Lifeway Foods, Inc. (LWAY) Q3 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to the Lifeway Foods Third Quarter 2016 Earnings Conference Call. At this time, all participants' are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Hunter Wells of ICR. Thank you, Mrs. Wells. You may now begin.

Good morning, and welcome to Lifeway Foods earnings conference call to discuss the company's results for the third quarter 2016. On the call with me today are Julie Smolyansky, President and Chief Executive Officer, Ed Smolyansky, Chief Operating Officer and John Waldron, Chief Financial Officer. By now, everyone should have had access to the release, which went out at yesterday afternoon at approximately 4:00 PM or 5:00 PM Eastern Time. If you've not received the release, it is available on the Investor Relations portion of Lifeway's website at, www.lifewaykefir.com. This call is being webcast and a replay will be available on the company's website. Before we begin, we would like to remind everyone that the prepared remarks contain forward-looking statements and management may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance and, therefore, undue reliance should not be placed on them. Similarly, descriptions of Lifeway's objectives, strategies, plans, goals or targets contained herein are also considered forward-looking statements. Actual results could differ materially from those projected in any forward-looking statements. Lifeway assumes no obligation to update any forward-looking projections that may be made in today's release or calls posted on their website. And with that, I would like to turn the call over to Lifeway's CEO, Julie Smolyansky.

