ITEM 1 BUSINESS
OVERVIEW
Lifeway Foods, Inc. (the "Company",
"Lifeway", “we”, or “our”) was co-founded in 1986 by Michael and Ludmila Smolyansky shortly after
their emigration from Russia to the United States. Mr. and Mrs. Smolyansky were the first to successfully introduce kefir to the
U.S. consumer on a commercial scale, initially catering to ethnic consumers in the Chicago, Illinois metropolitan area. In the
thirty years that have followed, Lifeway has grown to become the largest producer and marketer of kefir in the U.S. and an important
player in the broader market spaces of probiotic-based products and natural, "better for you" foods.
PRODUCTS
Lifeway's primary product is drinkable kefir,
a fermented dairy product. Kefir has a tart and tangy taste similar to yogurt and the consistency of a smoothie. Kefir also has
a slightly effervescent quality all its own. Unlike yogurt, Lifeway incorporates a unique blend of probiotic kefir cultures in
the fermentation process. The probiotic feature, in concert with the base-line nutritional value of a staple beverage that is high
in protein, calcium and vitamin D, and low in calories, presents a unique and differentiated taste profile.
We manufacture (or have manufactured) our products
under our own brand, as well as under private labels on behalf of certain customers. Our product categories are:
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Drinkable kefir, sold in a variety of organic and non-organic sizes, flavors, and types, including
low fat, non-fat, whole milk, protein, BioKefir (a 3.5 oz. kefir with additional probiotic cultures), and Kefir with Oats.
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ProBugs, a line of kefir products in drinkable, frozen, and freeze dried formats, designed for
children.
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Frozen Kefir, available in both bars and pint-size containers.
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European-style soft cheeses.
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As of December 31, 2016, the Company offered
over 50 varieties of its kefir products including more than 20 flavors. In late 2016, we announced that we would begin offering
Kefir Cups, a strained, cupped version of our kefir; and Organic Farmer Cheese Cups, a cupped version of our soft cheeses, both
served in resealable 5 oz. containers with mini-spoons. We have also announced that we will begin offering Lifeway Elixir, a line
of sparkling organic probiotic beverages, and probiotic supplements for adults and children. Because these product line launches
occurred in late 2016 or early 2017, they had no significant impact on 2016 financial performance.
Net sales of products by category were as follows
for the years ended December 31:
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2016
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2015
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In thousands
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$
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%
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$
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%
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Drinkable Kefir other than ProBugs
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$
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105,983
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85.6%
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$
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100,812
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85.0%
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Lifeway cheese products
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10,258
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8.3%
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9,725
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8.2%
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ProBugs Kefir products
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6,383
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5.1%
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6,775
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5.7%
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Frozen Kefir
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1,255
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1.0%
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1,275
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1.1%
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Net Sales
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$
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123,879
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100%
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$
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118,587
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100%
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Product innovation and new product
development
The Company is committed to maintaining its
position as the leading producer of kefir and routinely evaluates opportunities for new product flavors and formulations, improved
package design, new product configurations and other innovation opportunities. Beyond our kefir products, the Company has an ongoing
effort to extend the strength of the Lifeway brand and leverage the capabilities of the Lifeway organization into categories outside
of the dairy aisle, including into non-food categories. As noted above, these product innovation and development efforts led to
the launch of our cupped kefir and cupped cheese product line, a line of probiotic supplements, and a probiotic beverage line.
Lifeway considers research and development
of new products to be a significant part of our overall business philosophy and leverages its existing staff to conduct its innovation,
research, and development efforts, rather than a dedicated research and development staff. Accordingly, we did not incur significant
research and development expenses in 2016.
PRODUCTION
Manufacturing
During 2016 and 2015, approximately 99% of
our revenue was derived from products manufactured at our own facilities. We currently operate the following manufacturing and
distribution facilities:
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Morton Grove, Illinois, which produces drinkable kefir, our drinkable ProBugs kefir, and cheese
products;
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Skokie, Illinois, which produces cheese products;
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Waukesha, Wisconsin, which produces drinkable kefir products and our drinkable ProBugs products,
and which has the capacity to store and distribute products;
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Niles, Illinois, which stores and distributes all products, including those manufactured by co-packers;
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Philadelphia, Pennsylvania, which produces drinkable kefir and cheese products.
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We own these manufacturing facilities, and
all our fixed assets associated with manufacturing, storage, and distribution of our products are located in the United States.
Co-Packers
In addition to the products manufactured in
our own facilities, independent manufacturers (“co-packers”) manufacture some of our products. We have co-packer agreements
to manufacture drinkable kefir in European markets, our freeze-dried ProBugs kefir products, our frozen kefir products, our probiotic
supplements, and our sparkling organic probiotic beverages. During 2016 and 2015, approximately 1% of our revenue was derived
from products manufactured by independent co-packers. Our co-packers are audited regularly by our staff and are required to follow
our specifications and Good Manufacturing Practices (GMPs). Additionally, the co-packers are required to ensure our products are
manufactured in accordance with our quality and safety specifications and that they are compliant with all applicable laws and
regulations.
SALES AND DISTRIBUTION
Sales Organization
We sell our products primarily through our
direct sales force, brokers and distributors. Our sales organization strives to cultivate strong, collaborative relationships with
our customers that facilitate favorable shelf placement for our products, which, we believe will drive sales volumes when combined
with our marketing efforts and our brand strength. Our relationships with food brokers provide additional retail customer coverage
as a supplement to our direct sales force. These brokers are paid commissions that vary based on the scope of services provided
and customers served.
