Research Report – Update - Taglich Brothers · Research Report – Update ... Lifeway Kefir contains ten active "friendly" microorganisms and is probiotic* in nature because it

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Research Report – Update Investors should consider this report as only a single factor in making their investment decision.

Lifeway Foods, Inc. Rating: Speculative Buy Howard Halpern LWAY $8.24 – (NasdaqGM) November 27, 2012 2009A 2010A 2011A 2012E 2013E Gross sales (in millions)* $58.1 $63.5 $ 77.1 $88.4 $100.4 Earnings per share (diluted) $0.33 $0.22 $0.17 $0.34 $0.40 52-Week range $11.10 – $7.90 Fiscal year ends: December Shares outstanding a/o 11/8/12 16.4 million Revenue/shares (TTM) $5.22 Approximate float 4.6 million Price/Sales (TTM) 1.6X Market Capitalization $135 million Price/Sales (2013) E 1.3X Tangible Book value/shr $1.20 Price/Earnings (TTM) 30.4X Price/Book 6.9 Price/Earnings (2013) E 20.6X Annual Dividend $0.07 Projected 2012 Dividend yield 0.008% * Reclassification occurred as of December 31, 2010 to include a promotional allowances line creating a net sales line (gross less promotional allowances. The reclassification had no effect on previously reported gross profit or net income.

Lifeway Foods, Inc. is a manufacturer of cultured, probiotic and functional food products in the health food industry, and is America’s leading supplier of the cultured dairy product known as Kefir.

Key investment considerations:

Maintaining Speculative Buy rating and 12-month price target of $11.50 per share. Lifeway Foods’ brand awareness campaign and nationwide distribution should drive three-year annualized sales growth of 16% to $100 million by 2013. Our forecast reflects distribution of the company’s frozen Kefir through 2,500 stores in 3Q12, up from less than 500 last year. Monthly frozen Kefir sales more than doubled in 3Q12 to $233,000, up from $100,000 in 3Q11. As national distribution expands, frozen Kefir sales should approach $300,000 a month in 4Q12. 3Q12 gross sales (reported on November 14, 2012) grew by 16% to $22.6 million, $300,000 below our forecast. EPS increased to $0.09 from $0.06 per share. We projected EPS of $0.10 per share. In 3Q12, conventional milk prices were 20% lower than the year-ago period, partly offset by a 10% increase in organic milk prices. We trimmed our 2012 EPS projection by $0.01 to $0.34 per share on gross sales of $88.1 million, down $300,000 from our prior forecast. The decreases reflect 3Q12 results. We have increased our operating expense margin forecast to 23.2% from 22.2%, due to continued spending on growth initiatives such as an in-store Kiosk test and promotion of frozen ProBugs Kefir for kids. We maintained our 2013 projections for $100 million in gross sales and EPS of $0.40 per share. The 13.6% sales increase is due to an additional 1,000 stores distributing frozen Kefir nationwide (~4,000 total). Net income reflects better leveraging of costs as the operating expense margin falls to 21.5%.

Lifeway Foods, Inc.

