Infitialis is a research collective that exposes fraud and folly in financial markets in an effort to identify bubbles before they implode. Investors in industries deemed popular or en vogue by the general public have a propensity to engage in folly often resulting in the manifestation of valuation bubbles of companies in those industries. As the great Charles Mackay wrote in 1841: "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." Nearly two hundred years later, these words are still relevant, as even nowadays men find it difficult to act against the herd while the herd goes mad.
Infitialis: Track Record of Exposing Fraud or Folly is Unmatched
After our MLNX exposé delivered >40% returns and successfully called the top on what was becoming a cult stock and hedge fund hotel, readers encouraged us to focus our considerable resources on identifying similar NASDAQ or NYSE listed equities. As a result, we have spent the last two months examining thousands of equities in search for a company that shared the same characteristics as MLNX: overly hyped, mathematically irreconcilable in its valuation and exhibiting abnormal insider selling demonstrating a clear misalignment with shareholders.
In this report, we will present our short thesis on Annie's, Inc. (BNNY). Founded in 1989 by a wife and husband team to produce natural macaroni and cheese dinners for New England communes, Annie's, Inc. currently sells organic packaged foods, including macaroni and cheese, snack crackers, and fruit snacks. Annie's balance sheet resembles that of an OTCBB micro-cap, with less than $15 million in cash and only $42 million in tangible equity, while its market valuation has been bid up to a shocking $740 million - reflecting a ridiculous multiple of 123 times 2012 Free Cash Flow of $6 million. In other words, shareholders purchasing today would have to wait over a century for the company to earn the equivalent of its current market value. We believe Annie's is materially overvalued and its stock will shortly trade in the $10-$15 range once investors realize that everything about the company smells like a nasty bruksch.
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The Bunny Business
Operating in a simple industry and producing less than $7 million in revenue in 1999, Annie's was acquired in 2002 by Solera Capital LLC ("Solera"), a New York City private equity buy-out shop, at an effective cost of less than $6.00/share. In preparation for Solera's exit from the business, Annie's became a public company this spring after Solera turbocharged its revenue growth in an unsustainable fashion over the last few years. Solera originally filed to offer 5.0 million shares of the Company with a $14-16/share range, the road show price-talk was subsequently raised to $16-18/share, and finally priced the IPO at $19.00/share. BNNY's stock proceeded to rise by 89% its first day of trading, and is currently up 116% from its IPO pricing, making it one of 2012's hottest IPOs. BNNY's lead book runner on the IPO was JPMorgan. As documented in this WSJ article, Solera had a special relationship with JPMorgan with JPM even being a limited partner investor in the Solera funds that own BNNY! This connection may explain why BNNY was allowed to go public with such a tiny float and the fawning sell-side equity research provided by the underwriters after the pricing.
Of the 5.75 million Annie's shares sold in the IPO on 03/29/12, only 0.95 million were primary shares issued by Annie's; the rest were insiders happily selling out at an effective price of $17.67/share after the underwriting discounts and commissions. The IPO transaction was clearly designed as liquidity event for Solera as net of offering fees and expenses. The Company raised only $11.1 million to pay the $1.3 million termination fee associated with the existing Solera advisory services agreement and fund its future growth. Solera sold 4.4 million shares for net proceeds of $78 million, adding to its previously earned management fees and dividends of approximately $30.0 million from the Company, which has resulted in the recoupment of more than 100% of its cumulative investment in Annie's of ~$80.0 million.
Unlike the Annie's IPO pricing and trading experience, on Thursday, 10/25/12, the WhiteWave Foods Company (WWAV), the producer of the branded Silk soymilk and other organic products, was spun off from Deans Foods (DF) at $17/share after an initial price talk of $14-16/share. However, while WhiteWave shares opened at $19.00/share on the first day of trading, they quickly slipped below the IPO price, closed the day at $16.75/share, and have generally traded below the IPO price since; as more than 28.3 million shares traded on the IPO day, it appears JPMorgan, the IPO stabilization agent, was quite active in the market attempting to support the share price on the first day of trading. While WhiteWave's product portfolio has produced a similar growth trajectory as Annie's due to the same secular trends and the company has a much more robust corporate infrastructure and management team, WhiteWave is valued at approximately 12.5x forward EBITDA versus Annie's extremely rich 28.7x multiple. As WhiteWave is now publicly valued by the equity market and provides investors with another pure-play exposure to the organic and natural food trend, we strongly believe the relative valuation gap between these two firms will quickly narrow with Annie's trading to the downside.