Distribution inside the United States
Lifeway's products reach the consumer through
four primary "route-to-market" pathways:
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Direct
store delivery ("DSD");
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Under the retail-direct channel, our products
are sold to the retailer and shipped to that retailer's distribution center. In turn our retail customer then delivers the product
to its respective stores within its chain. Customers in this route-to-market grouping include among others Kroger, Walmart and
Costco. Under the retail direct model, optimal product merchandising, assortments and product presentation are attended to by the
retailer with support from Lifeway's broker network. Sales to our retail-direct customers represents about 50% of total Company
net sales.
Under the distributor channel, our products
are sold to distributors and shipped to those distributors’ designated warehouses. In turn, our distributor customers then
sell the product to their retail customers and ship the products to their retail customers. Our distributors often use a DSD model
of their own to make deliveries directly to individual stores but also make deliveries to a retailer's warehouse. Our distributor
customers include among others United Natural Foods, Kehe Foods and C&S Wholesale. Optimal product merchandising, assortments
and product presentation at the retail end of the channel are attended to by the distributor with support from Lifeway's broker
network. Sales to our distributor customers represents about 45% of total Company net sales.
Under the direct store delivery (DSD) route
to market, we distribute our products directly to the grocer's dairy cooler using a fleet of Company-owned vehicles and a team
of Lifeway merchandisers who engage face-to-face with store management to ensure optimal product assortments and presentation.
We operate our DSD model in the Chicago, Illinois metropolitan area only. Sales to our DSD customers represents approximately 5%
of total Company net sales.
In the Chicago, Illinois metropolitan
area, Lifeway operates three retail stores and a food truck under its Lifeway Kefir Shop subsidiary. The Company sells its frozen
kefir products through these retail outlets. Sales through these retail outlets represents less than 1% of net sales.
Distribution outside of the U.S
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Substantially all of Lifeway's products are
distributed within the United States; however, certain of our distributors sell our products to retailers in Mexico, Costa Rica,
Dubai, Hong Kong, China, portions of South America, and the Caribbean. Additionally, the Company's products reach consumers in
Canada, the United Kingdom, Ireland, Norway, and Sweden under third party co-manufacturing agreements and in-country distributor
arrangements. Sales outside the United States represents less than 1% of net sales.
Distribution arrangements
Our generally standardized agreements with
independent distributors allow us the latitude to establish new relationships with independent distributors as the need arises.
Lifeway does not offer exclusive territories to any of its distributors.
Independent distributors are provided Lifeway
products at wholesale prices for distribution to their retail accounts. Lifeway believes that the price at which its products are
sold to its distributors is competitive with the prices generally paid by distributors for similar products in the markets served.
Due to the perishable nature of our products and the costs associated with moving product back through the channel, the Company
does not offer return privileges to any of its distributors or channel customers; however, from time to time we do provide our
customers with allowances for non-saleable product.
MARKETING
We use a combination of sales incentives, trade
promotions, and consumer promotions to market our products.
Sales Incentives and Trade Promotion
Allowances
The Company offers various sales incentives
and trade promotional programs to its retailer and distributor customers from time to time in the normal course of business. These
sales incentives and trade promotion programs typically include rebates, in-store display and demo allowances, allowances for non-saleable
product, coupons and other trade promotional activities. Trade promotions support price features, displays, and other merchandising
of our products by our retail and distributor customers. These arrangements are recorded as a reduction to net sales in the Company’s
consolidated statements of operations.
Consumer Promotions and Marketing
Campaigns
The Company engages in an ongoing and wide
variety of marketing and media campaigns - primarily digital and social media, print advertising in some newspapers and magazines,
and, to a lesser extent, targeted television advertising. These marketing and media efforts are complemented by participation in
sponsorships of cultural and community events, various festivals, industry-related trade shows, and in-store promotional events.
Our consumer marketing efforts also include cooperative advertising programs with our retail customers and various couponing campaigns,
online consumer relationship programs, and other similar forms of promotions.
Our marketing efforts are aimed at stimulating
demand with new and existing consumers by elevating awareness and consumption of kefir and probiotics, as well as enhancing our
brand equity. Our awareness marketing seeks to promote the verifiable nutritional profile, purity, benefits, and good taste of
our kefir.
COMPETITION
Lifeway competes with a limited number of other
domestic kefir producers and consequently faces a small amount of direct competition for kefir products; however, Lifeway's kefir-based
products compete with other dairy products, notably spoonable and drinkable yogurt, and, increasingly, with non-dairy probiotic
products that incorporate kefir cultures but are not kefir. Many of our competitors are well-established and have significantly
greater financial resources than Lifeway to promote their products.
SUPPLIERS
We purchase our ingredients such as raw milk,
cane and other forms of sugar from unaffiliated suppliers. In addition, we purchase and use significant quantities of packaging
materials to package our products and natural gas, fuels, and electricity for our facilities. Purchases are made through purchase
orders or contracts, and price, delivery terms, and product specifications vary. Although the prices for our principal ingredients
can fluctuate based on economic, weather, and other conditions, Lifeway believes it has ready access to multiple suppliers for
all ingredient and packaging requirements.
MAJOR CUSTOMERS
During the year ended December 31, 2016, two
distributors, United Natural Foods, Inc. and KEHE, represented approximately 15% and 8% of the Company's total net sales. These
customers collectively accounted for approximately 25% of accounts receivable as of December 31, 2016.