Taglich Brothers, Inc. 2

Recommendation Maintaining our Speculative Buy rating and $11.50 12-month price target. LWAY’s brand awareness campaign boosted its 2011 sales growth rate to 21.4%, up from 9.3% in 2010. Concerns of food price inflation could cloud the growth outlook for LWAY, as production gains that occurred through August 2012 began to wane in September and October of 2012. Near-term raw conventional milk prices are likely to remain steady in 4Q12 compared to 3Q12, but rising organic milk prices could partially offset production gains. Our $11.50 per share 12-month price target is based on LWAY’s historical (three-year) and industry (trailing twelve month) average price to sales multiple of 2.8X. We reduced the multiple to 2X to account for food inflation, applying the multiple and a discount factor of 7% to our 2013 $6.11 sales per share estimate to obtain a year-ahead target of $11.50 per share. Our target implies a potential return of 40% in the next twelve months including the annualized dividend yield of less than 1%. The October 2012 Dairy Market Report forecast anticipates 2013 wholesale US milk prices to average $20 per hundredweight (ctw), up $2 from an estimated average of $18 in 2Q12. The US Department of Agriculture (USDA) and IBISWorld forecasted milk price increases of 1% and 8%, respectively in 2012 and 2013. On December 31, 2011, Danone owned approximately 21.1% of LWAY’s common shares. If Danone sold its stake in Lifeway Foods, it would most likely have a negative effect on the company’s stock price. Agreements formerly in place barred Danone from acquiring additional shares or introducing a Kefir product. The agreement expired without an extension (currently being discussed) and no agreement has been reached as of the date of this report. The Company Lifeway Foods, Inc. (NasdaqGM: LWAY) manufactures a cultured dairy beverage called Kefir and also develops Kefir-related products at its manufacturing and production facilities in Illinois, Pennsylvania, and Minnesota. Its Kefir-based product portfolio is distributed in Illinois through approximately 1,200 local stores including major retail chains (i.e., Jewel Food Stores, Dominick's Finer Foods, Whole Foods) and independent retailers. The product portfolio includes assorted cream cheese offerings that are distributed under the Cream Cheese Gourmet brand in the Philadelphia and New York metropolitan areas. Lifeway’s products are also distributed to stores throughout the US (Whole Foods, Costco Midwest and Northern California, Stop & Shop Northeast, Kroger, Ralphs, and Safeway stores – Midwest and West, BJ’s Wholesale Club stores and Walmart Supercenter stores). Verbal distribution agreements in the US are flexible, offering latitude to expand into new markets and establish new relationships on an ongoing basis. The developments listed to the right have raised brand awareness and distribution opportunities. Kefir Lifeway Kefir contains ten active "friendly" microorganisms and is probiotic* in nature because it promotes the growth of microorganisms naturally. The product is a source of calcium, protein, minerals, and B-complex vitamins, and is highly digestible due to its acidity and enzymes. Kefir is similar to, but distinct from, yogurt due to a different fermentation process. Less sugar is required so it contains fewer calories. *Probiotics are defined as live cultures consumed for a health benefit

Lifeway Foods, Inc.


Strategy for Growth Increased Innovation and Distribution In 2012, the company commenced distribution of its 8-ounce Kefir 4-packs to 200 Target PFresh stores, which carry an array of perishable and frozen foods, meat, and dairy, and to at least 453 SuperTarget supermarket stores. Expansion into the remaining 675 Target PFresh stores could add to sales in 2013. The company introduced new flavors of its frozen Kefir, including pumpkin, chocolate and dolce de leche (candy of milk). Additional 2012 frozen products should include Greek Style Fro-Yo yogurt and ProBugs, the currently popular Kefir beverage for children. As a frozen version, ProBugs™ is intended to provide customers with a healthy alternative to the current choices within the frozen snack/dessert section of the supermarket. At September 30, 2012, frozen Kefir products were available in approximately 2,500 retail locations. US distribution could reach approximately 3,000 retail locations by the end of 2012 and 5,000 by the end of 2013. For 2013, the company anticipates international distribution of frozen Kefir in the United Kingdom through a co-packing arrangement. UK distribution should be followed by retail distribution into additional European countries (France, Germany, and Balkan states). The company switched to a new packaging supplier for 2012 and has reduced the material used in its packaging, which is expected to reduce cost of goods sold by $1 million annually, resulting in better leveraging of expenses. Based on personal observation, it appears that Lifeway’s traditional Kefir products are distributed in the North East to Stop & Shop, Wild by Nature, and Whole Foods locations on Long Island, New York. The number of flavors offered is increasing, with placement in the dairy section moving to eye level from the very top shelf. Frozen Kefir reached the New York metropolitan area in May 2012 at Whole Foods stores and in November the number of flavors on the shelf expanded. Sequential Growth Potential The graph at right shows our quarterly sales expectations through 4Q13. We project sequential growth in all but the seasonally slow 4Q periods. We project weekly sales in 2013 could approach $1,925 due to a 5% price increase and addition distribution of frozen Kefir. Dairy Market The dairy market has changed since the April 2012 Dairy Market Report observed that there was a growing consensus that milk prices would weaken in 2012. Weakness in milk prices through September 2012 has since reversed and is forecast to end the year $6 per hundredweight (cwt) higher at $22 per cwt from the mid-year low of $16 cwt in 2Q12. The revised forecast is due to declining milk production stemming from the fear of rising feed costs and reduced herd size. The futures market indicates that milk prices are expected to average $20 per hundredweight in 2013. Cropp Cooperative forecasts that organic milk prices will increase by 8% to $26.55. The rise in organic milk prices is due to a 65% increase in prices of organic corn fed to dairy cows, a consequence of Midwest drought conditions that started in 2011 and have persisted in 2012.

