The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management's discussion and analysis of financial condition and results of operations for the fiscal year ended March 31, 2012 ("fiscal 2012") included in our Annual Report on Form 10-K filed with the SEC on June 8, 2012. This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,( the "Exchange Act"). These statements are often identified by the use of words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "should," "estimate" or "continue" and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those in this Quarterly Report on Form 10-Q and in our Form 10-K discussed in the section titled "Risk Factors." The forward-looking statements in this Quarterly Report on Form 10-Q represent our views as of the date of this Quarterly Report on Form 10-Q. We anticipate that subsequent events and developments will cause our views to change. However, while we may elect to update these forward-looking statements at some point in the future, we have no current intention of doing so except to the extent required by applicable law. You should, therefore, not rely on these forward-looking statements as representing our views as of any date subsequent to the date of this Quarterly Report on Form 10-Q.

Overview

Annie's, Inc. is a rapidly growing natural and organic food company with a widely recognized brand, offering consumers great-tasting products in large packaged foods categories. We sell premium products made from high-quality ingredients at affordable prices. We have the #1 natural and organic market position in four product lines: macaroni and cheese, snack crackers, fruit snacks and graham crackers.

Our loyal and growing consumer following has enabled us to migrate from our natural and organic roots to a brand sold across the mainstream grocery, mass merchandiser and natural retailer channels. We offer over 125 products and are present in over 25,000 retail locations in the United States and Canada.

Our net sales are derived primarily from the sale of meals, snacks, dressings, condiments and other products under the Annie's Homegrown and Annie's Naturals brand names. We have experienced strong growth, driven by our meals and snacks categories, resulting from our focus on supporting our best-selling items and the introduction of new products in these categories. We have reduced our offerings in our dressings and condiments product lines and discontinued our cereal product line in the fourth quarter of fiscal 2012, which resulted in low or negative quarter over quarter growth in that category in recent quarters. In the most recent quarter, despite the impact of discontinuance of the cereal, the category achieved strong growth quarter over quarter driven by stronger consumption trends.

Gross profit is net of cost of sales, which consists of the costs of ingredients in the manufacture of products, contract manufacturing fees, inventory write-off, packaging costs and in-bound freight charges. Ingredients account for the largest portion of the cost of sales followed by contract manufacturing fees and packaging.

Our selling, general and administrative expenses consist primarily of marketing and advertising expenses, freight and warehousing, wages, related payroll and employee benefit expenses, including stock-based compensation, commissions to outside sales representatives, legal and professional fees, travel expenses, other facility-related costs, such as rent and depreciation, and consulting expenses. The primary components of our marketing and advertising expenses include trade advertising, samples, consumer events, sales data, consumer research and search engine and digital advertising.

Voluntary Product Recall

On January 22, 2013, we announced a voluntary product recall of our certified organic and made with organic pizza products. The voluntary product recall was a result of our contract manufacturer for pizza crusts identifying small metal fragments in the pizza dough during a manufacturing run and in some finished pizza crusts made on the same day. We immediately halted production and began investigating the issue. Soon thereafter, we determined that the small metal fragments originated at the third-party flour mill from where we source our pizza flour. We then initiated a recall of all lots of pizza product manufactured with this supplier's flour from our first purchase from the supplier in May 2012.

The full costs of the voluntary product recall include customer and consumer returns, costs associated with returned product, destruction charges and inventory write-off, retailer margin and customer fees and incentives. We also face the potential for lost sales from our consumers.

As a result of the voluntary product recall, we recorded charges that negatively impacted our net sales and net income by $1.6 million and $1.3 million, respectively, for the three and nine months ended December 31, 2012. The recorded charges were based on our best estimates and information available to us when we recorded the charges. We expect to recover a substantial portion of the recall-related costs from our product recall insurance. We may seek to recover additional costs from the third-party flour mill. Any recovery would be recorded to offset the charges once recovery is probable. We expect the effects of the voluntary product recall to be reflected in our financial statements over the next few quarters.

In addition, we expect to incur approximately $1.0 million of costs associated with product returns and related costs for sales subsequent to December 31, 2012 including the destruction and write off of inventory consisting of non-pizza products manufactured with flour sourced from the same third-party flour mill that provided flour for the recalled pizza products. None of these affected non-pizza products were shipped to customers. We expect to record these costs associated with the voluntary product recall in the fourth quarter of fiscal 2013.

We have restarted the production of our certified organic and made with organic pizza products using flour from an alternative supplier with which we have a long-standing relationship and began shipping replacement product into distributors and retailers as of February 11, 2013 in order to replenish retail shelves and inventories. We expect to see a recovery in sales of our pizza products in the late fourth quarter of fiscal 2013 and first quarter of fiscal 2014, as retailers seek to restock inventory of pizza products.