SEGMENTS
The Company has determined that it has
one reportable segment based on how the Company's chief operating decision maker manages the business and in a manner consistent
with the internal reporting provided to the chief operating decision maker. The chief operating decision maker, who is responsible
for allocating resources and assessing Company performance, has been identified collectively as the Chief Financial Officer, the
Chief Operating Officer, the Chief Executive Officer and Chairperson of the board of directors. Substantially all of the consolidated
revenues of the Company relate to the sale of fermented dairy products which are produced using the same processes and materials
and are sold to consumers through a network of distributors and retailers in the United States.
DANONE SA
Since October, 1999 Danone SA, through subsidiaries
(collectively “Danone”), has been the beneficial owner of approximately 20% of the outstanding common stock of Lifeway.
Lifeway and Danone are parties to a Stockholders' Agreement dated October 1, 1999, which as amended provides Danone the right to
nominate one director, provides Danone with anti-dilutive rights relating to certain future offerings and issuances of capital
stock, and grants Danone limited registration rights.
INTELLECTUAL PROPERTY
We own more than thirty United States trademarks
and service marks that have been registered with the United States Patent and Trademark Office. We also own other trademarks and
service marks for which we have filed applications for U.S. registration. We have licenses to use certain trademarks inside and
outside of the United States and to certain product formulas, all subject to the terms of the agreements under which such licenses
are granted. The Company's policy is to pursue registration of its marks whenever appropriate and to vigorously oppose any infringements
of its marks. The Company regards its Lifeway family of trademarks and other trademarks as having substantial value and as being
an important factor in the marketing of its products. The loss of such identification would have a material adverse impact on our
operations and share price.
Depending on the jurisdiction, trademarks are
generally valid as long as they are in use and/or their registrations are properly maintained and they have not been found to have
become generic. Registrations of trademarks can also generally be renewed indefinitely as long as the trademarks are in use. In
addition, we own numerous copyrights, registered and unregistered, registered domain names, and proprietary trade secrets, technology,
know-how, processes and other proprietary rights that are not registered.
REGULATION
Lifeway is subject to extensive regulation
by federal, state and local governmental authorities. In the United States, agencies governing the manufacture, marketing, and
distribution of our products include, among others, the Federal Trade Commission (“FTC”), the United States Food &
Drug Administration (“FDA”), the United States Department of Agriculture (“USDA”), the United States Environmental
Protection Agency (“EPA”), the Occupational Safety and Health Administration (“OSHA”) and their state and
local equivalents. Under various statutes, these agencies prescribe, among other things, the requirements and standards for quality,
safety, and representation of our products to consumers. We are also subject to federal laws and regulations relating to our organic
products and production. For example, as required by the National Organic Program ("NOP"), we rely on third parties to
certify certain of our products and production locations as organic. Our facilities are subject to various laws and regulations
regarding the release of material into the environment and the protection of the environment in other ways.
Internationally, we are subject to the laws
and regulatory authorities of the foreign jurisdictions in which we manufacture and sell our products, including the Food Standards
Agency in the United Kingdom; the Canadian Food Inspection Agency in Canada; the National Service of Health, Food Safety and Agro-Food
Quality (known by its Spanish-language acronym “SENASICA”) and the Federal Commission for the Protection from Sanitary
Risks (“COFEPRIS”) in Mexico; the Food Safety Authority in Ireland; and the European Food Safety Authority which supports
the European Commission, as well as individual country, province, state, and local regulations.
MILK INDUSTRY REGULATION
Our primary raw material is conventional and
organic raw milk. Raw milk primarily contains raw skim milk, in addition to a small percentage of butterfat and other components.
The federal government establishes minimum prices for raw milk purchased in federally regulated areas. Some states have established
their own rules for determining minimum prices. The federal government announces prices for raw milk each month. While we are subject
to federal government regulations that establish minimum prices for milk, the prices we pay producers of organic raw milk are generally
well above such minimum prices, as organic milk production is generally costlier, and organic milk therefore commands a price premium.
In addition to the prices for raw milk, we also pay producer (“over-order”) premiums, federal order administration
costs, and other related charges that vary by milk product, location, and supplier.
FOOD SAFETY
Lifeway takes appropriate precautions
to ensure the safety of our products. In addition to routine inspections by state and federal regulatory agencies, including the
USDA and FDA, we have instituted Company-wide quality systems that address topics such as supplier control; ingredient, packaging,
and product specifications; preventive maintenance; pest control; and sanitation. Each of our facilities also has in place a hazard
analysis critical control points (“HACCP”) plan that identifies critical pathways for contaminants and mandates control
measures that must be used to prevent, eliminate or reduce relevant food-borne hazards. To the extent that the federal Food Safety
Modernization Act applies to Lifeway’s business, we develop food safety plans and implement preventive measures to protect
against food contamination. We also maintain a product recall plan, including lot identifiability and traceability measures that
allow us to act quickly to reduce the risk of consumption of any product that we suspect may pose a health issue.
We maintain general liability insurance, including
product liability coverage, which we believe to be sufficient to cover potential product liabilities.
We have also implemented the Safe Quality Food
(“SQF”) program at all of our facilities. SQF is a fully integrated food safety and quality management protocol designed
specifically for the food sector. The SQF code, based on universally accepted CODEX Alimentarius, HACCP guidelines and the Global
Food Safety Initiative (“GFSI”) standards, offers a comprehensive methodology to manage food safety and quality simultaneously.
Safe Quality Food or SQF certification provides an independent and external validation that a product, process or service complies
with international, regulatory and other specified standards. Our Waukesha facility is SQF level III certified, the highest level
of such certification from GFSI.
SEASONALITY
The Company's business is not seasonal.
EMPLOYEES
As of December 31, 2016 the Company employed
approximately 320 employees, approximately 125 of which were members of a union bargaining unit.