Lifeway Foods, Inc.


Market Comment Lifeway Foods’ product portfolio includes cultured dairy products known as Kefir, which includes probiotic functional cultures. Food Technology Magazine observed that despite the prevalence of health problems, many people do not seek medical attention. An estimated one-third of consumers plan on self-treatment. Also, nearly one-third of the 60% that buy functional food products are doing so to alleviate a specific health condition. Data from consulting firm Mintel indicates that 63% of consumers are seeking weight control and cholesterol lowering functional foods closely followed by functional digestion products, immunity products, and enhanced metabolism/blood pressure lowering products. Kefir products provide the company with growth opportunities in the second and third top categories (digestion and immunity).

Frozen dairy products (ice cream, sherbet, yogurt, tofu) revenue grew by 3.5% to $4.5 billion in 2011. Leading overall growth, according to consulting firm SymphonyIRI Group, was the frozen yogurt/tofu segment, which increased revenue by 6.5% to $212 million. IBISWorld reported revenue from frozen yogurt stores reached $1.6 billion in 2011 due to the growing popularity of frozen yogurt chains such as Pinkberry, Red Mango, and Yogurtland. Heightened consumer awareness should benefit Lifeway as its frozen Kefir becomes more widely distributed in supermarkets across the US. Keys to growth include an emphasis on the regular introduction of new products and, most importantly, the introduction of products that are considered healthy. US demand for dairy products is driven by disposable income growth, population growth and consumer preferences. The US population is forecasted to grow at a marginal rate of 0.8% per year through 2017, which will support some volume growth. IBISWorld forecasts real disposable income growth at an average annual rate of 2.2% through 2017, which could fuel purchases of more expensive dairy foods. IBISWorld anticipates that consumers will continue to be very concerned with health and nutrition. Consequently, they will demand more functional dairy products such as those with probiotics, increased calcium and organic varieties. This should drive the overall per capita consumption of dairy products though 2013. Competition There are no publicly traded direct Kefir competitors. With LWAY’s acquisition of Kefir producers Helios and Fresh Made in 2006 and 2009, respectively, the company became the dominant producer in the US. Consumer research firm Mintel projects US yogurt sales should top $7 billion, up 9% from $6.4 billion in 2011 and $5.9 billion in 2010. Growth in the category reflects the introduction of specialized yogurts such as Greek style and probotic enriched yogurts. IBISWorld expects fluid milk and dairy product consumption to increase strongly over the next five years as the health benefits of dairy products become increasingly significant to specific age groups such as young children and aging baby boomers. Projections Our sales forecasts are predicated on customer acceptance of the new frozen Kefir product, including ProBugs designed for kids, and 2013 distribution to an average of 4,000 stores, the 2Q13 launch of distribution of frozen products to the UK, a 5% price increase starting in 1Q13, and distribution to more than 500 Target stores.

Lifeway Foods, Inc.


