Although Annie's had strung together some solid earnings results, I never bought the notion that the stock commanded the premium investors were willing to pay. Annie's (then) traded at a price-to-earnings ratio of 61, which was (then) twice the earnings multiple of Hain Celestial (HAIN). If that weren't bad enough, Annie's valuation also tripled shares of Mondelez (MDLZ). And these are two top-notch performers in packaged foods.
This suggested the Street was expecting strong growth from a hot packaged food sector that has been anything but appetizing. Although the company does focus more on natural and organic foods (a growing segment), management had developed ambitions to compete more with the likes of Kraft (KRFT). In other words, Annie's wanted to broaden its scope. This made perfect sense, and investors were correct to applaud the idea.
The Street, however, didn't factor in the cost this conversion would incur on near-term margins. All of this would take place while the company relies on a higher-earning demographic for its business. Annie's success was too heavily predicated on a robust economy. All told, at a P/E of 61, there were too many risks for my taste.
Three months later, these shares are down 13%. After having correctly called the top, investors want to know if it's time to take a nibble. While management has done a stellar job selling investors on the long-term sustainability of the natural and organic foods market, Annie's is still a relatively young company that has less than two years as a public issue.
That the company's stock has soared well over 140% during that span is remarkable. I do believe, however, that this has been another case of "theme-based investing." And we've seen this same reaction in the tech sector as well where, for instance, all cloud-related stocks traded at sky-high valuation. This is because everybody believed the cloud and "Big Data" was the next big thing. That buzz has somewhat fizzled.
Similarly, I believe Annie's has seen its stock ride the wave of Whole Foods (WFM) and Fresh Market (TFM), two companies that created the stir around healthy lifestyles, particularly any product preceded by the word "organic."
Although this industry has now exceeded "niche" status, companies are still challenged to offer product differentiation. It's harder to accomplish these days, especially for Annie's, which, unlike General Mills (GIS) and Nestle (NSRGY), sells a relatively limited number of products. Bulls will argue that this creates potential for the company to expand.
This it assumes that General Mills or even Campbell Soup (CPB) will not realize the opportunity that they might have in the organic category. This is precisely what Kraft has done. So with little to no price and/or product differentiation, what will Annie's have left? Consequently, this has recently taken a toll on margins. So there is still some work to do on the operating side to get me to believe these shares make any sense at all.
Monday, Annie's will report fiscal third-quarter earnings results and management will get a chance to win back some skeptics. The Street will be looking for 18 cents in earnings per share on revenue of $45.9 million, a 21% year-over-year revenue growth. I have no doubt Annie's will hit its revenue target. Profits and guidance will be what drives this story.
Management's goal to broaden the company's scope should be interesting. And I'm curious to see what the company says about new products and categories it will enter. This, more than anything, will indicate how serious the company really is about competing on the scale of Kraft and Nestle.
I realize this is a young company. With that in mind, growing pains and operational struggles are expected. But that doesn't mean investors should take unnecessary risks. And until I see more signs of margin and profitability improvement, I can't recommend this stock.
At the time of publication, the author held no position in any of the stocks mentioned.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.