Insiders Don't Believe in the Bunny, So Why Should You?
Year to date, Solera and other Annie's insiders have dumped in excess of $200 million of shares into the market, which is more than 1.3x the Company's 2012 revenue! This is not a business being "built to last" in Jim Collins speak; it is being manipulated for insiders to blast out of! First, on 07/27/12, Credit Suisse and JPMorgan, the lead book-running managers in the Company's IPO, waived the original 180 day post-IPO lock-up restriction for the Company's common stock held by certain Annie's insiders and shortly thereafter earned an additional $5.9 million in underwriting fees on the secondary share sale. This premature waiver allowed Solera and selected insiders to deluge an additional 3.2 million shares on public investors as Solera further reduced their ownership stake in Annie's to less than 38.3%. Critically, while Solera was prematurely reducing its stake in Annie's before the expiration of the original lock-up agreement, the private equity firm was simultaneously attempting to market a new ~$1bn fund, despite the relatively unspectacular overall return profile of its precedent fund, based on its success with the Annie's investment. At the current share price, Solera still has approximately $270 million of unrealized gains waiting to be crystallized through its ownership of 6.5 million Annie's shares. As we explained, the cost basis of these shares is now zero, as Solera has already recouped its investment in Annie's.
Next, Ms. Ann E. Withey, the original founder of Annie's and the current "Inspirational President" of the company, took advantage of the 07/31/12 lock-up waived secondary offering to sell a whopping 42.8% of her remaining stake in the company for gross proceeds of $3.3 million, which is a significant payday for a commune-dwelling organic farmer!
Next, on 11/01/12, Ms. Sarah Bird, "Senior Vice President - Marketing and Chief Mom Officer," Mr. Mark Mortimer, "Senior Vice President - Sales/Chief Customer Officer," and Mr. Lawrence Waldman, "Senior Vice President - Supply Chain and Operations" sold 95.8%, 100.0%, and 100.0%, respectively, of their existing equity positions in Annie's at prices of $40.57-41.09/share.
Finally, just three days ago on 11/06/12, Mr. Lawrence Waldman, exercised his 10,000 options with a strike at $8.88/share and immediately sold the shares for $40.10, netting a profit of $312,200.
With Ms. Ann E. Withey and other critical members of Annie's management team even more economically checked-out of the Company's operations and share price success, it is difficult to believe Annie's will be able to further grow the organizational culture that has monetized the "green" movement over the last few years.
Numerous Business Risks to Current Market Valuation
There are multiple reasons why Infitialis believes Annie's is highly overvalued. First, Annie's future product growth is severely limited by the current organic sourcing capacity constraints as it takes in excess of three years for new organic farming capacity to come on-line and be certified; this physical supply constraint will likely constrain Annie's future revenue and margin expansion ability. While the organic food supply chain may eventually reach equilibrium with current demand, in the near term, this supply imbalance tilts the competitive advantage to producers as opposed to manufacturers and presents significant execution risk for the Company's management team.
Second, Annie's is only a couple of steps removed from its roots as a commune start-up relative to most NYSE-listed businesses. For example, the NYSE recently threatened to delist the Company for its failure to properly notify the NYSE and investors of its annual shareholder meeting as required by the exchange regulations. In addition, the Company has only 85 employees and only recently acquired an Enterprise Resource Planning (ERP) system to institutionalize the business planning and internal controls. Annie's plans to hire aggressively (including sales, marketing, operations and finance teams), which significantly constrains any hopes for meaningful margin expansion due to increasing fixed costs. Annie's operational growing pains and managerial mistakes will likely continue into the future based on the limited track record of the management team and operating history as a public company.
