ITEM 1 BUSINESS
OVERVIEW
Lifeway 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 over 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
Our primary product is drinkable kefir,
a cultured dairy product. Lifeway Kefir is a tart and tangy cultured milk smoothie that is high in protein, calcium and vitamin
D. Thanks to our exclusive blend of kefir cultures, each cup of kefir contains 12 live and active cultures and 15 to 20 billion
beneficial CFU (Colony Forming Units) at the time of manufacture.
We manufacture (directly or through co-packers)
our products under our own brand, as well as under private labels on behalf of certain customers. As of December 31, 2017, Lifeway
offered over 50 varieties of our kefir products including more than 20 flavors. In addition to our core drinkable kefir products,
we offer 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 also offer Lifeway Elixir, a line of non-dairy, sparkling organic
probiotic beverages, as well as probiotic supplements for adults and children. In late 2017, we also announced that we would begin
offering Skyr, a strained cupped Icelandic yogurt, and Plantiful, a plant-based probiotic beverage made from organic and non-GMO
pea protein with 10 vegan kefir cultures.
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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European-style soft cheeses, including farmer cheese in resealable cups.
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Cream and other, which consists primarily of cream, a byproduct of making our kefir.
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ProBugs, a line of kefir products in drinkable, frozen, and freeze dried formats, designed for children.
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Other Dairy, which include Cupped Kefir and Icelandic Skyr, a line of strained kefir and yogurt products in resealable cups.
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Frozen Kefir, available in both bars and pint-size containers.
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Net sales of products by category were
as follows for the years ended December 31:
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2017
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2016
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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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90,514
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76%
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$
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96,782
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78%
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Cheese
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11,516
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10%
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11,007
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9%
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Cream and other (a)
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6,527
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5%
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6,114
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5%
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ProBugs Kefir
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4,537
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4%
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6,722
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5%
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Other dairy
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4,138
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4%
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1,279
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1%
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Frozen Kefir (b)
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1,661
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1%
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1,975
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2%
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Net Sales
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$
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118,893
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100%
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$
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123,879
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100%
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(a)
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Includes cream byproducts and other non-dairy products for resale
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(b)
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Includes Lifeway Kefir Shop sales
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Product innovation and new product
development
Lifeway 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 core drinkable kefir products, we have
an ongoing effort to extend the strength of the Lifeway brand and leverage the capabilities of the Lifeway organization into categories
both inside and outside of the dairy aisle, including into non-food categories. In 2017, we focused relatively more of our personnel,
financial resources, and management’s attention on product innovations and growth opportunities than in prior years. As noted
above, these product innovation and development efforts led to new sources of revenue from our cupped kefir and cupped cheese,
probiotic supplements, and non-dairy based probiotic beverage lines. New items introduced through our innovation efforts were offset
by lower volumes of our core drinkable kefir products in 2017.
Lifeway considers research and development
of new products to be a significant part of our overall business philosophy. Where possible, we leverage our existing staff and
facilities to conduct our innovation, research, and development efforts, rather than maintaining a dedicated research and development
staff and facilities or relying solely on third parties.
PRODUCTION
Manufacturing
During 2017 and 2016, approximately 98%
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, drinkable ProBugs kefir, Kefir Cups, and cupped cheese products;
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Skokie, Illinois, which produces cheese products;
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Waukesha, Wisconsin, which produces drinkable kefir products and from which we store and distribute products;
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Niles, Illinois, which stores and serves as a distribution point for products, including those manufactured by co-packers;
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Philadelphia, Pennsylvania, which produces drinkable kefir, cheese, and butter 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 2017 and 2016,
approximately 2% of our revenue was derived from products manufactured by 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.
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, we sell
our products to the retailer that either the retailer’s carrier picks up or Lifeway ships through third party carriers for
delivery to those retailers’ distribution centers. In turn, our retailers then deliver the products to their respective
stores. Customers in this route-to-market grouping include Kroger, Walmart and Costco. Under the retail direct model, optimal
product merchandising, assortments and product presentation are attended to by the retailer with limited support from Lifeway’s
broker network. Sales to our retail-direct customers represent about 49% of our total net sales.