Thanks, Hunter. And thank you, to everyone, who's joined us on today's conference call. I will begin by providing an overview of key business highlights for the third quarter of 2016 and then I will review our strategic initiative. Next, John will discuss the quarterly and year-to-date financial results in more detail. Finally, Ed and I will be available to take your questions. Third quarter net sales increased to $30 million from $29.6 million in the prior year. Our improved top-line reflects the steady progress that we've made to expand our distribution and propel increased velocity of our kefir products. I am pleased with our solid performance however, before I dive into the details, I would like to take a few minutes for those who maybe new on the call to provide a little bit more color about who we are and why we're strongly positioned for future success. It's an exciting time to be leading in the U.S. – the leading U.S. kefir producer and marketer of kefir, live and active – excuse me, exciting time to be U.S. producer and marketer of kefir, a live and active cultured dairy product packed with protein, calcium, and probiotics. For 30 years Lifeway has dominated the category owning over 90% of total kefir sales in the U.S. Our mission is to provide the best probiotic and nutritious food that resonates strongly with consumers who are increasingly concerned with eating healthy. 43% of consumers’ today buy yogurt and kefir for benefits associated with digestive health. Additionally, a study by Mantel recently stated that the yogurt and yogurt drink category is expected to grow over $11 billion by 2021. These trends coupled with our less than 5% penetration of the total U.S. household provide tremendous opportunities for us to take our business to the next level of growth. But how will we get there? Number one, increasingly Lifeway's brand awareness. Over the past year, we've made key investments into our marketing strategies in order to further grow our consumer awareness of Lifeway. Just this past year, we have invested in the production of nationally launched commercial, collaborations with designers such as Cynthia Rowley, and partnerships with athletes and health advocates like U.S. Olympian Carli Lloyd to help drive awareness of Lifeway. Looking ahead, this is an area, we'll continue to focus on in efforts to further increase our household penetration. Moving on to our next strategy. Number two, developing innovative products. Lifeway began with a single product, a 32 ounce bottle of plain drinkable kefir. Today, we have hundreds of different varieties, flavors and sizes of kefir to suit the many tastes and preferences of our consumers. We are proud of our ability to innovate and this continues to be an important focus of area that we maintain our position, as the leading name as kefir. In fact, we are pushing into new categories and offering choices to consumers with the launch of supplements, Kefir Cups and Cups Farmer Cheese. And finally, number three, expanding distribution across sales channels and geographies. Once sold exclusively in niche and specialty health food stores, kefir has gone mainstream. Today, Lifeway products can be purchased at major retailers all across America. And there's still white space remaining for us to sell. Jennifer Reilly, our new Senior Executive Vice President of Sales and her team continues to make solid progress in expanding our footprint at both new and existing retailers. We also recently added new talent to our sales team that will be fully dedicated to unlocking food service and small format opportunities. Also under Jennifer's leadership, we intent to step up our focus at Lifeway's top customers in 2017. We have clearly, articulated growth strategy, a committed team of employees, a phenomenal product and a proven track record of success. Our marketing and sales initiatives are working. Lifeway's total U.S. household penetration was up 28% over last year. Still we know there's a much work to be done and we could not be more excited for the future opportunities that lay ahead of us and our ability to achieve increased growth and expand profitability across our businesses as we execute on those strategic initiatives. I would now like to turn our review to our recent results. We are pleased with the continued progress we made to grow our top-line and expanded distribution of Lifeway's product to new and existing retailers. Some of our Q3 wins include 1,200 stores added at Food Lion primarily in the Southeast region of the U.S. This is a significant milestone for us as Food Lion is a new customer with substantial white space opportunity for future expansion. We've expanded throughout – additional expansion across multi-outlet retail channels all across the South. SKUs of our Protein Kefir, Whole Milk Kefir and ProBugs added across traditional and natural banners. Turning to private label, we are posting strong shipments on our private label products with select retailers. And distribution gains are not limited to the U.S. just a few weeks ago we made the exciting announcement that Lifeway will launch four of our most popular flavors of drinkable Kefir in Ireland. Starting in November Lifeway will be available in over 140 stores across two major retailers in Ireland. As many of you are already aware, this will not be our first foray into international markets. In recent years, we have expanded our reach into Canada, Latin America and the United Kingdom. We are very encouraged with our recent performance in Canada. Third quarter sales were up 157% compared to the prior quarter and we've also added distribution of our product at select Whole Foods in Canada. While our international footprint is small, it continues to grow and we look forward evaluating additional opportunities for international expansion, as global demand for probiotic products continue to rise. Earlier this year, we announced our plan to expand our advertising and marketing initiatives to help drive increased brand awareness of Lifeway. This has continued to be an important area of focus for us. In our third quarter, we debuted a campaign, featuring our brand ambassador, two time Olympic Gold Medalist and FIFA World Cup Champion, Carli Lloyd. The campaign resulted in millions of impressions across digital media and websites such as espn.com. Additionally, we aired the commercial during the premier episode of Harry Connick Junior's new talk show, which was ranked the best national talk debut in the past three years. We continue to be pleased with the results of our strategic partnership with Carli and I look forward to sharing future updates on our marketing initiatives on upcoming calls. In summary, we are very pleased with our improved business results and remain confident in our long-term growth opportunities, as we continue to execute on our strategic initiatives. We've made essential investments in marketing and – in manufacturing facilities to help support our long-term growth. I'm impressed with our recent progress and confident on our ability to execute on our strategic initiatives, in order to drive long-term growth and increase value for our shareholder. With that, I'd like to turn the call over to John to discuss our financial results in more detail. John?

