Lifeway Foods, Inc. 10-Q

ITEM 1. FINANCIAL STATEMENTS. LIFEWAY FOODS, INC. AND SUBSIDIARIES Consolidated Balance Sheets September 30, 2022 and December 31, 2021 (In thousands) September 30, 2022 December 31, Unaudited 2021 Current assets Cash and cash equivalents $ 8,933 $ 9,233 Accounts receivable, net of allowance for doubtful accounts and discounts & allowances of $ 1,400 and $ 1,170 at September 30, 2022 and December 31, 2021 respectively 11,507 9,930 Inventories, net 9,192 8,285 Prepaid expenses and other current assets 1,369 1,254 Refundable income taxes 653 344 Total current assets 31,654 29,046 Property, plant and equipment, net 20,905 20,130 Operating lease right-of-use asset 135 216 Goodwill 11,704 11,704 Intangible assets, net 7,573 7,978 Other assets 1,800 1,800 Total assets $ 73,771 $ 70,874 Current liabilities Current portion of note payable $ 1,000 $ 1,000 Accounts payable 9,119 6,614 Accrued expenses 4,378 3,724 Accrued income taxes – 725 Total current liabilities 14,497 12,063 Line of credit 2,777 2,777 Note payable 2,725 3,470 Operating lease liabilities 74 85 Deferred income taxes, net 3,201 3,201 Other long-term liabilities – 147 Total liabilities 23,274 21,743 Commitments and contingencies – – Stockholders' equity Preferred stock, no par value; 2,500 shares authorized; no shares issued or outstanding at September 30, 2022 and December 31, 2021 – – Common stock, no par value; 40,000 shares authorized; 17,274 shares issued; 15,495 and 15,435 outstanding at September 30, 2022 and December 31, 2021, respectively 6,509 6,509 Paid-in capital 3,271 2,552 Treasury stock, at cost ( 12,997 ) ( 13,436 ) Retained earnings 53,714 53,506 Total stockholders' equity 50,497 49,131 Total liabilities and stockholders' equity $ 73,771 $ 70,874 See accompanying notes to consolidated financial statements 3 LIFEWAY FOODS, INC. AND SUBSIDIARIES Consolidated Statements of Operations For the three and nine months ended September 30, 2022 and 2021 (Unaudited) (In thousands, except per share data) Three Months Ended September 30, Nine months Ended September 30, 2022 2021 2022 2021 Net sales $ 38,140 $ 29,553 $ 105,730 $ 88,091 Cost of goods sold 29,962 21,915 85,032 63,273 Depreciation expense 590 645 1,833 2,099 Total cost of goods sold 30,552 22,560 86,865 65,372 Gross profit 7,588 6,993 18,865 22,719 Selling expenses 2,843 2,722 8,527 8,510 General and administrative 3,415 3,194 9,546 8,702 Amortization expense 135 33 405 33 Total operating expenses 6,393 5,949 18,478 17,245 Income from operations 1,195 1,044 387 5,474 Other income (expense): Interest expense ( 77 ) ( 30 ) ( 171 ) ( 72 ) Gain on investments – – – 2 Loss on sale of property and equipment – ( 5 ) – ( 88 ) Other (expense) income, net ( 5 ) ( 2 ) ( 10 ) ( 61 ) Total other income (expense) ( 82 ) ( 37 ) ( 181 ) ( 219 ) Income before provision (benefit) for income taxes 1,113 1,007 206 5,255 Provision (benefit) for income taxes 130 527 ( 2 ) 1,851 Net income $ 983 $ 480 $ 208 $ 3,404 Earnings (loss) per common share: Basic $ 0.06 $ 0.03 $ 0.01 $ 0.22 Diluted $ 0.06 $ 0.03 $ 0.01 $ 0.22 Weighted average common shares: Basic 15,490 15,473 15,462 15,572 Diluted 15,848 15,651 15,759 15,712 See accompanying notes to consolidated financial statements 4 LIFEWAY FOODS, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders’ Equity (Unaudited) (In thousands) Common Stock Issued In treasury Paid-In Retained Total Shares $ Shares $ Capital Earnings Equity Balance, January 1, 2021 17,274 $ 6,509 ( 1,669 ) $ ( 12,450 ) $ 2,600 $ 50,195 $ 46,854 Stock-based compensation – – – – 64 – 64 Net income – – – – – 1,306 1,306 Balance, March 31, 2021 17,274 $ 6,509 ( 1,669 ) $ ( 12,450 ) $ 2,664 $ 51,501 $ 48,224 Issuance of common stock in connection with stock-based compensation – – 45 339 ( 463 ) – ( 124 ) Stock-based compensation – – – – 287 – 287 Net income – – – – – 1,618 1,618 Balance, June 30, 2021 17,274 $ 6,509 ( 1,624 ) $ ( 12,111 ) $ 2,488 $ 53,119 $ 50,005 Issuance of common stock in connection with stock-based compensation – – 35 258 ( 258 ) – – Treasury stock purchased – – ( 250 ) ( 1,583 ) – – ( 1,583 ) Stock-based compensation – – – – 157 – 157 Net income – – – – – 480 480 Balance, September 30, 2021 17,274 $ 6,509 ( 1,839 ) $ ( 13,436 ) $ 2,387 $ 53,599 $ 49,059 5 LIFEWAY FOODS, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders’ Equity (Unaudited) (In thousands) Common Stock Issued In treasury Paid-In Retained Total Shares $ Shares $ Capital Earnings Equity Balance, January 1, 2022 17,274 $ 6,509 ( 1,839 ) $ ( 13,436 ) $ 2,552 $ 53,506 $ 49,131 Stock-based compensation – – – – 109 – 109 Net loss – – – – – ( 895 ) ( 895 ) Balance, March 31, 2022 17,274 $ 6,509 ( 1,839 ) $ ( 13,436 ) $ 2,661 $ 52,611 $ 48,345 Issuance of common stock in connection with stock-based compensation – – 38 280 ( 399 ) – ( 119 ) Stock-based compensation – – – – 746 – 746 Net income – – – – – 120 120 Balance, June 30, 2022 17,274 $ 6,509 ( 1,801 ) $ ( 13,156 ) $ 3,008 $ 52,731 $ 49,092 Issuance of common stock in connection with stock-based compensation – – 22 159 ( 159 ) – – Treasury stock purchased – – – – – – - Stock-based compensation – – – – 422 – 422 Net income – – – – – 983 983 Balance, September 30, 2022 17,274 $ 6,509 ( 1,779 ) $ ( 12,997 ) $ 3,271 $ 53,714 $ 50,497 See accompanying notes to consolidated financial statements 6 LIFEWAY FOODS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) (In thousands) Nine months ended September 30, 2022 2021 Cash flows from operating activities: Net income $ 208 $ 3,404 Adjustments to reconcile net income to operating cash flow: Depreciation and amortization 2,238 2,132 Non-cash