Under the distributor channel, we sell
our products to distributors that either the distributor’s carrier picks up or Lifeway ships through third party carriers
for delivery to those distributors’ designated warehouses. In turn, our distributors then sell and ship our products to their
retail customers. Our distributors often use a DSD model of their own to make deliveries directly to individual stores, but they
also make deliveries to retailers’ distribution centers. Our distributor customers include United Natural Foods (UNFI), KeHE
Distributors, and C&S Wholesale Grocers. The distributor attends to optimal product merchandising, assortments, and product
presentations at the retail end of the channel, with support from Lifeway’s direct sales force and broker network. Sales
to our distributor customers represent about 45% of our total net sales.
Under the direct store delivery (DSD) route
to market, we distribute our products directly to the retailer 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 presentations. We operate our DSD model
in the Chicago, Illinois metropolitan area only. Sales to our DSD customers represent approximately 4% of our total net sales.
In the Chicago, Illinois metropolitan area,
Lifeway operates three retail stores and a food truck under its Lifeway Kefir Shop subsidiary. The Lifeway Kefir Shop sells its
frozen and drinkable kefir products through these retail outlets. Sales through these retail outlets represent 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, Lifeway products reach consumers in
the United Kingdom, Ireland, Norway, Sweden, and the Middle East under third party co-manufacturing agreements and in-country broker
and distributor arrangements. Sales outside the United States represents less than 1% of net sales.
Channel- and Market-Specific Distribution and Broker
Representation Arrangements
Lifeway’s generally standardized
agreements with independent distributors and food brokers allow us the latitude to establish new relationships as the opportunities
and needs arise. Where appropriate given the relationship, market, and business opportunity, we offer exclusive channels, markets,
and/or territories to our distributors and brokers.
We provide our independent distributors
with products at wholesale prices for distribution to their retail accounts. Lifeway believes that the prices at which we sell
our products to distributors are 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, we
do not offer return privileges to any of our distributors or channel customers; however, from time to time we do provide our customers
with allowances for non-saleable product.
Lifeway engages independent food brokers generally on a commission
basis, subject in some cases to a minimum commission guarantee. The commissions vary based on the scope of services provided and
customers served. Our brokers represent our products to a variety of prospective buyers. These buyers could be specialty stores,
retail grocery chains, wholesalers, foodservice operators and distributors, drug chains, mass merchandisers, industrial users,
schools and universities, or military installations. With support from our direct sales force, brokers may provide other value-added
services. These may include scheduling and coordinating promotions, merchandising, centralized ordering, and data collection services.
MARKETING
We use a combination of sales incentives,
trade promotions, and consumer promotions to market our products.
Sales Incentives and Trade Promotion
Allowances
Lifeway 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. We record these arrangements as a reduction to net
sales in our consolidated statements of income (loss) and comprehensive income (loss).
Consumer Promotions and Marketing
Campaigns
We engage 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. We complement these marketing and media efforts by sponsoring cultural and
community events, and various festivals, as well as participating in 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, 2017,
two customers, United Natural Foods, Inc. (UNFI) and Trader Joes, represented approximately 14% and 8% of our total net sales.
These customers collectively accounted for approximately 19% of
net
accounts receivable
as of December 31, 2017.
SEGMENTS
Lifeway has determined that it has one
reportable segment based on how our 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 our consolidated revenues
relate to the sale of cultured dairy products that we produce using the same processes and materials and are sold to consumers
through a common 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 22% 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 designate one director nominee, 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 fifty domestic and international
trademarks and service marks. In addition, we own numerous registered and unregistered copyrights, registered domain names, and
proprietary trade secrets, trade dress, technology, know-how, processes, and other proprietary rights that are not registered.
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. We also 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. Lifeway’s
policy is to pursue registration of intellectual property whenever appropriate. We protect our intellectual property rights by
relying on a combination of trademark, copyright, trade dress, trade secret and other intellectual property laws, and domain name
dispute resolution systems; as well as licensing agreements, third-party confidentiality, nondisclosure, and assignment agreements;
and by policing third-party misuses of our intellectual property. We regard the Lifeway family of trademarks and other intellectual
property as having substantial value and as being an important factor in the marketing of our products. The loss of such protection
would have a material adverse impact on our operations and share price.
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 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. Additionally, 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 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 various types of 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 and Morton Grove facilities
are SQF certified at the highest level of such certification.
SEASONALITY
Lifeway’s business is not seasonal.
EMPLOYEES
As of December 31, 2017, we employed approximately
340 employees, approximately 126 of which were members of a union bargaining unit.