AVAILABLE INFORMATION
The Company maintains a corporate website for
investors at www.lifeway.net and it makes available, free of charge, through this website its annual report on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports that the Company files with or furnishes to
the Securities and Exchange Commission (the "SEC"), as soon as reasonably practicable after it electronically files such
material with, or furnishes it to, the SEC.
ITEM 1A
RISK FACTORS
In evaluating and understanding us and our
business, you should carefully consider the risks described below, in conjunction with all of the other information included in
this Annual Report on Form 10-K, including "Management's Discussion and Analysis of Financial Condition and Results of Operations"
contained in Part II, Item 7 and "Quantitative and Qualitative Disclosures About Market Risk" contained in Part II, Item
7A. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware
of, or that we currently believe are not material, may become important factors that adversely affect our business. If any of the
events or circumstances described in the following risk factors actually occurs, our business, financial condition, results of
operations, and future prospects could be materially and adversely affected.
Our product categories face a high level
of competition, which could negatively impact our sales and results of operations.
We face significant competition for limited
retailer shelf space in each of our product categories. Competition in our product categories is based on product innovation, product
quality, price, brand recognition and loyalty, effectiveness of marketing, promotional activity, and our ability to identify and
satisfy consumer tastes and preferences. We believe that our brands have benefited in many cases from being the first to introduce
products in their categories, and their success has attracted competition from other food and beverage companies that produce branded
products, as well as from private label competitors. Some of our competitors, such as Danone, General Mills, Inc., Dean Foods,
WhiteWave Foods, Hain Celestial Group, and Nestle S.A., have substantial financial and marketing resources. These competitors and
others may be able to introduce innovative products more quickly or market their products more successfully than we can, which
could cause our growth rate to be slower than we anticipate and could cause sales to decline.
We also compete with producers of non-dairy
products, which have lower ingredient and production-related costs. As a result, these competing producers may be able to offer
their products to customers at a lower price point. This could cause us to lower our prices, resulting in lower profitability or,
in the alternative, cause us to lose market share if we fail to lower prices. Furthermore, private label competitors are generally
able to sell their products at lower prices because private label products typically have lower marketing costs than their branded
counterparts. If our products fail to compete successfully with other branded or private label offerings, demand for our products
and our sales volumes could be negatively impacted.
Additionally, due to high levels of competition,
certain of our key retailers may demand price concessions on our products or may become more resistant to price increases for our
products. Increased price competition and resistance to price increases have had, and may continue to have, a negative effect on
our results of operations.
We may not be able to successfully implement our growth strategy
for our brands on a timely basis or at all.
We believe that our future success depends,
in part, on our ability to implement our growth strategy of leveraging our existing brands with our current and new products to
drive increased sales. Our ability to implement this strategy depends, among other things, on our ability to:
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enter into distribution and other strategic arrangements with third-party
retailers and other potential distributors of our products;
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compete successfully in the product categories in which we choose
to operate;
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introduce new and appealing products and innovate successfully on
our existing products;
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develop and maintain consumer interest in our brands;
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increase our brand recognition and loyalty; and
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enter into strategic arrangements with third-party suppliers to obtain
necessary raw materials.
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We may not be able to implement this growth
strategy successfully, and our sales and income growth rates may not be sustainable over time. Our sales and results of operations
will be negatively affected if we fail to implement our growth strategy or if we invest resources in a growth strategy that ultimately
proves unsuccessful.
If we fail to anticipate and respond
to changes in consumer preferences, demand for our products could decline.
Consumer tastes and preferences are difficult
to predict and they evolve over time. Demand for our products depends on our ability to identify and offer products that appeal
to these shifting preferences. Factors that may affect consumer tastes and preferences include:
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dietary trends and increased attention to nutritional values, such
as the sugar, fat, protein, fiber or calorie content of different foods and beverages;
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concerns regarding the health effects of specific ingredients and
nutrients, such as sugar, other sweeteners, dairy, soybeans, nuts, oils, vitamins, fiber and minerals;
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concerns regarding the public health consequences associated with
obesity, particularly among young people;
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decisions by non-dairy beverage manufacturers to mislabel their products
as “kefir” in order to benefit from our branding and marketing efforts, a marketing ploy that can cause significant
confusion and misunderstanding among consumers; and
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increased awareness of the environmental and social effects of food
processing.
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If consumer demand for our products declines,
our sales volumes and our business could be negatively affected.
We are subject to the risk of product
contamination and product liability claims, which could harm our reputation, force us to recall products and incur substantial
costs.
The sale of food products for human consumption
involves the risk of injury to consumers. Such injuries may result from tampering by unauthorized third parties, inadvertent mislabeling,
product contamination or spoilage including the presence of foreign objects, substances, chemicals, other agents, or residues introduced
during the storage, processing, handling or transportation phases. We also may be subject to liability if our products or production
processes violate applicable laws or regulations, including environmental, health, and safety requirements, or in the event our
products cause injury, illness, or death.
Under certain circumstances, we may be required
to recall or withdraw products, suspend production of our products or cease operations, which may lead to a material adverse effect
on our business. In addition, customers may cancel orders for such products as a result of such events. Even if a situation does
not necessitate a recall or market withdrawal, and even if we and each of our co-packers and suppliers comply in all material respects
with all applicable laws and regulations, we may become subject to claims or lawsuits relating to such matters. Even if a product
liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused
illness or physical harm, including the risk of reputational harm being magnified and/or distorted through the rapid dissemination
of information over the Internet, including through news articles, blogs, chat rooms, and social media, could adversely affect
our reputation with existing and potential customers and consumers and our corporate and brand image. Moreover, claims or liabilities
of this type might not be covered by our insurance or by any rights of indemnity or contribution that we may have against others.
