Lifeway Foods, Inc. — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014; comparisons are with the corresponding 2013 periods. Lifeway produces and distributes dairy products, led by Kefir, as well as other food products.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Gross sales | $32.59m | $25.84m | $64.66m | $53.43m |
| Net sales | $29.57m | $23.08m | $58.70m | $47.46m |
| Gross profit | $7.50m | $7.60m | $14.57m | $16.04m |
| Operating income | $1.52m | $2.49m | $2.55m | $6.22m |
| Net income | $1.09m | $1.40m | $1.75m | $3.77m |
| Diluted EPS | $0.07 | $0.09 | $0.11 | $0.23 |
- Net sales grew 28% in Q2 and 24% for the six-month period, attributed by management primarily to Kefir, ProBugs Organic Kefir for kids, and BioKefir.
- Profitability weakened despite sales growth. Gross margin was approximately 25.4% in Q2 versus 32.9% a year earlier, and 24.8% for the half versus 33.8%. Operating margin was approximately 5.2% versus 10.8% in Q2 and 4.4% versus 13.1% for the half.
- Management attributed the cost pressure primarily to milk, the company’s largest raw material, costing about 30% more year over year. Selling expenses also rose, including higher advertising and promotional spending.
- Six-month operating cash flow was $2.10m, down from $5.03m. Investing used $2.10m, including $1.76m in property and equipment purchases. Cash declined $0.44m to $2.87m.
- At June 30, current assets were $24.68m and current liabilities $8.25m (working capital $16.43m); cash and investments totaled approximately $5.86m. Total notes payable were $9.43m, including $0.88m current; the company reported approximately $5.0m of undrawn line-of-credit capacity.
- Total assets were $63.94m and stockholders’ equity $44.74m. Property and equipment, net, was $21.49m, up from $14.72m at June 30, 2013, reflecting investment that followed the July 2013 purchase of Golden Guernsey assets for approximately $7.4m.
Changes, outlook and risks
- The principal year-over-year change was a sharp decline in operating and net income as cost of goods sold grew faster than sales. Lower effective income tax rates partly offset the earnings decline.
- Management said it expected to fund foreseeable liquidity needs internally. The filing provides no quantified revenue, earnings, or margin guidance.
- The company was out of compliance with one financial ratio under its Private Bank agreements at June 30, 2014, but subsequently obtained a bank waiver. The loans carry variable interest rates; management estimated a 1 percentage-point rate increase would add about $99,000 of annualized interest expense on the outstanding balance.
- Disclosure controls and procedures were deemed ineffective at the reasonable-assurance level as of June 30, 2014 because of material weaknesses in financial reporting controls. Reported weaknesses included insufficient segregation of duties, fragmented financial-statement preparation, inadequate period-end and inventory processes, and inadequate entity-level controls. Management described remediation steps and said it was continuing to seek outside assistance.
- Two customers together accounted for approximately 32% of gross sales for the first half; the filing’s risk discussion says two customers represented 30% of Q2 net sales and 34% of accounts receivable. Customer concentration is therefore material.
- Other key risks include competition and pricing pressure, raw-material availability and cost, production and distribution capacity, food safety and product liability, debt covenants and interest rates, and consumer demand. Employees at the Wisconsin facility had begun seeking a vote on union representation.
- Management said ordinary-course litigation was not expected to have a material adverse effect. No material pending legal proceedings were reported.
Important facts for investors to verify
- Whether the bank waiver fully resolves the covenant breach and what ongoing covenant headroom remains.
- Whether milk costs, pricing, product mix, and promotional spending continue to pressure gross margins.
- Whether operating cash generation can support capital investment and debt service while cash balances remain lower than a year earlier.
- Customer concentration and the potential effect of losing or renegotiating business with major customers.
- Progress in remediating the disclosed material weaknesses and whether controls become effective.