It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. With that said let's apply this process to Sprouts Farmers Market (NASDAQ: SFM).
1.) What does the company do?
When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells.
Sprouts Farmers Market is a grocery store that sells organic and natural foods at competitive prices. Sprouts Farmers Market operates roughly 180 stores.
2.) What do the fundamentals look like?
Investors should also look for companies that grow revenue and free cash flow over the long-term and retain some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains.
Sprouts Farmers Market's fundamentals since Jan. 2011 are excellent. Revenue, net income, and free cash flow increased 372%, 956%, and 1,320% respectively according to Y Charts. However, Sprouts Farmers Market's total return declined 24% vs. a 19% increase in the S&P 500 since the company's Initial Public Offering in August 2013 according to Y Charts, with the declining price due in part to subsequent sales of large blocks of stock by major shareholders.
Acquisitions, store expansion and same store sales increases contributed to revenue and net income expansion over the past five years. However, impairment costs stemming from store closures served as a drag against this growth. Net income growth filtered down to free cash flow growth exceeding capital expenditures growth, which is exceptional.
Sprouts Farmer Market continues to do well in 2014. Year-to-date revenue, net income, and free cash flow increased 23%, 109%, and 78% respectively. Same store sales and store expansion contributed to across the board growth. The healthy and trendy appeal of the company serves as a draw to consumers.
Sprouts Farmers Market also sits on a good balance sheet. Cash and long-term debt to equity ratios came in at 30% and 49% respectively in the most recent quarter. Long-term debt creates interest which chokes out profitability and cash flow. Investors should always look for companies with long-term debt to equity ratios of 50% or less.
3.) How much management-employee ownership is there?
Investors should also look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits which will enhance share price and their personal wealth along with the wealth of shareholders.
Directors and officers collectively own 3.8% of this company. Douglas Sanders, Sprouts Farmers Market's President and Chief Executive Officer, owns 1.4% of the company's stock giving him extra incentive to maximize company profit.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents" which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist.
Last year, external auditors gave the company's financial statements a "presents fairly" opinion meaning that it's clean based on the audit. They provided no opinion on internal financial controls. However, management indicated some issues with internal controls pertaining to the "costing of non-perishable inventories" in 2013.
5.) What types of risk does it have?
It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. Sprouts Farmers Market operates solely in the United States which means political risk resides in the relatively low range.
Sprouts Farmers Market operates in a crowded industry competing with other organic grocers such as Whole Foods Markets (NASDAQ:WFM). Sprouts Farmers Market's lower price philosophy led to a relatively lower operating margin of 5.7% in 2013 vs. 6.8% for Whole Foods Market.
Even after the stock price decline, Sprouts Farmers Market still trades at a high P/E ratio of 54 vs. 19 for the S&P 500 and 25 for Whole Foods Market. This means that the company's market price risk resides in the stratosphere. It's a little better on a forward basis with Sprouts Farmers Market trading at a forward P/E ratio of 37 versus 18 for the S&P 500.
6.) What does its forward analysis look like?
Look for Sprouts Farmers Market's organic food to serve as a magnet for consumers. The company's robust fundamental growth definitely warrants a second look. However, investors need to heed caution over its internal controls issues and its sky high P/E ratio. The first time the company disappoints Wall Street its stock price will retract further.
Stockdissector is NOT an investment advisor and he owns shares in Whole Foods Market and will not execute any trades in the company for 3 market days.