U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-KSB

 

 

Commission file number: 0-17363

 

 

 

 

LIFEWAY FOODS, INC.

(Name of small business issuer in its charter)

 

 

Issuer’s telephone number:
(847) 967-1010

 

Securities registered under Section 12(b) of the Exchange Act:

None

 

Securities registered under Section 12(g) of the Exchange Act:

Common Stock, No Par Value

 

Check whether the issuer is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  o

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.  þ

 

The issuer’s revenues for its most recent fiscal year were: $27,720,713

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates (approximately 4,263,682 shares) computed by reference to the price at which the stock was sold as of March 1, 2007 ($9.34 per share as quoted on the National Market System of the Nasdaq Stock Market) was: $39,822,790.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o     No þ

 

(APPLICABLE ONLY TO CORPORATE REGISTRANTS)

 

The number of shares outstanding of each of the issuer’s classes of common equity, as of March 1, 2007 is 16,897,826 shares of Common Stock.

 

DOCUMENTS INCORPORATED BY REFERENCE:

 

Portions of the Notice of Annual Meeting and Proxy Statement, to be filed no later than April 30, 2007, for the Registrant’s 2007 Annual Meeting of Shareholders, scheduled to be held June 9, 2007, are incorporated by reference in Part III.

 

Transitional Small Business Disclosure Format (check one):  Yes o     No þ

 

 

LIFEWAY FOODS, INC.

 

Table of Contents

 

 

CAUTIONARY STATEMENT IDENTIFYING IMPORTANT FACTORS
THAT COULD CAUSE THE COMPANY’S ACTUAL RESULTS TO
DIFFER FROM THOSE PROJECTED IN FORWARD LOOKING STATEMENTS

 

In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, readers of this document and any document incorporated by reference herein, are advised that this document and documents incorporated by reference into this document contain both statements of historical facts and forward looking statements. Forward looking statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those indicated by the forward looking statements. Examples of forward looking statements include, but are not limited to (i) projections of revenues, income or loss, earnings or losses per share, capital expenditures, dividends, capital structure and other financial items, (ii) statements of Lifeway Foods, Inc.’s plans and objectives, including the introduction of new products, or estimates or predictions of actions by customers, suppliers, competitors or regulatory authorities, (iii) statements of future economic performance, and (iv) statements of assumptions underlying other statements and statements about Lifeway Foods, Inc. or its business.

 

This document and any documents incorporated by reference herein also identify important factors which could cause actual results to differ materially from those indicated by forward looking statements. These risks and uncertainties include price competition, the decisions of customers or consumers, the actions of competitors, changes in the pricing of commodities, the effects of government regulation, possible delays in the introduction of new products, customer acceptance of products and services, and other factors which are described herein and/or in documents incorporated by reference herein.

 

The cautionary statements made pursuant to the Private Litigation Securities Reform Act of 1995 above and elsewhere by Lifeway Foods, Inc. (“Lifeway” or the “Company”) should not be construed as exhaustive or as any admission regarding the adequacy of disclosures made by Lifeway prior to the effective date of such act. Forward looking statements are beyond the ability of Lifeway to control and in many cases we cannot predict what factors would cause results to differ materially from those indicated by the forward looking statements.

 

BUSINESS DEVELOPMENT

 

Lifeway Foods, Inc. commenced operations in February 1986, and was incorporated under the laws of the State of Illinois on May 19, 1986. The Company’s principal business activity is the manufacturing of probiotic, cultured, functional dairy and non-dairy health food products. Lifeway’s primary products are kefir, a drinkable dairy beverage similar to but distinct from yogurt, in several flavors sold under the name “Lifeway Kefir”; a line of various drinkable yogurts sold under the “La Fruta” and “Tuscan” brands; and “BasicsPlus,” a dairy based immune-supporting dietary supplement beverage. The Company also produces several soy-based kefir beverages under the “SoyTreat” trademark. In addition to the drinkable products, Lifeway manufactures “Lifeway Farmer Cheese,” a line of various farmer cheeses; “Sweet Kiss,” a fruit sugar-flavored spreadable cheese similar in consistency to cream cheese; and a line of assorted fruit and vegetable flavored cream cheese under the brand “Cream Cheese Gourmet.” The Company also manufactures and markets a vegetable-based seasoning under the “Golden Zesta” brand. In the Chicago metropolitan area, Lifeway distributes its products on its own trucks and via one distributor. The Company distributes “Cream Cheese Gourmet” branded cream cheese products in the Philadelphia metropolitan area using its own trucks. Lifeway manufactures all of its products at Company-owned facilities and distributes its products primarily throughout the United States.

 

SUBSIDIARY ENTITIES

 

On September 30, 1992, Lifeway formed a wholly-owned subsidiary, LFI Enterprises, Inc. (“LFIE”), incorporated in the State of Illinois. Until August 1, 2001, LFIE operated a “Russian” theme restaurant and supper club facility. On August 1, 2001, Lifeway ceased operations at the facility after condemnation proceedings

were initiated by the Village of Niles, Illinois, which sought to control the property for municipal purposes. This property was sold in January 2003 for a capital gain of approximately $1.2 million.

 

On March 19, 2004, LFIE formed Lifeway Foods Canada, LLC, an Illinois limited liability company (“LFC”), to serve as a holding company for prospective operations within Canada. LFIE is the manager and sole member of LFC.

 

On July 26, 2004, Lifeway, by its subsidiary, LFIE, acquired certain assets and inventory of Ilya’s Farms, Inc., a twelve year old, privately-held gourmet cream cheese producer based in the Philadelphia metropolitan area. No prior relationship existed between Ilya’s Farms, Inc. or its principal, Michael Kofman, and either the Company or LFIE.

 

The total cash purchase consideration of $575,600 for the assets and inventory of Ilya’s Farms, Inc. was paid by LFIE in cash from Company funds without financing. Additionally, there are certain royalty payments to be made in connection therewith. The Company provided a guaranty of payment for the transaction. The acquisition included approximately $64,000 of tangible assets (including certain manufacturing equipment and a delivery truck) and inventory as well as the brand name “Ilya’s Farms” and other trademarks and the recipes and manufacturing processes previously used by Ilya’s Farms, Inc. The equipment acquired by LFIE from Ilya’s Farms, Inc. was previously used to manufacture cream cheese products. The inventory which was purchased by LFIE consisted entirely of different varieties of cream cheese. The founder of Ilya’s Farms, Inc., Michael Kofman, assisted LFIE over a one-month transition period and is available, if needed, on a consulting basis going forward. Additionally, LFIE has hired the 10 employees formerly employed by Ilya’s Farms, Inc.

