Annie's Continues to Fly Close to the Sun

The health-food movement is one of the fastest growing segments in today's grocery business. Though the actual use of the word "health" is sometimes overstretched in supermarket aisles, one cannot deny that these products are increasingly popular among conscious shoppers. One of the leaders in health-oriented prepared foods and snacks, Annie's , reported stronger-than-expected earnings for its fiscal third quarter, but the stock didn't react in tandem. Let's take a look at what held Annie's back and determine whether you should be interested in this quickly growing food company.

Healthy company
For those who may not frequent the grocery store aisles, Annie's is a natural and organic food purveyor, from frozen meals to fruit cups to macaroni and cheese. The company has been public for only about 11 months, and while it is growing undeniably well, a high initial valuation has kept the return to less than 2%.

It's tough for some to understand the lack of capital appreciation -- the company is a successful disruptor in a highly competitive and typically low-margin business and (some believe) warrants a premium valuation. And things seem only to be improving, as its most recent earnings release suggests nothing less than outperforming growth.


Outperformance
For the third fiscal quarter, Annie's was able to increase its net sales by nearly 23% to $37.9 million over the prior-year quarter's $29.3 million. The net sales figure did, however, exclude returned items from a product recall. In the management's conference call, CEO John Foraker mentioned that consumption trends continue to look very favorable for the company -- growing in the high-teens across all channels. The company is seeing particularly strong growth in its more premium items -- deluxe mac 'n' cheese and specialty dressings. Perhaps the (slowly) improving economic environment in the United States is encouraging shoppers to aim a little higher on the totem pole. Annie's is increasing its frozen food lines beyond its pizzas, which have been, with one hiccup, successful.

That one hiccup, though, was more of a burp. Recently, the company announced a voluntary recall of its frozen pizzas. This was a widespread recall that pulled the items out of freezers from major retailers such as Whole Foods Market and Target because of the possibility that the dough contained "metal fragments." While that's enough to keep me from running to the nearest Whole Foods to buy one, the company made an immediate and dedicated effort to rectify the situation. Management is expecting to quickly regain footing among its pizza customers.

The recall, while substantial, was not enough to meaningfully slow overall growth. Net income still grew by more than 23% to $2.7 million ($0.15 per share), even with large capital expenditures (large capex is typical of a company growing as fast as Annie's). The Street was expecting a penny less. Management told investors and analysts the recall resulted in an approximate $2.3 million charge. Barring any further quality-control issues, one can expect at least this amount in income growth going forward.

All in all, it looks as if Annie's products are gaining traction at a very attractive rate. Meals were up 25%, snacks up 22%, and condiments up 18%. Looking forward, the company is expecting fourth-quarter growth to be in the high teens, with the pizza recall effects taken into consideration.

The balance sheet for the company remains strong, with $30 million in cash -- or nearly 5% of its market value. Annie's holds minimal debt as well.

So with double-digit growth in the face of a major product recall, it would appear as if Annie's is a good place for your growth investment capital. Well, that would be incorrect.

Valuation suicide
Annie's may be a fantastically run company with a great product line (metal pizza excluded), but it doesn't warrant a price of 35 times next year's earnings. I can't think of any company I would pay 30 times its earnings for, let alone one that operates in this line of business.

Compare it with a Laundromat (I love Laundromats as examples). If you were to go into your neighborhood Laundromat and ask the owner how much his business will make in a year, and he said $1 million, would you write him a check for $35 million? Not unless your Laundromat turned clothes into iPads.

If you want another, more concrete comparison, look at Kraft Foods . Now, Kraft obviously isn't a pure play on the natural and organic health-food movement. Far from it, really. But Kraft is a major force on aisle shelves in nearly every grocery store. It is a $28 billion snack monster. I find Kraft to be richly valued at 17.83 times forward earnings -- half that of Annie's.

I have no doubt Annie's will continue to grow nicely and offer shoppers healthy alternatives to the usual snack foods and prepared meals. But, please, don't ever pay this kind of premium. For anything. Ever.

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The article Annie's Continues to Fly Close to the Sun originally appeared on Fool.com.

Fool contributor Michael B. Lewis has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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