We maintain product liability insurance in an amount that we believe to be adequate. However, we cannot be sure that we will not
incur claims or liabilities for which we are not insured or that exceed the amount of our insurance coverage. A product liability
judgment against us or a product recall could have a material adverse effect on our business, consolidated financial condition,
results of operations or liquidity.
We rely on independent certification for a number of our products
and facilities.
We rely on independent certification,
such as certifications of our products as “organic”, or “gluten-free,” to differentiate our products from
others. The loss of any independent certifications could adversely affect our market position as a probiotic-based products and
natural, "better for you" foods Company, which could harm our business. We rely on independent SQF certification at
some of our facilities, a certification that some of our customers require us to maintain.
We must comply with the requirements of independent
organizations or certification authorities in order to label our products as certified. For example, we can lose our “organic”
certification if a manufacturing plant becomes contaminated with non-organic materials, or if it is not properly cleaned after
a production run. In addition, all organic raw materials must be certified organic. Our products could lose their organic certifications
if our raw material suppliers lose their organic certifications. Similarly, we could lose our SQF certification if we do not meet
the requirements established by GFSI. The loss of these certifications could cause us to lose customers that require Lifeway products
and/or facilities to carry some or all of them, which could negatively affect our sales and results of operations.
The loss of any of our largest customers
could negatively impact our sales and results of operations.
Two of our customers together accounted for
23% of our net sales in the fiscal year ended December 31, 2016. Where we enter into written agreements with our customers, they
are generally terminable or after short notice periods by the customer. In addition, our customers sometimes award contracts based
on competitive bidding, which could result in lower profits for contracts we win and the loss of business for contracts we lose.
The loss of any large customer for an extended period of time could negatively affect our sales and results of operations.
We may not be able to successfully complete
strategic acquisitions, establish joint ventures, or integrate brands that we acquire.
We intend to continue to grow our business
in part through the acquisition of new brands and through the establishment of strategic alliances including potential joint ventures.
We cannot be certain that we will successfully be able to:
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identify suitable acquisition candidates or joint venture partners
and accurately assess their value, growth potential, strengths, weaknesses, contingent and other liabilities, and potential profitability;
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secure regulatory clearance for our acquisitions
and joint ventures;
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negotiate acquisitions and joint ventures
on terms acceptable to us; or
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integrate any acquisitions that we complete.
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Acquired companies or brands may not achieve
the level of sales or profitability that justify our investment in them, or an acquired company may have unidentified liabilities
for which we, as a successor owner, may be responsible. These transactions typically involve a number of risks and present financial
and other challenges, including the existence of unknown disputes, liabilities, or contingencies and changes in the industry, location,
or regulatory or political environment in which these investments are located, that may arise after entering into such arrangements.
The success of any acquisitions we complete
will depend on our ability to effectively integrate the acquired brands or products into our existing operations. We may experience
difficulty entering new categories or geographies, integrating new products into our product mix, integrating an acquired brand's
distribution channels and sales force, achieving anticipated cost savings, or retaining key personnel and customers of the acquired
business. Integrating an acquired brand or products into our existing operations requires management resources and may divert management's
attention from our day-to-day operations. If we are not successful in integrating the operations of acquired brands or products,
or in executing strategies and business plans related to our joint ventures, our business could be negatively affected.
We may have to pay cash, incur debt, or issue
equity, equity-linked, or debt securities to pay for any such acquisition, any of which could adversely affect our financial results.
Our continued success depends on our
ability to innovate successfully and to innovate on a cost-effective basis.
A key element of our growth strategy is
to introduce new and appealing products and to successfully innovate on our existing products. Success in product development
is affected by our ability to anticipate consumer preferences, and to launch new or improved products successfully and on a cost-effective
basis. Furthermore, the development and introduction of new products requires substantial marketing expenditures, which we may
not be able to finance or which we may be unable to recover if the new products do not achieve commercial success and gain widespread
market acceptance. If we are unsuccessful in our product innovation efforts, our business could be negatively affected.
Increases in the cost of raw milk could
reduce our gross margin and profit.
Conventional and organic raw milk, our primary
raw material, is an agricultural commodity that is subject to price fluctuations. Although both conventional and organic milk prices
in fiscal 2016 were relatively low compared to historical levels, there can be no assurance that such prices will remain at these
levels in the future. The supply and price of raw milk may be impacted by, among other things, weather, natural disasters, real
or perceived supply shortages, lower dairy and crop yields, general increases in farm inputs and costs of production, political
and economic conditions, labor actions, government actions, and trade barriers. Increases in the market price for raw milk or over-order
premiums charged by producers may also impact our ability to enter into purchase commitments at a fixed price. There can be no
assurance that our purchasing practices will mitigate future price risk. As a result, increases in the cost of raw milk could have
an adverse impact on our profitability.
In addition, the dairy industry continues to
experience periodic imbalances between supply and demand for organic raw milk. Industry regulation and the costs of organic farming
compared to costs of conventional farming can impact the supply of organic raw milk in the market. Oversupply levels of organic
raw milk can increase competitive pressure on our products and pricing, while supply shortages can cause higher input costs and
reduce our ability to deliver product to our customers. Cost increases in raw materials and other inputs could cause our profits
to decrease significantly compared to prior periods, as we may be unable to increase our prices to offset the increased cost of
these raw materials and other inputs. If we are unable to obtain raw materials and other inputs for our products or offset any
increased costs for such raw materials and inputs, our business could be negatively affected.
Reduced availability of raw materials
and other inputs, as well as increased costs for them, could adversely affect us.