Trends and Other Factors Affecting Our Business

Net sales growth continues to be driven by increased penetration of mainstream grocery and mass merchandiser channels, product innovation, increased brand awareness and greater consumer demand for natural and organic food products. In the twelve months ended December 31, 2012, we have experienced acceleration in consumer trends for many of our products. We also have benefited from improved placement in the mainstream grocery channel, which we believe has resulted in increased sales of our products. Our net sales growth has been primarily driven by volume; however, we have demonstrated the ability to execute price increases as needed to maintain margins, driven by our strong brand loyalty and perceived value relative to the competition.

We purchase finished products from independent contract manufacturers. We have long standing, strategic relationships with many of our contract manufacturers and suppliers of organic ingredients. We enter, either directly or through contract manufacturers, into forward pricing contracts with certain ingredient suppliers. This practice provides us with significant visibility into our cost structure over the next six to twelve months. In fiscal 2012, our contracted ingredients represented approximately 48% of our material costs and 25% of our cost of sales. Over the past 18 months, we have experienced increased costs for many of our inputs and expect these higher costs to continue throughout the remainder of our fiscal year ending March 31, 2013 ("fiscal 2013"). We strive to maintain or improve gross margins despite increasing commodity costs through a combination of cost management and price increases. We actively manage our input and production costs through commodity management practices, vendor negotiation, productivity improvements and cost reductions in our supply chain. We invest significant time and effort to achieve permanent cost reductions in our supply chain. To drive these initiatives, we have begun to selectively invest capital in equipment located at our contract manufacturers to drive down costs, improve throughput and improve product quality.

Selling, general and administrative expenses have increased as a result of the investment we have made in building our organization and adding headcount to support our growth and operating as a public company. During the course of fiscal 2013, we have continued to invest in our business with the addition of customer facing sales and operations staff. Many of our selling, general and administrative expenses are variable with volume including freight and warehouse expenses and commissions paid to our sales brokers. In addition, we continue to make investments in marketing to drive trial of our products and promote awareness of our brand and in research and development to support our robust innovation pipeline. Starting in fiscal 2012, we incurred incremental expense related to getting ready to operate as a public company. We expect to incur approximately $2 million in incremental expense annually related to being a public company.

Results of Operations

The following table sets forth items included in our consolidated statements of
operations in dollars and as a percentage of net sales for the periods
presented:



                                                    Three Months Ended December 31,            % of Net Sales              Nine Months Ended December 31,             % of Net Sales
                                                      2012                   2011            2012          2011              2012                   2011            2012          2011
                                                                                                 (in thousands, except for percentages)

Net sales                                        $       36,283         $       30,838        100.0 %       100.0 %     $       117,262         $      98,320        100.0 %       100.0 %
Cost of sales                                            23,267                 18,275         64.1 %        59.3 %              72,539                60,034         61.9 %        61.1 %


Gross profit                                             13,016                 12,563         35.9 %        40.7 %              44,723                38,286         38.1 %        38.9 %
Operating expenses:
Selling, general and administrative expenses             10,687                  8,847         29.5 %        28.7 %              32,437                25,206         27.7 %        25.6 %


Total operating expenses                                 10,687                  8,847         29.5 %        28.7 %              32,437                25,206         27.7 %        25.6 %


Income from operations                                    2,329                  3,716          6.4 %        12.1 %              12,286                13,080         10.5 %        13.3 %
Interest expense                                            (40 )                  (25 )       (0.1 )%       (0.1 )%               (120 )                 (66 )       (0.1 )%       (0.1 )%
Other income (expense), net                                  31                     43          0.1 %         0.1 %                 116                  (428 )        0.1 %        (0.4 )%


Income before provision for income taxes                  2,320                  3,734          6.4 %        12.1 %              12,282                12,586         10.5 %        12.8 %
Provision for income taxes                                  919                  1,502          2.5 %         4.9 %               4,965                 4,926          4.2 %         5.0 %


Net income                                       $        1,401         $        2,232          3.9 %         7.2 %     $         7,317         $       7,660          6.2 %         7.8 %

Our discussion of our results of operations in this Quarterly Report on Form 10-Q includes certain net sales, gross profit, gross margin, selling, general and administrative expenses, income from operations and net income figures that exclude the impact of our voluntary product recall of pizza products announced on January 22, 2013. These figures are non-GAAP financial measures. We calculate these non-GAAP figures by eliminating the impact of our voluntary product recall, which we do not consider indicative of our ongoing operations. We believe these non-GAAP figures provide additional information to facilitate the comparison of our past and present financial results and better visibility into our normal operating results by isolating the effects of the voluntary product recall. These non-GAAP financial measures should not be considered in isolation or as alternatives to GAAP financial measures and investors should not rely on any single financial measure to evaluate our business.

