not grow its revenue and EBITDA in the years ahead. Analyst projections show revenue growth of 20% per annum for the next few years with EBITDA growing at 20-25% per annum. That's very healthy growth and I have no doubt that BNNY will achieve this growth.
The sole problem lies in the fact that BNNY's common stock is priced well beyond perfection in a "la-la" valuation land which is completely ungrounded in any reality. Accordingly, I believe BNNY's stock has a significant asymmetric return profile - further stock price appreciation is very limited at this lofty valuation, while the downside potential is great. Like fad stocks of the past, BNNY will eventually fall to earth, it's just a matter of time.