We anticipate stable conventional raw milk prices through 4Q12 that will reverse starting in 1Q13 and rise through 2013 causing gross margin compression in 2013. Partly offsetting the rise in the cost of milk should be a $1 million reduction in packaging and bottling costs due to a new vendor agreement that provides for lower material costs and added manufacturing flexibility that facilitates improved production scalability. Operations For 2012, we project EPS of $0.34 per share on net sales growth of 14.2% to $79.9 million ($88.1 million less estimated promotional allowances of $8.2 million). Our prior EPS forecast was $0.35 per share on sales of $79.8 million. We increased our net sales forecast by $400,000 to $8.2 million due to lower than anticipated promotional allowances reflecting reduced couponing and product returns. The $0.01 per share decrease in our EPS forecast reflects a 3Q12 $0.01 per share shortfall relative to our projection. In 2011 the company reported net sales of $70 million ($77.1 million less promotional allowances of $5 million). We project gross organic product sales of $38 million (43% of total) and non-organic sales of $58 million. The company does not disclose individual product sales, but based on our own observations, original Kefir is its sales leader, followed by organic product offerings and ProBugs for kids. We estimate full year frozen Kefir sales of $3 million, down from our prior forecast of $3 million, which reflects results for the first nine months of 2012. Our gross profit forecast maintains growth of 28% to $28.9 million due to lower milk prices in 2Q12 and 3Q12 and better than anticipated leveraging of operating expense. Our gross margin forecast is 32.9% up from 29.2% in 3Q11 due to a 20% year-over-year reduction in milk prices and lower packaging and bottling expenses, partly offset by higher transportation costs. Operating expenses should increase to $20.4 million from $17.5 million last year. The increase from 2011 is due to a marketing program aimed at building consumer awareness and the hiring of 100 new employees to support revenue growth. Operating expense margin should increase to 23.2% from 22.7% reflecting expense growth exceeding sales growth. The 17% increase in operating expenses is due to increased hiring and brand awareness activities to drive sales of its new frozen Kefir product. In 2012, interest expense is projected to decrease to $176,000 from $247,000 due to a repayment of a portion of long-term debt. For 2013, we project net sales of $91.6 million ($100 million less promotional allowances of $8.5 million) with net income of $6.5 million or $0.40 per share. We previously projected net sales of $94.4 million ($100.4 million less promotional allowances of $8.5 million) with net income of $6.5 million or $0.40 per share. Net sales growth of 13.6% should be driven by the increase in distribution of its frozen Kefir products to 5,000 stores (by the end of 2013) and international distribution of frozen products in Europe through co-packing operations in the UK. We estimate that organic sales will account for 44% of gross sales or $44 million. We project gross margins to contract to 31.6% from our 2012 estimate of 32.9%, due to a tilt in the product mix to lower margin organic products and higher conventional milk prices than previously anticipated. Operating expense margin should improve to 21.5% from our 2012 forecast of 23.2% due to sales growth of 13.6%, partly offset by a 5.1% increase in operating expenses. We forecast a $256,000 increase in selling expenses reflecting the ongoing brand awareness campaign and an $789,000 increase G&A expenses to maintain staffing levels of 100 seen in the second half of 2012. Finances In 2012, we project cash earnings of $7.7 million and an increase in working capital of $1.1 million stemming from an increase in accounts receivables and inventories, partly offset by increases in accruals and accounts payables. Cash from operations of $6.6 million should cover capital expenditures, debt repayment, and common stock dividends, increasing cash by $1.2 million to $2.3 million at December 31, 2012.

Lifeway Foods, Inc.


In 2013, we project cash earnings of $8.5 million and an increase in working capital of $330,000 stemming from an increase in accounts receivables and inventories, partly offset by increases in accruals and accounts payables. Cash from operations of $8.2 million should cover capital expenditures, debt repayment, and common stock dividends, increasing cash by $2 million to $4.4 million at December 31, 2013. Sales Advance in 3Q12 In 3Q12 gross sales increased by 16% to $22.6 million due to the growing awareness of the Kefir brand, increased distribution of ProBugs Organic Kefir for kids, and BioKefir. Frozen Kefir, introduced in 2Q11, contributed $700,000 to sales in 3Q12. Net sales (after $2 million in promotional allowances) were $20.6 million compared to $17.7 million a year earlier. Gross margin improved to 33% from 32% due to a 20% decrease in conventional milk prices in 3Q12 vs. 3Q11, partly offset by a 10% increase in organic milk prices freight costs reflecting high oil prices. Gross profit increased by 19.8% to $7.5 million. Operating expenses increased by 15.6% to $5.4 million due to G&A expenses rising by 26% to $2.4 million in order to support distribution of the new product offerings and an 8% increase in selling expenses to $3 million. Operating margin expense improved to 23.9% from 24.1% in 3Q11. Non-operating expense was $17,000 compared to $96,000 in 3Q11. The improvement was due to lower interest expenses and a gain on sale of investment securities, partly offset by lower interest income. The 3Q12 income tax rate was 32% compared to 30% 3Q11. 3Q12 net income was $1.4 million or $0.09 per share, compared to net income of $1 million or $0.06 per share in the year earlier period. Net sales growth in the first nine months of 2012 was 13.8% to $60.6 million due in part to frozen Kefir sales of $2.2 million compared to $500,000 last year. Gross margin improved to 33.3% from 32.8% as the decline in 2Q12 and 3Q12 milk prices exceeded the increase in 1Q12. Operating expense margin improved to 22.7% from 23.3% due to better leveraging of expenses reflecting higher sales growth (14.5%) than expense growth (11.5%). Operating income margin improved to 10.6% from 9.5% in the first nine months of 2011 resulting in operating income increasing by 27.9% to $7.1 million. The increase in operating income reflects sales growth and improved gross margin, which outpaced growth in operating expenses. Other expense fell to $47,000 from $197,000 due to lower interest costs. Net income improved to $4.5 million or $0.28 per share from $3.2 million or $0.20 per share. Finances In the first nine months 2012 cash earnings of $6.2 million and a small increase in working capital of $96,000 resulted in cash from operations of $6.1 million. Cash from operations covered capital expenditures on equipment and repayment of debt, and increased cash by $1.3 million to $2.4 million at September 30, 2012. In 3Q12 cash earnings of $2.2 million and an increase in working capital of $220,000 resulted in cash from operations of $2 million. Working capital increased due to higher receivables and prepaid balances, offset by higher payables and accruals. Cash from operations of $2 million covered capital expenditures and repayment of debt, and increased cash by $379,000 to $2.4 million at September 30, 2012.