Three Months Ended December 31, 2012 Compared to Three Months Ended December 31, 2011

Net Sales



                                         Three Months Ended December 31,              Change               % of Net Sales
                                           2012                  2011              $          %          2012         2011
                                                              (in thousands, except for percentages)

Meals                                 $        16,223       $        14,235     $ 1,988       14.0 %       44.8 %       46.2 %
Snacks                                         14,908                12,225       2,683       21.9 %       41.1 %       39.6 %
Dressings, condiments and other                 5,152                 4,378         774       17.7 %       14.2 %       14.2 %


Net sales                             $        36,283       $        30,838     $ 5,445       17.7 %      100.0 %      100.0 %

Net sales increased $5.4 million, or 17.7%, to $36.3 million during the three months ended December 31, 2012 compared to $30.8 million during the three months ended December 31, 2011. The net sales for the three months ended December 31, 2012 included a $1.6 million reduction due to the voluntary product recall of our certified organic and made with organic pizza products. The increase in net sales (net of the effects of the voluntary product recall) reflects an increase in net sales of snacks, meals and dressings, condiments and other of $2.7 million, $2.0 million and $0.8 million, respectively. The increase in snacks was primarily due to growth in our grahams, crackers, mixed snacks and snack mix product lines. The increase in meals was predominantly driven by strong growth in natural macaroni and cheese products offset by the voluntary product recall of frozen pizza products. Organic frozen pizza first shipped in January 2012 and made with organic frozen pizza first shipped during second quarter. As discussed earlier, we initiated a voluntary product recall of all frozen pizza products in January 2013.

The increase in dressings, condiments and other was attributable to strong performance of natural and organic dressings and condiments, partially offset by the discontinuation of our cereal product line. Distribution gains and our mainline placement initiatives also contributed to net sales growth, primarily in the mainstream grocery channel. The net sales increase was primarily driven by volume with approximately 3% of growth driven by higher average selling prices.

Excluding the impact of our voluntary product recall, our net sales would have increased $7.0 million, or 22.7%, to $37.9 million during the three months ended December 31, 2012 compared to $30.8 million during the three months ended December 31, 2011.

Gross Profit



                           Three Months Ended December 31,               Change
                             2012                   2011              $          %
                                   (in thousands, except for percentages)

       Cost of sales    $       23,267         $       18,275      $ 4,992       27.3 %


       Gross profit     $       13,016         $       12,563      $   453        3.6 %


       Gross margin %             35.9 %                 40.7 %

Gross profit increased $0.5 million, or 3.6%, to $13.0 million for the three months ended December 31, 2012 from $12.6 million for the three months ended December 31, 2011. Gross margin decreased 4.8 percentage points to 35.9% from 40.7% during the three months ended December 31, 2012 compared to the three months ended December 31, 2011. The decrease in gross margin is primarily attributable to a reduction in net sales of $1.6 million due to voluntary product recall and a corresponding increase in cost of sales of $0.7 million for estimated costs associated with the product recall. The estimated costs associated with the product recall comprised of affected inventory write-off $0.6 million and costs incurred by contract manufacturers $0.1 million. The effect of the charge for voluntary product recall costs on gross margin was approximately 4.5 percentage points. To a lesser extent, the decrease in gross margin resulted from higher commodity costs, partially offset by a price increase that was implemented in October 2012 and the cumulative impact of various cost reduction initiatives. We expect to see slightly higher commodity costs in the fourth quarter versus our year-to-date results driven by higher dairy costs. We also expect to invest in incremental trade promotions beyond our original plans to support pizza in our fourth quarter. As a result, we expect our fourth quarter gross margin to be in the low to mid 39 percentage range with a full year margin in the mid 39 percentage range.

Excluding the impact of the voluntary product recall, our gross profit would have increased $2.7 million, or 21.6%, to $15.3 million for the three months ended December 31, 2012 from $12.6 million for the three months ended December 31, 2011 and gross margin would have decreased 0.3 percentage points to 40.4% from 40.7% during the three months ended December 31, 2012 compared to the three months ended December 31, 2011.

Operating Expenses

Operating expenses:
Selling, general and administrative
expenses $ 10,687 $ 8,847 $ 1,840 20.8 %

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $1.8 million, or 20.8%, to $10.7 million during the three months ended December 31, 2012 from $8.8 million during the three months ended December 31, 2011. This increase was due primarily to an increase in payroll expense resulting from increased headcount to support our growth and operations as a public company. Additionally, public company-related expenses impacted selling, general and administrative expenses during the three months ended December 31, 2012 compared with the three months ended December 31, 2011. Selling, general and administrative expenses for the three months ended December 31, 2012 were not impacted due to voluntary product recall since it was announced in January 2013. However, we expect an increase in expenses due to administrative costs associated with the management of the recall including legal expenses in our fourth fiscal quarter ending March 31, 2013. As a percentage of net sales, selling, general and administrative expenses increased 0.8 percentage points to 29.5% during the three months ended December 31, 2012 from 28.7% during the three months ended December 31, 2011. While leveraging in the second half of fiscal 2013, we expect selling, general and administrative expenses as a percentage of net sales for fiscal 2013 to be on par with our prior fiscal year.

