Annie's, Inc. - Why Did PwC Abandon This BNNY?

| About: Annie's, Inc. (BNNY)

I thought bunnies were supposed to be cute and cuddly little creatures? Well after looking at Annie’s, Inc.... maybe not. This company has recently “hit the trifecta:” a restatement of its financials (2014 10K, p. 54), a material weakness report on its controls over financial reporting (2014 10K, pp. 45 and 74), and an auditor resignation (2014 8K dated June 1)... all in the space of a week. And if this weren’t bad enough, along comes a class action suit alleging false and/or misleading financial statements and disclosures.

But should we really be surprised. No, not really since until this year the company avoided scrutiny of its accounting and controls via its JOBS Act status as an “emerging growth company”(2014 10K, p. 32). It has been less than a year since I reminded you in Garbage In, Garbage Out – Are Accountants Really to Blame? that:

Proponents of “emerging-growth” company (EGC) internal control reporting exemptions claim cost savings that promote business development. The reality is that most ECGs simply have no internal controls.

So, did PricewaterhouseCoopers (PwC) really dump Bernie, Annie’s mascot, just over a restatement and some internal control weaknesses? After all, there’s many a PwC client that has committed far greater sins and still remained a client of the firm (hint: Financial Crisis of 2007 and 2008). Just how could PwC disapprove of Bernie, Annie’s “Rabbit of Approval?” This is just the kind of question this grumpy old accountant likes to tackle.

Management Under Fire

Given recent allegations made in the class action suit filed in United States District Court, Northern District of California, and docketed under 3:14-cv-03001, it seems reasonable to first investigate whether Annie’s management had any incentives to engage in inappropriate financial reporting behaviors.

Clearly, management experienced significant pressures to report positive performance results. The following factors individually and collectively may have created demands to engage in aggressive financial reporting:

The company’s history of operating losses as evidenced by its retained earnings deficit (2014 10K, p. 47):

  • The recent rapid growth in profitability despite declining gross profit percentages (2014 10K, p. 34)

  • Restrictions imposed by credit agreements (2014 10K, p. 22)

  • The steady decline in the company’s stock price per share from a high of $51.36 on November 15, 2013 to its current price of 33.14 (a decline of over 35 percent)

  • The role of stock based rewards in management compensation (2014 10K, pp. 63-65)

And all of these hurdles had to be addressed in a highly competitive market (2014 10K, pp. 9 and 12).

Could the company’s operating environment contribute to or facilitate inappropriate financial reporting by management? The recent negative report on internal controls over financial reporting would seem to suggest so. Acknowledging “an insufficient complement of finance and accounting resources” (2014 10K, p. 74) is a fairly damning admission for any organization, much less a publicly-traded company. The statement suggests an environment devoid of controls and oversight… one just perfect for aggressive financial reporting. And contrary to managements’ assertions, there is no quick fix to this problem.

Then, there is the issue of key officer turnover at Annie’s. Amanda K. Martinez joined the company as Executive Vice President in January 2013 (2013 8K dated January 5), was promoted in December 2013 (2013 8K dated December 9), and resigned without a stated reason in March 2014 just prior to the end of the fiscal year (2014 8K dated March 26). Also, the company’s previous chief financial officer, Kelly J. Kennedy, resigned effective November 12, 2013 and was succeeded by Zahir Ibrahim on the following day (2013 8K dated October 16). Such changes in the C-suite can wreak havoc on internal controls, and potentially negatively affect financial reporting.

So, is there any quantitative support for my qualitative concerns about the quality of Annie’s financial reporting? Absolutely! Let’s first see what the Beneish Model reveals about the likelihood of earnings manipulation by the company’s management.

Using inputs from Annie’s 2014 10K, the Beneish Model reveals only a slight probability of earnings manipulation driven primarily by the rapid increase in sales and disparity between operating income and operating cash flows (OCF) (i.e., accruals). More on OCF shortly.

The Conservatism Ratio also provides some evidence of aggressive revenue recognition. This metric compares reported GAAP income before taxes with an estimate of an entity’s taxable income (current taxes payable divided by the effective tax rate). Generally, a ratio approximating one suggests relatively conservative income recognition practices, while those larger than one may signal increasingly aggressive revenue recognition practices.

Coupled with the company’s rapid growth in sales and profitability, and the aforementioned apparent disconnect between operating income and OCF, the Conservatism Ratio seems to confirm concerns about aggressive revenue and expense recognition practices.

But there’s more… the company’s financial reports raise additional questions for investors about accounting quality and transparency and provide more clues to PwC’s recent departure.

Transparency Failures

Non-GAAP Metrics

By now you all know how I feel about non-GAAP metrics. So, why does the company feel compelled to rely on flaky pro-forma disclosures when its GAAP numbers look so good? Selected financial data (2014 10K, p. 28) reports a history of increasing net sales, gross profits, income from operations, and improving Earnings Per Share (for the last three years), and the statement of cash flows (SCF) reports dramatic annual increases in OCF (2014 10K, p. 49). And the company uses pro-forma reporting not just for EBITDA but for net sales and gross profit as well. Particularly troubling are the nature if its non-GAAP adjustments, which go well beyond those witnessed even in the case of Black Box, and include product recall adjustments, plant (not business) acquisition costs, secondary offering costs, management fees, and fair value changes (2014 10K, p. 29 note 3).