 

On August 3, 2006, the Company acquired all of the issued and outstanding stock of Helios Nutrition, Ltd. (“Helios”) from the stockholders of Helios for a combination of 202,650 shares of the Company’s common stock, $2,500,000 in cash, and a promissory note issued by the Company in favor of Amani Holdings, LLC in the principal amount of $4,200,000.

 

BUSINESS OF ISSUER

 

PRODUCTS

 

Lifeway’s primary product is kefir, which, like the better-known product of yogurt, is a fermented dairy product. Kefir has a slightly effervescent quality, with a taste similar to yogurt and a consistency similar to buttermilk. It is a product distinct from yogurt because it incorporates the unique microorganisms of kefir as the cultures to ferment the milk. Lifeway’s Kefir is a drinkable product intended for use as a breakfast meal or a snack, or as a base for lower-calorie dressings, dips, soups or sauces. Kefir is also used as the base of Lifeway’s plain farmer’s cheese, a cheese made without salt, sugar or animal rennet. In addition, kefir is the primary ingredient of Lifeway’s “Sweet Kiss” product, a fruit sugar-flavored, cream cheese-like spread which is intended to be used as a dessert spread or frosting.

 

Kefir contains a unique mixture of several live microorganisms and nutrients such as proteins, minerals and vitamins. Kefir is highly digestible and, due to its acidity and enzymes, stimulates digestion of other foods. Kefir is considered to be the most favorable milk product for people suffering from genetically-based lactose intolerance. A study published in the May 2003 issue of the Journal of the American Dietetic Association suggests that kefir improves lactose digestion and tolerance in adults with lactose maldigestion. Studies also indicate that kefir may stimulate protein digestion and appetite, decrease the cholesterol content in blood, improve salivation and excretion of stomach and pancreatic enzymes and peristalsis. As compared to yogurt, many naturopathic practitioners consider kefir to be the best remedy for digestive troubles because it has a very low curd tension (the curd breaks up very easily into small particles). The curd of yogurt, on the other hand, holds together or breaks into lumps. The small size of the kefir curd facilitates digestion by presenting a large surface area on which digestive agents may work.

 

Kefir is a good source of calcium, protein, and Vitamin B-complex. In addition, because the fermentation process produces a less sour tasting product than yogurt, less sugar is required to make a desirable product, and the end product contains fewer calories than regular yogurt.

 

Lifeway currently sells some or all of the products listed below, except as specifically noted, to various retail establishments including supermarkets, grocery stores, gourmet shops, delicatessens and convenience stores.

 

LIFEWAY’S KEFIR.  “Lifeway’s Kefir” is a drinkable kefir product manufactured in ten regular and low-fat varieties, including plain, raspberry, blueberry, strawberry, cherry, peach, banana-strawberry, cappuccino, chocolate and vanilla, and sold in 32 ounce containers featuring color-coded caps and labels describing nutritional information. In March 1996, Lifeway began marketing its non-fat, low cholesterol kefir in six flavors — plain, raspberry, strawberry, strawberry-banana, peach and blueberry. The kefir product is currently marketed under the name “Lifeway’s Kefir,” and is typically sold by retailers from their dairy sections.

 

LIFEWAY’S ORGANIC SOYTREAT.  “SoyTreat” is a soy alternative to dairy kefir and is made from organic soy milk, which is derived from non-genetically modified soybeans. SoyTreat can be consumed by those who desire the benefits of kefir, but are lactose intolerant or interested in a soy-based alternative to milk. SoyTreat also provides 6.25g of soy protein per serving, and features the United States Food and Drug Administration-approved health claim, “25g of soy protein a day as part of a diet low in saturated fat can help lower cholesterol and reduce the risk of heart disease.” At present SoyTreat is manufactured in five flavors: strawberry, apple, peach, coconut and coffee latte.

 

LIFEWAY’S ORGANIC KEFIR.  “Lifeway’s Organic Kefir” meets the organic standards and specifications of the United States Department of Agriculture for organic products and is manufactured in four flavors: plain, raspberry, strawberry and peach. Lifeway’s Organic Kefir is sweetened with organic cane juice.

 

LIFEWAY’S SLIM6.  “Lifeway’s Slim6” is a line of low-fat kefir beverages with no added sugar designed for consumers who follow low-carbohydrate diets. Lifeway’s Slim6 has only 8 grams of carbohydrates and 2.5 grams of fat per 8-ounce serving and is available in five flavors: strawberries n’ cream, mixed berry, tropical fruit, strawberry-banana and an original, unsweetened version.

 

LA FRUTA DRINKABLE YOGURT.  “La Fruta” is a yogurt like drink similar to a milkshake or smoothie that is specifically formulated to accommodate the Hispanic market, the fastest growing demographic in the U.S. La Fruta is manufactured in six flavors: strawberry, mango, pina colada, banana- strawberry, horchata and tres leches.

 

LA FRUTA CHEESE.  “La Fruta Cheese” is a cheese product similar to cream cheese that is specifically formulated to accommodate the Hispanic market, the fastest growing demographic in the United States. La Fruta Cheese is manufactured in a tres leches flavor.

 

TUSCAN BRAND DRINKABLE YOGURT.  “Tuscan Brand Drinkable Yogurt” is a cultured dairy beverage mainly marketed on the East Coast and manufactured in a variety of flavors which vary depending upon distributor demand.

 

FARMER CHEESE.  “Farmer Cheese” is based on a cultured soft cheese and is intended to be used in a variety of recipes as a low fat, low-cholesterol, low-calorie substitute for cream cheese or ricotta, and is available in various styles.

 

SWEET KISS.  “Sweet Kiss” is a sweet cheese probiotic spread available in five flavors: plain, plain with raisins, apple, peach and chocolate.

 

ELITA; BAMBINO.  “Elita” and “Bambino” cheeses are low-fat, low-cholesterol kefir based cheese spreads which are marketed as an alternative to cream cheese.

 

KRESTYANSKI TWOROG.  “Krestyanski Tworog” is a European-style kefir-based soft style cheese which can also be used in a variety of recipes, eaten with a spoon, used as a cheese spread, or substituted in recipes for cream cheese, ricotta cheese or cottage cheese and is marketed to consumers of various Eastern European ethnicities.