Excluding the impact of the voluntary product recall, our selling, general and administrative expenses as a percentage of net sales would have decreased 0.5 percentage points to 28.2% during the three months ended December 31, 2012 from 28.7% during the three months ended December 31, 2011.

Income from Operations



                                             Three Months Ended December 31,                     Change
                                             2012                      2011                 $               %
                                                         (in thousands, except for percentages)

Income from operations                  $         2,329           $         3,716        $ (1,387 )        (37.3 )%


Income from operations as a
percentage of net sales                             6.4 %                    12.1 %

As a result of the factors above, income from operations decreased $1.4 million, or 37.3%, to $2.3 million during the three months ended December 31, 2012, from $3.7 million during the three months ended December 31, 2011. Income from operations as a percentage of net sales decreased 5.7 percentage points to 6.4% in the three months ended December 31, 2012, from 12.1% in the three months ended December 31, 2011.

Excluding the impact of voluntary product recall, our income from operations would have increased $0.9 million, or 23.5% to $4.6 million for the three months ended December 31, 2012 from $3.7 million for the three months ended December 31, 2011.

Interest Expense

Interest expense $ (40 ) $ (25 ) $ (15 ) nm

Interest expense during the three months ended December 31, 2012 primarily related to non-cash imputed interest expense related to financing of product formulas intangible asset acquired in fiscal 2012. Interest expense during the three months ended December 31, 2011 consisted of expense related to borrowings on our revolving line of credit.

Other Income (Expense), Net

Other income (expense), net $ 31 $ 43 $ (12 ) nm

Other income (expense), net during the three months ended December 31, 2012 and 2011 consisted of royalty income.

Provision for income taxes

Three Months Ended December 31, Change 2012 2011 $ %

Provision for income taxes $ 919 $ 1,502 $ (583 ) (38.8 )%

Effective tax rate 39.6 % 40.2 %

Our effective tax rate was 39.6% for the three months ended December 31, 2012, compared to 40.2% in the same period last year. The effective tax rate is based on a projection of our annual fiscal year results. Our effective tax rate for the three months ended December 31, 2012 was lower than the effective tax rate for the three months ended December 31, 2011 due to the impact of state income tax credits. We expect our full year effective tax rate for fiscal 2013 to be approximately 40.4%.

In addition, during the three months ended December 31, 2012, we recognized $6.7 million of tax deductions associated with stock option exercises. As of December 31, 2012, $6.0 million of these tax deductions are considered "excess" stock compensation-related deductions, resulting in a reduction in taxes payable of $4.5 million, recording a tax refund receivable of $3.0 million, with a corresponding increase in additional paid in capital of $7.5 million. We will recognize the remaining $0.4 million of stock compensation-related deductions as a reduction in taxes payable in future periods as we generate state taxable income.

Net income

Three Months Ended December 31, Change 2012 2011 $ %

Net income $ 1,401 $ 2,232 $ (831 ) (37.2 )%

As a result of the factors above, net income decreased $0.8 million, or 37.2%, to $1.4 million for the three months ended December 31, 2012 from $2.2 million for the three months ended December 31, 2011.

Excluding the impact of the voluntary product recall, our net income would have increased $0.5 million, or 23.1%, to $2.7 million for the three months ended December 31, 2012 from $2.2 million for the three months ended December 31, 2011.

Nine Months Ended December 31, 2012 Compared to Nine Months Ended December 31, 2011

Net Sales



                                        Nine Months Ended December 31,               Change                % of Net Sales
                                           2012                  2011             $           %          2012         2011
                                                             (in thousands, except for percentages)

Meals                                $         52,759       $       41,411     $ 11,348       27.4 %       45.0 %       42.1 %
Snacks                                         47,517               40,461        7,056       17.4 %       40.5 %       41.2 %
Dressings, condiments and other                16,986               16,448          538        3.3 %       14.5 %       16.7 %


Net sales                            $        117,262       $       98,320     $ 18,942       19.3 %      100.0 %      100.0 %

Net sales increased $18.9 million, or 19.3%, to $117.3 million during the nine months ended December 31, 2012 compared to $98.3 million during the nine months ended December 31, 2011. The net sales for the nine months ended December 31, 2012 included a $1.6 million reduction due to the voluntary product recall of . . .