AVAILABLE INFORMATION
Lifeway maintains a corporate website for
investors at www.lifewayfoods.com 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 we file with or furnish to the
SEC as soon as reasonably practicable after we electronically file such material with, or furnish 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, Dean Foods, Chobani,
Hain Celestial Group, and Nestle, 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, such as Millennium Products and PepsiCo, that 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, the acquisition of new brands, and the establishment of strategic alliances including potential joint ventures.
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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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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negotiate acquisitions and joint ventures on terms acceptable to us; or
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The success of any acquisitions we complete
or joint ventures that we establish will depend on our ability to effectively integrate the acquired brands, products, or joint
ventures into our growth strategy. 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.
We may have to pay cash, incur debt, or issue equity, equity-linked,
or debt securities to fund our growth strategy, any of which could adversely affect our financial results.
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 yogurt and 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.
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. In 2017, new items introduced through
our innovation efforts partially offset lower volumes of our core drinkable kefir products. However, our future investments may
not result in the growth we expect, or when we expect it, for a variety of reasons including those described herein. Our future
product development will be reliant on our ability to identify and develop potential new growth opportunities. This process is
inherently risky and will result in investments in time and resources for which we do not achieve any return or value. Each of
our product categories is subject to rapidly changing and evolving consumer preferences that require substantial resources, calculated
risk-taking, and responsiveness. Successful product innovation is also affected by our ability to launch new or improved products
successfully and on a timely and cost-effective basis. Furthermore, the development and introduction of new products requires substantial
expenditures, which we may not be able to finance or which we may be unable to recover. If we do not deliver innovative products
in a cost-effective and timely manner that are attractive to consumers; if we are otherwise unsuccessful entering and competing
in growth categories; if the growth categories in which we invest our limited resources do not emerge as viable opportunities or
do not produce the growth or profitability we expect, or when we expect it; or if we do not correctly anticipate changes and evolutions
in consumer preferences, our business and results of operations could be adversely affected.
The consolidation of our customers
or the loss of any of our largest customers could negatively impact our sales and results of operations.
Customers, such as supermarkets and food
distributors, continue to consolidate. This consolidation has produced larger, more sophisticated organizations with increased
negotiating and buying power that are able to resist price increases or demand increased promotional programs, as well as operate
with lower inventories, decrease the number of brands that they carry and increase their emphasis on private label products, all
of which could negatively impact our business. The consolidation of retail customers also increases the risk that a significant
adverse impact on their business could have a corresponding material adverse impact on our business.
Two of our customers together accounted
for 22% of our net sales in the fiscal year ended December 31, 2017. Where we enter into written agreements with our customers,
they are generally terminable 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, the reduction of purchasing levels, or the cancellation of any business from a large customer
for an extended period of time could negatively affect our sales and results of operations.
We rely on sales made by or through our
independent distributors to customers. Distributors purchase directly for their own account for resale. The loss of, or business
disruption at, one or more of these distributors may harm our business. If we are required to obtain additional or alternative
distribution agreements or arrangements in the future, we cannot be certain that we will be able to do so on satisfactory terms
or in a timely manner. Our inability to enter into satisfactory distribution agreements may inhibit our ability to implement our
business plan or to establish markets necessary to expand the distribution of our products successfully.
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 of the SQF Code. 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.
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 2017 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 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.
We have a number of supply agreements with
suppliers and co-packers that require them to provide us with specific finished goods, including packaging, kefir, probiotic supplements,
and probiotic beverages. For some of these products, we essentially rely on a single supplier or co-packer as our sole source for
the item. 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 sourcing agreement could result in disruptions to our supply
of finished goods and have an adverse effect on our results of operations. Additionally, our suppliers and 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 supplier or co-packer or taking other steps to seek to minimize or avoid supply disruption, such as establishing
new arrangements with other providers. A new arrangement may not be available on terms as favorable to us as our existing 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 manufacturing or
distribution chains or information technology systems, including disruption due to cybersecurity threats, could adversely affect
our business.
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.
Furthermore, damage or disruption to our
manufacturing or distribution capabilities due to weather, natural disaster, fire, environmental incident, terrorism, cybersecurity
threats and other security breaches, pandemic, strikes, the financial or operational instability of key 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, cybersecurity threat, 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.
Furthermore, our insurance coverage may not be adequate to cover all related costs.
Our information technology systems are
also critical to the operation of our business and essential to our ability to successfully perform day-to-day operations. These
systems include, without limitation, networks, applications, and outsourced services in connection with the operation of our business.
