Lifeway Foods, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018; unaudited consolidated results. Dollar amounts below are in thousands unless otherwise stated. Lifeway manufactures and sells cultured dairy products, principally drinkable kefir, primarily in the United States.
Financial performance
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Net sales | $28,742 | $32,117 | Down 10.5% |
| Gross profit | $8,037 | $8,457 | Down 5.0% |
| Gross margin | 28.0% | 26.3% | Up 1.7 percentage points |
| Operating income | $151 | $266 | Down 43.2% |
| Net income | $70 | $124 | Down 43.5% |
| Diluted earnings per share | $0.00 | $0.01 | Lower |
| Operating cash flow | $853 | $2,250 | Down $1,397 |
Operating margin was 0.5%, versus 0.8% a year earlier. Management attributed the higher gross margin to lower promotional allowances, input costs, and delivery costs; these benefits were partly offset by unfavorable product mix and the effect of lower sales on fixed costs. Operating expenses fell 3.7%, but rose as a share of sales to 27.4% from 25.5%.
Balance sheet, cash flow, and financing
- At March 31, cash was $3,722, down from $4,978 at December 31, 2017. Current assets were $23,388 and current liabilities were $10,086.
- Total notes payable were $6,069, compared with $6,279 at year-end. The balance sheet classified none as current at March 31; the loans were secured by substantially all company assets and carried variable rates of approximately 4.15%–4.16% at quarter-end.
- Cash decreased by $1,256. Operating cash flow of $853 and investing outflows of $847, including $879 of capital expenditures, were accompanied by financing outflows of $1,262. The latter included $1,052 used to repurchase approximately 131,000 shares and $210 of debt repayment.
- Management said operating cash flow declined due to lower net income and timing of payments to suppliers and service providers, partly offset by improved receivables turnover. Cash provided by operations in Q1 2017 included different working-capital movements.
Material changes and business drivers
- Sales fell $3,375. Management reported volume and mix reduced sales by 13.5%, pricing by 1.0%, while trade promotions and allowances contributed a favorable 4.0%. Lower branded and private-label drinkable kefir volumes were partly offset by new product introductions; management also cited broader weakness in dairy and cultured dairy volumes.
- Drinkable kefir other than ProBugs accounted for 76% of sales, down from 78%; ProBugs fell to 3% from 5%. Other dairy rose to 5% from 2%, and cheese to 10% from 9%.
- Two customers represented approximately 22% of Q1 2018 sales. A large customer’s switch to picking up product rather than having it delivered affected pricing and freight costs.
- Advertising expense was $1,389 versus $1,768. Selling expenses declined, primarily due to lower advertising and marketing costs, while selling expenses as a percentage of sales increased to 14.0% from 13.2%.
Outlook, risks, and unusual items
- Management expected liquidity needs to be met through operating cash flow, cash, and credit availability, and stated it believed financing sources adequate. It provided no specific sales or earnings forecast. Management expected U.S. tax reform to benefit future earnings, diluted EPS, and cash flow; the estimated effective tax rate for Q1 2018 was 35.1%, versus 39.2% a year earlier. The company said its review of tax-reform effects would continue as guidance became available.
- On May 7, 2018, after quarter-end, Lifeway refinanced its term loans and prior revolving facility with a three-year revolving credit facility of up to $10 million, with a possible lender-approved incremental facility of up to $5 million. Availability is subject to a borrowing base; the facility is secured by substantially all assets and includes financial covenants, including a minimum fixed-charge coverage ratio of 1.25-to-1.0 and a maximum senior-debt-to-EBITDA ratio of 3.00-to-1.0.
- The filing’s covenant disclosures are inconsistent: Note 7 says Lifeway was not in compliance with the minimum fixed-charge coverage covenant at March 31 and had obtained a waiver through December 31, 2018; the MD&A says it was in compliance with applicable covenants as of March 31. The filing also says the new facility was entered into after quarter-end. Clarify which agreement and covenant status each statement refers to.
- The company disclosed an ongoing confidential, informal SEC Division of Enforcement inquiry, begun in 2016, concerning internal controls and disclosure controls for fiscal 2013 through the date of the inquiry letter. Lifeway said it was cooperating and noted the SEC had cautioned that the inquiry did not indicate a violation. Management stated current disclosure controls were effective and reported no material change in internal control during the quarter.
- Lifeway reported ordinary-course litigation and said existing legal accruals were not material; it could not estimate possible losses or ranges for contingencies. It reported no material change to the risk factors in its 2017 Form 10-K. Key risks cited include dairy input-price and supply-chain changes, regulation, legal or investigative proceedings, product-launch execution, liquidity, and loan-covenant compliance.
Important facts for investors to verify
- Reconcile the covenant-compliance statements, the waiver, and the terms and borrowing availability of the post-quarter refinancing.
- Assess whether sales and drinkable-kefir volume declines persist, and whether new products offset weaker core-product demand and mix.
- Review cash conversion, working-capital movements, capital spending, and the funding capacity available under the borrowing-base facility.
- Monitor customer concentration, the SEC inquiry, and the status and potential exposure of legal contingencies.