Lifeway's Cost Crisis

If you've ever read a contract, you are probably familiar with the concept of "force majeure." It refers to events such as war, political revolution, volcanoes erupting, frogs raining from the sky, and the like, which can totally change the circumstances surrounding a transaction.

After seeing what happened last week to one of my favorite small caps, Lifeway Foods (NASDAQ:LWAY), I am seriously considering adding "the doubling of raw milk prices" to my list of forces majeure to watch out for. According to its earnings release, in the second quarter of 2004, Lifeway experienced a small complication: The price of the main ingredient for its products doubled.

Oops. Yeah. That could be a problem.

Today, I want to take another look at Lifeway and see how it has handled this dairy disaster. Lifeway went into 2003 with $7.8 million in net cash and equivalents. Halfway through 2004, the firm has now amassed $11.2 million. Because of the almost total absence of stock dilution at Lifeway, shares outstanding remained steady at 8.4 million.

Net earnings were $1.2 million for the first half of 2004, down from $1.7 million in the first half of 2003, when the company recorded a $1.2 million gain from a property sale. That's the GAAP picture; now let's look at free cash flow. Historically, Lifeway's free cash flow has approximated or exceeded its reported GAAP earnings. In the first half of 2004, however, the company produced $321,000 in free cash flow in Q1 and $536,000 in Q2, for a total of $857,000. That's considerably less "real money" than the company made under GAAP, but it also represents much less of a decline (from last year's $858,000 in free cash flow) than occurred under GAAP.

Because we generally consider free cash flow to provide a better measure of a business's true profitability than GAAP gives, there are two conclusions we can draw from the above. First, that Lifeway did not actually suffer as much from the milk price hikes, as the GAAP numbers would suggest. Second, that year-on-year growth in free cash flow was still stagnant.

However, comments voiced by Lifeway management in the recently released 10-Q suggest that this could change in the second half. Milk prices are said to be on the decline, yet the company has already phased in price increases for its products. Lifeway shareholders will be hoping that this translates into healthier results in the third quarter than we saw in the first two.

Fool contributor Rich Smith no longer owns shares in Lifeway Foods.