interest expense 5 9 Non-cash rent expense – 1 Bad debt expense – 6 Deferred revenue ( 23 ) ( 23 ) Stock-based compensation 755 608 Loss on sale of property and equipment – 88 (Increase) decrease in operating assets: Accounts receivable ( 1,576 ) ( 1,832 ) Inventories ( 907 ) ( 642 ) Refundable income taxes ( 309 ) ( 384 ) Prepaid expenses and other current assets ( 115 ) ( 152 ) Increase (decrease) in operating liabilities: Accounts payable 3,085 1,695 Accrued expenses 1,003 1,498 Accrued income taxes ( 725 ) ( 553 ) Net cash provided by operating activities 3,639 5,855 Cash flows from investing activities: Purchases of property and equipment ( 2,609 ) ( 1,685 ) Acquisition, net of cash acquired ( 580 ) ( 5,220 ) Net cash used in investing activities ( 3,189 ) ( 6,905 ) Cash flows from financing activities: Purchase of treasury stock – ( 1,583 ) Payment of deferred financing cost – ( 25 ) Proceeds from note payable – 5,000 Repayment of note payable ( 750 ) ( 250 ) Net cash used in financing activities ( 750 ) 3,142 Net (decrease) increase in cash and cash equivalents ( 300 ) 2,092 Cash and cash equivalents at the beginning of the period 9,233 7,926 Cash and cash equivalents at the end of the period $ 8,933 $ 10,018 Supplemental cash flow information: Cash paid for income taxes, net $ 640 $ 2,788 Cash paid for interest $ 158 $ 60 Non-cash investing activities Increase (decrease) in right-of-use assets and operating lease obligations $ 19 $ 45 See accompanying notes to consolidated financial statements 7 LIFEWAY FOODS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) (In thousands, except per share data) Note 1 – Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”) for interim financial information, and do not include certain information and footnote disclosures required for complete, audited financial statements. In the opinion of management, these statements include all adjustments necessary for a fair presentation of the results of all interim periods reported herein. The consolidated financial statements and related notes should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2021. Results of operations for any interim period are not necessarily indicative of future or annual results. Principles of consolidation The consolidated financial statements include the accounts of Lifeway Foods, Inc. and all its wholly owned subsidiaries (collectively “Lifeway” or the “Company”). All significant intercompany accounts and transactions have been eliminated. Restatement of Previously Issued Consolidated Financial Statements As previously disclosed in Note 1 to the Company’s consolidated financial statements included in the 2021 Form 10-K, the Company identified past errors in the accounting for deferred income tax liabilities and goodwill that resulted from a 2009 acquisition when preparing the 2021 consolidated financial statements. In the 2021 Form 10-K, the Company restated its historical consolidated financial statements to properly reflect the impact of the 2009 acquisition, which resulted in adjustments to goodwill and deferred income tax liabilities in the affected periods. The consolidated financial statements for the three and nine months ended September 30, 2021 included in this Quarterly Report on Form 10-Q have been similarly restated to reflect the correction of these errors and should be read in conjunction with Notes 1 and 17 to the Company’s consolidated financial statements included in the 2021 Form 10-K. Reclassification Certain amounts have been reclassified from cash flows from investing to cash flows from operations on the consolidated statement of cash flows for the nine months ended September 31, 2021. This reclassification had no impact on the consolidated statements of operations, consolidated balance sheets, or consolidated statements of stockholders’ equity. The Company determined the reclassification to be immaterial to the previously filed consolidated financial statements. Note 2 – Summary of Significant Accounting Policies A detailed description of our significant accounting policies can be found in the Annual Report on Form 10-K for the fiscal year ended December 31, 2021. Use of estimates The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial statements include the reserve for promotional allowances, the valuation of goodwill and intangible assets, stock-based and incentive compensation, and deferred income taxes. Cash and cash equivalents The Company has $ 0 of restricted cash which is included in cash and cash equivalents as of September 30, 2022. The restricted cash escrow funds of $ 580 were deposited by Lifeway in connection with the August 18, 2021 acquisition of certain assets of GlenOaks Farms, Inc. The funds were security for the liability and indemnity obligations of seller as defined under the asset purchase agreement. The escrow funds of $ 580 were remitted to the sellers in August 2022. 