Our business depends heavily on raw materials
and other inputs in addition to conventional and organic raw milk, such as sweeteners, diesel fuel, packaging material, resin,
and other commodities. Our raw materials are generally sourced from third-party suppliers, and we are not assured of continued
supply, pricing, or exclusive access to raw materials from any of these suppliers. In addition, some of our raw materials are also
agricultural products, and therefore subject to the same vulnerabilities described above for raw milk. Other events that adversely
affect our third-party suppliers and that are out of our control could also impair our ability to obtain the raw materials and
other inputs that we need in the quantities and at the prices that we desire. Such events include problems with our suppliers'
businesses, finances, labor relations, costs, production, insurance, and reputation.
The organic ingredients we use in some of our
products are less plentiful and available from a fewer number of suppliers than their conventional counterparts. Competition with
other manufacturers in the procurement of organic product ingredients may increase in the future if consumer demand for organic
products increases.
Interruption of our supply chain, including a disruption in
operations at any of our production and distribution facilities, could affect our ability to manufacture or distribute products,
could adversely affect our business and sales, and/or could increase our operating costs and capital expenditures.
The success of our business depends, in part,
on maintaining a strong production platform and we rely primarily on internal production resources to fulfill our manufacturing
needs. Our ongoing initiatives to expand our production platform and our productive capacity could fail to achieve such objectives
and in any case could increase our operating costs beyond our expectations and could require significant additional capital expenditures.
If we cannot maintain sufficient production, warehousing, and distribution capacity, either internally or through third party agreements,
we may be unable to meet customer demand and/or our manufacturing, distribution, and warehousing costs may increase, which could
negatively affect our business.
We have a number of supply agreements with
co-packers that require them to provide us with specific finished goods, including kefir, probiotic supplements, and probiotic
beverages. For some of these products, we essentially rely on a single co-packer as our sole source for the product. The failure
for any reason of any such sole source or other co-packer to fulfill its obligations under the applicable agreements with us or
the termination or renegotiation of any such co-pack agreement could result in disruptions to our supply of finished goods and
have an adverse effect on our results of operations. Additionally, our co-packers are subject to risk, including labor disputes,
union organizing activities, financial liquidity, inclement weather, natural disasters, supply constraints, and general economic
and political conditions that could limit their ability to timely provide us with acceptable products, which could disrupt our
supply of finished goods, or require that we incur additional expense by providing financial accommodations to the co-packer or
taking other steps to seek to minimize or avoid supply disruption, such as establishing a new co-pack arrangement with another
provider. A new co-pack arrangement may not be available on terms as favorable to us as our existing co-pack arrangements, if at
all.
Our inability to maintain sufficient internal
capacity or establish satisfactory co-packing, warehousing and distribution arrangements could limit our ability to operate our
business or implement our strategic growth plan, and could negatively affect our sales volumes and results of operations.
Disruption of our supply or distribution
chains could adversely affect our business.
Damage or disruption to our manufacturing or
distribution capabilities due to weather, natural disaster, fire, environmental incident, terrorism, pandemic, strikes, the financial
or operational instability of key suppliers, distributors, warehousing, and transportation providers, or other reasons could impair
our ability to manufacture or distribute our products. We rely on a limited number of production and distribution facilities. A
disruption in operations at any of these facilities or any other disruption in our supply chain relating to common carriers, supply
of raw materials and finished goods, or otherwise, whether as a result of casualty, natural disaster, power loss, telecommunications
failure, terrorism, labor shortages, contractual disputes or other causes, could significantly impair our ability to operate our
business and adversely affect our relationship with our customers. If we are unable or it is not financially feasible to mitigate
the likelihood or potential impact of such events, our business and results of operations could be negatively affected and additional
resources could be required to restore our supply chain.
Our debt and financial obligations could
adversely affect our financial condition and ability to operate our business.
As of December 31, 2016, we had outstanding
borrowings of approximately $7 million substantially all of which consists of term loan borrowings. We also had additional borrowing
capacity of approximately $5 million under our line of credit, of which none was outstanding as of December 31, 2016.
Our loan agreements contain certain restrictions and requirements
that among other things:
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require us to maintain a minimum fixed charge ratio and a tangible
net worth threshold;
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limit our ability to obtain additional financing in the future for
working capital, capital expenditures and acquisitions, to fund growth or for general corporate purposes;
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limit our future ability to refinance our indebtedness on terms acceptable
to us or at all;
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limit our flexibility in planning for or reacting to changes in our
business and market conditions or in funding our strategic growth plan; and
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impose on us financial and operational restrictions.
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Our debt level and the terms of our financing
arrangements could adversely affect our financial condition and limit our ability to successfully implement our growth strategy.
Our ability to meet our debt service obligations
will depend on our future performance, which will be affected by the other risk factors described in this Annual Report on Form
10-K. If we do not generate enough cash flow to pay our debt service obligations, we may be required to refinance all or part of
our existing debt, sell our assets, borrow more money or raise equity. There is no guarantee that we will be able to take any of
these actions on a timely basis, on terms satisfactory to us, or at all.
Our notes bear interest at variable rates.
If market interest rates increase, it will increase our debt service requirements, which could adversely affect our cash flow.
Our loan agreements also contain provisions
that restrict our ability to:
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borrow money or guarantee debt;
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make specified types of investments and
acquisitions;
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pay dividends on or redeem or repurchase
stock;
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enter into new lines of business;
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enter into transactions with affiliates;
and
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sell assets or merge with other companies.