Thank you, Julie and good morning to those who have joined us on the call. Today, I'll review our third quarter and year-to-date results for the period ended September 30, 2016. And I'll turn the call back over to Julie for the closing remarks. Before, I comment on our third quarter, I want to bring to your attention that in connection with our third quarter Form 10-Q that was filed yesterday, we have revised our prior period financial statements to properly reflect the classification of certain overhead costs and cost of goods sold. These costs have previously been incorrectly included in general and administrative expenses. Additional discussion regarding this revision is included in the first footnote of our financial statements. Turning to the quarter, third quarter net sales increased 1.3% to $30 million from $29.6 million in the same period last year, reflecting volume gains in organic and private label products and the introduction of new items partially offset by increased investments in trade programs. Gross margins decreased to 26.6% from 30.2% in the same period one year ago, primarily due to increased trade promotion and unfavorable mix. Selling expenses increased approximately $1.6 million to $4.3 million in the third quarter of 2016 from $2.7 million in the year ago period. The increase in selling expenses reflects the stepped up advertising investment that Julie mentioned in her remarks. General and administrative expenses decreased by $0.7 million or 17.3% to $3.3 million reflecting lower professional fees partially offset by higher compensation levels. The effective tax rate for the third quarter of 2016 exceeded 100% compared to 50.9% in the third quarter of 2015. The higher tax rate in the third quarter of 2016 is primarily due to the relatively low level of profits we reported in the third quarter of 2016. Additional information regarding our tax rates has been included in the third quarter form 10-Q. Net loss was approximately $64,000 or $0.00 per diluted share in the third quarter of 2016 compared to net income of $893,000 or $0.05 per diluted share in the third quarter of 2015. Turning now to our year-to-date results. Net sales increased by $4.6 million or approximately 5.2% to $93.7 million during the nine-month period in September 30, 2016, from $89 million during the same period a year ago, driven by volume gains in our private label and organic products, the introduction of new items and lower trade promotion. Gross margin increased to 28.2% from 26.2% last year, reflecting lower input costs, primarily milk, and lower trade promotion, partially offset by unfavorable mix. Selling expenses increased approximately 24.4% to $10.7 million from $8.6 million in the first nine months of 2015, reflecting our investments in advertising, while general and administrative expenses decreased approximately 3.2% to $10.3 million. Our effective tax rate for the first nine months of 2016 was 33% compared to 50.8% last year, primarily reflecting the implementation of tax planning strategy in 2016. Net income was approximately $3 million or $0.19 per diluted share compared to net income of $1.6 million or $0.10 per diluted share for the nine month period ended September 30, 2015. We did not repurchase any shares of common stock during the third quarter, approximately 1.2 million shares are available to repurchase under our authorized program as of September 30, 2016. The stock repurchase program has no expiration date and may be suspended or discontinued at any time. That concludes my planned remarks. Now, I'd like to turn the call back over to Julie.

Thanks, John. We have made solid progress in 2016 to strengthen our business. We are beginning to see the positive results of our strategic marketing investment and our confidence in our ability to accelerate and expand distribution of our unique and healthy product portfolio. Our team remains focused on execution of our strategic initiative, which we believe are building blocks to strengthen our business and enable us to unlock additional value for our shareholders. Looking ahead, we are confident in our ability to increase consumer awareness of Lifeway, and achieve improved business performance. Thank you, for joining us on the call today and for your interest in Lifeway. This concludes our overview for the third quarter of 2016. Ed, John, and I would now like to open the call up for questions. Operator?

Thank you. We'll now be conducting a question-and-answer session. [Operator Instructions] One moment please while we poll for questions. Thank you. Our first question is from the line of Eric Gottlieb with D.A. Davidson. Please, proceed with your question.

Good morning. I just had one – I'll ask again. Could we get more details as to discounting and gross sales at least a commentary about them versus last quarter or last year?

Sure, I think I can take that. From a volume and mix perspective for the standalone quarter, we had, kind of, a low single-digit uptick in the volumes that affected the velocity of sales for the quarter. And offsetting that was the elevated level of the trade promotion that I referenced which attracted another, kind of, low single-digit from the overall velocity for the quarter year-over-year.

Got it. Okay. And then, your commentary and your release doesn't really match the numbers that I'm seeing; household penetration is up 28%, but sales are only up 1.3%, can you explain the disconnect there?

I can try to take and then, I'll let Julie or Ed comment, so our household penetration, and I think this is in Julie's remarks, is roughly a 5% household penetration and so, it was previously closer to a 4% and we do the straight math on the penetration rate, it moves it from a small single-digit to the slightly larger small single-digit, kind of, household penetration. And so the disconnect between, kind of, that lift and the sales lift is largely consequential, but we think is the implication that we're getting into more households, we're in more homes, we're in more pantries, we're more refrigerators, I should say and I think we have consumers that are in and out of the product. But I think that the positive story here is that, we're reaching more consumers, it may not stick, they may not stay with us and we try it and think about it, pause and then come back to the product, but we look to that metric as an obvious indicator of upside and we're encouraged I think with that increase, it's the suggestion that the advertising and marketing campaigns are working and we want to keep fueling that and getting the consumer to stick with our product.

Okay. Fair enough. You are also cited an unfavorable mix, what was the details on that, what products increased versus last year, what products decrease that led to that mix?

Yeah. So, I think, there is a little bit of product mix and maybe a little bit of customer mix that's working in the negative direction. And you appreciate that our portfolio of products, they are not all the same, a 32 ounce plain bottle of kefir bottle has a different margin profile than an 8 ounce bottle of kefir. And our organic product compared to our conventional product has a different margin profile. Organics in particular has a relatively lower margin profile, 8 ounce product generally has a lower margin profile. So, the implication I think is that those – kind of those lower margin profile products are increasing in terms of the total mix. And the organic product in particular is one that has increased year-over-year. We introduced the whole-milk organic products at Expo West last year, we gained distribution and it's starting to now be a part of the mix and has an unfavorable impact. From the customer perspective, we have a range of customers. We sell direct to retailers obviously, but we also sell indirect through distributors and we have customers that pick up the product, we have customers that deliver the products. So across, kind of, all of those variables you get different margin rates down to the customer and some of that is moving in a direction that's having modest-adverse effect on the gross profit rate.

Got it. Now looking at kefir sales, results have been a sequential decline for three quarters now, despite for all those marketing efforts and new business wins. Again, gross margin, gross sales breakout would help here, but I'm wondering why sales have been weak. Have you lost any business, you talk about wins, but have you lost any?

Yeah. No, so we're not losing any accounts, I mean there's nothing moving in a negative direction from the number of accounts that we're selling into. For a nine-month period year-over-year, we have volume gains that are in the, kind of, middle-to-high single digit kind of a category. So we're not losing customers, we are gaining volume, the trade promotion on a year-to-date basis, it's actually, marginally favorable year-over-year for nine months. But we're not losing customers and I guess, those are my comments.

Okay. And then marketing expenses. What kind of level should we go – like Carli Lloyd is that – that's done and paid for?

There's going to be a little trickle into the fourth quarter because the campaign, kind of, ran over the quarter end. So I think, there's two weeks of the advertising that's running in the fourth quarter but by and large the dollars are behind us at the end of the third quarter.

Okay. And then the tax rate going forward? I know, it jumps around a lot, but in the past you'd said that the 50% rate has kind of gone and we should be in the high-30's, despite what happened this quarter, is that still the case?

Yeah. So my expectation is consistent with what I think we've talked about in the prior quarter, which is absent the discrete items that affect the rate, we expect to be in the high-30s, as you mentioned. In 2016, we had a favorable resolution of a matter regarding an audit process with the IRS. And so when we finished the year, we'll be below that 37% to 39% kind of a rate giving effect to that favorable outcome, which probably takes the rate down several 100 basis points, but it's unique to that event.

Okay. Fair enough. With that I'll pass it on. Thank you.

Thanks, Eric.

Our next question is from the line of Howard Halpern with Taglich Brothers. Please, proceed with your questions.

Good morning. You talked about I guess, some customer wins in the third quarter. Did you actually ship in the third quarter or is that going to favorably impact the fourth quarter, such as the food line?

Yeah. I think most of the third quarter gains are kind of in front of us in terms of the distribution gains. The addition of Food Lion, I think we started actually shipping inside of the third quarter, but it wasn't for the total quarter. So, you'll see more of that incrementality in the fourth quarter. And then the other items that Julie mentioned in her remarks are not net new retailers, it's just more distribution within the existing retail customers that we had and that's, I couldn't comment on the exact timing and pacing of that, but I think you'll see more of it in the fourth quarter than we saw in the third.

Okay. And I guess, in terms of the gross margin and the mix, do you see that unfavorability continuing or you have a way that you're going to start to mitigate that and we won't really see that too much going forward?

Yeah. So, Julie commented about the things that are coming out of our innovation funnel for 2017. The Cup Kefir product, the Cup Cheese as well as our supplements, the margin profile on those items are relatively higher than the historical margin rates. So depending on kind of the volumes that we are able to achieve in 2017 that bodes well for margin rate expansion. In terms of the unfavorable mix, with respect to the organics I think time will tell, but that's a hot item with consumers. So I would expect that's going to continue to grow. We're being thoughtful about the actions we're taking to protect the margin and do the right thing for the retailer and the consumer. So, perhaps that unfavorable mix may change in a favorable way, but that's kind of out in front of us still. And then in terms of, kind of, the growth strategies, Julie also mentioned the fact that we've added dedicated resources to our sales organization with a focus on new channels and that is strategically underway, our initiatives to expand into food service and small store formats, as the prospect of what we think is important volume for us, it'll put us in c-stores and food service establishments, that won't, on its own necessarily drive volume and profitability, on its own as much as it will drive trial with the broader consumer base that will then feed back into the traditional formats, right. So, we get to c-stores, consumer tries, likes it, and then search buying the 32 ounce product at our traditional groceries. So, that strategic initiative is going to have some consequence on gross profit margins, it'll add incremental gross profit dollars, but I think it will have some prospects of pushing the rate lower.

Okay. So, just in your general view out there with the marketing that's going on, what is going to occur hopefully early in 2017. You're fairly confident that, at a minimum, you should be able grow it in the mid-single digits?

Yeah. We don't like to give guidance. We like to think of ourselves as a growth company and low-single digits to me doesn't translate enough to a growth company. So, we've got the new leadership in our sales function, I think they're having very important impacts here in the third and fourth quarters. This is a great brand, it's a great product and if we get that household penetration up and have the right kind of marketing, it bodes well for something higher than a low single-digit type of a growth rate.

I guess, one last one. Do you have – because you've talked about a household penetration and how it might go up and then fall back and then go up again. Do you have a program out there to attempt to find those customers who are trying it? And then a way to get them back into the stores to buy it?

Yeah. I don't have a – I don't know if Julie has a thought for you on that point, or Ed...

Yeah. I mean, that's what we do every single day at Lifeway. It was just – that's basically what we do every day for 30 years.

Okay. Okay. Well, keep up the work. Then, we'll see you after the fourth quarter.

All right. Thank you.

Thank you. Our next question is a follow-up from the line of Eric Gottlieb with D.A. Davidson. Please, go ahead with your question.

Yes, hi. Thanks, for taking the follow-up. Just one last thing on milk pricing. I've noticed, we've had a – it's trickled up in recent months, and we're expected to probably stay here maybe go slightly higher as we move through the year and next year. I'm wondering, how that affects your business? How that trickles through?

Our product has a lot of price elasticity still and it's again, something that we've always had to navigate and plan around for 30 years. Milk is our biggest raw material cost. And if the prices go up, then we adjust – potentially raise the prices on our product, when milk goes up there's other things that potentially go down. So it's not just black and white, there's a whole range of other variables they go into the pricing and profit on our business. But we're confident that we can successfully move forward even if milk prices go up and they've been historically low for quite some time. So there's that thing and then the other piece of this is, we are also launching additional products that don't have any milk components in them, like supplements and pills where there is a very strong margin associated with it and while we don't have nearly the volume that we do in our kefir products than these new items, it's still something that we can, kind of, build and grow and nurture as we go forward. So I don't feel concerned about milk prices today.

Okay, great. That's all I wanted to know.

Yeah, I have not been concerned for 30 years, the entire time of Lifeway they go up, they go down, people react, but the business continues to be strong and we adjust how we do things based on those prices.

Got it. Thank you.

Yes.

Thank you. As there are no additional questions at this time. I'll turn the floor back to Julie Smolyansky for closing remarks.

Thank you for your participation today. We appreciate the hard work and dedication of our employees and the support of our loyal customers and shareholders. We look forward to sharing our 2016 fourth quarter and year-to-date results with you in the coming months. Have a good day.

Thank you. This concludes today's Lifeway's Foods conference. Thank you for your participation. You may now disconnect your lines at this time.