 

CREAM CHEESE GOURMET.  Lifeway produces a line of over 40 flavors of cream cheeses under the “Cream Cheese Gourmet” brand name. The different flavors are manufactured in original and low-fat varieties and include such flavors as plain, strawberry, horseradish, lox & onion, bleu cheese, pesto, cinnamon & raisin, and vegetable. The Cream Cheese Gourmet line of cream cheeses was acquired by Lifeway in the acquisition of

substantially all of the assets of Ilya’s Farms, Inc. described elsewhere in this report and is marketed primarily to smaller and ethnic grocers, delicatessens and coffee shops.

 

BASICS PLUS.  “Basics Plus” is a patented kefir-based beverage product designed to improve gastrointestinal functions, enhancing the immune system. This product contains certain “passive immunity products” purchased from GalaGen, Inc. prior to its 2002 bankruptcy as described elsewhere in this report. Lifeway is currently engaged in discussion with several potential new suppliers of passive immunity products and is not currently manufacturing this beverage.

 

KEFIR STARTER.  “Kefir Starter” is a powdered form of kefir that is sold in envelope packets and allows a consumer to make his or her own drinkable kefir at home by adding milk. Lifeway continues to develop sales of the product internationally and via the internet.

 

GOLDEN ZESTA.  “Golden Zesta” is a vegetable-based seasoning, which, because of its low sodium content, may also be used as a salt substitute and is marketed to delicatessens, gourmet shops and ethnic grocers.

 

IT’S PUDDING.  “It’s Pudding!” is the only organic pudding, produced in the following flavors, Chocolate, Vanilla, Banana and Tapioca.

 

PROBUGS.  “ProBugs” is a kefir product that contains 10 live and active kefir cultures. Aimed at children ages 2-9, ProBugs comes in two flavors, “Sublime Slime Lime^tm” and “Orange Creamy Crawler^tm” and is packaged in patented no spill spout pouches designed as cartoon bug characters Peter and Polly ProBug^tm.

 

Lifeway intends to continue to develop new products based on kefir and Farmer Cheese. There is no assurance that such products or any other new products can be developed successfully or marketed profitably.

 

DISTRIBUTION

 

With its twelve company-owned trucks, Lifeway distributes its products directly and extensively in the State of Illinois, primarily in the Chicago metropolitan area. Lifeway also distributes over 40 different assorted cream cheese products under the Cream Cheese Gourmet brand name in the Philadelphia and Tri State metropolitan area.

 

In addition to the Chicago and Philadelphia and Tri State metropolitan areas, Lifeway’s products are distributed to stores throughout the United States. Lifeway has verbal distribution arrangements with various distributors throughout the United States. These verbal distribution arrangements, in the opinion of Lifeway, allow management the necessary latitude to expand into new areas and markets and establish new relationships with distributors on an ongoing basis. Lifeway has not offered any exclusive territories to any distributors.

 

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. In all areas served, distributors currently deliver the products directly to the refrigerated cases of dairy sections of their retail customers. Each distributor carries a line of Lifeway’s products on its trucks, checks the retail stores for space allocated to Lifeway’s products, determines inventory requirements of the store and places Lifeway products directly into the retailers’ dairy cases. Lifeway believes this method of distribution best serves the needs of each retail store, and is the best available means to ensure consistency and quality of product handling, quality control, flavor selection and favorable retail display. Under the distribution arrangements, each distributor must meet certain prescribed product handling, service and administrative requirements including, among others, frequency of delivery, replacement of damaged, old or substandard packages, and delivery of products directly to the refrigerated case.

 

Additionally, Lifeway has attempted international distribution of certain of its products by attempting to export to distributors operating in the Canadian provinces of Ontario and Quebec. Lifeway’s products are subject to strict import quotas imposed by the Trade Control Policy Division of the Department of Foreign Affairs and International Trade of Canada. In an attempt to address this situation, management is exploring various alternatives to permit expansion of Lifeway’s product line in Canada. Lifeway believes that it currently is in compliance with all applicable Canadian regulations.

 

MARKETING

 

Lifeway continues to promote the verifiable nutritional characteristics, purity and good taste of its kefir and kefir-based products. Lifeway primarily advertises its products through local radio stations, which advertisements are directed to both users and non-users of cultured milk products of all kinds. In addition, through newspaper and magazine advertising, Lifeway provides educational information on its products and appeals to the common perception that the products may be of particular benefit for a wide range of ills, including intestinal disorders, and continues to educate the public on the possible health benefits which could be derived from the use of kefir and kefir-based products. Lifeway believes that the potential for healthful benefits as suggested by the educational information it has obtained properly serves as the basis for such an advertising strategy.

 

In addition to local radio stations, newspapers and magazines, Lifeway promotes further exposure of its products through the internet, catalog advertising and promotion, store demonstrations throughout the United States, and participation in various trade shows. Lifeway also sponsors several different sporting events in the Chicago metropolitan area as an additional marketing tool.

 

Lifeway does not promote products manufactured under the LaFruta and Tuscan brand names with any marketing or advertising.

 

COMPETITION

 

Although Lifeway faces a small amount of direct competition in the United States and Canadian markets for kefir products, Lifeway’s kefir-based products compete with all other yogurt and other dairy products. Many producers of yogurt and other dairy products are well-established and have significantly greater financial resources than Lifeway to promote their products.

 

In connection with the certain Stockholders’ Agreement, as amended, between Lifeway, Danone Foods, Inc. and other parties, as well as certain other transactions between these two foregoing companies described elsewhere in this report, the parties agreed that they would not compete with each other during the term of the Stockholders’ Agreement, as extended, with respect to certain yogurt, cheese and kefir products. Specifically, Lifeway agreed not to produce or sell in the United States or Western Europe any type of yogurt, fromage frais, Italian style cheese, chilled desserts or any soy-based products, other than those that are kefir-based or those that were already being produced and sold by Lifeway as of December 24, 1999; and Danone agreed not to produce or sell any type of kefir-based products in the United States. On December 26, 2006, the term of the Stockholders’ Agreement was extended to December 31, 2007.

 

SUPPLIERS

 

Lifeway purchases its raw materials, such as milk, sugar and fruit from unaffiliated suppliers, and is not limited or contractually bound to any supplier. Lifeway has ready access to multiple suppliers for all of its raw materials and packaging requirements. Prior to making any purchase, Lifeway determines which supplier can offer the lowest price for the highest quality of product. The raw and packaging materials purchased by Lifeway are considered commodity items and are widely available on the open market with the exception of the licensed ingredient in BasicsPlus. Lifeway owns and operates the means of production of all of its products.