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These restrictions on the operation of our
business could harm us by, among other things, limiting our ability to take advantage of financing, merger and acquisition opportunities,
and other corporate opportunities. Various risks, uncertainties, and events beyond our control could affect our ability to comply
with these covenants. Unless cured or waived, a default would permit lenders to accelerate the maturity of the debt under the credit
agreement and to foreclose upon the collateral securing the debt.
We may need additional financing in the
future, and we may not be able to obtain that financing.
From time to time, we may need additional financing
to support our business and pursue our growth strategy, including strategic acquisitions. Our ability to obtain additional financing,
if and when required, will depend on investor demand, our operating performance, the condition of the capital markets, and other
factors. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all.
If we raise additional funds through the issuance of equity, equity-linked, or debt securities, those securities may have rights,
preferences, or privileges senior to those of our common stock, and, in the case of equity and equity-linked securities, our existing
stockholders may experience dilution.
We are subject to risks associated with our international
sales and operations, including foreign currency risks and risks from our expansion into countries in which we have no prior operating
experience.
We intend to continue to expand our global
footprint in order to enter into new markets. This may involve expanding into countries other than those in which we currently
operate. It may involve expanding into less developed countries, which may have less political, social or economic stability and
less developed infrastructure and legal systems. It is costly to establish, develop and maintain international operations and develop
and promote our brands in international markets. As we expand our business into new countries we may encounter regulatory, personnel,
technological, and other difficulties that increase our expenses or delay our ability to become profitable in such countries. This
may have a material adverse effect on our business.
Other risks associated with our operations
as we expand outside of the United States may include, among other things:
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legal and regulatory requirements in multiple jurisdictions that differ
from those in the United States and change from time to time, such as tax, labor, and trade laws, as well as laws that affect our
ability to manufacture, market, or sell our products;
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foreign currency exposures;
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political and economic instability, such
as the United Kingdom’s prospective withdrawal from the European Union;
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trade protection measures and price controls;
and
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diminished protection of intellectual
property in some countries.
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If one or more of these business risks occur,
our business and results of operations could be negatively affected.
Loss of our key management or other personnel,
or an inability to attract such management and other personnel, could negatively impact our business.
We depend on the skills, working relationships,
and continued services of key personnel, including our experienced senior management team. We also depend on our ability to attract
and retain qualified personnel to operate and expand our business. If we lose one or more members of our senior management team,
or if we fail to attract talented new employees, our business and results of operations could be negatively affected.
Employee strikes and other labor-related
disruptions may adversely affect our operations.
We have a union contract governing the terms
and conditions of employment for a significant portion of our workforce. Although we believe union relations since the union’s
certification as the exclusive bargaining representative of this portion of our workforce have been amicable, there is no assurance
that this will continue in the future or that we will not be subject to future union organizing activity. There are potential adverse
effects of labor disputes with our own employees or by others who provide warehousing, transportation, and distribution, both domestic
and foreign, of our raw materials or other products. Strikes or work stoppages or other business interruptions could occur if we
are unable to renew collective bargaining agreements on satisfactory terms or enter into new agreements on satisfactory terms,
which could impair manufacturing and distribution of our products or result in a loss of sales, which could adversely impact our
business, financial condition, or results of operations. The terms and conditions of existing, renegotiated, or new collective
bargaining agreements could also increase our costs or otherwise affect our ability to fully implement future operational changes
to enhance our efficiency or to adapt to changing business needs or strategy.
Our intellectual property rights are valuable, and any inability
to protect them could reduce the value of our products and brands.
We consider our intellectual property rights,
particularly our trademarks, but also our trade secrets, copyrights, and licenses, to be a significant and valuable aspect of our
business. We attempt to protect our intellectual property rights through a combination of trademark, copyright, and trade secret
laws, as well as licensing agreements, third-party confidentiality, nondisclosure, and assignment agreements, and by policing third-party
misuses of our intellectual property. Our failure to obtain or maintain adequate protection of our intellectual property rights,
or any change in law or other changes that serve to lessen or remove the current legal protections of our intellectual property,
may diminish our competitiveness and could materially harm our business.
We also face the risk of claims that we have
infringed third parties' intellectual property rights. Any claims of intellectual property infringement, even those without merit,
could be expensive and time consuming to defend, cause us to cease making, licensing, or using products that incorporate the challenged
intellectual property, require us to redesign or rebrand our products or packaging, divert management's attention and resources,
or require us to enter into royalty or licensing agreements to obtain the right to use a third party's intellectual property. Any
royalty or licensing agreements, if required, may not be available to us on acceptable terms or at all. Additionally, a successful
claim of infringement against us could result in our being required to pay significant damages, enter into costly license or royalty
agreements, or stop the sale of certain products, any of which could have a negative effect on our results of operations.
Litigation or legal proceedings could
expose us to significant liabilities and have a negative impact on our reputation.
We are or may become party to various claims
and legal proceedings in the ordinary course of our business. These claims and legal proceedings may include lawsuits or claims
relating to contracts, intellectual property, product recalls, product liability, the marketing and labeling of products, employment
matters, environmental matters, regulatory compliance, or other aspects of our business. Even when not merited, the defense of
these claims and legal proceedings may divert our management’s attention, and we may incur significant expenses in defending
these claims and proceedings. In addition, we may be required to pay damage awards or settlements or become subject to injunctions
or other equitable remedies, which could have a material adverse effect on our financial position, cash flows or results of operations.
The outcome of litigation is often difficult to predict, and the outcome of pending or future claims and legal proceedings may
have a material adverse effect on our financial position, cash flows or results of operations. We evaluate these claims and legal
proceedings to assess the likelihood of unfavorable outcomes and to estimate, if possible, the amount of potential losses. Based
on these assessments and estimates, we establish reserves or disclose the relevant litigation claims or legal proceedings, as appropriate.