And note how the company justifies these metrics (10K, 34):

We believe these non-GAAP figures provide additional metrics to evaluate our operations and, when considered with both our GAAP results and the related reconciliation to the most directly comparable GAAP measure, provide a more complete understanding of our business than could be obtained absent this disclosure.

— 2014 10K, p. 34

Yet, only four sentences later, Annie’s warns us that their non-GAAP metrics are of limited usefulness due to non-comparability:

Our computation of these non-GAAP figures is likely to differ from methods used by other companies in computing similarly titled or defined terms, limiting the usefulness of these measures.

— 2014 10K, p. 34

Who’s writing and reviewing this stuff? I think we know the answer… no one… that’s what a material weakness in internal controls is all about.

Revisions, Restatements, and Errors

Where would you expect to find a detailed discussion of material accounting errors requiring a restatement of a company’s set of financial statements? This Grumpy Old Accountant can tell you that creditable, transparent companies report such things in a separate note with an appropriate title to highlight the event. Not Annie’s… their error corrections are “buried” at the very end of note 2 (2014 10K p. 54) and labeled with the responsibility-avoiding caption of “revision.” This behavior speaks volumes.

Adequacy of Allowances and Reserve

We know that the company has booked some allowances by looking at the tax note for deferred tax assets (2014 10K, p. 69). The company reports total reserves and allowances related to temporary differences of approximately $1.2 million (tax effected), suggesting recorded GAAP allowances of approximately $3.5 million if adjusted using the federal statutory tax rate. Annie’s reports no allowance for uncollectable accounts (2014 10K, p. 52), and discloses no inventory obsolescence reserves despite recent inventory write-offs (2014 10K, pp. 35 and 36). So, to which assets do the “reserves” listed in the tax note relate? Once again, transparency and disclosure adequacy is an issue.

Sustainability of Reported Operating Cash Flows

The company’s limited discussion of cash flows from operating activities (2014 10K, p. 39), makes no mention of the fact that the current year increase in OCF over the prior year resulted primarily from account receivable declines (i.e., an $8.012 million swing from $7.580 million of increases receivables to a $432 thousand decrease). Does this make sense for a growing company? And let’s not ignore the fact that 2013 OCF were driven significantly by increasing liabilities. This weak disclosure’s lack of transparency makes one wonder what the company’s real OCF look like. So, let’s take a peek.

I “normalized” Annie’s reported OCF by adjusting for unusual or exceptional changes reported in the company’s statement of cash flows (operating section only) during the past three years. When one restores the operating section of Annie’s statement of cash flows to more “normal” activity levels, we find that OCF range between $8.6 million and $10.8 million over the past three years, are far cry from the soaring GAAP OCF reported in the 2014 filings.

Given Annie’s infatuation with non-GAAP reporting, let’s explore the changes and related differences in a schedule that actually provides some insight! As shown above, in 2012, the company’s OCF were abnormally low due to payment of unusually high amounts of accounts payable ($9,499). These “excess” payments were added back to OCF. In 2013, reported OCF were impacted in opposite directions by stock option tax benefits ($8,113), as well as unusually high liability accruals ($8194). So, both of these were reversed even though the amounts almost offset each other. And in 2014, the company liquidated its accounts receivable ($432), an interesting strategy for what is presumably a “growth” company. In this latter case, I assumed that the 2013 receivable increase was more appropriate for 2014 rather than the reported decrease. Not surprisingly, my adjustments reveal a much different picture of the company’s OCF. The soaring increases reported in OCF are gone, replaced by more modest, stable amounts that reflect a declining trend when compared to asset increases over the past three years.

The Goodwill Mystery

Also very troubling is that Annie’s provides little discussion as to the source of its reported goodwill other than it came from “prior acquisitions”. Why were excess purchase prices paid and for what acquired assets? Goodwill represents almost 30 percent of the company’s balance sheet at FYE 2014 yet we have no idea of what it represents. And given the company’s admitted material weaknesses in controls over financial reporting, how can we have any confidence that goodwill impairment tests are even believable? Given the impact of goodwill on the balance sheet and my declining ratio of normalized OCF as a percent of assets, one can’t help but wonder if an impairment charge is looming.

And that’s not all on the goodwill front. How can goodwill be allocated to the purchase of a plant facility (2014 10K, p. 70)? The company provides no indication in note 18 of its financial statements that the Joplin snack manufacturing plant purchase was a business acquisition.

Hopefully, by now you have a better idea why PwC abandoned this not-so-cute BNNY… myriad accounting issues, internal control problems, performance pressures, and non-transparent financial statements. And let’s not forget that the NEW CFO blessed these financial reports (2014 10K, p. 78). Toss in the threat of a little litigation and Bernie looks a lot less harmless. Good call PwC!

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