Investors should always make a list of the qualities they are looking for in an investment. The following six-point inspection serves as an example that can help guide you in the research process.
1.) What does the company do?
Being a shareholder is synonymous with being part owner of a business. Before you buy shares in a company it's important to understand what the business sells or does. With that said, let's look at Ingles Markets (NASDAQ: IMKTA) which operates grocery stores in the southeastern part of the United States with locations in the states of Alabama, Virginia, Tennessee, South Carolina, North Carolina, and Georgia. There are 203 locations overall.
2.) What do the fundamentals look like?
Ingles Markets' fundamentals are lacking. Revenue grew 15% from 2009-2013. However, net income declined 28% during that time. Debt refinancing costs and higher salary costs in 2013 contributed to the negative net income comparison during that time.
Free cash flow swung from a negative $38 million in 2009 to a positive $44 million in 2013. It's worth noting that Ingles Markets' free cash flow resided in the positive range only twice since 2009 in the years 2010 and 2013. The culprit lies in heavy capital expenditures devoted to the remodeling and modernization of its stores and construction of a distribution facility. The company's store count hasn't changed since 2010.
Its most recent balance sheet doesn't inspire much confidence either. A cash balance of $4 million only comprises 1% of stockholder's equity. Long-term debt clocks in at a whopping 207% of stockholder's equity. Investors should look for companies with long-term debt to equity ratios of 50% or less. Long-term debt creates interest that chokes out profitability and cash flow. So far in 2014, Ingles Markets' operating income only exceeds interest expense by three times despite recent refinancing efforts. The rule of thumb for safety resides at five times or more.
Ingles Markets does pay a dividend which isn't very sustainable given its choppy free cash flow history. Last year the company paid out 68% of its free cash flow in dividends. Currently, the company pays its publicly-traded Class A shareholders $0.66 per share per year. This equates to an annual dividend yield of 3%.
3.) How much management-employee ownership is there?
Investors should look for companies with high management and/or employee ownership. Managers who own large chunks of the company they run will take better care to maximize business profitability. This translates into higher stock prices and increased personal wealth on their behalf. Their interests are aligned with other shareholders.
The directors and executive teams at Ingles Markets control 83% of the voting power at the company. The Chairman and CEO Robert P. Ingle II owns 40% of the class A shares and 93% of class B shares giving him 81% of the voting power. Any decisions impacting company profitability will certainly affect his personal wealth. Also the Ingles investment/profit sharing plan controls 5% of the total voting power.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Investors should always pay attention to the external auditors report to a company's board of directors. The annual letters indicate whether the financial statements fit the bill for meeting generally accepted accounting principles and consider if the internal controls over financial reporting are adequate. If the external auditors issue an unqualified opinion or if the statements are fairly stated then chances are the financial statements are clean. However, an adverse or qualified opinion could mean deeper issues.
Looking at the past five years external auditors issued a clean opinion on Ingles Markets' financial statements and internal controls. However, it should be noted that Ingles Markets changed external auditors in 2012 but, Ingles Markets indicated it had no disagreements with the previous external auditors.
5.) What types of risks does it have?
It's always important for investors to weigh the various risks involving a business including geopolitical risks, competitive positioning, and market price risk. Ingles Markets operates solely in the southeastern United States, a stable region of the world, meaning that political risk resides in the low range. However, the company operates in a highly-competitive marketplace with retailing juggernauts like Wal-Mart (NYSE: WMT) and privately-held competitors such as Bi Lo and Food City.
Wal-Mart's 11,000 locations allow it the purchasing power to profitably sell items at a much cheaper price. In 2013, Wal-Mart's operating margins clocked in at 6% vs. 3% for Ingles Markets. Ingles Markets' stock trades at a relatively low P/E ratio of 12 vs. 18 for the S&P 500 according to Morningstar. It also trades at a forward P/E of 11 versus 17 for the S&P 500 meaning that the market risk resides in the low range.
6.) What does its forward analysis look like?
Ingles Markets' low market price risk doesn't counter balance the extraordinarily high fundamental risk brought on by its high debt load. Also, Ingles Markets' lies in a competitively disadvantageous position relative to its larger competitors and it doesn't help that the company made no strides in expanding its store base over the past five years. Investors should take their investing dollars elsewhere.
Disclosure: The author is long WMT.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.