These assessments and estimates are based on the information available to management at the time and involve a significant amount
of management judgment. Actual outcomes or losses may differ materially from our current assessments and estimates. If actual outcomes
or losses differ materially from our current assessments and estimates or additional claims or legal proceedings are initiated,
we could be exposed to significant liabilities.
Our business is subject to various environmental
and health and safety laws and regulations, which may increase our compliance costs or subject us to liabilities.
Our business operations are subject to numerous
requirements in the United States relating to the protection of the environment and health and safety matters, including the Clean
Air Act, the Clean Water Act, the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, and
the National Organic Standards of the U.S. Department of Agriculture, as well as similar state and local statutes and regulations
in the United States and in each of the foreign countries in which we do business. These laws and regulations govern, among other
things, air emissions and the discharge of wastewater and other pollutants, the use of refrigerants, the handling and disposal
of hazardous materials, and the cleanup of contamination in the environment.
We could incur significant costs, including
fines, penalties and other sanctions, cleanup costs, and third-party claims for property damage or personal injury as a result
of the failure to comply with, or liabilities under, environmental, health, and safety requirements. New legislation, as well as
current federal and other state regulatory initiatives relating to these environmental matters, could require us to replace equipment,
install additional pollution controls, purchase various emission allowances, or curtail operations. These costs could negatively
affect our results of operations and financial condition.
Violations of laws or regulations related
to the food industry, as well as new laws or regulations or changes to existing laws or regulations related to the food industry,
could adversely affect our business.
The food production and marketing industry
is subject to a variety of federal, state, local, and foreign laws and regulations, including food safety requirements related
to the ingredients, manufacture, processing, storage, marketing, advertising, labeling, and distribution of our products, as well
as those related to worker health and workplace safety. Our activities, both in and outside of the United States, are subject to
extensive regulation. We are regulated by, among other federal and state authorities, the U.S. FDA, the U.S. Federal Trade Commission
("FTC"), and the U.S. Departments of Agriculture, Commerce, and Labor, as well as by similar authorities in the foreign
countries in which we do business. Governmental regulations also affect taxes and levies, healthcare costs, energy usage, immigration,
and other labor issues, all of which may have a direct or indirect effect on our business or those of our customers or suppliers.
In addition, the marketing and advertising
of our products could make us the target of claims relating to alleged false or deceptive advertising under federal, state, and
foreign laws and regulations, and we may be subject to initiatives that limit or prohibit the marketing and advertising of our
products to children.
We are also subject to federal laws and regulations
relating to our organic products and production. For example, as required by the National Organic Program ("NOP"), we
rely on third parties to certify certain of our products and production locations as organic. Regulations and formal and informal
positions taken by the NOP pursuant to the Organic Foods Production Act of 1990, which created the NOP, are subject to continued
review and scrutiny.
Changes in these laws or regulations or the
introduction of new laws or regulations could increase our compliance costs, increase other costs of doing business for us, our
customers, or our suppliers, or restrict our actions, which could adversely affect our results of operations. In some cases, increased
regulatory scrutiny could interrupt distribution of our products or force changes in our production processes and our products.
Further, if we are found to be in violation of applicable laws and regulations in these areas, we could be subject to civil remedies,
including fines, injunctions, or recalls, as well as potential criminal sanctions, any of which could have a material adverse effect
on our business.
Three of our directors and executive
officers control a significant portion of our common stock and their interests may not align with the interests of our other shareholders.
Ludmila Smolyansky, the chairperson of
our board, Julie Smolyansky, our chief executive officer, president and director and Edward Smolyansky, our chief operating officer,
treasurer and secretary (together, the "Smolyansky Family") own approximately 49.8% of our issued and outstanding common
stock. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors
often perceive a disadvantage in owning shares in a company with one or several controlling shareholders.
Furthermore, our directors and officers,
as a group, which own in excess of 49.8% of our issued and outstanding common stock have the ability to significantly influence
or control the outcome of all matters requiring shareholder approval, including the election of directors and approval of significant
corporate transactions, such as mergers, consolidations or the sale of substantially all of our assets.
This concentration of ownership may have
the effect of delaying or preventing a change in control of our Company which could deprive our shareholders of an opportunity
to receive a premium for their shares as part of a sale of our Company and might reduce the price of our common stock. In addition,
without the consent of the Smolyansky Family, we could be prevented from entering into transactions that could be beneficial to
us. The Smolyansky Family may cause us to take actions that are opposed by other shareholders as their interests may differ from
those of other shareholders.
We have identified a material weakness
in our internal control over financial reporting. Maintaining effective internal control over financial reporting requires a continuing
investment in organizational capabilities and our failure to maintain effective control could result in material misstatements
in our financial statements, our failure to meet our reporting obligations and cause investors to lose confidence in our reported
financial information, which in turn could cause the trading price of our securities to decline.
We have identified a material weakness
in our internal control over financial reporting. A description of the material weakness can be found in Item 9A of this report.
As a result of such weaknesses, our management concluded that our disclosure controls and procedures and internal control over
financial reporting were not effective as of December 31, 2016.
Unless and until this material weakness
has been remediated, or should new material weaknesses arise or be discovered in the future, material misstatements could occur
and go undetected in the Company's interim or annual consolidated financial statements and we may be required to restate our financial
statements. In addition, we may experience delays in satisfying our reporting obligations or to comply with SEC rules and regulations,
which could result in investigations and sanctions by regulatory authorities. Any of these results could adversely affect our
business and the value of our common stock.