# Lifeway Foods, Inc. (LWAY) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Lifeway Foods, Inc.'s 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/814586/000168316822005054/lifeway_i10k-123121.htm
Accession: 0001683168-22-005054
Filing date: 2022-07-21
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/LWAY/
All MD&A years: /company/LWAY/mda/
Next year: /company/LWAY/mda/fy2022/ (FY 2022)

ITEM 7          
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the financial condition
and results of operations as of and for the years ended December 31, 2021 and 2020 should be read in conjunction with the audited consolidated
financial statements and the notes to those statements that are included elsewhere in this Annual Report on Form 10-K. In addition to
historical information, the following discussion contains certain forward-looking statements within the “safe harbor” provisions
of the Private Securities Litigation Reform Act of 1995. These statements relate to our future plans, objectives, expectations and intentions.
These statements may be identified by the use of words such as "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," "future,"
"predict," and "estimate," and similar terms or terminology, or the negative of such terms or other comparable terminology.
Although we believe the expectations expressed in these forward-looking statements are based on reasonable assumptions within the bounds
of our knowledge of our business, our actual results could differ materially from those discussed in these statements. Factors that could
contribute to such differences include, but are not limited to, those discussed in the “Risk Factors” section in Part I, Item
1A. We undertake no obligation to update publicly any forward-looking statements for any reason even if new information becomes available
or other events occur in the future.

[[GREPCENT_TABLE]]
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Restatement of Previously Issued Consolidated
Financial Statements

During the preparation of our fiscal 2021 consolidated
financial statements, we identified a material error in the accounting for our deferred income tax liabilities and goodwill. Specifically,
in connection with our 2009 acquisition of Fresh Made, Inc., we did not record a deferred income tax liability and corresponding increase
to goodwill related to the difference in the book and income tax bases for the $3.7 million Fresh Made indefinite-lived brand name intangible
asset acquired. The error resulted in a $1.18 million understatement of both deferred income tax liabilities and goodwill of as of January
1, 2020. The Restatement had no impact on our Consolidated Statements of Operations, Consolidated Statements of Cash Flows, or Consolidated
Statements of Stockholders’ Equity during 2021 and 2020. The impact of the Restatement on periods prior to 2020 had no effect on
opening retained earnings as of January 1, 2020.

The accounting adjustments required to correct
the error in the consolidated financial statements for the year ended December 31, 2020 as a result of completing the restatement
process are described in Note 1 – Basis of presentation - Restatement of Previously Issued Consolidated Financial Statements included
in “Part II – Item 8 – Financial Statements and Supplementary Data.” Note 17 – Restatement of previously
issued unaudited consolidated financial statements presents the accounting adjustments to correct the error in the quarterly consolidated
financial statements for the fiscal quarters in 2020 and 2021.

The accompanying Management’s Discussion
and Analysis of Financial Condition and Results for Operation gives effect to the Restatement adjustments made to the previously reported
Consolidated Financial Statements for the year ended December 31, 2020.

Recent Developments

COVID-19 Pandemic Impact

In December 2019, 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.

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 maintained full production capacity available at all locations and does not anticipate
manufacturing or staffing disruptions in the near term.

To date, we
have seen increased customer and consumer demand for our products. We have not experienced significant supply chain disruptions or labor
supply shortages and we have continued to be able to satisfy customer and consumer demand for our products. However, the COVID-19 pandemic,
or any future pandemic, may limit the availability of, or increase the cost of, employees, ingredients, packaging and other inputs necessary
to produce our products, and our operations may be negatively impacted. In 2021, our costs increased primarily due to inflationary price
increases of milk, other ingredients, packaging materials, and freight. However, because of market conditions or for competitive reasons,
our pricing actions may sometimes lag input cost changes, or we may not be able to pass along the full effect of increases in raw materials
and other input costs as we incur them.

