2023-10-11 07:42:57 ET
Summary
- Lifeway Foods experienced a significant increase in gross margins, leading to a doubling of share price, but the risk/reward is not enticing for new investors.
- The company's financials show manageable debt, a strong current ratio, and improved profitability as of Q2 '23.
- Revenue growth has been underwhelming, but recent partnerships and potential store expansions could lead to higher results. Valuation suggests the company is trading at a premium.
Investment Thesis
After a fantastic Q2, Lifeway Foods (LWAY) skyrocketed over 100% YTD. I wanted to take a look at the company's financials to see if it is warranted. The company's major expansion in gross margins was seen as a very positive development and contributed to the company's doubling of share price, however, I believe it was a little too quick and now the risk/reward is not very enticing for new investors, therefore I assign a hold rating for now.
Briefly on the Company
Lifeway Foods is a producer of pro-biotic foods in the US and internationally. Their primary product is drinkable kefir. The company also offers cheese products, butter, and sour cream. Its brands include Lifeway, Glen Oaks Farms, and Fresh Made.
Financials
As of Q2 '23 , $7.45m in cash and equivalents against around $4.8m in long-term debt. Many investors don't like debt on the books, however, if it is manageable, leverage can be a good way of running the company's day-to-day operations and planning for expansions.
The company's interest coverage ratio has been decent historically, and as of the latest quarter, stood at around 29x, which is much better than at the end of FY22. This means that the company's EBIT can cover interest expense on debt 29 times over. For reference, many analysts believe that 2x is sufficient, however, I think that a 5x ratio is much better, as I'd like to be more conservative. So, it looks like the company's debt is manageable, and it is at no risk of insolvency.
LWAY's current ratio is also on the stronger side and has been right at the top range of what I consider to be an efficient current ratio range of 1.5-2.0. As of the latest quarter it improved to 2.45, which is bordering on inefficient but still better than below 1. In my opinion, the range 1.5-2.0 is efficient because it tells us that the company isn't hoarding cash that could be used for further growth of the company or isn't holding too much inventory that could eat into the cashflows because of storage/holding costs or taking longer to receive money from customers.
In this case, the company's cash pile increased by 67% from FY22, which isn't bad, of course. I would like to see the company using the cash to reward shareholders by means of expanding the company's footprint, which will reward shareholders in the long run, or buy back shares (if the shares are considered cheap). Nevertheless, it is better to have a high current ratio than below 1, as it means the company can easily pay off its short-term obligations.
In terms of efficiency and profitability, the company's ROE and ROA left a lot to be desired. I look for at least 5% on ROA and 10% for ROE, which tells me that the management is adept at utilizing the company's assets and shareholder capital, however, in the case of LWAY, it's got a long way to go. This will call for a slightly higher margin of safety later.
The same story can be seen in the company's return on invested capital. I usually look for at least 10%, which tells me that the company has a competitive advantage, a strong moat, and that the management can find good opportunities to invest the capital in profitable projects. It seems that something is lacking in this department, which will require a higher margin of safety for the risks involved. I usually look for higher ROIC numbers because these companies tend to outperform in the long run.
In terms of revenues over the last decade, the company's growth was quite underwhelming in my opinion, averaging around 4% CAGR, however, in the last 4 years, the company averaged around 15% CAGR, which is decent. Can this be sustained? I highly doubt it. Therefore, I will go with the last decade's average growth for the next 10 years also, to be on the safer side, and that will add towards that extra margin of safety.
The company's margins have been very tight over the last few years and at the end of FY22, these have worsened. That is never a good sign. It's worth mentioning that the company saw a substantial gross margin expansion in Q2, of over 1100bps, or 11%, which can be primarily attributed to the company's higher volume sales of products and milk pricing, according to the Q2 transcript . The increase in gross margins meant that operating and net margins have benefited also, and stood at around 11% and 8%, respectively, as of Q2 '23. I would like to see these sustained over the next couple of years.
So, it looks like FY22 was a tough year for LWAY. It is not the only company that saw massive declines in profitability, however, it looks like everything is turning back around, and we are seeing higher profitability and efficiency as of the 1st half of '23, I would like to see this momentum continue into the 2nd half of FY23 and '24. I would like to see financial metrics like ROIC, and efficiency metrics improve going forward, but I will need to see more quarters.
Valuation
I decided to go with slightly more upbeat revenue assumptions than the company's historic average, due to how the last few years performed and the company's new partnership with 140 CVS stores that are yet to contribute to revenue substantially, however, if the company can maintain and add more stores, it can achieve higher than historical average results. For my base case scenario, I went with around 7% CAGR. For the optimistic case, I went with around 9% CAGR, while for the conservative case, I went with a 5% CAGR. I believe these three scenarios are achievable and very likely outcomes.
In terms of EPS growth, for the base case scenario, I went with .60 cents, .79 cents, and .87 cents for FY23, FY24, and FY25, respectively. After that, the company will see an EPS growth of around 7% CAGR., bringing the total CAGR over the model to around 10% from FY22 to FY32. For the optimistic case, I went with a 14% CAGR over the period, while for the conservative case, I went with a 9% CAGR over the next decade.
On top of these estimates, I added a 15% margin of safety, which I think is sufficient given how beat up my revenue assumptions are and given the results of the latest quarter developed. With that said, Lifeway's intrinsic value is around $8 a share, implying that the company is trading at a premium to its fair value.
Closing Comments
It seems like that huge run-up in share price YTD made the company slightly too expensive for my taste, and the risk/reward isn't as enticing as it once was even just back in August it was trading below its fair value, right before the company reported the massive improvement in its gross margins. From then on, the company skyrocketed, which I believe was a bit too much of a take-off.
I would recommend holding before starting a position, as that is what I will be doing because it is not worth chasing the momentum at this point. The company isn't very well covered, and the average volume is around 80,000 shares per day, which makes for huge fluctuations in price (while writing this article, the share price is up over 5% on 15k shares traded. It seems that the company's valuation after the report overshot in my opinion. Given that the macroeconomic uncertainty still lingering, I would be cautious right now and will want to see how everything develops in the next 3-6 months as interest rates might still go higher and stay higher for longer.
For further details see:
Lifeway Foods: I Will Not Be Chasing The Momentum, Risk/Reward Not Enticing Here