 

MAJOR CUSTOMERS

 

Lifeway distributes its products to numerous accounts throughout the United States. Concentrations of credit with regard to trade accounts receivable and sales are limited due to the fact that Lifeway’s customers are spread across different geographic areas. The customers are concentrated in the retail food industry. In 2006, Lifeway’s largest customer represented approximately 9% of sales and reflected sales in various regions of the United States outside the Chicago, Illinois metropolitan area.

 

TRANSACTIONS WITH GROUPE DANONE SA

 

All share amounts and prices in this subsection are historical and have not been adjusted for the stock split which occurred in the first quarter of 2004 or in the second quarter of 2006. On October 1, 1999, Lifeway and certain

members of the Smolyansky family sold shares of restricted common stock to Danone at $10.00 per share. Later in 1999, Danone purchased additional shares of common stock from certain individuals, including shares purchased in transactions with certain Company affiliates, including Lifeway’s founder Michael Smolyansky, Val Nikolenko, Vice President of Production and Pol Sikar, a director, and his affiliates. As a result of these transactions, Danone became the beneficial owner of 20% of the outstanding common stock of Lifeway. Pursuant to the terms and conditions of the transaction, Lifeway granted certain limited rights to Danone, which include a right to nominate one director, anti-dilutive rights relating to future offerings and limited registration rights. In addition, as described above, Lifeway and Danone are parties to a Stockholders’ Agreement dated October 1, 1999, pursuant to which the parties agreed that they would not compete with each other through December 30, 2005 with respect to certain yogurt, cheese and kefir products. The Stockholders’ Agreement also provides that Danone may not own more than 20% of the outstanding common stock of Lifeway as a result of direct or indirect acquisition of shares. Danone’s interest as of December 31, 2006 was approximately 20.1% due to reductions in Lifeway’s shares outstanding, primarily due to share repurchases by Lifeway. On December 26, 2006, the term of the Stockholders’ Agreement was extended to December 31, 2007. The ability of Danone to sell such a large stake in Lifeway could have a negative effect on the Company’s stock price.

 

PATENTS, TRADEMARKS, LICENSES, ROYALTY AGREEMENTS

 

All trademark registrations have been granted by the United States Patent and Trademark Office (“USPTO”), unless otherwise noted below. Each trademark registration may be renewed upon expiration. Lifeway intends to make all timely filings as required for all trademarks listed.

 

 

PATENTS, TRADEMARKS, LICENSES, ROYALTY AGREEMENTS

 

Lifeway also uses the following unregistered trademarks, and claims common law rights to: “Elita,” “Healthy Foods Today for a Better Life Tomorrow,” “Milkshake Smoothie,” “Toplenka,” “White Cheese,” “Drink It to Be Beautiful Inside and Out,” and “Cream Cheese Gourmet.”

 

On December 27, 1990, Lifeway purchased the Tuscan brand-name liquid drinkable yogurt customer list along with a limited license of the trademark and use of the Tuscan liquid yogurt U.P.C. codes from a third party.

 

In October 1998 Lifeway entered into a sublicense agreement with GalaGen, Inc. and Metagenics, Inc. with an effective date of May 1, 1998 (“Lifeway sublicense”), wherein GalaGen sublicensed patent rights of Metagenics for kefir-based products containing natural immune components exclusively to Lifeway. Under the rights granted to it by the Lifeway sublicense, Lifeway manufactures and sells products using the Basics Plus trademark. GalaGen had acquired the primary license for such patent rights in an agreement executed with Metagenics in April 1998. The terms of the Lifeway sublicense provide that Metagenics will permit Lifeway to continue to have the exclusive patent rights to produce or sell kefir-based products containing natural immune components in the event the original license between GalaGen and Metagenics is terminated, and such termination was not caused by Lifeway. On February 25, 2002, GalaGen filed a petition for bankruptcy in the Unites States Bankruptcy Court, District of Minnesota, which terminated both its primary license with Metagenics and its participation in the Lifeway sublicense. The license and sublicense were excluded from the sale of assets of GalaGen pursuant to an order of the Bankruptcy Court. Lifeway has not received any indication that Metagenics will not permit Lifeway to continue to

have the exclusive patent rights to produce or sell kefir-based products containing natural immune components. Thus, Lifeway believes that it continues to have the exclusive patent rights licensed directly from Metagenics. Either party may terminate the license agreement for cause. The term of the license agreement expires when the last valid claim of the patent rights expires, which currently is July 2, 2013, however, this term can be extended in accordance with the terms of the license agreement.

 

In connection with the purchase of Ilya’s Farm, Inc., the Company has undertaken a royalty obligation of 5% of all sale of Ilya’s Farm, Inc.’s products, which is paid quarterly, in arrears.

 

REGULATION

 

Lifeway is subject to regulation by federal, state and local governmental authorities regarding the distribution and sale of food products. Although Lifeway believes that it currently has all material government permits, licenses, qualifications and approvals for its operations, there can be no assurance that Lifeway will be able to maintain its existing licenses and permits or to obtain any future licenses, permits, qualifications or approvals which may be required for the operation of Lifeway’s business.

 

Lifeway believes that it is currently in compliance with all applicable environmental laws and that the cost of such compliance was not material to the financial position of Lifeway.

 

In addition, any Lifeway products exported to Canada would be subject to strict quotas imposed by the Trade Control Policy Division of the Department of Foreign Affairs and International Trade of Canada. Lifeway believes that it currently is in compliance with all applicable Canadian regulations. The Company exported $5000 in products to Canada in 2006.

 

RESEARCH AND DEVELOPMENT

 

Lifeway continues its program of new product development, centered around the nutritional and “low calorie” features of its proprietary kefir formulas.

 

Lifeway conducts primarily all of its research internally, but at times will employ the services of an outside testing facility. During 2006 and 2005, the amount Lifeway expended for research and new product development was not material to the financial position of Lifeway.

 

EMPLOYEES

 

Lifeway currently employs approximately 120 employees, all of whom are full-time employees. Substantially all of these employees are engaged in the manufacturing of the Company’s products. None of Lifeway’s employees are covered by collective bargaining agreements.

