Lifeway Foods, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in this Form 10-Q is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements, the accompanying notes, and the MD&A included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the “Form 10-K”). Unless otherwise specified, any description of “our”, “we”, and “us” in this MD&A refer to Lifeway Foods, Inc. and our subsidiaries. Cautionary Statement Regarding Forward-Looking Statements In addition to historical information, this quarterly report contains “forward-looking” statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words such as “anticipate,” “from time to time,” “intend,” “plan,” “ongoing,” “realize,” “should,” “may,” “could," "believe," "future," "depend," "expect," "will," "result," "can," "remain," "assurance," "subject to," "require," "limit," "impose," "guarantee," "restrict," "continue," "become," "predict," "likely," "opportunities," "effect," "change," "predict," and "estimate,” and similar terms or terminology, or the negative of such terms or other comparable terminology. Examples of forward-looking statements include, among others, statements we make regarding: · Expectations of the effect on our financial condition of claims, litigation, environmental costs, contingent liabilities and governmental and regulatory investigations and proceedings; · Strategy for acquisitions, customer retention, growth, product development, market position, financial results and reserves; Estimates of the amounts of sales allowances and discounts to our customers and consumers; · Our belief that we will maintain compliance with our loan agreements and have sufficient liquidity to fund our business operations. Forward looking statements are based on management’s beliefs, assumptions, estimates and observations of future events based on information available to our management at the time the statements are made and include any statements that do not relate to any historical or current fact. These statements are not guarantees of future performance and they involve certain risks, uncertainties and assumptions that are difficult to predict. Actual outcomes and results may differ materially from what is expressed, implied or forecast by our forward-looking statements due in part to the risks, uncertainties, and assumptions that include: · The actions of our competitors and customers, including those related to price competition; · The decisions of customers or consumers; · Our ability to successfully implement our business strategy; · Changes in the pricing of commodities · The effects of government regulation; · The impact of the COVID-19 outbreak on our business, suppliers, consumers, customers, and employees; · Disruptions to our supply chain, or our manufacturing and distribution capabilities, including those due to cybersecurity threats and the COVD-19 outbreak; and · Such other factors as discussed throughout Part I, Item 1 “Business”; Part I, Item 1A “Risk Factors”; and Part II, Item 7 “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2020 and that are described from time to time in our filings with the SEC. These factors are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other unknown or unpredictable factors could also have material adverse effects on future results. We intend these forward-looking statements to speak only at the date made. Except as otherwise required to be disclosed in periodic reports required to be filed by public companies with the SEC pursuant to the SEC's rules, we have no duty to update these statements, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. 20 Recent Developments COVID-19 Pandemic Impact In December 2019, a novel coronavirus disease ("COVID-19") was first reported and subsequently characterized by the World Health Organization ("WHO") as a pandemic in March 2020. In an effort to reduce the global transmission of COVID-19, various policies and initiatives have been implemented by governments around the world, including orders to close businesses not deemed "essential", shelter-in-place orders enacted by state and local governments, and the practice of social distancing measures when engaging in essential activities. Lifeway has seen increased orders from retail customers in response to increased consumer demand for food at home in response to government mandated social distancing and shelter in place orders in the United States and the immune boosting quality of our products. Local, state, and national governments continue to emphasize the importance of food supply during this pandemic and asked that food manufacturers and retailers remain open to meet the needs of our communities. The health and safety of our employees throughout this pandemic is paramount, and we have taken numerous steps to keep our employees safe including enhanced sanitation protocols, implementation of social distancing measures at our manufacturing operations, masks and personal protective equipment for employees across our facilities, preventative temperature screenings across all manufacturing locations, the rollout of new benefits that help support our employees and their families, and remote work arrangements for administrative support functions to comply with shelter-in-place orders. In addition, a cross-functional task force has been established to monitor and coordinate