Recently, in 2022, social distancing,
shelter-in-place and work-from-home mandates and recommendations have begun to be reduced or eliminated. The increased customer demand
for our products as consumers increased their at-home consumption and e-commerce purchasing during the COVID-19 pandemic may change or
decrease due to the decrease in social distancing and stay-at-home and work-from-home mandates and recommendations. We are unable to predict
the nature and timing of when such change may occur, if at all.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

Results of Operations

Comparison of Year Ended December 31, 2021
to Year Ended December 31, 2020 (in 000’s)

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

Net Sales

Net sales were $119,065 for the year ended December
31, 2021, an increase of $17,039 or 16.7% 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.
Approximately 11% of the net sales increase results from our acquisition of Glen Oaks Farms during the third quarter of 2021. Approximately
20% of the net sales increase results from the Farmers to Families Food Box program with the 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 decreased
to 24.1% during the year ended December 31, 2021 from 26.4% during the same period in 2020. The decrease versus the prior year was primarily
due to the unfavorable impact of milk pricing, and the inflationary price increases of other ingredients, packaging materials, and freight,
partially offset by the decrease in depreciation expense and favorable labor efficiency due to increased volumes. We took favorable pricing
actions beginning in December 2021 to recover input and freight cost inflation. However, for market conditions or competitive reasons,
our pricing actions may also lag input cost changes, or we may not be able to pass along the full effect of increases in raw materials
and other input costs as we incur them.

Selling Expenses

Selling expenses increased by $900 to $11,097
during the year ended December 31, 2021 from $10,197 during the same period in 2020. The increase versus prior year is primarily due to
increased investment in advertising and marketing programs, partially offset by lower compensation and broker expense.

General and Administrative Expenses

General and administrative expenses decreased
$50 to $11,611 during the year ended December 31, 2021 from $11,661 during the same period in 2020. The decrease is primarily a result
of lower compensation, related party consulting, and office rent expense, partially offset by higher employee 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 $2,305 and $1,596 during the year ended December 31, 2021 and 2020, respectively.

Our effective income tax rate was 41.0% in 2021
compared to 33.1% in 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. The Company consistently reflects non-deductible officer compensation
expense, non-deductible compensation expense related to equity incentive awards and separate state tax rates from year to year. Although
similar items were reflected in 2021, the percentage effect is different due to the difference 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 in the period in which they occur.

[[GREPCENT_TABLE]]
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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.

Income taxes are discussed
in Note 10 in the Notes to the Consolidated Financial Statements.

Net Income (Loss)

We reported net income of $3,311 or $0.21 per
basic and diluted common share for the year ended December 31, 2021 compared to net income of $3,232 or $0.21 per basic and diluted common
share in the same period in 2020.

Liquidity and Capital Resources

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, and to ensure the continuation
of the Company as a going concern, through anticipated cash flows from operations, our revolving credit facility and cash and cash equivalents.
If additional borrowings are needed, approximately $2,223 was available under the Revolving Credit Facility as of December 31, 2021. See
Note 7 to our Consolidated Financial Statements for additional information regarding our Revolving Credit Facility. We are in compliance
with the terms of the Credit Agreement and expect to meet foreseeable financial requirements. 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.

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.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

Sources and Uses of Cash

Lifeway had a net increase in cash and cash equivalents
of $1,307 and $4,090 during the years ended December 31, 2021 and 2020, respectively. The drivers of the year over year change are as
follows:

Net cash provided by operating activities was
$6,144 in 2021 compared to $6,385 in 2020, a decrease in cash provided of $241. The decrease is primarily due to the change in working
capital.

Net cash used in investing activities was $7,722
in 2021 compared to $1,890 in 2020, an increase in cash used of $5,832. The increase 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 $1,922 in 2021 compared to $1,895 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
$2,885 during the year ended December 31, 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 the Debt Obligations section below for further detail.

On June 24, 2021, 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.

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

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.

As of December 31, 2021, we had $2,777 outstanding
under the Revolving Credit Facility and $4,470 outstanding under the note payable, net of $30 of unamortized deferred financing fees.
We had $2,223 available for future borrowings under the Revolving Credit Facility as of December 31, 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%. The interest rate on debt outstanding
under the Loans as of December 31, 2021 was 2.15%.

We are in compliance with all applicable financial
debt covenants as of December 31, 2021. See Note 7 to our Consolidated Financial Statements for additional information regarding our
indebtedness and related agreements.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet financing
arrangements as defined in Item 303(a)(4) of Regulation S-K.

Contractual Obligations

Not applicable.