 

On May 16, 1988, Lifeway purchased an approximately 26,000 square foot parcel of real property, including an approximately 8,500 square foot one-story brick building in good condition, located at 7625 N. Austin Avenue, Skokie, Illinois. Lifeway uses this facility for manufacturing and storage and has no plans to improve or renovate this property. The acquisition loan to Lifeway from 1st National Bank of Morton Grove, collateralized by the real estate, was refinanced in 1998 by Lifeway and paid off in full on February 21, 2002. Lifeway is the only occupant of this property and presently holds fee simple title free and clear of all encumbrances thereto. The value of this property may be subject to real estate market forces that typically affect industrial real estate in the area immediately surrounding the property. The Company’s book value for this property is approximately $529,172.

 

On October 16, 1996, Lifeway purchased a 110,000 square foot commercially-zoned parcel of real property, including a 46,000 square foot one-story brick building in good condition, located at 6431 Oakton Avenue, Morton Grove, Illinois. This property is used as Lifeway’s corporate headquarters and main manufacturing facility. This property has been improved every year since the time of purchase by the addition of custom-built refrigerated storage space and the addition of various machinery and equipment used to manufacture, package and store Lifeway’s products. Lifeway is the only occupant of this property and presently holds fee simple title subject to a

mortgage which secures the property as collateral for the acquisition loan to Lifeway from MB Financial Bank of Morton Grove. The acquisition loan was refinanced in September 2006 at a rate of 7% and is payable in monthly principal and interest installments of $3,273, with a balloon payment of $416,825 due in September 2011. At December 31, 2006, the loan had a balance of $453,355. The value of this property may be subject to real estate market forces that typically affect industrial real estate in the area immediately surrounding the property. The Company’s book value for this property is approximately $1,229,054.

 

In June, 2005 the Company purchased a 100,000-square-foot distribution and warehousing facility that is equipped with 40,000 square feet of refrigeration. The facility, located at 6101 Gross Point Road in Niles, Illinois, will be used to store raw materials and finished goods in order to relieve space pressures at the Company’s existing 50,000-square foot building, less than a mile away. The additional space at the Company’s main plant will be used to expand production capacity for the Company’s kefir and other probiotic products. Lifeway is the only occupant of this property and presently holds fee simple title subject to a mortgage which secures the property as collateral for the acquisition loan to Lifeway from Harris Bank at a rate of 5.6% and is payable in monthly principal and interest installments of $19,513 with a balloon payment of $2,652,142.70 due July 14, 2010. At December 31, 2006, the loan had a balance of $2,905,288. The value of this property may be subject to real estate market forces that typically affect industrial real estate in the area immediately surrounding the property. The Company’s book value for this property is approximately $4,324,309.

 

Included in the purchase of Pride of Main Street Dairy on August 3, 2006, Lifeway acquired an approximately 35,000 square foot commercially zoned parcel of real estate located at 214 Main Street S, Sauk Centre, MN, including a 16,000 square foot two-story brick building used for production, and a 5,600 square foot storage facility. This property is used as the main headquarters and main production facility for Pride of Main Street Dairy. The building was built in the 1920’s with addition in 1990. The facility is being used to produce all of the Pride of Main Street Dairy products, and approximately 70% of the Helios Nutrition Organic Kefir, with the remaining 30% being produced in Lifeway’s main production facility in Morton Grove, Illinois. Pride of Main Street is the only occupier of this property and presently holds fee simple title free and clear of all encumbrances thereto. The value of this property may be subject to real estate market forces that typically affect industrial real estate in the area immediately surrounding the property. The Company’s book value for this property is approximately $98,932.

 

For financial statement and tax purposes, Lifeway depreciates its buildings and improvements on a straight line basis over 31 and 39 years.

 

Management believes that Lifeway has adequate insurance coverage for all its properties.

 

Lifeway is from time to time engaged in litigation matters arising in the ordinary course of business none of which presently is expected to have a material adverse effect on its business results or operations.

 

No matter was submitted during the fourth quarter of the fiscal year ended December 31, 2006, to a vote of security holders through the solicitation of proxies or otherwise.

 

MARKET INFORMATION

 

Lifeway’s Common Stock, no par value, the only class of common equity of Lifeway, is traded on The Nasdaq Stock Market National Market System under the symbol “LWAY.” Trading commenced on March 29, 1988.

 

The range of high and low bid quotations for Lifeway’s Common Stock for the quarterly periods within the two most recent fiscal years, as reported by The Nasdaq Stock Market National Market System, is set forth in the following table:

 

 

Note: The foregoing quotations have been adjusted for the August 14, 2006 two-for-one company stock split.

 

As of March 1, 2007, there were approximately 83 holders of record of Lifeway’s Common Stock. The Company has no information regarding beneficial owners whose shares are held in street name.

 

DIVIDENDS

 

Lifeway has paid no cash dividends on its Common Stock and management does not anticipate that such dividends will be paid in the foreseeable future.

 

SALES OF UNREGISTERED SECURITIES

 

There were no sales of unregistered securities in 2006, 2005 or 2004 other the than issuance of 202,650 shares of Common Stock in payment of a portion of the purchase price for the acquisition by the Company on August 3, 2006 of all of the issued and outstanding stock of Helios Nutrition, Ltd. These shares were issued in reliance upon applicable exemptions from registration under Section 4(2) of the Securities Act of 1933, as amended.

 

PURCHASES OF THE COMPANY’S SECURITIES

 

SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES*

 

 

 

EQUITY COMPENSATION PLAN INFORMATION

 

 

 

 

 

Comparison of Quarter Ended December 31, 2006 to Quarter Ended December 31, 2005

 

The following analysis should be read in conjunction with the audited financial statements of the Company and related notes included elsewhere in this annual report and the unaudited financial statements and Management’s Discussion and Analysis contained in our Form 10-QSB, for the fiscal quarters ended March 31, 2006, June 30, 2006, and September 30, 2006.

 

RESULTS OF OPERATIONS

 

Sales increased by $2,686,066,(approximately 52%) to $7,893,644 during the three month period ended December 31, 2006 from $5,207,578 during the same three month period in 2005. This increase is primarily attributable to increased sales and awareness of Lifeway’s flagship line, Kefir, as well as the acquisition of the Helios Organic Kefir line and the Pride of Main Street milk line. Helios Nutrition and its subsidiary, Pride of Main Street Dairy, which were acquired August 3, 2006, accounted for a total of $1,276,384 in sales, with the Helios kefir brand accounting for $1,092,284 in sales, and the Pride of Main Street line accounting for $184,100 in sales.

