This Growth Company Just Raised a Huge Red Flag

Unlike its all-natural, organic food products, it’s hard to tell what ingredients are in this company right now.

Jun 9, 2014 at 12:12PM

Annie's, Inc. (NYSE:BNNY) stock has had a rough time in the past few days, having fallen almost 20% after both fourth-quarter earnings and forward estimates disappointed analysts, and the company's auditor, PricewaterhouseCoopers, announced on Wednesday that it will resign, citing "an insufficient complement of finance and accounting resources." 

Despite strong earnings growth since its IPO two years ago, the stock is now down almost 50% from its high last October. So just how bad is this recent news, and is the stock cheap enough yet to consider buying anyway?

Do you want the bad news first, or the bad news?
Well, the good news is, adjusted net sales increased 19% for the year, and the "disappointing" earnings growth came in at 37.5%. The company is also expecting similar sales growth in the coming year, so clearly there's a lot of consumer demand for the company's products, including its boxed mac-and-cheese meals, which command an estimated 7% share of the mac-and-cheese market, most of which was probably stolen from Kraft Foods, whose own "Kraft dinner" is still considered a generic term for the entire category in some places, similar to "Coke" and "Saran Wrap."

Unfortunately, the bad news is that that sales growth will probably be for naught. While the fourth quarter's earnings fell shy of analyst estimates, more troubling was the company's outlook for the year ahead, predicting that EPS growth would be in a range of $0.88 to $0.95 per share -- which translates to just 0% to 8% growth.

The main reason for the slowdown is that gross margins have fallen precipitously. The company faced higher-than-expected input costs in the fourth quarter, particularly for organic wheat, leading adjusted gross margin to fall 410 basis points. Management doesn't expect costs to improve in the near future, but it did say that forward cost coverage should be better and the company is working on improving its supply chain to better meet increasing growth. Annie's expects gross margin for fiscal 2015 to end up comparable to this year, which is bad, but at least the company is taking steps to contain rising costs, which may lead to higher margins down the road.

Unfortunately, even as Annie's tries to keep the lid on rising input costs, management expects sales, general, and administrative expenses to rise as the company seeks out new talent to support future growth. That doesn't really help things right now, but it's to be expected of any growth company, and Annie's can't be faulted for it.

Wait, what was that about losing an auditor?
With the bad news out of the way, here's the bad news: In the recently submitted annual report, management disclosed that it had "identified a material weakness in its internal control over financial reporting," followed by a disclosure the next day that PricewaterhouseCoopers will resign as the company's auditor.

While PricewaterhouseCoopers claims that the material weakness didn't result in any material misstatements yet, there is a "reasonable possibility" that material misstatements will not be detected "on a timely basis." That very fact makes me wary of taking management's word for it that no misstatements have occurred yet, and if they have, this recent period could have been even worse than it already appears. Even if misstatements have been avoided so far, the possibility that they will happen in the future is a huge risk for investors, especially now that the company is currently without an auditor.

To make matters worse, at least 10 different law firms have announced investigations into the company on behalf of shareholders for possible breach of fiduciary duty and federal securities laws by the board of directors. Whether there's merit to any of the investigations or it's all just a bunch of ambulance chasing remains to be seen, but there's no denying that it puts a huge cloud of doubt over the company.

The Foolish bottom line
If Annie's were just experiencing some temporary margin pressure from the high cost of wheat, I'd happily suggest buying the stock. After falling so much in just the last few days, the company's PEG ratio, a useful valuation measure for growth companies, is 0.81, implying the stock is undervalued by a fair amount.

Unfortunately, it's also suffering from troubling legal issues that present a huge red flag for investors. There's a chance it will blow over and investors who buy now will be rewarded, but there's also a chance that the company will restate its earnings for the worse and be subjected to costly lawsuits. Unlike Annie's all-natural, organic food products, it's hard to tell what ingredients are in this company right now.

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Jacob Roche has no position in any stocks mentioned. The Motley Fool owns shares of Annie's. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

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KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.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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