Lifeway Foods, Inc.


Debt Debt as of September 30, 2012 totaled $5.7 million, of which $581,000 was short-term. Total debt consisted of a note payable to Private Bank ($5.5 million, matures February 2014), a note payable to Ford Credit ($55,382, maturity date of July 2015), and a note payable to Fletcher Jones ($87,629, maturity date of May 2017. At September 30, 2012, Lifeway Foods was in compliance with fixed charge ratio and tangible net worth covenants on its note payable with Private Bank. Marketable Securities The company’s $2 million portfolio of marketable securities, at fair value as of September 30, 2012, consisted of 60% in fixed income type securities (government/corporate/municipal bonds) and 40% in equities, mutual funds, and preferred securities. The company had total net unrealized losses at September 30, 2012 of $15,000 consisting of equities/mutual funds/preferred stock unrealized losses of $12,000 and corporate bond losses of $3,900. Risks In our view, these are the principal risks underlying the stock: Commodities The price of conventional and organic raw materials such as milk, sugar, and fruit from unaffiliated suppliers can be volatile, causing wide variations in the gross margin. Regulation Lifeway is subject to federal, state and local regulation of the distribution and sale of food products. Products exported to Canada are subject to strict quotas imposed by the Canadian government. The company may seek to manufacture product within Canada. Groupe Danone SA Relationship The extension of the non-compete period and standstill period of the stockholders’ agreement expired on December 31, 2011. Discussions continue on an additional extension, by has not yet been publicly announced as of the date of this report. As of September 30, 2012, Danone owned approximately 21.1% of LWAY’s common shares. If Danone were to sell its stake in Lifeway Foods, the stock price could be adversely affected. Internal Controls The company identified one remaining material weakness in the company’s internal controls as of September 30, 2012 of the four identified last year. To remedy the last remaining weakness the company hired an internal controller to build controls, including additional segregation of financial duties and monitoring control systems Management Control Ludmila Smolyansky (mother of the company’s CEO and CFO), chairperson of the board of directors, beneficially owns or controls approximately 45.2% of common shares outstanding as of November 2012. The chairperson has the ability to substantially influence corporate decisions that may not be in the best interest of the shareholders at large. Miscellaneous The company’s financial results are subject to other risks and uncertainties including competition, operations, financial markets, regulatory risk, and/or other events. These risks may cause actual results to differ from expected results. Trading Volume Liquidity could be a concern. In 2010 average daily volume for LWAY’s shares were 16,004 and declined to 14,578 in 2011. Over the last three-months to November 23, 2012 average daily volume decreased to 11,453 shares. Average daily volume remains relatively low with a float of 4.6 million shares and 16.4 million outstanding shares; therefore, investors need to be aware that by nature a thinly traded equity can have significant price volatility.