 

Sales for the existing Lifeway Foods line increased by $1,411,282 (approximately 27%) to $6,617,250 during the three-month period ended December 31, 2006 from $5,207,578 during the same three-month period in 2005. This increase is primarily attributable to increased sales and awareness of Lifeway’s existing s flagship line, Kefir, as well as Lifeway’s new kids kefir drink, Probugs^tm.

 

Cost of goods sold as a percentage of sales was approximately 70% during the fourth quarter 2006, compared to about 67% during the same period in 2005. This increase is attributable to the acquisition of Helios Nutrition and its subsidiary, Pride of Main Street Dairy on August 3, 2006. The cost of goods sold component, as a percentage of sales for Helios and its subsidiary was approximately 80% for the period following the acquisition. We believe as we continue to consolidate raw material purchases, transportation costs, and production operations, this cost of goods component will decrease.

 

Operating expenses as a percentage of sales was approximately 20% during the fourth quarter 2006, compared to about 15% during the same period in 2005. This increase is primarily attributable to legal expenses associated with the acquisition of Helios Nutrition and its subsidiary, Pride of Main Street. In addition, the operating expenses

as a percentage of sales component for Helios and its subsidiary was approximately 30% for the period following the acquisition. We believe as we continue to consolidate our overall operations, this operating expense component will decrease.

 

Total other income for the three months ended December 31, 2006 was $47,808, compared with $181,183 during the same period in 2005. This decrease is primarily attributable to the interest expense related to the $4.2 million dollar note payable issued for the acquisition of Helios Nutrition on August 3, 2006. The interest expense related to this note was approximately $54,080. Full details of this note are discussed in Note 8 of the notes to the financial statements.

 

Comparison of Year Ended December 31, 2006 to Year Ended December 31, 2005

 

Sales increased by $7,589,059,(approximately 38%) to $27,720,713 during the twelve month period ended December 31, 2006 from $20,131,654 during the same twelve month period in 2005. This increase is primarily attributable to increased sales and awareness of Lifeway’s flagship line, Kefir, as well as the acquisition of the Helios Organic Kefir line and the Pride of Main Street milk line. Helios Nutrition and its subsidiary, Pride of Main Street Dairy, which were acquired August 3, 2006, accounted for a total of $2,173,998 in sales, with the Helios kefir brand accounting for $1,856,237 in sales, and the Pride of Main Street line accounting for $317,761 in sales.

 

Sales for the existing Lifeway Foods line increased by $5,415,061 (approximately 27%) to $25,546,715 during the twelve-month period ended December 31, 2006 from $20,131,654 during the same twelve-month period in 2005. This increase is primarily attributable to increased sales and awareness of Lifeway’s existing s flagship line, Kefir, as well as Lifeway’s new kids kefir drink, Probugs^tm.

 

Cost of goods sold as a percentage of sales was approximately 62% in 2006, compared to about 60% in 2005. This increase is attributable to the acquisition of Helios Nutrition and its subsidiary, Pride of Main Street Dairy on August 3, 2006. The cost of goods sold as a percentage of sales component for Helios and its subsidiary was approximately 70% for the period following the acquisition.

 

We believe as we continue to consolidate raw material purchases, transportation costs, and production operations, this cost of goods component will decrease.

 

Operating expenses as a percentage of sales was approximately 23% in 2006, compared to about 23% in 2005. Included in operating expenses is the component, general and administrative expenses, which increased 48% to $3,343,341 in 2006 from $2,253,076. This increase is primarily attributable to the legal and regulatory expenses related to the stock split and the Helios acquisition. Even though we incurred these one-time expenses in 2006, we were able to keep the overall operating expenses as a percentage of sales equal to that in 2005.

 

Amortization expense during the years ended 2006 and 2005 was $186,278 and $65,442, respectively. This increase is attributable to the amortization of the intangible assets acquired from Helios Nutrition and its subsidiary, Pride of Main Street on August 3, 2006.

 

Total other income for 2006 was $410,773, compared with $681,703 during the same period in 2005. This decrease is primarily attributable to the interest expense related to the $4.2 million dollar note payable issued for the acquisition of Helios Nutrition on August 3, 2006. The interest expense related to this note was approximately $133,310. Full details of this note are discussed in Note 8 of the notes to the financial statements.

 

Provision for income taxes was $1,745,075, or a 37.6% tax rate in 2006 compared with $1,534,592, or a 37.6% tax rate in 2005. Income taxes are discussed in Note 9 of the Notes to Consolidated Financial Statements.

 

Total net income for the group was $2,895,824, or $.17 per split adjusted share for the twelve months ended December 31, 2006, compared with $2,548,473 or $.15 per split adjusted share in the same period in 2005. This represents a 14% year over year increase.

 

SOURCES AND USES OF CASH IN 2006

 

Net cash used in investing activities was $3,456,474 during the twelve months ended December 31, 2006, which is a decrease of $2,110,507 compared to the same period in 2005. This decrease is primarily due to the

Company’s purchase of a storage and distribution facility in 2005 of approximately $4.2 million. The company also used $2,551,679 net of cash acquired to purchase Helios Nutrition. The acquisition is discussed in Note 1 of the Notes to Consolidated Financial Statements.

 

Net cash used by financing activities was $1,507,298 during the twelve months ended December 31, 2006, which is an increase of net cash used of $4,062,575 compared to $2,555,286 of net cash provided by financing activities during the same period in 2005. This decrease is primarily attributable to the Company financing the purchase of the above- mentioned facility in 2005. The Company took out a $3 million dollar note that has a maturity of 5 years, at an interest rate of 5.6%. The Company also purchased 100,000 shares of its treasury stock at a cost of $648,634 in the twelve months of 2006. In the first twelve months of 2005, the Company purchased 100,000 shares of its treasury stock at a cost of $401,554.

 

A significant portion of our assets are held in marketable securities. The majority of our marketable securities are classified as available-for-sale on our balance sheet, while the mortgage-backed securities are classified as trading. All of these securities are stated thereon at market value as of the end of the applicable period. Gains and losses on the portfolio are determined by the specific identification method.

 

We anticipate being able to fund the Company’s foreseeable liquidity requirements internally. We continue to explore potential acquisition opportunities in our industry in order to boost sales while leveraging our distribution system to consolidate and lower costs.

