Continuing with the deep value theme I started two weeks ago, today I want to tell you about a company with growing sales, rising margins, beaucoup free cash flow, and a P/E less than 9: Nutraceutical (NASDAQ:NUTR). This is the most promising value stock I've unearthed in the past three months.

Park City, Utah-based Nutraceutical manufactures and sells branded nutritional supplements. Brands include Solaray, KAL, Natural Max, Premier One, VegLife, Sunny Green, Action Labs, Natural Sport, ActiPet, Thompson, Ultimate Nutrition, and Miztique. These are the snazzy brands that are sold exclusively through independent health and natural food stores, of which there are 15,000 in the U.S. Also included in Nutraceutical's distribution are organic grocery chains, like Whole Foods Market (NASDAQ:WFMI) and Wild Oats Market (NASDAQ:OATS). Where you won't find any of Nutraceutical's products are mass market retailers, like Wal-Mart (NYSE:WMT), Kroger (NYSE:KR), or Safeway (NYSE:SWY).

This exclusivity works to Nutraceutical's advantage for a couple of reasons: For one, natural food retailers tend to favor brands that are sold exclusively to the "healthy foods channel." Nutraceutical caters to these stores' desire for unique brands that are known for their high quality. Also, within this niche, Nutraceutical benefits from a substantially larger direct sales force than any of its competitors.

That a company as small as Nutraceutical, with $111 million in trailing annual sales, is one of the nation's largest specialty vitamin companies speaks to the fragmented nature of this industry. It was this very fragmentation that in 1993 led Nutraceutical's management, with the backing of Bain Capital, to embark upon a consolidation strategy.

I'm normally leery of acquisition-based growth strategies, but this one has all the earmarks of success. Nutraceutical's acquisitions have been small, manageable, and mostly paid for in cash. And since its first full year of operations in 1995, the company has been profitable.

Also boding well for Nutraceutical's business are the following factors:

1. Growing sales per share
Over the past three years, sales per share have grown 4.6% annually. That's not much growth, but Nutraceutical has done well to buck a downward industry trend. Over the past three years, the nutritional supplement industry as a whole has declined from $9.6 billion to around $9.0 billion in sales. The declining industry trend is a bit disconcerting, but Nutraceutical CEO Bill Gay recently said the overall trend in the healthy food channel is "relatively flat." Even in a flat industry, Nutraceutical can continue to grow modestly through product extensions and further acquisitions.

2. Rising margins
Since 1998, Nutraceutical's gross margins have expanded from 44.8% to 51.3%, with net margins increasing from 5.4% to 11.2% during the same time. In other words, through gross margin improvement alone, Nutraceutical has more than doubled its bottom line over the past five years. The result has been 22.8% compound annual growth in earnings per share.

The catalyst for this margin improvement has been a lower mix of bulk unbranded vitamin sales. In 1997, bulk materials accounted for 21% of sales; today it's closer to 7% of sales -- and still declining. As Nutraceutical continues to emphasize growth of its branded products over the unbranded bulk materials, margins may have further room to rise even yet.

3. Paying off debt
Nutraceutical's corporate life began with a high level of debt financing to fund acquisitions. But as these acquisitions have begun to spin out cash, the company has been fantastically diligent in paying down its debt. Over the past three years, Nutraceutical has been especially aggressive in reducing net debt -- from a level of $38 million (debt less cash) in 1999 to $13 million by the end of 2002. And as of March, net debt is down to just over $5 million. Barring a great number of cash acquisitions, Nutraceutical should have a positive cash balance within a few years.

4. Opportunistic share buybacks
In addition to judiciously paying down debt, Nutraceutical management has also been savvy in buying back shares when the price is right. In 2000, when the stock dropped to its all-time lows below $5, management took a big swing, buying back 7.5% of the company for only $3.3 million -- an average price per share of $3.60. By way of comparison, the stock is around $10 today. This is a management team that knows how to allocate capital.

5. Shareowner management
Given the last point, it should come as no surprise that Nutraceutical is run by shareowner managers. Bain Capital, which has two board seats, owns 42.7% of the company. Other executives and directors collectively own an additional 14.5% of outstanding shares. All told, that's 57.2% of the company's ownership in the hands of those who are steering the ship. There's nothing like substantial ownership to keep shareholder and managerial incentives aligned. As one example, option grants have been very reasonable over the years, averaging about 1.1% of diluted shares for each of the past seven years.

I saved the best for last. At around $10, Nutraceutical has a market cap of $116 million. That's 8.8 times earnings and 6.2 times free cash flow. Working capital adjustments have helped to boost free cash flow in the past year, but in general, that P/FCF multiple is legit. Consider that over the past six years, Nutraceutical has generated 22.9% more free cash flow than reported net income. Even with only modest growth, Nutraceutical deserves a higher multiple.

Nutraceutical is clearly a Hidden Gem. If you're interested in small caps that are currently overlooked in the market and poised for market-beating returns, check out Tom Gardner's Motley Fool Hidden Gems newsletter. Try it for 30 days absolutely free.

Matt Richey ( is a senior analyst for The Motley Fool. At the time of publication, he held shares of Nutraceutical. The Motley Fool is investors writing for investors.