Lifeway Foods, Inc. Consolidated Balance Sheets

2009 – 2013E (in thousands)


Source: Company reports and Taglich Brothers estimates

Lifeway Foods, Inc. Annual Income Statement Model




Lifeway Foods, Inc. Quarterly Income Statement Model

20011A – 2013E (in thousands)



Lifeway Foods, Inc. Cash Flow Statements




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Price Chart

Taglich Brothers Current Ratings Distribution

Investment Banking Services for Companies Covered in the Past 12 Months Rating # % Buy 1 4 Hold Sell Not Rated

Lifeway Foods, Inc.


Important Disclosures As of the date of this report, we, our affiliates, any officer, director or stockholder, or any member of their families do not have a position in the stock of the company mentioned in this report. Taglich Brothers, Inc. does not currently have an Investment Banking relationship with the company mentioned in this report and was not a manager or co-manager of any offering for the company with in the last three years. All research issued by Taglich Brothers, Inc. is based on public information. Since December 2000, the company has paid and continues to pay a monthly monetary fee of $1,500 (USD) to Taglich Brothers, Inc. for the creation and dissemination of research reports.

General Disclosures The information and statistical data contained herein have been obtained from sources, which we believe to be reliable but in no way are warranted by us as to accuracy or completeness. We do not undertake to advise you as to changes in figures or our views. This is not a solicitation of any order to buy or sell. Taglich Brothers, Inc. is fully disclosed with its clearing firm, Pershing, LLC, is not a market maker and does not sell to or buy from customers on a principal basis. The above statement is the opinion of Taglich Brothers, Inc. and is not a guarantee that the target price for the stock will be met or that predicted business results for the company will occur. There may be instances when fundamental, technical and quantitative opinions contained in this report are not in concert. We, our affiliates, any officer, director or stockholder or any member of their families may from time to time purchase or sell any of the above-mentioned or related securities. Analysts and members of the Research Department are prohibited from buying or selling securities issued by the companies that Taglich Brothers, Inc. has a research relationship with, except if ownership of such securities was prior to the start of such relationship, then an Analyst or member of the Research Department may sell such securities after obtaining expressed written permission from Compliance.

Analyst Certification

I, Howard Halpern, the research analyst of this report, hereby certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers; and that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report.

Public Companies mentioned in this report:

Groupe Danone (OTC Other: DANYO)

Lifeway Foods, Inc.


Meaning of Ratings Buy - the company is undervalued relative to its market and peers. We believe its risk reward ratio strongly advocates purchase of the stock relative to other stocks in the marketplace. Remember, with all equities there is always downside risk. Speculative Buy - We believe that the long run prospects of the company are positive. We believe its risk reward ratio advocates purchase of the stock. We feel the investment risk is higher than our typical “buy” recommendation. In the short run, the stock may be subject to high volatility and continue to trade at a discount to its market.

Neutral - We will remain neutral pending certain developments.

Underperform - We believe that the company may be fairly valued based on its current status. Upside potential is limited relative to investment risk. Sell - We believe that the company is significantly overvalued based on its current status. The future of the company's operations may be questionable and there is an extreme level of investment risk relative to reward. Dropping Coverage – We have discontinued research coverage of the company due to termination of research services, non-payment for such services or departure of the analyst.

Some notable Risks within the Microcap Market Stocks in the Microcap segment of the market have many risks that are not as prevalent in Large-cap, Blue Chips or even Small-cap stocks. Often it is these risks that cause Microcap stocks to trade at discounts to their peers. The most common of these risks is liquidity risk, which is typically caused by small trading floats and very low trading volume which can lead to large spreads and high volatility in stock price. In addition, Microcaps tend to have significant company specific risks that contribute to lower valuations. Investors need to be aware of the higher probability of financial default and higher degree of financial distress inherent in the microcap segment of the market. From time to time our analysts may choose to withhold or suspend a rating on a company. We continue to publish informational reports on such companies; however, they have no ratings or price targets. In general, we will not rate any company that has too much business or financial uncertainty for our analysts to form an investment conclusion, or that is currently in the process of being acquired.

Research Report – Update - Taglich Brothers · Research Report – Update ... Lifeway Kefir contains ten active "friendly" microorganisms and is probiotic* in nature because it

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