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. Right now, let's talk about Reed's (NYSEMKT: OTCQX:REED).
1.) What does the company do?
When my wife and I were traveling the western part of the United States, we stopped at a restaurant and noticed something odd. The establishment served carbonated sodas that didn't come from the big three beverage companies, such as Coca-Cola (NYSE: KO), PepsiCo (NYSE: PEP), or Dr Pepper Snapple Group (NYSE: DPS). I ordered one of the specialty sodas. Always on the lookout for new investment ideas to research and write about, I started searching the bottle for a holding company I could recognize. I discovered the name Reed's. Reed's, in addition to specialty sodas such as Virgil's Rootbeer and Flying Cauldron Butterscotch Beer, sells candies such as Reed's Peanut Butter Ginger Chews and ice cream such as Reed's Chocolate Ginger Ice Cream. However, just because a company sells a cool product doesn't make it a good company. Investors need to check out a company's fundamentals.
Source: Reed's website
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.
Reed's does not stand on its own two feet. Reed's has done well on the top line front. Its revenue expanded 174% over the past five years. However, it is still unprofitable, and free cash flow is intermittent due to investments in its distribution infrastructure, product development and acquisitions, and sales cost (see charts below).
REED Revenue ((TTM)) data by YCharts
REED Net Income ((TTM)) data by YCharts
The scenario hasn't changed much for FY 2015. In the most recent quarter, Reed's grew its revenue 19% year-over-year. However, its net loss widened 23% vs. the same time last year. The company invested in sales promotion via trade shows. Reed's also experienced some difficulty in some out of stocks with its Kombucha tea products and lost some distributors as a result. Reed's also swung to a negative free cash flow reading of $809 thousand vs. $12 thousand the same time last year.
Reed's leans heavily on debt to finance operations and expansion. In the most recent quarter, Reed's had long-term debt amounting to 117% of stockholder's equity. I like to see companies harbor long-term debt amounting to 50% or less of stockholder's equity. Reed's turned an operating loss, which means its $200 thousand interest expense isn't covered by business profits. On the plus side, Reed's possessed $1.2 million on its balance sheet, which amounted to 34% of stockholder's equity. I like to see companies harbor cash amounting to 20% of stockholder's equity or greater.
3.) How much management-employee ownership is there?
Investors should always 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. Christopher J. Reed, the company's CEO, and his wife, own 24.7% of the company, which means he wants to see the company succeed.
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. It is especially important to look at this letter when evaluating small companies like Reed's. In the most recent 10-K Reed's auditors said the financial statements were fairly presented.
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. Reed's does operate in "select international markets," which means it has some exposure to political risk. Reed's investors are also at risk due to the small size. Small operational hiccups, like out of stocks, or something resulting in a large lawsuit, could permanently derail the company. Reed's has a long way to go before achieving the distribution scale and might of its competitors Coca-Cola and PepsiCo. Reed's P/E ratio is incalculable making it difficult to gauge stock market price risk.
6.) What does its forward analysis look like?
Due to the large amount of indebtedness, operational volatility and the unproven nature of its products, conservative investors may want to stay away for the time being. However, the vast expansion of Reed's top line makes it a worthy addition to your watch list. Consumers love products with natural and organic labeling because it makes them seem healthier. Eventually the company could achieve enough scale to start generating cash on its own and paying down debt. In addition, it could make a good takeover target by a larger beverage rival. Reed's products could really benefit a large carbonated soda company looking to adapt to changing consumer taste towards beverages perceived to be healthier.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.