8 Advertising and promotional costs Lifeway expenses advertising costs as incurred and is reported in Selling expense in the Company’s consolidated statement of operations. Total advertising expense was $ 2,585 and $ 2,892 for the nine months ended September 30, 2022 and 2021, respectively. For the three months ended September 30, 2022 and 2021 total advertising expenses were $ 848 and $ 726 , respectively. Segments The Company is managed as a single reportable segment. The Chief Executive Officer, who is the Company’s Chief Operating Decision Maker (“CODM”), reviews financial information on an aggregate basis for purposes of allocating resources and assessing financial performance, as well as for making strategic operational decisions and managing the organization. Substantially all of Lifeway’s consolidated revenues relate to the sale of cultured dairy products that it produces using the same processes and materials and are sold to consumers through a common network of distributors and retailers in the United States. Recent accounting pronouncements Issued by not yet effective In October 2021, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. The new guidance provides a single comprehensive accounting model on revenue recognition for contracts with customers and requires that the acquirer in a business combination recognize and measure contract assets and liabilities acquired in a business combination in accordance with Topic 606 (Revenue from Contracts with Customers). The amendments in this ASU are effective for fiscal years beginning after December 15, 2022. Early adoption is permitted, including adoption in an interim period. With early adoption, the amendments are applied retrospectively to all business combinations for which the acquisition date occurs on or after the beginning of the fiscal year that includes the interim period of adoption and prospectively to all business combinations that occur on or after the date of initial application. Management is evaluating the impact of the new guidance and does not currently expect the adoption of this ASU to have a material impact on its consolidated financial statements. In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The new guidance provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. The guidance will be effective prospectively as of March 12, 2020 through December 31, 2022 and interim periods within those fiscal years. Management is evaluating the impact of the new guidance and does not currently expect the adoption of this ASU to have a material impact on its consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, in November 2018 issued an amendment, ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, and in November 2019 issued two amendments, ASU 2019-10, Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842): Effective Dates, and ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments – Credit Losses. The series of new guidance amends the impairment model by requiring entities to use a forward-looking approach based on expected losses rather than incurred losses to estimate credit losses on certain types of financial instruments, including trade receivables. This may result in the earlier recognition of allowances for losses. The guidance should be applied on either a prospective transition or modified-retrospective approach depending on the subtopic. The guidance is effective for annual periods beginning after December 15, 2022, including interim periods within those fiscal years, with early adoption permitted. Management is currently evaluating the impact that the new guidance and does not currently expect the adoption of this ASU to have a material impact on its consolidated financial statements. 9 Note 3 – Inventories, net Inventories consisted of the following: Schedule of inventories September 30, 2022 December 31, 2021 Ingredients $ 2,536 $ 2,279 Packaging 3,254 2,723 Finished goods 3,402 3,283 Total inventories $ 9,192 $ 8,285 Note 4 – Property, Plant and Equipment, net Property, plant and equipment consisted of the following: Schedule of property, plant and equipment September 30, 2022 December 31, 2021 Land $ 1,565 $ 1,565 Buildings and improvements 18,296 17,920 Machinery and equipment 32,733 32,073 Vehicles 640 640 Office equipment 936 900 Construction in process 1,894 417 56,064 53,515 Less accumulated depreciation ( 35,159 ) ( 33,385 ) Total property, plant and equipment, net $ 20,905 $ 20,130 Note 5 – Goodwill and Intangible Assets Goodwill Goodwill consisted of the following: Schedule of goodwill Total Balance at December 31, 2021, before accumulated impairment loses $ 12,948 Accumulated impairment losses ( 1,244 ) Balance at December 31, 2021 $ 11,704 Balance at September 30, 2022 $ 11,704 10 Intangible Assets Other intangible assets, net consisted of the following: Schedule of finite-lived intangible assets September 30, 2022 December 31, 2021 Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying Amount Amortization Amount Amount Amortization Amount Intangible assets with finite lives: Recipes $ 44 $ ( 44 ) $ – $ 44 $ ( 44 ) $ – Customer lists and other customer related intangibles 4,529 ( 4,529 ) – 4,529 ( 4,529 ) – Customer relationship 3,385 ( 1,172 ) 2,213 3,385 ( 1,052 ) 2,333 Brand names 7,948 ( 2,588 ) 5,360 4,248 ( 2,303 ) 1,945 Formula 438 ( 438 ) – 438 ( 438 ) – Total finite lived intangible assets $ 16,344 $ ( 8,771 ) $ 7,573 $ 12,644 $ ( 8,366 ) $ 4,278 Intangible assets with indefinite lives: Brand names (1) $ – $ – $ – $ 3,700 $ – $ 3,700 Total intangible assets $ 16,344 $ ( 8,771 ) $ 7,573 $ 16,344 $ ( 8,366 ) $ 7,978 (1) During the fourth quarter of 2021, the Company completed an assessment of the useful life of its one indefinite-lived brand name intangible asset and determined that it should adjust the estimated useful life from an indefinite length to 15 years. The change in accounting estimate was effective January 1, 2022, at which time the Company began amortizing the intangible asset over 15 years. The cost and accumulated amortization is included in Brand Names in the intangible assets with finite lives in the table above as of January 1, 2022. The Company has reclassified the $3,700 net book value as of December 31, 2021 from goodwill to finite lived intangible assets to conform the presentation as of September 30, 2022. Estimated amortization expense