Critical Accounting Estimates 

Critical accounting estimates are those estimates
made in accordance with U.S. GAAP that involve a significant level of estimation uncertainty and have had or are reasonably likely to
have a material impact on the financial condition or results of operations of the registrant. In many cases, the accounting treatment
of a particular transaction is specifically dictated by U.S. GAAP with no need for the application of our judgement. In certain circumstances,
the preparation of our Consolidated Financial Statements in conformity with U.S. GAAP requires us to use our judgment to make certain
estimates and assumptions. These estimates affect the reported amounts of assets and liabilities and disclosures of contingent assets
and liabilities at the date of the Consolidated Financial Statements and the reported amounts of net sales and expenses during the reporting
period. We believe in the quality and reasonableness of our critical accounting estimates; however, materially different amounts might
be reported under different conditions or using assumptions, estimates or making judgments different from those that we have applied.
Management has discussed the development and selection of these critical accounting policies, as well as our significant accounting policies
(see Note 2 to the Consolidated Financial Statements), with the Audit Committee of our Board of Directors. We have identified the policies
described below as our critical accounting policies.

[[GREPCENT_TABLE]]
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Goodwill and intangible asset valuation

Goodwill totaled $11,704 as of December 31, 2021.
The Company completed its annual goodwill impairment analysis as of December 31, 2021. Our assessment did not result in an impairment.
Goodwill represents the excess purchase price over the fair value of the net tangible and other identifiable intangible assets acquired.
We estimate the fair value of our one reporting unit annually (as of December 31), or more frequently if certain conditions exist, using
a combination of the fair values derived from both the income approach and the market approach. Under the income approach, we calculate
the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on our estimates
of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used to determine
the present value of future cash flows is based on the weighted-average cost of capital adjusted for the relevant risk associated with
business-specific characteristics and the uncertainty related to the business's ability to execute on the projected cash flows. The market
approach estimates fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with
similar operating and investment characteristics. The resulting fair value, based on the income and market approaches, is then compared
to the carrying value to determine if impairment is necessary.

We reviewed our indefinite lived intangible assets,
which consist of brand names totaling $3,700 as of December 31, 2021, using the relief from royalty method. Significant assumptions include
the royalty rate, revenue growth rates, and discount rates. Our assumptions were based on historical performance and management estimates
of future performance. Our assessment did not result in an impairment in 2021.

Sales discounts & allowance.

We offer various trade promotions and sales incentive
programs to customers and consumers. From time to time, we grant certain sales discounts to customers which are classified as a reduction
in sales. The measurement and recognition of discounts and allowances involve the use of judgment and our estimates are made based on
historical experience and specific customer program accruals. Differences between estimated and actual discount and allowance costs are
normally not material and are recognized in earnings in the period such differences are determined. The process for analyzing trade promotion
programs could impact our results of operations and trade spending accruals depending on how actual results of the programs compare to
original estimates. As of December 31, 2021, we had $1,170 of accrued discounts and allowances.

Share-based compensation.

Certain employees and non-employee directors
receive various forms of share-based payment awards and we recognize compensation expense for these awards based on their grant date
fair values. The fair values of stock option awards are estimated on the grant date using the Black-Scholes option pricing model, which
incorporates certain assumptions regarding the expected term of an award and expected stock price volatility. The expected term is determined
under the simplified method, using an average of the contractual term and vesting period of the stock options. The expected volatility
is based on the historic volatility of our common stock. We do not estimate forfeitures in measuring the grant date fair value, but rather
account for forfeitures as they occur. Key assumptions are described in further detail in Note 11 to our consolidated financial statements.
No stock options were issued during 2021 or 2020.

Income taxes.

We pay income taxes based on tax statutes, regulations,
and case law of the various jurisdictions in which we operate. At any given time, multiple tax years are subject to audit by the various
taxing authorities. Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are
recognized for the future tax effects of temporary differences between financial and income tax reporting using tax rates in effect for
the years in which the differences are expected to reverse.

[[GREPCENT_TABLE]]
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We recognize an income tax benefit from an uncertain
tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based
on the technical merits of the position. The income tax benefit recognized in our financial statements from such a position is measured
based on the largest estimated benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. These judgments
and estimates made at a point in time may change based on the outcome of tax audits and changes to, or further interpretations of, regulations.
If such changes take place, there is a risk that our tax rate may increase or decrease in any period, which would impact our earnings.
Future business results may affect deferred tax liabilities or the valuation of deferred tax assets over time. 

Recent Accounting Pronouncements.

See Note 2, Summary of Significant Accounting
Policies, in the Notes to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for information
regarding recent accounting pronouncements.