the Company's response to COVID-19. During the first quarter of 2020, Management, anticipating the spread of COVID-19 and its effects, implemented a plan to mitigate effects of COVID-19 on supply and transportation of materials used to make and package our products, staffing, and transportation of our products to customers. Management’s proactive planning allowed the Company to avoid disruption to its manufacturing facilities and production, transportation, and sales and to meet the increased demand without delay. The Company has full production capacity available at all locations at this time and does not anticipate manufacturing or staffing disruptions in the near term. 21 Results of Operations Three Months Ended June 30, 2021 Compared to Three Months Ended June 30, 2020 The following table presents certain information concerning our financial results, including information presented as a percentage of consolidated net sales: Three Months Ended June 30, 2021 2020 $ % $ % Net sales 29,162 100.0% 25,014 100.0% Cost of goods sold 20,846 71.5% 17,279 69.1% Depreciation expense 639 2.2% 807 3.2% Total cost of goods sold 21,485 73.7% 18,086 72.3% Gross profit 7,677 26.3% 6,928 27.7% Selling expenses 2,566 8.8% 2,720 10.9% General & administrative expenses 2,617 9.0% 2,731 10.9% Amortization expense – 0.0% 39 0.1% Total operating expenses 5,183 17.8% 5,490 21.9% Income from operations 2,494 8.6% 1,438 5.7% Other income (expense): Interest expense (20 ) (0.1% ) (30 ) (0.1% ) Gain on investments – 0.0% 4 0.0% Loss on sales or property and equipment (76 ) (0.2% ) (33 ) (0.1% ) Other Income, net (49 ) (0.2% ) 5 0.0% Total other income (expense) (145 ) (0.5% ) (54 ) (0.2% ) Income before provision for income taxes 2,349 8.1% 1,384 5.5% Provision for income taxes 731 2.5% 404 1.6% Net income 1,618 5.5% 980 3.4% 22 Net Sales Net sales finished at $29,162 for the three-month period ended June 30, 2021, an increase of $4,148 or 16.6% versus prior year. The net sales increase was primarily driven by higher volumes of our branded drinkable kefir. Approximately 50% of the increase results from the Farmers to Families Food Box program with the United States Department of Agriculture (“USDA”) which began during the middle of the first quarter of 2021 and ended during May 2021. Gross Profit Gross profit as a percentage of net sales was 26.3% during the three-month period ended June 30, 2021. Gross profit percentage was 27.7% in the prior year. The decrease versus the prior year was primarily due to the unfavorable impact of milk pricing, and to a lesser extent the increased pricing of other inputs, partially offset by the decrease in depreciation expense. Selling Expenses Selling expenses decreased by $154 to $2,566 during the three-month period ended June 30, 2021 from $2,720 during the same period in 2020. The decrease versus prior year was primarily due to favorable compensation expense. General and Administrative Expenses General and administrative expenses decreased $114 to $2,617 during the three-month period ended June 30, 2021 from $2,731 during the same period in 2020. The decrease is primarily a result of lower compensation expense due to organizational changes made in 2020 and lower professional fees. Provision for Income Taxes The provision for income taxes includes federal, state and local income taxes. The provision for income taxes was $731 and $404 during the three months ended June 30, 2021 and 2020, respectively. Our effective income tax rate for the three months ended June 30, 2021 was 31.1% compared to 29.8% in the same period last year. During the first quarter of 2020, the company’s effective tax rate was reduced due to provisions of the CARES Act. That law provided for the carryback of certain net operating losses to years in which the tax rates were significantly higher. The tax benefit was recorded as a discrete item in the first quarter of 2020. The statutory Federal and state tax rates remained consistent from 2020 to 2021. The Company has a number of items that are nondeductible or are discrete adjustments to tax expense. Although similar items were reflected in 2021, the percentage effect is lower due to the increase in pre-tax income in 2021 compared to 2020. Our effective tax rate may change from period to period based on recurring and non-recurring factors including the relative mix of pre-tax earnings (or losses), the underlying income tax rates applicable to various state and local taxing jurisdictions, enacted tax legislation, the impact of non-deductible items, changes in valuation allowances, and the expiration of the statute of limitations in relation to unrecognized tax benefits. We record discrete income tax items such as enacted tax rate changes and completed tax audits in the period in which they occur. Section 162(m) of the Internal Revenue Code (the “Code”) limits the deductibility of compensation paid to certain of our executives. Under the Tax Cuts and Jobs Act (the “Act”) amendments to Section 162(m), no tax deduction in taxable years beginning after December 31, 2017 is allowed for compensation paid to any covered employee to the extent that the total compensation for that covered employee exceeds $1,000,000 in any taxable year. Although the Act eliminated the prior tax deduction under Section 162(m) for performance-based executive