on intangible assets for the next five years is as follows: Schedule of amortization expense on intangible assets Year Amortization Three months ended December 31, 2022 $ 135 2023 $ 540 2024 $ 540 2025 $ 540 2026 $ 540 Note 6 – Accrued Expenses Accrued expenses consisted of the following: Schedule of accrued expenses September 30, 2022 December 31, 2021 Payroll and incentive compensation $ 3,438 $ 2,951 Real estate taxes 536 359 Current portion of operating lease liabilities 61 131 Other 343 283 Total accrued expenses $ 4,378 $ 3,724 11 Note 7 – Debt Note payable consisted of the following: Schedule of debt September 30, 2022 December 31, 2021 Term loan due August 18, 2026. Interest (4.94% at September 30, 2022) payable monthly. $ 3,750 $ 4,500 Unamortized deferred financing costs ( 25 ) ( 30 ) Total note payable 3,725 4,470 Less current portion ( 1,000 ) ( 1,000 ) Total long-term portion $ 2,725 $ 3,470 The scheduled maturities of the term loan, excluding deferred financing costs, at September 30, 2022 are as follows: Schedule of maturities of long-term debt Three months ended December 31, 2022 $ 250 2023 1,000 2024 1,000 2025 1,000 2026 500 Total term loan $ 3,750 Credit Agreement 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” and, as amended and modified by the Fourth Modification, the “Modified 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. 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. As amended, all outstanding amounts under the revolving line of credit and term loan 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 revolving line of credit fee of 0.20 % and, in conjunction with the issuance of any letters of credit, a letter of credit fee of 0.20 %. The Modified Credit Agreement includes customary representations, warranties, and covenants, including financial covenants requiring the Company to maintain a fixed charge coverage ratio of no less than 1.25 to 1.00, and a minimum working capital financial covenant, as defined, of no less than $11.25 million, in each of the fiscal quarters ending through the expiration date. The Modified Credit Agreement 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 Credit Agreement may be accelerated. The loans and all other amounts due and owed under the Credit Agreement and related documents are secured by substantially all of the Company’s assets. Lifeway was in compliance with the fixed charge coverage ratio and minimum working capital covenants at September 30, 2022. 12 Revolving Credit Facility As of September 30, 2022, the Company had $ 2,777 outstanding under the Revolving Credit Facility. The Company had $ 2,223 available for future borrowings under the Revolving Credit Facility as of September 30, 2022. Lifeway’s interest rate on debt outstanding under the Revolving Credit Facility as of September 30, 2022 was 4.61 %. Note 8 – Leases The Company leases certain machinery and equipment with fixed base rent payments and variable costs based on usage. Remaining lease terms for these leases range from less than one year to five years. Some of its leases include options to extend the leases for up to 5 years and have been included in our calculation of the right-of-use asset and lease liabilities. Lifeway includes only fixed payments for lease components in the measurement of the right-of-use asset and lease liability. Variable lease payments are those that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time. There are no residual value guarantees. Lifeway does not currently have leases which meet the finance lease classification as defined under ASC 842. Lifeway treats contracts as a lease when the contract conveys the right to use a physically distinct asset for a period of time in exchange for consideration, it directs the use of the asset and obtain substantially all the economic benefits of the asset. The Company does not record leases with an initial term of 12 months or less on the balance sheet. Expense for these short-term leases is recorded on a straight-line basis over the lease term. Total lease expense was $ 191 and $ 245 (including short term leases) for the nine months ended September 30, 2022 and 2021, respectively. Total lease expense was $ 44 and $ 76 (including short term leases) for the three months ended September 30, 2022 and 2021, respectively. Right-of-use assets and lease liabilities are measured and recognized based on the present value of the future minimum lease payments over the lease term at the commencement date. Lifeway has elected the practical expedient to combine lease and non-lease components into a single component for all of its leases. When the Company is unable to determine an implicit interest rate, it uses its incremental borrowing rate based on the information available at the commencement date in determining the present value of future payments for those leases. Lifeway includes options to extend or terminate the lease in the measurement of the right-of-use asset and lease liability when it is reasonably certain that it will exercise such options. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term. Future maturities of lease liabilities were as follows: Future maturities of lease liabilities Year Operating Leases Three months ended December 31, 2022 $ 27 2023 63 2024 46 2025 22 2026 6 Thereafter – Total lease payments 164 Less: Interest ( 29 ) Present value of lease liabilities $ 135 The weighted-average remaining lease term for its operating leases was 2.51 years as of September 30, 2022. The weighted average discount rate of its operating leases was 14.20 % as of September 30, 2022. Cash paid for amounts included in the measurement of lease liabilities was $ 121 and $ 153 for the nine months ended September 30, 2022 and 2021, respectively. Cash paid for amounts included in the measurement of lease liabilities was $ 35 and $ 46 for the three months ended September 30, 2022 and 2021, respectively. 