Annie's Surfing A Rising Tide In Food

By Stephen D. Simpson, CFA | February 14, 2013 AAA

Annie's (NYSE:BNNY) looks like one of those companies that is destined to be controversial and frustrating for the skeptics. The company's business model is predicated on selling premium-priced packaged foods to customers who believe it's somehow better for them, and while skeptics will almost certainly question how sustainable that model is, plenty of companies have prospered for years by selling people on the notion that there is value in paying up for their particular products.

In the meantime, the more pressing financial questions revolve around the company's ability to successfully introduce new products and drive better margins while they do. Not surprisingly, the stock is no particular bargain today, but growth investors are not likely to abandon it for that particular reason.

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Beating Targets in a Noisy Quarter
Although a product recall altered the numbers for Annie's fiscal third quarter, the company had a strong result on balance.

Reported revenue rose 18%, but I suspect most analysts and investors will choose to go along with the company's recall-adjusted figures. By that calculation, revenue rose nearly 23% and slightly exceeded the average analyst estimate. Comps grew about 25%, with growth of 25% in meals, 22% in snacks and 18% in dressings/condiments.

While Annie's continues to show very strong revenue growth, the margin leverage is more uncertain. Adjusted gross margin declined slightly from last year (about a quarter-point), but did beat the analyst target by more than half a point. Likewise with operating income - nearly a 24% growth in adjusted income was solid, and the company's operating margin was solidly above expectation, but Annie's showed minimal operating leverage.

SEE: A Look At Corporate Profit Margins

Forgive and Forget Seems to Be the Norm, and Likely for Annie's too
Annie's customers pay a premium for this company's food, so it seems reasonable to think that their expectations are higher when it comes to product quality. Even so, it doesn't seem, so far, that the company's recall of its frozen pizza is going to create any lasting problems.

The recall stemmed from an equipment failure at a contract manufacturing facility where bits of metal ended up in the flour that went into the pizza dough. While the metal bits were small enough to evade the plant's metal detectors, an inspection ultimately revealed the cause (a broken metal screen) and there have been no reports of any harm done by the product.

It's worth noting that there's nothing at all unusual about this recall in the bigger picture. I cannot think of a food company of any significant size (including Kraft (Nasdaq:KRFT), Kellogg (NYSE:K) and General Mills (NYSE:GIS)) that hasn't had a recall, and the public generally moves on quickly.

SEE: 5 Most Costly Product Recalls Slideshow

Addressing a Large and Growing Market
Annie's is definitely in a lucrative segment within the packaged food industry. Of the more than half-trillion dollars of sales in this industry, natural and organic foods represent less than 10% (about $40 billion), but sales of these foods are growing at a high single-digit rate - well more than double the rate of the industry as a whole. While Annie's doesn't sell organic food exclusively (about one-third is organic and half is "made with organic ingredients"), it nevertheless sits squarely in the middle of this "better for you" food trend.

While the health claims for this food category are largely unproven, the public generally doesn't care and has chosen to vote with its collective wallet. While the premiums on Annie's products (compared to conventional offerings from Kraft, Campbell Soup (NYSE:CPB) and so on) can run from about 10% to over 100%, Annie's has seen solid growth. Meanwhile, major retailers like Target (NYSE:TGT) and Costco (Nasdaq:COST) have increasingly moved these products from the specialty health/natural foods shelves to the main packaged food aisles.

A Different Model
Annie's doesn't run itself in the same way as most packaged food companies. Well-known players like Campbell Soup and Kraft own and operate their own plants, largely handle their own distribution and so on. Annie's, though, runs an asset-light model where it contracts with outside manufacturers to produce its food (to its specifications) and distributors like United Natural Foods (Nasdaq:UNFI) to get it to stores.

While not owning/operating its own plants may sound like a potential negative, it's actually pretty commonplace in the packaged food industry. Pretty much all of Trader Joe's products, for instance, are made on a third-party basis (in fact, Annie's mac and cheese is one and the same with Trader Joe's). Many well-known food brands are little more than a licensing arrangement, and a small office in some business park (with the rest of the business conducted on an asset-light third-party basis).

At some point, I would think Annie's might want its own plants. Right now, Annie's margins are roughly on par with packaged food giants like Kellogg and Campbell Soup, despite the premium prices of its products. As the company essentially has to pay some of its margin to its manufacturers (they need to make money, too), I think there will be a point in time where the company's sales base argues for the synergies of owning its own manufacturing - but I think that day is a long way in the future.

Ample, but not Unlimited, Opportunities
At this point, Annie's has multiple drivers for growth. For starters, the company can grow by simply getting more of its products on more of the shelves of regular grocery stores and supermarkets. The company has done quite well with the distribution of its signature mac and cheese boxed meal, but the retail penetration rates for products like cheddar crackers and granola bars are much lower. Since people can't buy what they don't see, moving more of its line into stores is a key item on the strategic to-do list.

New product introductions are also likely to be a major driver. The company currently offers more than 125 products, but as previously mentioned, they are not all equally well-known or available. What's more, the company has had some failures in the past - the company tried a line of cereal, but struggled to make much headway against Kellogg and General Mills (perhaps because these companies devote a lot of time, energy and capital to talking up their healthy/organic offerings). Given the sheer size of individual market categories like soup (nearly $10 billion) and frozen pizza ($5 billion) relative to Annie's revenue (likely less than $200 million this fiscal year), there's ample room to grow before market share and crowding-out become real worries.

Will the Market Bear the Cost?
As I said in the intro, I expect Annie's to be a controversial company and stock given the premium pricing of its products. Personally, I think it's a moot point. Companies ranging from Coach (NYSE:COH) to lululemon (Nasdaq:LULU) to Whole Foods Market (Nasdaq:WFM) have thrived with premium-priced offerings when shoppers could have easily gone across the street for something just as good (or nearly so) at a much lower price.

So long as the customer believes that they're getting value for their money, it's not going to be a problem for Annie's. Yes, regular packaged food companies are seeing more price elasticity than in the past and many shoppers have traded down to store brands, but there are still plenty of shoppers with the means and willingness to pay 50% more for their mac and cheese. Barring a major scandal (like the company knowing that a manufacturer wasn't using organic/natural ingredients), I don't see the pricing as an issue.

SEE: Will Your Wallet Love Eating Organic?

The Bottom Line
If there's a value problem with Annie's, then it's with the stock. There aren't that many growth stories in food, and when they show up, investors bid them up. In the case of Annie's, we have a company that not only offers another play on natural/organic food (alongside companies like Whole Foods, United Natural Foods and a handful of others), but a growing one at that with a sizable market penetration left to gain.

Even if I assume that Annie's can grow its revenue at a long-term CAGR of over 17% and even if I assume that free cash flow margins will exceed industry averages and grow into the teens, investors still expect even more. Consequently, I'm not surprised that the cash flow-implied fair value of $31 or so is below today's price.

While I'm typically a value-oriented investor, I don't always define value in the strict "Graham and Dodd" way. What's more, I have no problem with investors who are willing to pay a premium to buy into legitimate growth stories. So while I personally doubt I'll be adding Annie's to my portfolio, I'm in no rush to assume that the stock's steep valuation will preclude further gains so long as 20%-plus top-line growth is the order of the day.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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