Third, Annie's plans to take full advantage of the reduced disclosure requirements and regulations for an "Emerging Growth Company" under the recent U.S. Congress JOBS Act. The reduced disclosure and governance requirements of the JOBS Act legislation is an unproven and potentially significant risk for public investors as it severely reduces the securities regulations under the Sarbanes-Oxley Act. In addition, Solera held in excess of 50% of Annie's voting power as of the record date of 2012 annual meeting of stockholders and then subsequently reduced its economic interest in the company to approximately 38.3% with the secondary offering of shares before the original lock-up expiration. Based on this track record of trampling upon the rights of public shareholders, it appears there is a continued possibility for the significant divergence between the interests of Annie's insiders and public investors.
Fourth, Annie's operates a "capital light" business model and has outsourced ALL of its product manufacturing and inventory logistics; Annie's clearly discloses "we do not own any real property" in the footnotes of its SEC filings. While this operations model has allowed the Company to historically generate impressive ROIC metrics relative to its publicly-traded packaged food comps, this makes the business extremely susceptible to third-party shipment delays, excessive price fluctuations for inputs, and potential food safety issues. For example, in the quarter ended 09/30/12, Annie's purportedly missed out on approximately $1 million in purported incremental net revenue opportunities because of production planning shortfalls with its contracted manufacturers. If Annie's is truly producing a "premium" consumer product worthy of a lofty price-point relative to competing products, it seems the business should require significant control and supervision over the production process; Annie's current share price does not allow for any operational disappointments.
Annie's stated mission is "to cultivate a healthier, happier world by spreading goodness through nourishing foods, honest words and conduct that is considerate and forever kind to the planet." However, the stereotypical "upper-income suburban moms" that pay premium prices for the Company's products are starting to realize the Annie's packaged foods are really not that nutritionally different from traditional mass-market packaged foods. For example, please compare the nutritional label information for the food products (available via hyperlink):
- Annie s Mac & Cheese vs. Kraft Macaroni & Cheese Original
- Annie s Cheddar Bunnies vs. Pepperidge Farm Cheddar Goldfish
Surprisingly, the products are almost identical in standardized nutritional content, with Annie's actually slightly worse for consumers by several key metrics. For more than double the price, "upper-income suburban moms" are paying up for an "organic," but not necessarily healthy, food option. Before adding butter/milk, the Annie's Mac & Cheese has 24% of the recommended daily sodium (and assuming the average consumer only eats a single 1-cup "serving," which is less than 40% of a single Annie's Mac & Cheese box). A single serving of 50 Annie's Cheddar Bunnies have 6g of fat, vs. 5g of fat in a serving of 55 Pepperidge Farm Cheddar Goldfish. As the nutritional information between these "traditional" and "organic" packaged foods is very similar and suggests to the ingredients/recipes/formulas of the competing products are very homogenous. Thus, investors should question if Annie's really has a sustainable competitive advantage in the packaged foods market by essentially swapping traditional flour and dairy inputs for organic inputs, placing a whimsical "Rabbit of Approval" bunny graphic on a standard cardboard box, and marketing it as a significantly differentiated product on grocery shelves.
Even more problematic for Annie's future growth prospects is the fact its premium product pricing will limit future market share adoption of its products. In the current economic environment, how many additional packaged food consumers are willing to pay a premium of approximately 63% over the cost of comparable options for Annie's packaged food products?
Annie's Premium Pricing Comparison to Traditional Packaged Foods
Finally, despite a market perception otherwise, Annie's ability to transfer its premium pricing strategy to additional products has been less than perfect. In the quarter ended 09/30/12, sales in the condiments and dressings category decreased 8.0% on a quarter-over-quarter basis due to slowing customer demand and competitor pricing promotions. Moreover, Annie's breakfast cereals line of products, launched with great fanfare in FY11, was discontinued in FY12 after struggling to gain sales channel traction and failing to "meet growth objectives."