13 Note 9 – Commitments and contingencies Litigation Lifeway is involved in various legal proceedings, claims, disputes, regulatory matters, audits, and proceedings arising in the ordinary course of, or incidental to the Company’s business, including commercial disputes, product liabilities, intellectual property matters and employment-related matters. Lifeway records provisions in the consolidated financial statements for pending legal matters when it believes it is probable that a loss will be incurred and the amount of such loss can be reasonably estimated. The Company evaluates, on a periodic basis, developments in legal matters that could affect the amount of any accrual and developments that would make a loss contingency both probable and reasonably estimable. If a loss contingency is not both probable and estimable, it does not establish an accrued liability. Currently, none of its accruals for outstanding legal matters are material individually or in the aggregate to its financial position and it is management’s opinion that the ultimate resolution of these outstanding legal matters will not have a material adverse effect on its business, financial condition, results of operations, or cash flows. However, if the Company is ultimately required to make payments in connection with an adverse outcome, it is possible that such contingency could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. Note 10 – Income taxes Income taxes were recognized at effective rates of ( 0.8 ) % and 35.2 % for the nine months ended September 30, 2022 and 2021, respectively. The effective tax rate for the three months ended September 30, 2022 was 11.7 % compared to 52.3 % for the three months ended September 30, 2021. The Company has historically calculated the provision for income taxes during interim reporting periods by applying an estimate of the annual effective tax rate for the full fiscal year income, excluding unusual or infrequently occurring discrete items, for the reporting period. In accordance with the authoritative guidance, the Company used a discrete effective tax rate method to calculate income taxes for the quarter and year to date periods ended March 31, 2022 and June 30, 2022 because small changes in the estimated level and mix of annual income or loss by jurisdiction would result in significant changes in the estimated annual effective tax rate making the historical method unreliable. During the quarter and year to date period ended September 30, 2022, the Company utilized an estimate of the annual effective tax rate for the full fiscal year income, excluding unusual or infrequently occurring discrete items, as small changes in the estimated level and mix of annual income or loss by jurisdiction would not result in significant changes in the estimated annual effective tax rate. The Company’s 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 jurisdictional mix of earnings, enacted tax legislation, state income taxes, the impact of non-deductible items, changes in valuation allowances, settlement of tax audits, and the expiration of the statute of limitations in relation to unrecognized tax benefits. The Company records discrete income tax items such as enacted tax rate changes and completed tax audits in the period in which they occur. The Company consistently reflects non-deductible officer compensation expense, non-deductible compensation expense related to equity incentive awards and separate state tax rates from period to period. Although similar items were reflected in 2022, the percentage effect is different due to the difference in pre-tax (loss) income in 2022 compared to 2021. Unrecognized tax benefits were $ 0 and $ 98 at September 30, 2022 and 2021, respectively. The Company settled its one unrecognized tax benefit during the quarter ended March 31, 2022. The Company does not expect material changes to its unrecognized tax benefits during the next twelve months. However, the outcome of tax audits cannot be predicted with certainty. If a tax audit is resolved in a manner inconsistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Note 11 – Stock-based and Other Compensation Omnibus Incentive Plan In December 2015, Lifeway stockholders approved the 2015 Omnibus Incentive Plan, which authorized the issuance of an aggregate of 3.5 million shares to satisfy awards of stock options, stock appreciation rights, unrestricted stock, restricted stock, restricted stock units, performance shares and performance units to qualifying employees. Under the Plan, the Board or its Audit and Corporate Governance Committee approves stock awards to executive officers and certain senior executives, generally in the form of restricted stock or performance shares. The number of performance shares that participants may earn depends on the extent to which the corresponding performance goals have been achieved. Stock awards generally vest over a three-year performance or service period. At September 30, 2022, no shares remain available for award under the 2015 Omnibus Incentive Plan as it was terminated on August 31, 2022. However, any outstanding awards under the 2015 Omnibus Incentive Plan are unaffected by the termination of the 2015 Omnibus Incentive Plan or by the approval of the 2022 Omnibus Incentive Plan (the “2022 Plan”) as described below. 