compensation, it included a transition rule under which the changes to Section 162(m) will not apply to awards made to our covered employees who had the right to participate in our 2015 Omnibus Incentive Plan pursuant to written binding contracts in effect as of November 2, 2017, as long as those contracts have not subsequently been modified in any material respect. Accordingly, subject to further guidance from the Treasury Department and the Internal Revenue Service (“IRS”), the performance-based compensation paid to our executives under our Omnibus Plan remained eligible for the Section 162(m) exemption through 2019. Beginning in 2020, compensation exceeding the threshold for covered employees is non-deductible for income tax purposes. Income taxes are discussed in Note 10 in the Notes to the Consolidated Financial Statements. 23 Six Months Ended June 30, 2021 Compared to Six Months Ended June 30, 2020 The following table presents certain information concerning our financial results, including information presented as a percentage of consolidated net sales: Six Months Ended June 30, 2021 2020 $ % $ % Net sales 58,538 100.0% 50,402 100.0% Cost of goods sold 41,358 70.7% 35,903 71.2% Depreciation expense 1,454 2.4% 1,574 3.1% Total cost of goods sold 42,812 73.1% 37,477 74.4% Gross profit 15,726 26.9% 12,925 25.6% Selling expenses 5,788 9.9% 5,295 10.5% General & administrative expenses 5,508 9.4% 5,876 11.6% Amortization expense – 0.0% 78 0.2% Total operating expenses 11,296 19.3% 11,249 22.3% Income from operations 4,430 7.6% 1,676 3.3% Other income (expense): Interest expense (42 ) (0.1% ) (69 ) -0.1% Gain on investments 2 0.0% 4 0.0% Loss on sales or property and equipment (83 ) (0.1% ) (28 ) -0.1% Other Income, net (59 ) (0.1% ) 2 0.0% Total other income (expense) (182 ) (0.3% ) (91 ) -0.2% Income before provision for income taxes 4,248 7.3% 1,585 3.1% Provision for income taxes 1,324 2.3% 459 0.9% Net income 2,924 5.0% 1,126 2.2% 24 Net Sales Net sales finished at $58,538 for the six-month period ended June 30, 2021, an increase of $8,136 or 16.1% versus prior year. The net sales increase was primarily driven by higher volumes of our branded drinkable kefir. Approximately 42% of the increase results from the Farmers to Families Food Box program with the United States Department of Agriculture (“USDA”) which began during the middle of the first quarter of 2021 and ended during May 2021. Gross Profit Gross profit as a percentage of net sales increased to 26.9% during the six-month period ended June 30, 2021 from 25.6% during the same period in 2020. The increase versus the prior year was primarily due to the favorable impact of operating leverage that arises from higher net sales relative to fixed costs. Selling Expenses Selling expenses increased by $493 to $5,788 during the six-month period ended June 30, 2021 from $5,295 during the same period in 2020. The increase versus prior year primarily reflects an increase in advertising expense related to a television and digital advertising campaigns in the first quarter of 2021, partially offset by lower compensation expense. General and Administrative Expenses General and administrative expenses decreased $368 to $5,508 during the six-month period ended June 30, 2021 from $5,876 during the same period in 2020. The decrease is primarily a result of lower compensation expense, lower professional fees, and reduced office lease expense Provision for Income Taxes The provision for income taxes includes federal, state and local income taxes. The provision for income taxes was $1,324 and $459 during the six months ended June 30, 2021 and 2020, respectively. Our effective income tax rate for the six months ended June 30, 2021 was 31.2% compared to 29.0% in the same period last year. During the first quarter of 2020, the company’s effective tax rate was reduced due to the provisions of the Cares Act. The law provided for the carry back of certain net operating losses to years in which the tax rates were significantly higher. The tax benefit was recorded as a discrete item in the first quarter of 2020. The statutory Federal and state taxes rates remained consistent from 2020 to 2021. The Company has a number of items that are nondeductible or are discrete adjustments to tax expense. Although similar items were reflected in 2021, the percentage effect is lower due to the increase in pre-tax income in 2021 compared to 2020. Our effective tax rate may change from period to period based on recurring and non-recurring factors including the relative mix of pre-tax earnings (or losses), the underlying income tax rates applicable to various state and local taxing jurisdictions, enacted tax legislation, the impact of non-deductible items, changes in valuation allowances, and the expiration of the statute of limitations in relation to unrecognized tax benefits. We record discrete income tax items such as enacted tax rate changes and completed tax audits in the period in which they occur. Section 162(m) of the Internal Revenue Code (the “Code”) limits the deductibility of compensation paid to certain of our executives. Under the Tax Cuts and Jobs Act (the “Act”) amendments to Section 162(m), no tax deduction in taxable years beginning after December 31, 2017 is allowed for compensation paid to any covered employee to the extent that the total compensation for that covered employee exceeds $1,000,000 in any taxable year. Although the Act eliminated the prior tax deduction under Section 162(m) for performance-based executive compensation, it included a transition rule under which the changes to Section 162(m) will not apply to awards made to our covered employees who had the right to participate in our 2015 Omnibus Incentive Plan pursuant to written binding contracts in effect as of November 2, 2017, as long as those contracts have not subsequently been modified in any material respect. Accordingly, subject to further guidance from the Treasury Department and the Internal Revenue Service (“IRS”), the performance-based compensation paid to our executives under our Omnibus Plan remained eligible for the Section 162(m) exemption in 2019. Beginning in 2020, compensation exceeding the threshold for covered employees is non-deductible for income tax purposes. Income taxes are discussed in Note 10 in the Notes to the Consolidated Financial Statements. 25 Liquidity and Capital Resources The ultimate impact that the COVID-19 pandemic or any future pandemic or disease outbreak will have on our business and our consolidated results of operations is uncertain. To date we have seen increased customer and consumer demand for our products as consumers initially began pantry loading and have increased their at-home consumption as a result of social distancing and stay-at-home and work-from-home mandates and recommendations. However, this increased customer and consumer demand may decrease in the coming months if and when the need for social distancing and stay-at-home and work-from-home mandates and recommendations decrease, and we are unable to predict the nature and timing of when that impact may occur, if at all. Although to date we have not experienced supply chain constraints, and we have continued to be able to fully satisfy customer and consumer demand for our products, the continued unprecedented demand for food and other consumer packaged goods products as a result of the COVID-19 pandemic or any future pandemic may limit the availability of, or increase the cost of, ingredients, packaging and other raw materials necessary to produce our products, and our operations may be negatively impacted. Additionally, pandemics or disease outbreaks could result in a widespread health crisis that could adversely affect economies and financial markets, consumer spending and confidence levels resulting in an economic downturn that could affect customer and consumer demand for our products. Our efforts to manage and mitigate these factors may be unsuccessful, and the effectiveness of these efforts depends on factors beyond our control, including the duration and severity of any pandemic or disease outbreak, as well as third party actions taken to contain its spread and mitigate public health effects. The ultimate impact of the COVID-19 pandemic on our business will depend on many factors, including, among others, the duration of social distancing and stay-at-home and work-from-home mandates and recommendations and whether additional waves of COVID-19 or different variants of COVID-19 will affect the United States and other markets, our ability and the ability of our suppliers to continue to operate our and their manufacturing facilities and maintain the supply chain without material disruption and procure ingredients, packaging and other raw materials when needed despite unprecedented demand in the food industry, and the extent to which macroeconomic conditions resulting from the pandemic and the pace of the subsequent recovery may impact consumer eating and shopping habits. We cannot predict the duration or scope of the disruption. Therefore, the financial impact cannot be reasonably estimated at this time. To date, our manufacturing facilities have not been significantly impacted. We have full production capacity available at all locations at this time. On March 16, 2020, the food industry, including grocery stores and their suppliers, and transportation were classified by the U.S. federal government as critical infrastructure industry. As a result, our employees and facilities, as well as the retailers and distributors that sell our products, will be able to remain in operation. During the first quarter of 2020, Management, anticipating the spread of Covid-19 and its effects, implemented a plan to mitigate effects of Covid-19 on supply and transportation of materials used to make and package our products, staffing, and transportation of our products to customers. While the situation is fluid, we have evaluated all manufacturing locations and do not anticipate any staffing shortages or interruption of our production, transportation and sale of products in the near term. Cash Flow At this time, the COVID-19 pandemic has not materially impacted our operations. We expect to meet our foreseeable liquidity and capital resource requirements through anticipated cash flows from operations; our revolving credit facility; and cash and cash equivalents to ensure the continuation of the Company as a going concern. The success of our business and financing strategies will continue to provide us with the financial flexibility to take advantage of various opportunities as they arise. Given the dynamic nature of COVID-19, we will continue to assess our liquidity needs while continuing to manage our discretionary spending and investment strategies. 