 

Other Developments

 

On May 23, 2005, Lifeway’s Board of Directors approved awards of an aggregate amount of 5,600 shares to be awarded under its Employee and Consulting Services and Compensation Plan to certain employees and consultants for services rendered to the Company. The stock awards were made on June 1, 2005 and have vesting periods of one year. The expense for the awards is measured as of June 1, 2005 at $12.50 per share for 5,600 shares, or a total stock award expense of $70,000. This expense was recognized as the stock awards vest in 12 equal portions of $5,833, or 466 shares per month for one year.

 

Off-Balance Sheet Arrangements

 

We have never entered into any off-balance sheet financing arrangements and have never established any special purpose entities. We have not guaranteed any debt or commitments of other entities or entered into any options on non-financial assets.

 

Critical Accounting Policies

 

Lifeway’s analysis and discussion of its financial condition and results of operations are based upon its consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). The preparation of financial statements in accordance with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. US GAAP provides the framework from which to make these estimates, assumptions and disclosures. Lifeway chooses accounting policies within US GAAP that management believes are appropriate to accurately and fairly report Lifeway’s operating results and financial position in a consistent manner. Management regularly assesses these policies in light of current and forecasted economic conditions and has discussed the development and selection of critical accounting policies with its audit committee of the Board of Directors. For further information concerning accounting policies, refer to Note 2 — Nature of Business and Significant Accounting Policies in the notes to the consolidated financial statements.

 

Forward Looking Statements

 

In this report, in reports subsequently filed by Lifeway with the SEC on Form 10-QSB and filed or furnished on Form 8-K, and in related comments by management, our use of the words “believe,” “expect,” “anticipate,” “estimate,” “forecast,” “objective,” “plan,” “goal,” “project,” “explore,” “priorities/targets,” and similar expressions is intended to identify forward-looking statements. While these statements represent our current judgment on what

the future may hold, and we believe these judgments are reasonable, actual results may differ materially due to numerous important factors that are described in this report and other factors that may be described in subsequent reports which Lifeway may file with the SEC on Form 10-QSB and filed or furnished on Form 8-K, including but not limited to:

 

 

The annotated consolidated financial statements of the Company that constitute Item 7 of this report commence on the pages that follow this page.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Stockholders of

Lifeway Foods, Inc. and subsidiaries

 

We have audited the accompanying balance sheet of Lifeway Foods, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005 and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Lifeway Foods, Inc. and subsidiaries as of December 31, 2006 and 2005 and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

 

/s/ Plante & Moran, PLLC

 

Elgin, IL

April 2, 2007

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

CONSOLIDATED FINANCIAL STATEMENTS

 

DECEMBER 31, 2006 and 2005

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Consolidated Statements of Financial Condition

December 31, 2006 and 2005

 

 

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Consolidated Statements of Income and Comprehensive Income

For the Years Ended December 31, 2006 and 2005

 

 

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Consolidated Statements of Changes in Stockholders’ Equity

For the Years Ended December 31, 2006 and 2005

 

 

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2006 and 2005

 

 

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

December 31, 2006 and 2005

 

Note 1 — NATURE OF BUSINESS

 

Lifeway Foods, Inc. (The “Company”) commenced operations in February 1986 and incorporated under the laws of the state of Illinois on May 19, 1986. The Company’s principal business activity is the production of dairy products. Specifically, the Company produces Kefir, a drinkable product which is similar to but distinct from yogurt, in several flavors sold under the name “Lifeway’s Kefir;” a plain farmer’s cheese sold under the name “Lifeway’s Farmer’s Cheese;” a fruit sugar-flavored product similar in consistency to cream cheese sold under the name of “Sweet Kiss;” and a dairy beverage, similar to Kefir, with increased protein and calcium, sold under the name “Basics Plus.” The Company also produces several soy-based products under the name “Soy Treat” and a vegetable-based seasoning under the name “Golden Zesta.” The Company currently distributes its products throughout the Chicago Metropolitan area and various cities in the East Coast through local food stores. In addition, the products are sold throughout the United States and Ontario, Canada by distributors. The Company also distributes some of its products to Eastern Europe.

 

On August 3, 2006 the Company executed a Stock Purchase Agreement with George Economy, Amani Holdings, LLC and other shareholders (“the stockholders”) of the capital stock of Helios Nutrition, Ltd. (“Helios”) and Pride Main Street Dairy, L.L.C. pursuant to which the Company purchased all of the issued and outstanding stock of Helios from the Stockholders for a combination of an aggregate amount of 202,650 in shares of the Company’s common stock, no par value, $2,563,000 in cash, and a promissory note issued by the Company in favor of the Stockholders in the principal amount of $4,200,000. The Stock Payment, the Cash Payment and Promissory Note are subject to adjustment under certain circumstances in accordance with the terms of the Stock Purchase Agreement.

 

The final net purchase price for the assets was $8,063,000 including professional fees related to the acquisition. The following table summarizes the fair values of the assets acquired and the liabilities assumed at the date of acquisition.

 

 

At closing, $2,563,000 was paid of the total purchase, $1,300,000 was paid in stock, with the balance due as a $4,200,000 note to be paid in sixteen equal installments over sixteen quarters. The goodwill is expected to be deductible for tax purposes.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

The following unaudited proforma information presents the results of operations of the Company as if the acquisition had taken place at the beginning of 2006:

 

 

Note 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

A summary of the significant accounting policies applied in the preparation of the accompanying financial statements follows:

 

Principles of consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, LFI Enterprises, Inc., Helios Nutrition, Ltd. and Pride of Main Street, L.L.C. All significant intercompany accounts and transactions have been eliminated.

 

Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial statements include the allowance for doubtful accounts, the valuation of Goodwill and intangible assets and deferred taxes.

 

Revenue Recognition

 

Sales represent sales of Company produced dairy products that are recorded at the time of shipment and the following four criteria have been met: (i) the product has been shipped and the Company has no significant remaining obligations; (ii) persuasive evidence of an agreement exists; (iii) the price to the buyer is fixed or determinable and (iv) collection is probable. In addition, shipping costs invoiced to the customers are included in net sales and the related cost in cost of sales.

 

Cash and cash equivalents

 

All highly liquid investments purchased with an original maturity of three months or less are considered to be cash equivalents.