14 On August 31, 2022, Lifeway stockholders approved the 2022 Plan. Under the 2022 Plan, the Compensation Committee of the Board of Directors may grant awards of various types of compensation, including, nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units, cash-based awards and other stock-based awards. The maximum number of shares authorized to be awarded under the 2022 Plan is 3.25 million shares of common stock, which includes shares that remained available under the now terminated 2015 Omnibus Incentive Plan. Awards granted under the 2022 Plan are generally subject to a minimum vesting period of at least one year. Awards may be subject to cliff-vesting or graded-vesting conditions, with graded vesting starting no earlier than one year after the grant date. The Plan Administrator may provide for shorter vesting periods in an award agreement for no more than five percent of the maximum number of shares authorized for issuance under the 2022 Plan. As of September 30, 2022, 3.00 million shares remain available to award under the 2022 Plan. Stock Options The following table summarizes stock option activity during the nine months ended September 30, 2022: Schedule of stock option activity Options Weighted average exercise price Weighted average remaining contractual life Aggregate intrinsic value Outstanding at December 31, 2021 41 $ 10.42 4.22 $ – Granted – – – – Exercised – – – – Forfeited – – – – Outstanding at September 30, 2022 41 $ 10.42 3.47 $ – Exercisable at September 30, 2022 41 $ 10.42 3.47 $ – As of December 31, 2019, all outstanding options were vested and there was no remaining unearned compensation expense. 15 Restricted Stock Awards A Restricted Stock Award (“RSA”) represents the right to receive one share of common stock in the future. RSAs have no exercise price. The grant date fair value of the awards is determined by the Company’s closing stock price on the grant date. Lifeway expenses RSAs over the vesting period. The following table summarizes RSA activity during the nine months ended September 30, 2022. Schedule of RSA Activity Restricted Stock Awards Weighted Average Grant Date Fair Value Outstanding at December 31, 2021 94 $ 4.50 Granted 97 6.25 Shares issued upon vesting ( 27 ) 3.43 Forfeited – – Outstanding at September 30, 2022 164 $ 5.69 Vested and deferred at September 30, 2022 37 $ 5.60 For the nine months ended September 30, 2022 and 2021 total pre-tax stock-based compensation expense recognized in the consolidated statements of operations was $ 175 and $ 106 , respectively. For the nine months ended September 30, 2022 and 2021 tax-related benefits of $ 49 and $ 31 , respectively, were also recognized. For the three months ended September 30, 2022 and 2021 total pre-tax stock-based compensation expense recognized in the consolidated statements of operations was $ 48 and $ 37 , respectively. For the three months ended September 30, 2022 and 2021 tax-related benefits of $ 14 and $ 11 , respectively, were also recognized. Future compensation expense related to restricted stock awards was $ 624 as of September 30, 2022 and will be recognized on a weighted average basis over the next 1.57 years. Long-Term Incentive Plan Compensation Lifeway has established long-term incentive-based compensation programs for certain senior executives and key employees pursuant to the terms of its incentive plans. 2020 CEO Incentive Award During the fourth quarter 2020, Lifeway awarded a long-term equity-based incentive of $ 750 to its Chief Executive Officer (the “2020 CEO Award”) depending on Lifeways 2020 performance levels compared to the respective targets. The equity-based incentive compensation is payable in restricted stock that vests one-third in April 2022, one-third in April 2023, and one-third in April 2024. The issuance of vested equity awards is subject to approval under the Stock Purchase Agreement dated October 1, 1999. For the nine months ended September 30, 2022 and 2021, $ 186 and $ 255 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. For the three months ended September 30, 2022 and 2021, $ 44 and $ 85 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. As of September 30, 2022, the total remaining unearned compensation was $ 173 , of which $ 44 will be recognized in 2022, $ 105 in 2023, $ 24 in 2024, respectively, subject to vesting. During Q2 2021, the number of shares awarded became fixed and determinable. Therefore, the award liability was reclassified from long-term liabilities to paid in capital. 16 2021 Equity Award The 2021 long-term equity incentive plan compensation is based on Lifeway’s achievement of adjusted EBITDA performance versus the respective target established by the Board for 2021. Under the 2021 plan, collectively the participants earned equity-based incentive compensation of $ 1,069 based on Lifeway’s achievement of the respective financial target. The equity-based incentive compensation is payable in restricted stock that vests one-third in April 2022, one-third in April 2023, and one-third in April 2024. For the nine months ended September 30, 2022 and 2021, $ 364 and $ 150 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. For the three months ended September 30, 2022 and 2021, $ 85 and $ 150 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. As of September 30, 2022, the total remaining unearned compensation was $ 319 , of which $ 85 will be recognized in 2022, $ 194 in 2023, $ 40 in 2024, respectively, subject to vesting. During Q2 2022, the number of shares awarded became fixed and determinable. Therefore, the award liability was reclassified from long-term liabilities to paid in capital. 