A failure of our information technology systems to perform as we anticipate could disrupt our business and result in transaction
errors, processing inefficiencies, and sales losses, causing our business to suffer. In addition, our information technology systems
may be vulnerable to damage or interruption from circumstances beyond our control, including fire, natural disasters, systems failures,
and cybersecurity threats. Cybersecurity threats in particular are persistent, evolve quickly and include, without limitation,
computer viruses, unauthorized attempts to access information, denial of service attacks, and other electronic security breaches.
Like our customers, suppliers, subcontractors and other third parties with whom we do business generally, we expect that we will
continue to be the subject of cybersecurity threats. In some cases we must rely on the safeguards put in place by the third parties
with whom we do business to protect against security threats. We believe we have implemented appropriate measures and controls
and have invested in sufficient resources to appropriately identify and monitor these threats and mitigate potential risks, including
risks involving our customers and suppliers. However, there can be no assurance that any such actions will be sufficient to prevent
cybersecurity breaches, disruptions to mission critical systems, the unauthorized release of sensitive information or corruption
of data, or harm to facilities or personnel.
These threats and other events could disrupt
our operations, or the operations of our customers, suppliers, subcontractors and other third parties; could require significant
management attention and resources; could result in the loss of business, regulatory actions and potential liability; and could
negatively impact our reputation among our customers and the public. Any of these outcomes could have a negative impact on our
financial condition, results of operations, or liquidity.
Our debt and financial obligations
could adversely affect our financial condition and ability to operate our business.
As of December 31, 2017, we had outstanding
borrowings of approximately $6.3 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, 2017.
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 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 copyrights, registered domain names, and proprietary trade secrets, technology, know-how,
processes and other proprietary rights to be a significant and valuable aspect of our business. We attempt to protect our intellectual
property rights by relying on a combination of trademark, copyright, trade dress, trade secret, and other intellectual property
laws, and domain name dispute resolution systems; 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 FDA, USDA, the U.S. Federal Trade Commission
(“FTC”), and the U.S. Departments of 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.
The Smolyansky family controls a majority of our common
stock and has the ability to control the outcome of matters submitted for stockholder approval.
A majority of our common stock is controlled
by members of the Smolyansky family, and collectively, they have the ability to control the outcome of stockholder votes, including
the election of all of our directors and the approval or rejection of any merger, change of control, or other significant corporate
transaction. No person interested in acquiring Lifeway will be able to do so without obtaining the consent of the Smolyansky family.
We believe that having the Smolyansky family as a significant part of a long-term-focused, committed, and engaged stockholder base
provides us with an important strategic advantage, particularly in a business with a mature, well-recognized brand. This advantage
could be eroded or lost, however, should Smolyansky family members cease, collectively, to be controlling stockholders of Lifeway.
We desire to remain independent and family-owned, and we believe the Smolyansky family shares these interests. However, the Smolyansky
family’s interests may not always be aligned with other stockholders’ interests. By exercising their control, the Smolyansky
family could cause Lifeway to take actions that are at odds with the investment goals of institutional, short-term, non-voting,
or other non-controlling investors, or that have a negative effect on our stock price.
Because the Smolyansky family, collectively,
controls a majority of our common stock (approximately 50.2%), we are considered a “controlled company” under Nasdaq
Listing Rules. Controlled companies are exempt from Nasdaq listing standards that require a board composed of a majority of independent
directors, a fully independent nominating/corporate governance committee, and a fully independent compensation committee. Our Board
of Directors has determined that Lifeway will avail itself of these exemptions, though we currently maintain a Board composed of
a majority of independent directors. As a result of our use of controlled company exemptions, our corporate governance practices
differ from those of non-controlled companies, which are subject to all of the Nasdaq corporate governance requirements.
If we are unable to maintain effective
internal control over financial reporting in the future, the accuracy and timeliness of our financial reporting may be adversely
affected.
Maintaining effective internal control
over financial reporting is necessary for us to produce reliable financial statements. We previously identified and reported a
material weakness in our internal control over financial reporting in our Annual Report on Form 10-K for the year ended December
31, 2016. Although we have remediated this material weakness as of December 31, 2017, and while we have determined that our internal
control over financial reporting was effective as of December 31, 2017 as indicated in Management’s Annual Report on Internal
Control over Financial Reporting included in this Annual Report on Form 10-K, we cannot assure you that we will not identify additional
material weaknesses in our internal control over financial reporting in the future.