Lifeway Foods, Inc. — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. Financial statements are unaudited and amounts below are in millions of dollars unless otherwise noted. Lifeway manufactures fermented dairy products, primarily drinkable kefir, and reports one operating segment.
Financial performance
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net sales | $31.733 | $31.131 | $63.850 | $63.701 |
| Gross profit | $9.279 | $9.735 | $17.736 | $18.435 |
| Gross margin | 29.2% | 31.3% | 27.8% | 28.9% |
| Operating income | $1.898 | $3.049 | $2.164 | $4.663 |
| Net income | $1.036 | $2.107 | $1.160 | $3.062 |
| Diluted EPS | $0.06 | $0.13 | $0.07 | $0.19 |
- Q2 sales increased 1.9%; six-month sales were up 0.2%. Six-month sales by product included drinkable kefir of $55.248 million, cheese products of $5.189 million, ProBugs kefir of $2.767 million, and frozen kefir of $0.646 million.
- Operating income fell 37.8% in Q2 and 53.6% for the six-month period. Net income declined approximately 51% and 62%, respectively.
- Q2 operating margin was 6.0%, versus 9.8%; six-month operating margin was 3.4%, versus 7.3%.
- Effective tax rates increased to 43.6% for Q2 and 43.1% year to date, versus 27.2% and 31.3%. The 2017 rates included additional tax provisions for uncertain tax positions; 2016 benefited from a favorable settlement of uncertain tax positions.
Liquidity, cash flow, and debt
- At June 30, cash and cash equivalents were $9.349 million, current assets $29.461 million, and current liabilities $13.592 million. Working capital was approximately $15.869 million.
- Six-month operating cash flow was $3.323 million, compared with $1.861 million in 2016. Investing cash outflow was $2.366 million, including $2.400 million of capital spending, primarily for production equipment. Financing cash outflow was $0.420 million; cash increased $0.537 million.
- Total notes payable were $6.699 million, down from $7.119 million at year-end. Current maturities were $3.419 million, versus $0.840 million at year-end; management said it intended to fund maturities with available cash and/or new financing. A $5 million revolving facility was undrawn and expires July 2018.
- The company reported compliance with loan covenants. Term loans are variable-rate, secured by substantially all company assets, and include financial covenants that may restrict dividends or repurchases.
Changes and management commentary
- Management attributed modest sales growth to new item introductions, higher branded drinkable kefir and private-label sales, and pricing; trade promotions reduced sales growth. For the six months, volume/mix added 1.0%, pricing 0.7%, and promotions subtracted 1.5%.
- Higher milk costs and increased trade promotion reduced gross margin, partly offset by lower freight and delivery costs.
- Six-month selling expenses rose 18.8%, reflecting advertising, coupon campaign and trade-show costs, and salesforce growth. General and administrative expenses rose 8.7%, primarily due to salaries, executive incentive compensation, and an expanded management team.
- Accrued compensation and incentives rose to $3.207 million from $1.560 million at year-end. The 2017 incentive plan could provide participants aggregate cash and equity compensation of up to $11.025 million, depending on performance; $1.985 million was accrued for the first half.
Outlook, risks, contingencies, and unusual items
- No specific revenue or earnings guidance was provided. Management expected to fund foreseeable liquidity needs internally, anticipated continued covenant compliance, and said it was exploring acquisition opportunities.
- Management concluded disclosure controls and procedures were not effective at quarter-end because of a previously identified material weakness in internal control over financial reporting. Remediation was ongoing; management said additional procedures supported fair presentation of the reported statements.
- The company was cooperating with a confidential, informal SEC Enforcement inquiry initiated in 2016 concerning controls and reporting for 2013 through the inquiry date. The SEC stated the inquiry should not be taken as an indication of a securities-law violation.
- Legal matters arise in the ordinary course. Management did not expect a material adverse effect, but said outcomes and possible losses could not be predicted or reasonably estimated; an adverse outcome could be material.
- Two customers accounted for approximately 23% of six-month sales, creating customer concentration exposure. Other cited risks include milk and input-cost volatility, supply disruptions, food-industry regulation, liquidity and covenant compliance, and product launches.
- Related-party payments to the board chair included $0.500 million for consulting and $0.300 million in product royalties in the first half. On August 2, 2017, the company completed a tender offer for 86,000 shares at $9.50 per share, costing approximately $0.900 million including related costs, funded from cash.
- Management was evaluating new accounting standards, including revenue recognition (planned adoption January 1, 2018); it expected no material impact based on its work to date, but the assessment was incomplete.
Important facts for investors to verify
- Progress and testing of remediation for the material weakness, and any subsequent developments in the SEC inquiry.
- Whether margins recover as milk costs, promotional spending, and product mix change, and whether increased selling and compensation costs translate into sustained sales growth.
- How the $3.419 million current debt maturity is funded and whether covenant headroom remains adequate.
- Exposure to the two major customers and the effect of any customer or input-cost changes on results.
- Final accounting impact of adopting the revenue-recognition standard and the outcome of outstanding legal matters and uncertain tax positions.