Growth is good.
But you shouldn't make it the be-all and end-all of your investment due diligence. Case in point: kefir maker Lifeway Foods (NASDAQ:LWAY).
On Nov. 14, the little Illinois dairy company reported yet another quarter of stellar sales, helped by recently signed partners Target (NYSE:TGT), Wal-Mart (NYSE:WMT), and Cosi (NASDAQ:COSI), and longstanding partners Ruddick (NYSE:RDK), Whole Foods (NASDAQ:WFMI), and Wild Oats (NASDAQ:OATS). In Q3 2005, the company booked 26% greater sales than it had in Q3 2004, bringing its year-to-date progress up to 24% growth (as previously related by my Foolish colleague Rick Munarriz). However, the strength of Lifeway's sales failed to translate into growth in net profits, which increased just 8% in both quarterly and year-to-date comparisons.
What's more, the company made a single major purchase this year that both positioned it for further sales growth and eliminated any chance of generating positive free cash flow for the year. According to its 10-QSB filing with the SEC, filed simultaneously with the release of the earnings announcement, Lifeway has burned through $3.5 million in free cash flow so far this year, versus positive free cash flow of $1.7 million in the first nine months of last year. Even though that $3.5 million cash drain is smaller than the $3.8 million we were looking at four months ago, even if the company repeats this quarter's performance in Q4, it will still be on the wrong side of $3 million in negative free cash flow by year-end.
The company's new warehouse is the elephant in the living room, Lifeway's primary obstacle to achieving free cash flow growth this year. The good news is that elephants are ambulatory beasts. Lifeway's elephant will take another six weeks or so to mosey off its future fiscal 2006 cash flow statements, but once it's gone, I don't expect we'll be seeing it return any time soon. More significant to long-term shareholders, therefore, are the other costs that have been milking Lifeway's profits.
CFO Edward Smolyansky cited transportation, utilities, and production supplies as contributing to a significant contraction of Lifeway's gross margin, even with raw milk prices on the downturn. Sales may have risen 26%, you see, but the costs of making those sales leapt 37% for the quarter, and 30% year to date.
But here's the good news for Foolish investors: These are factors that you can monitor on your own. You need not depend on analysts to judge which way Lifeway's "costs of goods sold" will shift in Q4 and beyond. Are milk prices going up in your local supermarket? Then so will the cost of Lifeway's raw materials. Is gas costing less at the pump? So, too, will Lifeway's transportation costs fall. And with winter coming swiftly, you should have plenty of incentive to keep an eye on utility costs. All of which should ensure that, when Lifeway's Q4 results roll around, you'll have an excellent idea of what to expect.
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Fool contributor Rich Smith does not own shares of any company named above.
