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. 22 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. 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. 23 Results of Operations Three Months Ended September 30, 2021 Compared to Three Months Ended September 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 September 30, 2021 2020 $ % $ % Net sales 29,553 100.0% 26,039 100.0% Cost of goods sold 21,915 74.1% 17,710 68.0% Depreciation expense 645 2.2% 752 2.9% Total cost of goods sold 22,560 76.3% 18,462 70.9% Gross profit 6,993 23.7% 7,577 29.1% Selling expenses 2,722 9.2% 2,116 8.1% General & administrative expenses 3,194 10.9% 2,805 10.8% Amortization expense 33 0.1% 39 0.2% Total operating expenses 5,949 20.2% 4,960 19.1% Income from operations 1,044 3.5% 2,617 10.0% Other income (expense): Interest expense (30 ) (0.1% ) (27 ) (0.1% ) Gain on investments – 0.0% – 0.0% Loss on sales or property and equipment (5 ) 0.0% – (0.0% ) Other Income, net (2 ) 0.0% – 0.0% Total other income (expense) (37 ) (0.1% ) (27 ) (0.1% ) Income before provision for income taxes 1,007 3.4% 2,590 9.9% Provision for income taxes 527 1.8% 764 2.9% Net income 480 1.6% 1,826 7.0% 24 Net Sales Net sales finished at $29,553 for the three-month period ended September 30, 2021, an increase of $3,514 or 13.5% versus prior year. The net sales increase was primarily driven by higher volumes of our branded drinkable kefir, and to a lesser extent the favorable impact of our acquisition of Glen Oaks Farms during the third quarter of 2021. Gross Profit Gross profit as a percentage of net sales was 23.7% during the three-month period ended September 30, 2021. Gross profit percentage was 29.1% 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 freight and other inputs, partially offset by the decrease in depreciation expense. Selling Expenses Selling expenses increased by $606 to $2,722 during the three-month period ended September 30, 2021 from $2,116 during the same period in 2020. The increase from prior year is due to increased investment in advertising and marketing programs. General and Administrative Expenses General and administrative expenses increased $389 to $3,194 during the three-month period ended September 30, 2021 from $2,805 during the same period in 2020. The increase is primarily a result of incentive compensation expense. Provision for Income Taxes The provision for income taxes includes federal, state and local income taxes. The provision for income taxes was $527 and $764 during the three months ended September 30, 2021 and 2020, respectively. Our effective income tax rate for the three months ended September 30, 2021 was 52.3% compared to 29.5% in the same period last year. 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 during the quarter. Although similar items were reflected in 2021, the percentage increased due to nondeductible compensation expense under Section 162(m). Section 162(m) of the Internal Revenue Code (the “Code”) limits the deductibility of compensation paid to certain of our executives. Under 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. 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. Income taxes are discussed in Note 10 in the Notes to the Consolidated Financial Statements. 25 Nine Months Ended September 30, 2021 Compared to Nine Months Ended September 30, 2020 The following table presents certain information concerning our financial results, including information presented as a percentage of consolidated net sales: Nine Months Ended September 30, 2021 2020 $ % $ % Net sales 88,091 100.0% 76,441 100.0% Cost of goods sold 63,273 71.8% 53,613 70.2% Depreciation expense 2,099 2.4% 2,326 3.0% Total cost of goods sold 65,372 74.2% 55,939 73.2% Gross profit 22,719 25.8% 20,502 26.8% Selling expenses 8,510 9.7% 7,411 9.7% General & administrative expenses 8,702 9.9% 8,681 11.4% Amortization expense 33 0.0% 117 0.1% Total operating expenses 17,245 19.6% 16,209 21.2% Income from operations 5,474 6.2% 4,293 5.6% Other income (expense): Interest expense (72 ) (0.1% ) (96 ) (0.1% ) Gain on investments 2 0.0% 4 0.0% Loss on sales or property and equipment (88 ) (0.1% ) (28 ) 0.0% Other Income, net (61 ) 0.0% 2 0.0% Total other income (expense) (219 ) (0.2% ) (118 ) (0.1% ) Income before provision for income taxes 5,255 6.0% 4,175 5.5% Provision for income taxes 1,851 2.1% 1,223 1.6% Net income 3,404 3.9% 2,952 3.9% 26 Net Sales Net sales finished at $88,091 for the nine-month period ended September 30, 2021, an increase of $11,649 or 15.2% versus prior year. The net sales increase was primarily driven by higher volumes of our branded drinkable kefir. Approximately 29% of the net sales 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. Approximately 7% of the net sales increase results from our acquisition of Glen Oaks Farms during the third quarter of 2021. Gross Profit Gross profit as a percentage of net sales decreased to 25.8% during the nine-month period ended September 30, 2021 from 26.8% during the same period in 2020. 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 freight and other inputs, partially offset by the decrease in depreciation expense. Selling Expenses Selling expenses increased by $1,099 to $8,510 during the nine-month period ended September 30, 2021 from $7,411,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 and increased in person selling and marketing events, partially offset by lower compensation expense. General and Administrative Expenses General and administrative expenses increased $21 to $8,702 during the nine-month period ended September 30, 2021 from $8,681 during the same period in 2020. The increase is primarily a result of incentive compensation expense, partially offset by lower office lease and professional fee expense. Provision for Income Taxes The provision for income taxes includes federal, state and local income taxes. The provision for income taxes was $1,851 and $1,223 during the nine months ended September 30, 2021 and 2020, respectively. Our effective income tax rate for the nine months ended September 30, 2021 was 35.2% compared to 29.5% 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 increased due to nondeductible compensation expense under Section 162(m). 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. 27 Income taxes are discussed in Note 10 in the Notes to the Consolidated Financial Statements. 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 future 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, increasing supply chain constraints generally, and 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. 28 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. Sources and Uses of Cash Lifeway had a net increase in cash and cash equivalents of $2,092 and $3,780 during the nine-month period ended September 30, 2021 and 2020, respectively. The drivers of the year over year change are as follows: Net cash provided in operating activities was $6,435 during the nine-month period ended September 30, 2021 compared to net cash provided by operating activities of $5,348 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 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 $7,485 during the nine-month period ended September 30, 2021 compared to net cash used in investing activities of $1,163 in the same period in 2020. The increase in net cash used in investing activities in 2021 reflects the August 2021 acquisition of Glen Oak Farms, Inc. The $5,800 acquisition purchase price was funded through proceeds from our new $5,000 term loan and existing cash. Capital spending was $1,685 during the nine-month period ended September 30, 2021 compared to $1,168 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 provided by financing activities was $3,142 during the nine-month period ended September 30, 2021 compared to net cash used in financing activities of $405 in the same period in 2020. The increase in net cash provided by financing activities relates to the term loan entered into during August 2021 in connection with the acquisition of Glen Oaks Farms, Inc. See Debt Obligations section below for further detail. On June 24, 2021, the Lifeway’s Board authorized a plan to repurchase up to 250 shares of Common Stock in the open market within 24 months at no more than $10 per share. We repurchased all 250 shares of common stock at a cost of $1,583 during the three-month period ended September 30, 2021. 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 August 18, 2021, Lifeway entered into the Fourth Modification (the “Fourth Modification”) to the Amended and Restated Loan and Security Agreement (as amended and modified from time to time, the “Credit Agreement”) with its existing lender and certain of its subsidiaries. The Fourth Modification amends the Credit Agreement to provide for, among other things, a $5 million term loan by the existing lender to the borrowers to be repaid in quarterly installments of principal and interest over a term of five years (the “Term Loan”). The termination date of the Term Loan is August 18, 2026, unless earlier terminated. Except for the addition of the Term Loan, the Credit Agreement remains substantively unchanged and in full force and effect. 29 As of September 30, 2021, we had $2,777 outstanding under the Revolving Credit Facility and $4,726 outstanding under the note payable, net of $24 of unamortized deferred financing fees. We had $2,223 available for future borrowings under the Revolving Credit Facility as of September 30, 2021. 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% on the Revolving Credit Facility 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 the Loans as of September 30, 2021 was 2.15%. We are in compliance with all applicable financial debt covenants as of September 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.