2022 Equity Award Under the 2022 long-term incentive plan, participants can earn a specified number of target level Performance Share Units (“PSUs”) contingent upon the achievement of strategic milestones during the three-year Measurement Period, which is fiscal year 2022 to 2024. The strategic milestones are 1) 3-year cumulative net revenue, and 2) 3-year cumulative adjusted EBITDA. The target number of PSU awards are weighted 50% on net revenue and 50% on adjusted EBITDA. Collectively, the participants can earn 125,066 PSUs at the target level. Participants may earn more or less than the target number of shares based on actual results, however the minimum and maximum number of shares that can be earned are bound by minimum and maximum thresholds of net revenue and adjusted EBITDA. The PSU awards will be earned and will vest, if at all, after the end of the three-year measurement period based on achievement of the milestones. The PSU awards do not vest during the three-year measurement period. The PSUs have a grant date fair value of $6.25 dollars per share. For the nine months ended September 30, 2022 and 2021, $ 31 and $ 0 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. For the three months ended September 30, 2022 and 2021, $ 31 and $ 0 was expensed as stock-based compensation expense in the consolidated statements of operations, respectively. The 2022 long-term incentive plan also granted restricted stock unit awards that contain only a service condition and vest on the passage of time in three equal installments on each of the first three anniversaries of the August 31, 2022 grant date. The stock based compensation expense for these awards is included in the Restricted Stock Award section above. Non-Employee Director Plan On August 31, 2022, Lifeway stockholders approved the 2022 Non-Employee Director Equity and Deferred Compensation Plan (the “ 2022 Director Plan”), which authorizes the grant of restricted stock units (“RSUs”), which will vest on such schedule as the Company, in its sole discretion, shall determine. Each non-employee director of the Company is eligible to be a participant in the 2022 Director Plan until they no longer serve as a non-employee director. As of the date of each annual shareholder meeting, the Company may grant each director a number of RSUs for such year and set the vesting schedule for the RSUs granted. Whether and how many RSUs the Company will grant to directors in any year is subject to the sole discretion of the Company and shall in any event be subject to the 2022 Director Plan’s overall share limits. The maximum aggregate number of shares of common stock that may be issued under the 2022 Directors Plan is 500 thousand shares. As of September 30, 2022, 466 thousand shares remain available to award under the 2022 Director Plan. The aggregate fair market value of shares underlying RSU compensation that may be issued as RSU compensation to a director in any year shall not exceed $170. In addition to the grant of RSUs, the 2022 Director Plan also provides for the deferral by electing participants of all or part of their cash compensation (in 10% increments) into a deferred cash account, and they may defer all or part of their cash and/or RSU compensation (in 10% increments) into a deferred RSU account. Deferred benefits are paid in a lump sum upon the applicable director’s departure from the Board of Directors. Retirement Benefits Lifeway has a defined contribution plan which is available to substantially all full-time employees. Under the terms of the plan, the Company matches employee contributions under a prescribed formula. For the nine months ended September 30, 2022 and 2021 total contribution expense recognized in the consolidated statements of operations was $ 328 and $ 315 , respectively. For the three months ended September 30, 2022 and 2021, total contribution expense recognized in the consolidated statements of operations was $ 97 . Note 12 – Products and Customers Lifeway’s primary product is drinkable kefir. The Company manufactures (directly or through a co-manufacturer) and markets products under the Lifeway, Fresh Made, and GlenOaks Farms brand names, as well as under private labels on behalf of certain customers. The Company’s product categories are: · Drinkable Kefir, a cultured dairy product sold in a variety of organic and non-organic sizes, flavors, and types. · European-style soft cheeses, including farmer cheese, white cheese, and Sweet Kiss. · Cream and other, which primarily consists of cream, a byproduct of raw milk processing. · Drinkable Yogurt, sold in a variety of sizes and flavors. · ProBugs, a line of kefir products designed for children. · Other Dairy, which primarily consists of Fresh Made butter and sour cream. 17 Net sales by product category were as follows for the nine months ended September 30: Schedule of sales of products by category 2022 2021 $ % $ % Drinkable Kefir other than ProBugs $ 82,779 78 % $ 72,204 82 % Cheese 9,233 9 % 9,158 11 % Cream and other 5,438 5 % 2,568 3 % Drinkable yogurt 4,559 5 % 739 1 % ProBugs Kefir 2,481 2 % 2,197 2 % Other dairy 1,240 1 % 1,225 1 % Net Sales $ 105,730 100 % $ 88,091 100 % Net sales of products by category were as follows for the three months ended September 30: 2022 2021 $ % $ % Drinkable Kefir other than ProBugs $ 30,297 79 % $ 23,831 81 % Cheese 3,211 9 % 2,937 10 % Cream and other 1,874 5 % 877 3 % Drinkable yogurt 1,482 4 % 739 2 % ProBugs Kefir 882 2 % 766 3 % Other dairy 394 1 % 403 1 % Net Sales $ 38,140 100 % $ 29,553 100 % Significant Customers – Sales are predominately to companies in the retail food industry located within the United States. Two major customers accounted