 

The Company maintains cash deposits at several institutions located in the greater Chicago, Illinois and Philadelphia, Pennsylvania metropolitan areas. Deposits at each institution are insured up to $100,000 by the Federal Deposit Insurance Corporation or the Securities Investor Protector Corporation.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

 

Bank Balances Of Amounts Reported By Financial Institutions Are Categorized As Follows:

 

 

Marketable securities

 

All investment securities are classified as either as available-for-sale or trading, and are carried at fair value or quoted market prices. Unrealized gains and losses on available for sale securities are reported as a separate component of stockholders’ equity. Amortization, accretion, interest and dividends, realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are recorded in other income. Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, and Emerging Issue Task Force Abstract 03-01 the meaning of other-than-temporary impairment and its application to certain investments, provide guidance on determining when an investment is other-than-temporarily impaired. This evaluation depends on the specific facts and circumstances. Factors that we consider in determining whether an other-than-temporary decline in value has occurred include: the market value of the security in relation to its cost basis; the financial condition of the investee; and the intent and ability to retain the investment for a sufficient period of time to allow for possible recovery in the market value of the investment.

 

Accounts receivable

 

Credit terms are extended to customers in the normal course of business. The Company performs ongoing credit evaluations of its customers’ financial condition and generally requires no collateral.

 

Accounts receivable are recorded at invoice amounts, and reduced to their estimated net realizable value by recognition of an allowance for doubtful accounts. The Company’s estimate of the allowance for doubtful accounts is based upon historical experience, its evaluation of the current status of specific receivables, and unusual circumstances, if any. Accounts are considered past due if payment is not made on a timely basis in accordance with the Company’s credit terms. Accounts considered uncollectible are charged against the allowance.

 

Inventories

 

Inventories are stated at the lower of cost or market, cost being determined by the first-in, first-out method.

 

Property and equipment

 

Property and equipment are stated at depreciated cost or fair value where depreciated cost is not recoverable. Depreciation is computed using the straight-line method. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to income as incurred; significant renewals and betterments are capitalized.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

 

Property and equipment are being depreciated over the following useful lives:

 

 

Intangible assets

 

The Company accounts for intangible assets at historical cost. Intangible assets acquired in a business combination are recorded under the purchase method of accounting at their estimated fair values at the date of acquisition. Goodwill represents the excess purchase price over the fair value of the net tangible and other intangible assets acquired. Goodwill is not amortized and is reviewed for impairment at least annually. The Company amortizes other intangible assets over their estimated useful lives, as disclosed in the table below.

 

The Company reviews intangible assets and their related useful lives at least once a year to determine if any adverse conditions exist that would indicate the carrying value of these assets may not be recoverable. The Company conducts more frequent impairment assessments if certain conditions exist, including: a change in the competitive landscape, any internal decisions to pursue new or different strategies, a loss of a significant customer, or a significant change in the market place including changes in the prices paid for the Company’s products or changes in the size of the market for the Company’s products.

 

If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset is amortized prospectively over the revised remaining useful life.

 

Intangible assets are being amortized over the following useful lives:

 

 

Income taxes

 

Deferred income taxes arise from temporary differences resulting from income and expense items reported for financial accounting and tax purposes in different periods. Deferred taxes are classified as current or non-current, depending on the classification of the assets and liabilities to which they relate. Deferred taxes arising from temporary differences that are not related to an asset or liability are classified as current or non-current depending on the periods in which the temporary differences are expected to reverse.

 

The principal sources of temporary differences are different depreciation and amortization methods for financial statement and tax purposes, unrealized gains or losses related to marketable securities, capitalization of indirect costs for tax purposes, and the recognition of an allowance for doubtful accounts for financial statement purposes.

 

Treasury stock

 

Treasury stock is recorded using the cost method.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

 

Advertising costs

 

The Company expenses advertising costs as incurred. During the year ended December 31, 2006 and 2005, approximately $1,435,758 and $1,176,440 of such costs respectively, were expensed.

 

Earning per common share

 

Earnings per common share were computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. For 2006 and 2005, diluted and basic earnings per share were the same, as the effect of dilutive securities options outstanding was not significant.

 

Reclassification

 

Certain 2005 amounts have been reclassified to conform to the 2006 presentation.

 

Note 3 — INTANGIBLE ASSETS

 

Intangible assets, and the related accumulated amortization, consist of the following:

 

 

Amortization expense is expected to be as follows for the years ending December 31:

 

 

Amortization expense during the years ended 2006 and 2005 was $186,278 and $65,442, respectively.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

Note 4 — MARKETABLE SECURITIES

 

The cost and fair value of marketable securities classified as available for sale and trading are as follows:

 

 

 

Proceeds from the sale of marketable securities were $7,285,071, $5,810,391 during the years ended December 31, 2006 and 2005, respectively.

 

Gross gains (loss) of $355,767 and $445,327 were realized on these sales during the years ended December 31, 2006 and 2005, respectively.

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

 

The following table shows the gross unrealized losses and fair value of Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006:

 

 

Equities, Mutual Funds and Corporate Bonds — The Company’s investments in equity securities, mutual funds and corporate bonds consist of investments in common stock and debt securities of companies in various industries. The Company evaluated the near-term prospects of the issuer in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider any material investments to be other-than-temporarily impaired at December 31, 2006.

 

Preferred Securities — The Company’s investments in preferred securities consist of investments in preferred stock of companies in various industries. The Company evaluated the near-term prospects of the security in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider any material investments to be other-than-temporarily impaired at December 31, 2006.

 

Certificates of Deposit — The unrealized losses on the Company’s investments in certificates of deposit were caused by interest rate increases since the date of purchase. The contractual terms of these investments do not permit the issuers to settle the securities at a price less than the face value of the investment. Because the Company has the ability and intent to hold these investments until maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2006.

 

Municipal Bonds — The unrealized losses on the Company’s investments in mutual bonds were caused by interest rate increases since the date of purchase. Because the Company has the ability and intent to hold these investments until maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2006.

 

Note 5 — INVENTORIES

 

Inventories consist of the following:

 

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

Note 6 — PROPERTY AND EQUIPMENT

 

Property and equipment consist of the following:

 

 

Depreciation expense during the year ended December 31, 2006 and 2005 was $572,476, $585,503, respectively.

 

Note 7 — ACCRUED EXPENSES

 

Accrued expenses consist of the following:

 

 

Note 8 — NOTES PAYABLE

 

Notes payable consist of the following:

 

 

LIFEWAY FOODS, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements — (Continued)

Maturities of notes payables are as follows:

 

 

Note 9 — PROVISION FOR INCOME TAXES

 

The provision for income taxes consists of the following: