Description

Lifeway Foods (LWAY) is the absolute category leader in the US in the yogurt-based drink Kefir. For those who have not tried it, Kefir is a tart and tangy cultured milk beverage / smoothie that is high in protein, calcium and vitamin D and also contains 12 live and active cultures as well as 7 to 10 billion beneficial probiotic strains. It has many health benefits (immunity, digestion, probiotics, protein, bone and skin health etc.) but also taste greats (arguably, for some people it requires an acquired taste). I am an avid consumer of the Lifeway products – kefir has become a regular part of my family’s daily nutritional routine.

LWAY has 95% market share in the category and is available in most major stores – Whole Foods, WalMart, Costco, Trader Joe, Kroger etc. etc. The company sells kefir (various flavors), frozen kefir products (i.e. kefir made ice-cream), kids’ snacks (ProBug brand), juices/smoothies, soft cheeses as well as soy versions of its drinks for the lactose intolerant. It is also present in London (Whole Foods and Harvey Nichols) as well as Canada, although in these two countries it has outsourced its production to third parties. They are getting into pharmacies (CVS, Wallgreen), schools, university etc. All of the distribution is through third parties so the company is not investing in this part of the chain but instead focusing on product innovation and manufacturing.

Kefir is a lot more popular in Europe where consumption is about 20x higher than in the US but awareness is increasing quite rapidly in North America.  The company has done a good job in promoting its brands in social media, various cultural/sports/education events, partnering with celebrities etc. LWAY has increased awareness from a mere 10% to over 60% in the last decade. As a result, the company’s sales have shown a 15% CAGR growth in the last 5 years alone to a current run rate of c. $120mm. This was achieved by increasing penetration in the US (it is still mostly represented in the North-East / Chicago / Mid-west areas) as well as bringing new products to market. The management has been quite creative and successful in adding different product extensions. They have introduced various flavors such as plain, organic, multiple fruit flavors, various seasonal ones (i.e. egg-nog, pumpkin spice etc.), the have developed frozen kefir-based yogurts and ice-creams, high-content protein shakes, vegetable savory shakes, cereal/granola snacks, pill-based probiotics etc.  The products are protected with numerous patents, brands, trade secrets etc.  

LWAY’s main ingredient is milk and milk prices have collapsed in 2015. This is a boon for LWAY as it is not passing it on to customers by meaningfully changing its product prices. In other words, it captures this benefit. Milk prices in the US are set by the Government based on a complex formula factoring supply and demand. Supply has been increasing in recent years with the Greek Yogurt craziness but export demand declined this year. Russia, previously a large importer of US milk, has stopped all imports due to the Ukraine sanctions. China has also reduced its imports of US milk due to the stronger US$. This has led to oversupply and lower prices. Here are the projections for milk prices as supplied by the Government. They are down nearly 50% from 2014 and are expected to stay low through at least the first half of 2016.

To meet the growing demand for its products, LWAY started making its kefir drinks this year in a much larger facility in Wisconsin. It had gone through a couple of years of renovation. The other facilities were operating in close to full capacity so this provides manufacturing breathing room to the company. It is important to point that the company owns all its facilities (4 production plants, headquarters’ building, warehouse etc). The Gross Book Value of the PPE including the buildings (a number of them purchased over a decade ago) is around $43mm i.e. 23% of the market cap.

Historically LWAY had EBITDA margins in the 10-15% range (it was 20% in 2009) with milk being a big swing factor. During 2014, milk prices jumped to record high and LWAY’s margins were closer to 6-7% but they should revert to the higher end of the historical spectrum, as per the milk prices expectations for next year. In fact in Q3’2015, EBITDA margins climbed to almost 10%. Using the company’s historical growth rate of 15%, and margins of around 13% we get to EBITDA for 2015 and 2016 of around $18-20mm. The market cap of the Company is $185 and net debt is around $0 so this means that LWAY trades at around 9- 10x EV / Projected 15/16 EBITDA. 

There are no direct peers but there are some relatively good comps. The largest comparable company is White Wave (WWAV), and they produce organic milk (Horizon), soy and almond milk (Silk, Almond Joy) and organic butter (LandOLakes) as well as Organic Greek Yogurts (Wallaby) – one can argue that WWAV‘s brands are somewhat less “hot/hip” than LWAY’s but they have executed very well and have shown similar growth of 15% top line / 20% bottom line despite a much larger revenue base in the $3.5bn-$4bn range. WWAV is trading at 19x EV/2015 EBITDA and 15x EV/2016 EBITDA. The stock had gone in a straight line up in the last 3 years until August but has corrected since. Therefore one can argue that LWAY is undervalued relative to its best comp. HAIN Celestial, a maker of organic snacks has traded at 15x-16x EV/2015/2016 EBITDA for most of the last couple of years but has also been hit since August and is now closer to 11-12x EV/EBITDA.

LWAY was founded in 1986 by the Smolyansky family, who emigrated from Russia to Chicago and started producing their favorite yogurt drink in the basement. The company went public in the mid-1990s (it traded at around 20c back then and has been a 100+ bagger over 20+ years reaching a high of $20+ in 2014). The Smolyansky family still controls 46.5% of the shares. Danone approached them in the mid-1990s and purchased a 20% stake in the business. The two sides signed a non-compete and standstill agreement and the stake has remained, as is, for nearly two decades. LWAY has not issued shares since then (in fact it has repurchased small amounts from time to time) so Danone actually owns a bit closer to 22% now. Mario Gabelli owns about 5% of the stock (both personally and through the GAMCO funds). Gabelli first purchased the LWAY stock ten years ago in 2005. Adding it all up, the float is less than 25% of the shares.

From a first glance, LWAY looks like a great investment. It is a high growth company that is offering a new food category killer product with healthy benefits; it is a defensive consumer staples company with a dominant market share; it has large future growth opportunities; it has no net debt and has large family ownership  (i.e. owner / operator); it has a very solid strategic partner (Danone) and benefits from having a smart, long-term investor on board (Gabelli); it enjoys commodity tailwinds as well as expanded capacity from new production facilities. Lastly it has solid hard asset coverage and a reasonable and even cheap valuation compared to comps. These are all great things that should attract many long-term value investors to the stock.

However, there are a few RED FLAGS related to Corporate Governance. Family ownership / operation can be a great thing but it can be also a major obstacle. In this case I think it looks like it might be the latter. These red flags are being slowly addressed by the company but LWAY will benefit immensely from having an activist or a private equity fund involved in the operations to bring best governance practices to this otherwise attractive healthy food/beverage company.

The father Smolyansky ran the company from its foundation in 1986 until 2002 when he died from heart attack. His then-26 year old daughter became the CEO and his then-22 year old son became the CFO.  The founder’s daughter/son duo has been running the company for over 13 years so there are not total novices despite still being in their mid-to-late 30s. The company had less than $20mm of sales back when the father passed away vs the 2014 revenues of $120mm. That is a 6x top line expansion over 12 years. Not too bad given their youth and lack of professional experience when they started.

The daughter, Julie Smolyansky (the CEO) has been featured in top 40 women under 40 in Forbes and other small business magazines.   She appears well-regarded in the industry. She seems quite passionate about the business and quite creative with the products.  However, when it comes to the financial aspect of the business, an area, which until very recently was headed by the brother, Edward Smolyanky, there appears to be some lack of professionalism that one expects from a company of this size.  One could listen to just a couple of the past company conference calls to get a sense of the need for the Company to “up its game” as it relates to financial management.  Therefore, it is not surprising that the Company has had a number of accounting issues.

Since 2010, each of the annual reports discloses a letter from the auditor that the company lacks acceptable internal controls. Each of the annual reports has a long description of issues flagged by the accountants – improper capitalization and D&A of property and equipment, inadequate controls over expense involving senior management, inadequate accounting of income taxes, inadequate design of controls over journal entries, lack of reconciliation, inadequate IT systems etc. Interestingly all the issues revolve around the expense side and not the revenues recognition and it appears that most of the issues are around categorization of expenses. These issues have remained outstanding for over 5 years. Most interestingly LWAY has changed accountants 3 times in the last three years, leading to further delays in resolving the issues and filing proper financial statements.

The revenue is recognized when the products is shipped to the distributor, the price is known and the probability of collection is high. However, the company says that distributors get a wholesale price but in return they are not allowed to return product back the company. In other words, one can assume that the revenue base from an accounting perspective is solid so the issue, as stated above, is more related to expenses and the way they are reported and categorized. 

The Company’s accounting deficiencies should be fixable under proper supervision. The products are really good (I am biased) and one can see them everywhere in the health-conscious grocery stores.  It appears that the management has not been in a rush to fix the issues but they also have not made any attempt to hide them (i.e. the issues are fully disclosed). Neither are they looking to make some quick profits off of it – i.e. they are not paying themselves a special dividends (no dividends paid) or dumping shares (they have never sold shares). While they  receive good salaries they are not overly outrageous (both the CEO and the CFO made a $1mm each last year, which is not small but also not huge for $120mm of sales). That is why it is very hard to suspect that that these internal control issues are part of “hit-and-run” scheme. Under the proper supervision these issues should be fixable.

A couple of weeks ago, LWAY made an announcement which clearly acknowledged the problem. The CFO resigned in mid-December 2015 and a new CFO was promoted. The new CFO has significant and relevant experience – previously he was a chief accounting officer at Campbell Soup and a finance director at Navistar and has experience consulting companies in “crises-type” situations.

It is too early to comment on the new CFO’s contributions but he has the appropriate pedigree for the job. However, for now the internal control issues remain unresolved.  The latest 10-Q still discusses the material weakness in the company reporting systems and that the Audit Committee and the Board of Directors continues to work on the problems. Perhaps, as the nest step in improving the company’s governance, LWAY should review its BOD more closely. The Board of Directors is composed of the CEO’s mother (she gets $500-600K in consulting fees for being a Board Director) and a few other members, who appear to be from the same community, and have been on the board for many years. The Audit committee has not changed over the years despite the massive deficiencies in internal controls. Interestingly, though, the Board members, other than the family and the one representative from Danone, don’t own any shares and they get paid relatively little ($2,000-$5,000) for their board participation.

LWAY presents an interesting dichotomy. The company appears to care a lot about its products but not as much about it financial efficiency.  Perhaps, LWAY’s management doesn’t want or need to operate a public company - they don’t require access to the equity market for their funding and clearly the founding family has not sought to monetize its stake. In fact the CEO said that she wants to pass the legacy to her children. It is surprising that the usually outspoken Gabelli has not been more vocal about the internal control issues it but he is sitting on some large gains on his investment and perhaps it is too small for him to matter.

This company will benefit mightily from a private equity / activist investor who would come in, take a stake and add scale, governance best practices and better internal controls. The question is would the Smolyansky family sell? Chobani, the largest Greek Yogurt company in the US got a $1bn investment from TPG with the founder retaining a large stake in the business. He is still running the business but got a lot of managerial / professional help and Chobani has grown quite rapidly as a result. 

Catalyst

Fixing internal control issues under new CFO

Involvement of Private Equity / Activist Investor