for approximately 22 % and 23 % of net sales for the nine months ended September 30, 2022 and 2021, respectively. Two major customers accounted for approximately 23 % of net sales for the three months ended September 30, 2022 and 2021. Note 13 – Related Party Transactions Lifeway obtains consulting services from Ludmila Smolyansky, a member of the Company’s Board of Directors and former Chairperson of its Board of Directors. On December 28, 2020, Lifeway entered into an amended and restated consulting agreement (the “Agreement”), effective as of December 31, 2020, with Ms. Smolyansky. Under the terms and conditions of the Agreement, Ms. Smolyansky will continue to provide consulting services with respect to, among other things, the Company’s business strategy, international expansion and product management and expansion. For the services, the Company will pay an annual service fee of $500, and Ms. Smolyansky will also be eligible for an annual performance fee target of $500 based on the achievement of specified performance criteria. The annual service fee and target bonus amounts are subject to periodic change by the Compensation Committee of the Company’s Board of Directors on 30 days’ prior written notice to the Chairperson. The Agreement shall continue until either party provides at least a 10-day written notice of termination. On January 4, 2022, the Company notified Ms. Smolyansky that it was terminating the Agreement effective January 17, 2022. Service fees earned are included in general and administrative expenses in the accompanying consolidated statements of operations and were $ 22 and $ 375 during each of the nine months ended September 30, 2022 and 2021, respectively. Service fees earned are included in general and administrative expenses in the accompanying consolidated statements of operations and were $ 0 and $ 125 during each of the three months ended September 30, 2022 and 2021, respectively. 18 Lifeway is also a party to an endorsement agreement, dated as March 14, 2016, by and between the Company and Ludmila Smolyansky, a member of the Company’s Board of Directors and former Chairperson of its Board of Directors (the “Endorsement Agreement”) under which it pays the Chairperson a royalty based on the sale of certain Lifeway products, not to exceed $50 in any fiscal month. On September 6, 2022, the Company entered into an agreement (the “Termination Agreement”) with Ms. Smolyansky that terminated the Endorsement Agreement as of September 6, 2022. Pursuant to the Termination Agreement, the Company and Ms. Smolyansky have agreed, among other things, that (i) the Company will pay Ms. Smolyansky a lump sum payment of $400,000, (ii) Ms. Smolyansky will no longer have any further claims against the Company under the Endorsement Agreement, and (iii) the Endorsement Agreement was terminated and of no further force or effect except for the provisions thereof that expressly survive termination. Royalties earned are included in selling expenses in the accompanying consolidated statements of operations and were $ 400 and $ 450 during each of the nine months ended September 30, 2022 and 2021, respectively. Royalties earned were $ 100 and $ 150 during each of the three months ended September 30, 2022 and 2021, respectively. Note 14 – Subsequent Events On November 7, 2022, the Company entered into a Stock Purchase Agreement with Ludmila Smolyansky (“Ms. Smolyansky”), to purchase 850,340 shares of Lifeway common stock from Ms. Smolyansky. Pursuant to the Stock Purchase Agreement, the Company and Ms. Smolyansky have agreed, among other things, that (i) Ms. Smolyansky will sell the shares at a purchase price of $4.70 per share, which represents a twenty percent (20.0%) discount to the average closing price of the common stock on Nasdaq over the five (5) trading day period ended on the trading day immediately preceding the date of the Stock Purchase Agreement and (ii) Ms. Smolyansky will use a portion of the proceeds to satisfy in full certain obligations of Ms. Smolyansky, which are secured by previously disclosed pledges of common stock, causing all such pledges to be released. The purchased shares will be held in treasury by the Company. As a closing condition to the Stock Purchase Agreement, Ms. Smolyansky and Mr. Smolyansky will deliver an executed amendment (the “Amendment”) to that certain Settlement Agreement dated as of July 27, 2022 (the “Settlement Agreement”), between the Company and Ms. Smolyansky and Mr. Smolyansky. Pursuant to the Amendment, Ms. Smolyansky and Mr. Smolyansky each agree, among other things, to (i) grant the Company a right of first refusal, subject to Danone North America Public Benefit Corporation’s (“Danone”) right of first refusal, on substantially similar terms as Danone (ii) extend the standstill and all related terms under the Proxy Settlement Agreement through the date of the 2024 annual meeting of the Company’s shareholders (the “Standstill”); and (iii) to appear in person or by proxy and vote their respective remaining shares of common stock beneficially owned, individually or otherwise, and controlled by either of them and over which they have power and authority to vote during the Standstill (a) in accordance with the recommendations of the Board at any special meeting or annual meeting of the shareholders with respect to any proposal(s) not related to the sale of the Company or all or substantially all of the assets of the Company; and (b) in proportion to the vote of the other shareholders with respect to any proposal relating to any vote on the sale of the Company or all or substantially all of the assets of the Company. 19