Lifeway Foods, Inc. — Q1 2016 Form 10-Q
Business context and period: The filing covers the three months ended March 31, 2016, compared with Q1 2015. Lifeway manufactures fermented dairy products, primarily kefir, and reports one operating segment. Unless otherwise noted, financial amounts below are in thousands of dollars.
Financial performance
| Metric | Q1 2016 | Q1 2015 / comparison |
|---|---|---|
| Gross sales | $37,030 | $33,103; up 11.9% |
| Discounts and allowances | $4,460 | $3,481; 12.0% vs. 10.5% of gross sales |
| Net sales | $32,570 | $29,622; up 10.0% |
| Gross profit / margin | $8,588 / 26.4% | $8,383 / 28.3% |
| Operating income / margin | $1,112 / 3.4% | $1,410 / 4.8% |
| Net income | $648 | $654 |
| Basic and diluted EPS | $0.04 | $0.04 |
| Operating cash flow | $(1,016) | $2,137 |
Gross sales growth reflected higher drinkable kefir volume, including the flagship 32-ounce product, private-label sales, and new items. Gross profit increased slightly in dollars but fell as a percentage of sales, which management attributed mainly to higher indirect manufacturing costs at the expanding Waukesha facility and increased ingredient costs; improved labor productivity partly offset these pressures. Operating income declined 21.1%, as higher general and administrative expenses outweighed lower selling expenses. The effective tax rate was 38.8%, versus 49.9% in Q1 2015.
Liquidity, debt, and balance sheet
- At March 31, cash and cash equivalents were $3,786; investments were $2,484; certificates of deposit were $150. Current assets were $26,594 and current liabilities $10,028.
- Total notes payable were $7,749, including $840 current maturities; debt declined from $7,959 at year-end 2015. Notes carry variable rates based on prime or LIBOR plus 2.5%, are secured by substantially all company assets, and mature in 2018 and 2019.
- The $5 million revolving credit facility had no borrowings and was due to expire in July 2016 unless renewed. The company reported compliance with loan covenants at quarter-end.
- Cash fell $1,860 to $3,786 during the quarter. Operating cash use was attributed primarily to payment timing and higher income-tax payments. Investing cash use was $194; financing cash use was $650, including $440 for share repurchases and $210 of debt repayment.
- Inventory rose to $8,291 from $7,664; accounts receivable rose to $10,187 from $9,604. Total assets were $64,178 and stockholders’ equity was $45,522.
Material changes and notable items
- General and administrative expense increased 24.7% to $4,356, mainly due to higher executive and management salaries and professional fees. The filing cites process-improvement work addressing control deficiencies, transition to a new audit firm, and legal fees related to governance.
- Selling expense declined 10.8% to $2,944, reflecting substantially lower advertising; Q1 2015 included a national television campaign. Q1 2016 advertising expense was $241 versus $1,500.
- The company repurchased 38,589 shares for approximately $440 in Q1 under its $3.5 million authorization; approximately $1,513 remained available at March 31. Treasury stock increased by $440.
- Gross sales mix: drinkable kefir other than ProBugs $32,249; ProBugs $1,885; Farmer Cheese $2,637; frozen kefir $259. Two major customers represented approximately 23% of gross sales in Q1 2016.
- Related-party amounts included $255 in consulting fees and $150 in royalties paid or earned by the board chairman during the quarter. Both were recorded in expenses.
- Senior-executive incentive compensation for 2016 depends on sales and EBITDA targets and could total $0 to $4,000 in cash and equity awards. Cash bonuses of $400 had been earned by March 31; achievement of equity compensation for the remainder of 2016 was considered unlikely.
- No investment impairment was recorded in Q1 2016, compared with $180 in Q1 2015. Investments had $190 of gross unrealized losses at March 31, including $156 on securities in a loss position for at least 12 months.
Outlook, risks, and controls
Management expects foreseeable liquidity needs to be met through operating cash flow, borrowing, and available cash. It is exploring acquisition opportunities to increase sales and leverage manufacturing and distribution. The filing provides no numerical revenue or earnings guidance. Management cautions that interim results are not necessarily indicative of full-year results and that forward-looking statements are subject to risks described in the 2015 Form 10-K.
Disclosure controls and procedures were deemed ineffective at March 31, 2016 because previously reported material weaknesses in internal control over financial reporting remained under remediation. Management said additional procedures were performed to support the reliability of the reported statements. Remediation included improved accounting policies, reconciliations, journal-entry controls and close procedures, as well as changes to fixed-asset and tax-service processes. The filing states that unresolved deficiencies could result in material misstatements.
The company reported no material pending legal proceeding and no material changes to the risk factors in its 2015 Form 10-K. It noted no significant change in market-risk exposure from year-end. The revolving credit facility’s July 2016 expiration, variable-rate debt, investment valuation exposure, customer concentration, and internal-control weaknesses are relevant items to monitor.
Investor verification points
- Confirm whether the $5 million revolver was renewed or replaced before its July 2016 expiration.
- Track operating cash flow and working-capital movements, particularly receivables, inventory, supplier payments, and tax payments.
- Monitor gross margin recovery and whether manufacturing and ingredient-cost pressures persist as Waukesha production expands.
- Review progress and evidence of remediation of the disclosed material weaknesses and the timing of any conclusion that controls are effective.
- Assess performance against the 2016 sales and EBITDA targets underlying executive incentive compensation, and related-party consulting and royalty arrangements.
- Verify share-repurchase activity and remaining authorization, and monitor covenant compliance and debt balances.