In our view, Annie's is worth less than $20 per share (an aggressive 2.5x LTM sales, 17x LTM EBITDA) to an acquirer. This valuation reflects over 1.5x revenue and 9.0x EBITDA on an aggressive forecast for FY15, assuming uninterrupted high teens revenue growth as well as 140bps of EBIT operating margin expansion to 15.0% from 13.4% in FY12.
While Annie's is continuing to grow, it is starting to show signs of its core products being tapped out. After the DMD and GMCR situations, investors should be hyper-vigilant for momentum-based growth stories as they start to exhibit signs of cracking. Annie's heavily promoted its mac & cheese segment last year, so the Company's revenue growth has decelerated this year and the management team seems to be pinning investors' hopes for future growth more in the newly launched frozen pizza segment. However, the mass marketing of frozen pizzas via Costco and Target seems even more of a stretch from Annie's professed core competency of healthy organic food. If consumers truly want to eat a healthy and sustainable diet, they would be better served sourcing fresh vegetables and ingredients from their local farmers market, versus eating an Annie's frozen pizza, even if it supposedly contains organic ingredients.
For a comparable acquisition valuation metric, Smart Balance recently acquired Udi's, a gluten-free specialist that also produces frozen pizza, for approximately 1.7x revenue ($103.0 million net purchase price for $60.9 million in revenue). Moreover, Udi's doubled sales in the fiscal year prior to its acquisition, so appears to be at least as juicy of a growth story relative to Annie's LTM revenue of $141m. In addition, a valuation at 1.7x revenue implies approximately $14/share for Annie's, which happens to directly correlate with the initial IPO filing range. Also, Smart Balance (SMBL) recently bought Glutino for 1.2x revenue, which would imply just a $10 stock price for Annie's. Smart Balance attracted a 13-D filing from Gabelli and has risen considerably, so although it is likely trading at a "half-in-play" premium, the firm is currently valued at approximately 1.9x revenue (pro forma for the recent Glutino and Udi's acquisitions). Even if Smart Balance's equity valuation doubles from the current market price, and one utilizes an implied sales multiple of 2.8x, a non-dilutive acquisition values Annie's at approximately $22/share.
As per the illustrative discounted cash flow valuation below, even utilizing the aggressive growth assumptions of continued double-digit revenue extension, operating margin expansion of ~140bps to 15.0% (significantly higher than its historical results and peers in a highly competitive industry) and minimal CAPEX spend arrives at an intrinsic equity value of less than half the current market valuation. Because of the disconnect between a reasonable DCF valuation for the company and the current share price, sell-side equity analysts seem to be justify their lofty share price targets based on Annie's being a "a possible takeout candidate (per CNBC, etc.)" and the purported "scarcity value in the shares" [whatever that actually means].
Illustrative DCF Valuation - Assuming Continued Double Digit Sales Growth & Margin Expansion
Moreover, because of the highly competitive nature of the packaged food sector, operating margins generally remain range-bound in the upper single-digits to low-teens. Packaged food producers must fight tooth and nail for shelf space at groceries and there are low barriers to entry to prevent other manufacturers from cloning successful products made by their peers. It will likely be difficult for Annie's to materially increase its operating margin due to supply constraints for organic inputs, the Company's outsourced production and logistics operational model, and the continued entrance of new producers with similar products.
Annie's insiders have been willing sellers at $14-16/share (initial IPO filing price-talk), $17.67/share (IPO price), and $37.39/share (net secondary offering price) reaping over $200 million while leaving the actual business with only $15 million to operate. Put differently, the amount sold by insiders in one just year equates to over 50 years worth of free cash flow. The math is irreconcilable; as such, we strongly recommend Annie's public investors take advantage of these unsustainable prices before Solera dumps its remaining 6.98 million shares and the Company's overvaluation becomes obvious to the rest of the market. Speculative investors should consider a short position as we believe BNNY shares are more fairly valued in the $12-15 range.
***As we rush to print, we note two additional form 144s filed by Sarah Bird to sell 28,506 shares and Mark Mortimer for 38,000 shares. That's another $2.7 million worth of shares to be dumped in the coming days.