26 Sources and Uses of Cash Lifeway had a net increase in cash and cash equivalents of $2,486 and $783 during the six-month period ended June 30, 2021 and 2020, respectively. The drivers of the year over year change are as follows: Net cash provided in operating activities was $3,647 during the six-month period ended June 30, 2021 compared to net cash provided by operating activities of $1,911 in the same period in 2020. The increase in cash provided by operating activities is primarily due to the increase in cash generated through higher revenues and reduced expenses in 2021, and the change in working capital. Working capital consumption was higher in 2020 due to increased revenue in March 2020 as consumers anticipated the shelter in place directives that ultimately occurred as a result of the COVID-19 pandemic. Net cash used in investing activities was $1,161 during the six-month period ended June 30, 2021 compared to net cash used in investing activities of $723 in the same period in 2020. The increase in net cash used in investing activities in 2021 reflects higher capital spending. Capital spending was $1,161 during the six-month period ended June 30, 2021 compared to $728 in 2020. Our capital spending is focused in three core areas: growth, cost reduction, and facility improvements. Growth capital spending supports new product innovation and enhancements. Cost reduction and facility improvements support manufacturing efficiency, safety and productivity. Net cash used in financing activities was $0 during the six-month period ended June 30, 2021 compared to net cash used in financing activities of $405 in the same period in 2020. On November 1, 2017, Lifeway’s Board approved an increase in the aggregate amount under our previously announced 2015 stock repurchase program (the “2017 Repurchase Plan Amendment”), by adding to (i.e., exclusive of the shares previously authorized under the 2015 stock repurchase program) the authorization the lesser of $5,185 or 625 shares. We repurchased approximately 178 shares of common stock at a cost of $405 during the three-month period ended March 31, 2020 under the 2017 Repurchase Plan Amendment. As of June 30, 2021, there were no shares of common stock that remained available to be purchased under the 2017 Repurchase Plan Amendment. We intend to hold repurchased shares in treasury for general corporate purposes, including issuances under our 2015 Omnibus Incentive Plan. Treasury shares are accounted for using the cost method. Debt Obligations On September 30, 2020, Lifeway entered into the Third Modification to the Amended and Restated Loan and Security Agreement, as amended, (the “Third Modification”) with its existing lender. The Third Modification amends the Amended and Restated Loan and Security Agreement, as amended, by removing the monthly borrowing base reporting requirement effective September 30, 2020, including a covenant to maintain a quarterly minimum working capital financial covenant, as defined, of no less than $11.25 million each of the fiscal quarters commencing the fiscal quarter ended December 31, 2020 through the expiration date, and eliminating the tier interest pricing structure. The Amended and Restated Loan and Security Agreement continues to provide Lifeway with a revolving line of credit up to a maximum of $5 million (the “Revolving Loan”) and provides the Borrowers with an incremental facility not to exceed $5 million (the “Incremental Facility” and together with the Revolving Loan, the “Loans”). The Termination Date of the Revolving Loan was extended to June 30, 2025, unless earlier terminated. Except as described above, amended, the Modified Revolving Credit Facility remains substantively unchanged and in full force and effect, including customary representations, warranties, and covenants on the part of Lifeway, including financial covenants requiring us to maintain a fixed charge coverage ratio of no less than 1.25 to 1.00 each of the fiscal quarters ending through the expiration date. The Modified Revolving Credit Facility continues to provide for events of default, including failure to repay principal and interest when due and failure to perform or violation of the provisions or covenants of the agreement, as a result of which amounts due under the Modified Revolving Credit Facility may be accelerated. As of June 30, 2021, we had $2,777, outstanding under the Revolving Credit Facility. We had $2,223 available for future borrowings as of June 30, 2021. 27 As amended, all outstanding amounts under the Loans bear interest, at Lifeway’s election, at either the lender Base Rate (the Prime Rate minus 1.00%) or the LIBOR plus 1.95%, payable monthly in arrears. Lifeway is also required to pay a quarterly unused line fee of 0.20% and, in conjunction with the issuance of any letters of credit, a letter of credit fee of 0.20%. Lifeway’s interest rate on debt outstanding under our Revolving Credit Facility as of June 30, 2021 was 2.15%. We are in compliance with all applicable financial debt covenants as of June 30, 2021. See Note 7 to our Consolidated Financial Statements for additional information regarding our indebtedness and related agreements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable.