UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 2008
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number
MGP Ingredients, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Kansas |
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48-0531200 |
(State or Other Jurisdiction |
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(I.R.S. Employer |
of Incorporation or Organization) |
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Identification No.) |
100 Commercial Street, Box 130, Atchison, Kansas |
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66002 |
(Address of Principal Executive Offices) |
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(Zip Code) |
Registrants telephone number, including area code (913) 367-1480
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class |
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Name of Each Exchange on Which Registered |
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NONE |
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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class |
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Name of Each Exchange on Which Registered |
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Common Stock, no par value |
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The NASDAQ Stock Market LLC |
Indicate by check mark if the registrant is a
well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x
Indicate by check mark if the registrant is not
required to file reports pursuant to Section 13 or Section 15(d) of
the Act.
Yes o No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to their Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of accelerated filer, large accelerated filer and smaller company: in Rule 12b-2 of the Exchange Act. (Check One):
Large accelerated filer o Accelerated filer x Non-accelerated filer o Smaller reporting company o
Indicate by checkmark whether the registrant is a
shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
The aggregate market value of common equity held by non-affiliates, computed by reference to the last sales price as reported by NASDAQ on December 31, 2007, was $111,264,170.
The number of shares of the registrants common stock outstanding as of August 31, 2008 was 16,561,948.
DOCUMENTS INCORPORATED BY REFERENCE
The following documents are incorporated herein by reference:
(1) Portions of the MGP Ingredients, Inc. Proxy Statement for the Annual Meeting of Stockholders to be held on October 16, 2008 are incorporated by reference into Part III of this report to the extent set forth herein.
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Managements Discussion and Analysis of Financial Condition and Results of Operations |
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The calculation of the aggregate market value of the Common Stock held by non-affiliates is based on the assumption that non-affiliates do not include directors or executive officers. Such assumption does not constitute an admission by the Company or any director or executive officer that any director or executive officer is an affiliate of the Company.
ii
This report contains forward-looking statements as well as historical information. All statements, other than statements of historical facts, included in this Annual Report on Form 10-K regarding the prospects of our industry and our prospects, plans, financial position and business strategy may constitute forward-looking statements. In addition, forward-looking statements are usually identified by or are associated with such words such as intend, plan, believe, estimate, expect, anticipate, hopeful, should, may, will, could and or the negatives of these terms or variations of them or similar terminology. They reflect managements current beliefs and estimates of future economic circumstances, industry conditions, Company performance and financial results and are not guarantees of future performance. All such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those contemplated by the relevant forward-looking statement. Important factors that could cause actual results to differ materially from our expectations include, among others: (i) the availability and cost of grain, (ii) fluctuations in gasoline prices, (iii) fluctuations in energy costs, (iv) competitive environment and related market conditions, (v) our ability to realize operating efficiencies, (vi) the effectiveness of our hedging programs; (vii) access to capital and (viii) actions of governments. For further information on these and other risks and uncertainties that may affect our business, see Item 1A - Risk Factors
We make available through our web site (www.mgpingredients.com) under Investors Investor Relations, free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file or furnish such material with the Securities and Exchange Commission.
iii
As used herein, unless the context otherwise requires, the terms Company, we, us, our and words of similar import refers to the combined business of MGP Ingredients, Inc. and its consolidated subsidiaries.
MGP Ingredients, Inc. is a Kansas corporation headquartered in Atchison, Kansas. It was incorporated in 1957 and is the successor to a business founded in 1941 by Cloud L. Cray, Sr.
The Company is a fully integrated producer of certain ingredients and distillery products derived from grain and has three reportable segments, ingredient solutions, distillery products and other. Our ingredient solutions segment products primarily consist of specialty proteins, specialty starches, vital wheat gluten, commodity wheat starch and mill by-products. The distillery products segment consists of food grade alcohol, fuel grade alcohol, which is commonly known as ethanol, and distillers feed and carbon dioxide, which are co-products of our distillery operations. Our other segment products are comprised of resins and plant-based polymers and composites manufactured through the further processing of certain of our proteins and starches and wood.
We purchase corn directly from local and regional farms and grain elevators which we then convert into alcohol products and distillers feed. We also purchase wheat directly from local and regional farms and grain elevators and mill it into flour and mill feeds. We process the flour with water to extract vital wheat gluten, the basic protein component of flour, which we use primarily to process into specialty wheat proteins, which possess increased protein levels and/or enhanced functional characteristics. Most wheat protein products are dried into powder and sold in packaged or bulk form. We further process the starch slurry which results after the extraction of the protein component to extract premium wheat starch, a portion of which we sell as commodity starch and a portion of which we further process into specialty starches, and all of which we dry into powder and sell in packaged or bulk form. We mix the remaining starch slurry with corn and water and then cook, ferment and distill it into alcohol. We dry the residue of the distilling operations and sell it as a high protein additive for animal feed. Carbon dioxide which is produced during the fermentation process is trapped and sold. Mill feeds not used in the distilling operations are sold to feed manufacturers.
The principal locations at which we make our products are at our plants located in Atchison, Kansas, and Pekin, Illinois. We also operate a facility in Kansas City, Kansas for the further processing and extrusion of wheat proteins and starches, and a facility in Onaga, Kansas for the production of plant-based biopolymers and wood composites. We formerly operated our Pekin facility through a wholly-owned subsidiary, MGP Ingredients of Illinois, Inc., and our Kansas City, Kansas facility through a wholly-owned subsidiary, Kansas City Ingredient Technologies, Inc. We merged both subsidiaries into the Company on June 30, 2008.
Distillery Products
Profit margins in our distillery products segment were adversely impacted by the combined effect of higher corn prices and ethanol selling at a discount to gasoline. As industry-wide ethanol production capacity continued to expand, corn prices continued to reflect increased demand related to this increased ethanol production. Corn prices also increased due to USDA projections of lower corn acres to be planted in 2008. Our hedging program, consisting of derivatives and cash purchases, partially softened the impact of rising corn prices during the year.
During the quarter ended December 30, 2007, we completed and made operational measures that were implemented in fiscal 2007 to improve capacity and strengthen alcohol production efficiencies at our distillery operations in both Atchison, Kansas and Pekin, Illinois. Additionally, during the quarter ended December 30, 2007,
1
an $11.1 million dryer system for the manufacture of distillers feed became fully operational. The purpose of this dryer was to improve production efficiencies and lower energy costs as well as fulfill emission control standards. These factors have expanded production capacity; however, we encountered certain fermentation and other issues related to the alcohol production process at the Pekin facility that resulted in a production level below maximum capacity. The fermentation issues were addressed and corrected during the second quarter of fiscal 2008, but our third quarter production remained at less than capacity due to other production issues at our Pekin facility. During the fourth quarter of fiscal 2008, we implemented a planned reduction in fuel grade alcohol production in the face of increased raw material costs for corn and higher natural gas prices, and also due to the fact that fuel alcohol prices were at levels representing a major discount to gasoline prices.
We did not reduce our production of food grade alcohol because of customer requirements and generally more favorable conditions in this market. Our long-term strategy is to shift a portion of existing capacity from the production of fuel grade alcohol towards the increased production of food grade alcohol.
We continue to evaluate options related to reducing energy costs, including seeking a third party to provide a new coal boiler facility at our Pekin, Illinois plant.
Ingredient Solutions
Profitability in our ingredient solutions segment was adversely affected by significantly increased wheat costs compared to fiscal 2007. Sales in the ingredient solutions segment experienced an improvement in fiscal 2008 compared to fiscal 2007 due to increased sales of specialty proteins, specialty starches and vital wheat gluten. These increases, combined with a modest increase in sales of mill by-products, more than offset lower sales of commodity starch. The improvement in ingredient solutions sales was consistent with our strategy of creating a higher value product mix by increasing the volume of value-added specialty ingredients while reducing the production and sales of certain lower value proteins and starches. Although the significance of wheat gluten to our business had diminished in recent years, we experienced higher sales in fiscal 2008 and 2007 than in preceding years due to increased demand resulting from poor global wheat crops which yielded lower wheat gluten supplies than previously anticipated. Further, toward the end of the fiscal 2007 and continuing in fiscal 2008, sales were affected by increased demand for safe, quality gluten backed by supply and service reliability following a major recall of pet foods containing contaminated imported wheat flour misrepresented as gluten. In response to this demand, we increased wheat gluten production at our plants in Atchison, Kansas and Pekin, Illinois.
On July 2, 2007 we acquired a 50% interest in a German joint venture company which will produce and distribute our Wheatex® textured protein products in the European Union (EU) and elsewhere. If the venture succeeds, the new company may build its own plant in the EU. We have leased an extruder to the new company and licensed it to practice our Wheatex® technology and sell the product in the EU and certain countries that are proximate to the EU. Presently we anticipate production will begin in the second quarter of fiscal 2009. As of June 30, 2008, our total capital commitment to the joint venture is $750,000, of which we have contributed $375,000.
As noted in Other below, at the end of the third quarter we incurred a non-cash pre-tax impairment charge of $8.1 million, of which $3.4 million was related to plant and equipment included in our ingredient solutions segment used in the production of some varieties of our Wheatex® textured proteins.
Other
Although sales of our plant-based biopolymers increased substantially compared to sales in fiscal 2007, they continue to represent an emerging area of our business. This product line has been created for use in the production of biobased and bio-degradable plastic-like items which are eco-friendly. While commercialization of these biopolymers has begun, they continue to undergo further research and development as we explore additional enhancements to expand their functionality and use capabilities.
As reported in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, at the completion of the third quarter of fiscal 2008, we undertook a review of our long-lived assets in our other segment and concluded that an impairment charge on these assets was appropriate. Our pet business has suffered since we lost a
2
major customer in late 2006, but high wheat prices, changing consumer preferences and failure to obtain previously anticipated new business led to this decision. Our pet business assets are located at a joint use facility, and in the course of our review we also concluded to write-down all the assets at that facility, including those associated with certain of our Wheatex® textured wheat proteins. We recorded an $8.1 million impairment charge related to these combined assets of which $4.7 million was related to assets allocated to our other segment. We are evaluating the strategic alternatives for the plant and equipment at our Kansas City facility, and are pursuing the sale of the assets which are included in our other segment.
FINANCIAL INFORMATION ABOUT SEGMENTS
Note 13 of our Notes to Consolidated Financial Statements set forth in Item 8 of this Report, which is incorporated herein by reference, includes information about sales, depreciation, income before income taxes and identifiable assets for the last three fiscal years by reportable segment. Information about sales to external customers and assets located in foreign countries is included. As stated therein, we have restated the information for prior years to reflect a change in the composition of our reportable segments.
Our strategy is to focus on the development and marketing of specialty protein and starch products, as well as our plant-based biopolymer and resin products, for use in unique market niches while preserving a leadership position as a highly efficient, quality-oriented producer and marketer of alcohol products derived from corn. As such, we seek to provide value-added ingredient solutions and high quality food grade alcohol across a range of food and non-food product applications while exploiting opportunities to supply the marketplace with fuel grade alcohol as conditions warrant.
Market trends that we hope to benefit from include health and wellness lifestyle trends in the food area, growing demand for natural versus synthetic products, and increased emphasis use of alternative fuels. Increased interest in bio-economy initiatives also may create opportunities for us, particularly in regard to our partially and totally degradable biopolymers.
We have existing manufacturing capacity to grow our ingredient solutions business if the market for this business improves further. We seek to develop a more profitable product mix of higher valued specialty wheat proteins and wheat starches, which is especially critical during times when we face increased wheat costs, such as we encountered during fiscal 2008 and, to a lesser degree, in 2007. We continue to concentrate on growing specific high end, highly functional ingredient solutions for our customers. Simultaneously, we strive to optimize the economic value of our vital wheat gluten, which traditionally has commanded lower prices than our specialty proteins and starches. Recently, we have taken steps to restructure this area of our business to more appropriately align with current production and sales requirements. These steps have included concentrating our production and marketing efforts on supplying our core base of loyal customers with a more select array of high quality, premium ingredients that address nutritional, sensory and convenience issues and that can help build value while making more efficient use of our existing capacities. We continue to step up our product innovation and commercialization efforts and have revamped the responsibilities of our technical applications scientists, who now perform a significantly more integral role as solutions providers to our customers.
As noted above, various market factors have contributed to increased prices for wheat gluten compared to previous levels in recent years. As a result, we have increased production of this product. While this product warrants our short-term focus, we maintain as our long-term goal the continued development and commercialization of our value-added wheat proteins and starches.
We continue to maintain a solid presence in the alcohol industry and pursue efforts to maintain highly efficient alcohol production operations. We can produce food grade alcohol and ethanol at both our Atchison and Pekin locations. Since early 2004, the majority of our Atchison distillerys capacity has been dedicated to the production of high quality, high purity food grade alcohol for beverage and industrial applications and the majority of the Pekin distillerys capacity has been dedicated to the production of fuel ethanol. Our fuel grade alcohol
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business represents approximately 30% of our total revenues, which we expect will decrease over time as we grow our specialty ingredients and food grade alcohol business.
We continued to experience generally favorable conditions in the food grade alcohol market in fiscal 2008, providing our customers with what we believe is among the highest quality, high purity alcohol in the world. We have been in the food grade alcohol business since the Companys founding in 1941 and intend to maintain a solid presence in the food grade area.
As stated previously, biopolymers represent an emerging and developing part of our business. Currently, we have two commercial products in the market. The first product is a bio-based resin in which a large percentage of petroleum-based plastic can be replaced with materials made from renewable sources, specifically wheat starch. These biopolymers, which serve as bio-based alternatives to traditional plastics, may be utilized in a wide range of products, such as disposable cutlery, cosmetic cases and CD cases. The second product is a wood-based resin which compounds wood and biopolymer. This product is used in the manufacture of deck boarding and other wood applications in which long-term durability is required. These products are sold directly to producers of finished products. We are also in the process of developing and commercializing a fully bio-based, fully compostable resin.
The following table shows our sales from continuing operations by each class of similar products during the past three fiscal years ended June 30, 2008, July 1, 2007 and June 30, 2006, as well as such sales as a percent of total sales.
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PRODUCT GROUP SALES |
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June 30, 2008 |
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July 1, 2007 |
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June 30, 2006 |
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(thousands of dollars) |
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Amount |
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% |
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Amount |
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% |
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Amount |
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% |
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Ingredient Solutions: |
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Specialty Proteins |
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$ |
23,204 |
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5.9 |
% |
$ |
19,197 |
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5.2 |
% |
$ |
19,816 |
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6.1 |
% |
Specialty Starches |
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36,065 |
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9.2 |
% |
28,256 |
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7.7 |
% |
31,037 |
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9.6 |
% |
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Vital Wheat Gluten |
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31,399 |
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8.0 |
% |
13,646 |
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3.7 |
% |
8,943 |
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2.8 |
% |
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Commodity Wheat Starch |
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3,737 |
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1.0 |
% |
4,052 |
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1.1 |
% |
4,627 |
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1.4 |
% |
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Mill By-Products |
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6,589 |
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1.7 |
% |
2,640 |
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0.7 |
% |
1,870 |
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0.6 |
% |
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Total Ingredients |
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$ |
100,994 |
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25.8 |
% |
$ |
67,791 |
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18.4 |
% |
$ |
66,293 |
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20.5 |
% |
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Distillery Products: |
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Food-grade Alcohol |
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$ |
113,428 |
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28.9 |
% |
$ |
98,409 |
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26.7 |
% |
$ |
79,893 |
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24.8 |
% |
Fuel-grade Alcohol |
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132,978 |
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33.7 |
% |
164,163 |
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44.7 |
% |
128,824 |
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39.9 |
% |
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Distillery Co-products |
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39,332 |
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10.0 |
% |
31,821 |
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8.6 |
% |
28,254 |
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8.8 |
% |
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Total Distillery Products |
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$ |
285,738 |
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72.6 |
% |
$ |
294,393 |
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80.0 |
% |
$ |
236,971 |
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73.5 |
% |
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Other Products: |
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$ |
6,161 |
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1.6 |
% |
$ |
5,810 |
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1.6 |
% |
$ |
19,213 |
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6.0 |
% |
Net Sales |
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$ |
392,893 |
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100.0 |
% |
$ |
367,994 |
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100.0 |
% |
$ |
322,477 |
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100.0 |
% |
Substantially all of our sales are made directly or through distributors to manufacturers and processors of finished goods. Sales to our customers purchasing food grade alcohol are made on a spot, monthly, quarterly and annual basis depending on the customers needs and market conditions. However, depending on market conditions, we sell varying amounts of our fuel alcohol under longer term contracts. Contracts with ingredients customers are generally price and term agreements which are fixed for quarterly or six month periods, with very few agreements of twelve months duration or more. During fiscal 2008, our five largest distillery products customers accounted for
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28 percent of our consolidated revenues. None of these customers individually accounted for more than 10% of our consolidate revenues for fiscal 2008. Our five largest ingredients products customers combined accounted for 11 percent of our consolidated revenues.
Our ingredient solutions segment consists primarily of specialty wheat starches, specialty wheat proteins, vital wheat gluten, commodity wheat starch and mill feeds. In recent years, our specialty wheat proteins and starches have accounted for a sizeable share of our total sales in this segment. This primarily has been due to the following factors: product mix optimization, product innovation through increased research and development, partnering with customers on product development, increased capacity to produce these products and increased marketing efforts that have resulted in greater customer recognition.
Specialty Wheat Starches. Wheat starch constitutes the carbohydrate-bearing portion of wheat flour. We produce a pure white premium wheat starch powder by extracting the starch from the starch slurry, substantially free of all impurities and fibers, and then by spray, flash or drum drying the starch. Premium wheat starch differs from low grade or B wheat starches, which are extracted along with impurities and fibers and are used primarily as a binding agent for industrial applications, such as the manufacture of charcoal briquettes. We do not produce low grade or B starches because our integrated processing facilities are able to process the slurry remaining after the extraction of premium wheat starch into alcohol, animal feed and carbon dioxide. Premium wheat starch differs from corn starch in its granular structure, color, granular size and name identification.
A substantial portion of our premium wheat starch is altered during processing to produce certain unique specialty wheat starches designed for special applications. Our strategy is to market our specialty wheat starches in special market niches where the unique characteristics of these starches are better suited to a customers requirements for a specific use. We have developed a number of different specialty wheat starches, and continue to explore the development of additional starch products with the view to increasing sales of value-added specialty starches. We produce our Fibersym® resistant starch, which has become one of our more popular specialty starches, using a patented technology referred to below under Patents. We sell our specialty starches on a nationwide basis, primarily to food processors and distributors. In addition, we sell specialty starches for non-food applications in pet treat applications and in the manufacture of biopolymer products
Our specialty wheat starches are used primarily for food applications as an additive in a variety of food products to affect their nutritional profile, appearance, texture, tenderness, taste, palatability, cooking temperature, stability, viscosity, binding and freeze-thaw characteristics. Important physical properties contributed by wheat starch include whiteness, clean flavor, viscosity and texture. For example, our starches are used to improve the taste and mouth feel of cream puffs, éclairs, puddings, pie fillings, breadings and batters; to improve the size, symmetry and taste of angel food cakes; to alter the viscosity of soups, sauces and gravies; to improve the freeze-thaw stability and shelf life of fruit pies and other frozen foods; to improve moisture retention in microwavable foods; and to add stability and to improve spreadability in frostings, mixes, glazes and sugar coatings. We also sell our specialty starches for a number of non-food applications, which include pet and biopolymer products, and for use in the manufacture of adhesives, paper coatings, carbonless paper, and wall board.
Our wheat starches compete primarily with corn starch, which dominates the United States starch market. However, the unique characteristics of wheat starch provide it with a number of advantages over corn and other starches for certain baking and other end uses. Our principal competitors in the starch market are Cargill Incorporated (primarily corn and tapioca starch), National Starch and Chemical Corporation (corn starch), Manildra Milling Corporation (wheat starch), Penford Corporation (potato starch), Archer-Daniels-Midland Company (wheat and other grain starches) and various European companies. Competition is based upon price, name, color and differing granular characteristics which affect the food product in which the starch is used. Specialty wheat starches usually enjoy a price premium over corn starches and low grade wheat starches. Commodity wheat starch price fluctuations generally track the fluctuations in the corn starch market. As we experienced in fiscal 2008, the specialty wheat starch market usually permits pricing consistent with costs which affect the industry in general, including increased grain costs. However, this is not always the case; during fiscal 2006 and fiscal 2003, increases in grain and fuel prices outpaced market price increases in the specialty wheat starch market.
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Specialty Wheat Starches
· Fibersym® Resistant Starch series. These starches serve as a convenient and rich source of dietary fiber. Unlike traditional fiber sources like bran, our resistant starches possess a clean, white color and neutral flavor that allow food formulators to create a wide range of both traditional and non-traditional fiber enhanced products that are savory in both appearance and taste. Applications include pan breads, pizza crust, flour tortillas, cookies, muffins, pastries and cakes.
· FiberRite® RW Resistant Starch. FiberRite® RW is a product that boosts dietary fiber levels while also reducing fat and caloric content in such foods as breads, sweet goods, ice cream, yogurt, salad dressings, sandwich spreads and emulsified meats.
· Pregel Instant Starch series. Our Pregel starches perform as an instant thickener in bakery mixes, allowing fruit, nuts and other particles such as chocolate pieces to be uniformly suspended in the finished product. In coating systems, batter pick-up can be controlled for improved yield and consistent product appearance. Additionally, shelf-life can be enhanced due to improved moisture retention, allowing products to remain tender and soft over an extended storage period.
· Midsol Cook-up Starch series. These starches deliver increased thickening, clarity, adhesion and tolerance to high shear, temperature and acidity during food processing. Such properties are important in products such as soups, sauces, gravies, salad dressings, fillings and batter systems. Processing benefits of these starches also include the ability to control expansion in extruded breakfast cereals. In addition, they provide textural enhancement and moisture management in processed foods, especially during storage under frozen and refrigerated conditions.
Commodity Wheat Starch. As is the case with value-added wheat starches, our commodity wheat starch has both food and non-food applications, but such applications are more limited than those of value-added wheat starches and typically sell for a lower price in the marketplace. As noted above, commodity wheat starch competes primarily with corn starches, which dominate the marketplace and prices generally track the fluctuations in the corn starch market.
Specialty Wheat Proteins. We have developed a number of specialty wheat proteins for food and non-food applications. Specialty wheat proteins are derived from vital wheat gluten through a variety of proprietary processes which change the molecular structure of vital wheat gluten. Wheat proteins for food applications include gliadin, glutenin, products in the Arise®, Wheatex®, HWG 2009 and FP series and Pasta Power®. We also produce specialty proteins for use in personal care products. Our specialty wheat proteins generally compete with other ingredients and modified proteins having similar characteristics, primarily soy proteins and other wheat proteins, with competition being based on factors such as functionality, price and, in the case of food applications, flavor. Our principal competitors in the specialty proteins market are Archer-Daniels-Midland Company (wheat and other grain proteins), The Solae Company (soy), Manildra Milling (gluten and wheat proteins), US Energy (gluten) and various European companies. Although we are producing a number of our specialty wheat proteins on a commercial basis, some products are in the test marketing or development stage.
· Arise® series. Our Arise® series of products consists of specialty wheat proteins that increase the freshness and shelf life of frozen, refrigerated and fresh dough products after they are baked. Certain ingredients in this series are also sold for use in the manufacture of high protein, lower net carbohydrate products.
· Wheatex® series. This series consists of texturized wheat proteins made from vital wheat gluten by changing it into a pliable substance through special processing. The resulting solid food product can be further enhanced with flavoring and coloring and reconstituted with water. Texturized wheat proteins are used for meat, poultry and fish substitutes, extenders and binders. Wheatex® mimics the textural characteristics and appearance of meat, fish and poultry products. It
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is available in a variety of sizes and colors and can be easily formed into patties, links or virtually any other shape the customer requires. Because of its neutral taste, Wheatex® will not alter flavors that are added to the product. It also has excellent water-binding capacities for the retention of natural meat juices. Wheatex® is presently being sold for applications in vegetarian and extended meat products.
· FP series. The FP series of products consists of specialty wheat proteins, each tailored for use in a variety of food applications. These include proteins that can be used to form barriers to fat and moisture penetration to enhance the crispness and improve batter adhesion in fried products, effectively bond other ingredients in vegetarian patties and extended meat products, increase the softness and pliability of flour tortillas, and fortify nutritional drinks.
· Pasta Power®. This is a specialty wheat protein that is a cost-effective replacement for whole eggs and egg whites and enhances the strength, texture, quality and functionality of fresh, frozen and flavored pasta products. The added strength enables the canning of pasta and its treatment with spices without significant deterioration of the noodle or other pasta products, such as canned spaghetti and similar products.
· HWG 2009. This is a lightly hydrolyzed wheat protein that is rich in peptide-bonded glutamine, an amino acid that counters muscle fatigue brought on by exercise and other physical activities. Applications include nutritional beverages and snack products.
· Foam Pro® L. This is a hydrolyzed wheat protein that has been developed as a foam booster to naturally enhance detergent systems such as shampoos, liquid hand soaps and bath and shower gels.
· Aqua Pro® WAA. This is a solution of amino acids produced from natural wheat proteins that helps provide excellent moisturizing and film forming properties in both hair and skin systems.
· Aqua Pro® WP. This is an additive for shampoo that helps repair damaged hair and improves shine, luster and smoothness.
· Aqua Pro® QWL. This is a protein which enhances the functionality of hair conditioners.
Vital Wheat Gluten. Vital wheat gluten is a free-flowing light tan powder which contains approximately 75 percent to 80 percent protein. When we process flour to derive starch, we also derive vital wheat gluten. Vital wheat gluten is added by bakeries and food processors to baked goods, such as breads, and to pet foods, cereals, processed meats, fish and poultry to improve the nutritional content, texture, strength, shape and volume of the product. The neutral flavor and color of wheat gluten also enhances, but does not change, the flavor and color of food. The cohesiveness and elasticity of the gluten enables the dough in wheat and other high protein breads to rise and to support added ingredients, such as whole cracked grains, raisins and fibers. This allows the baker to make an array of different breads by varying the gluten content of the dough. Vital wheat gluten is also added to white breads, hot dog buns and hamburger buns to improve the strength and cohesiveness of the product.
Gliadin and glutenin are the two principal components that make up vital wheat gluten. Our patented process enables the separation of glutenin and gliadin for a variety of end uses without the use of alcohol, which has been the traditional method of separating the two. Glutenin, a large molecule responsible for the elastic character of vital wheat gluten, increases the strength of bread dough, improves the freeze-thaw characteristics of frozen dough and may be used as a functional protein source in beef jerky-type products, as well as in meat extension. Gliadin, the smaller of the two molecules, is soluble in water and other liquids, including alcohol, and is responsible for the viscous properties of wheat gluten. Those characteristics make it ideal to improve the texture of noodles and pastas. We produce vital wheat gluten from modernized facilities at the Atchison and Pekin plants. Gluten is shipped throughout the continental United States in bulk and in 50 to 100 pound bags to distributors and also is sold directly to major food processors and bakeries. Because of increased global capacities, along with subsidies and other protective measures afforded certain foreign exporters by their host governments, in recent years we had not been
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able to profitably compete with the foreign exporters and, until recently, had only produced gluten as a by-product in our production of specialty starches and proteins. However, sales of our commodity wheat gluten began to increase during fiscal 2007 due to increased demand resulting from poor global wheat crops which yielded lower wheat gluten supplies than previously anticipated. Sales increased further toward the end of the fiscal 2007 and into the start of fiscal 2008 as demand for safe, quality gluten backed by supply and service reliability became even more significant. This situation developed following a major recall of pet foods containing contaminated imported wheat flour misrepresented as gluten. In response to this demand, we increased wheat gluten production at our plants in Atchison, Kansas and Pekin, Illinois.
Vital wheat gluten in recent years has been considered a commodity, and therefore, competition primarily has been based upon price. Our principal competitors in the U.S. vital wheat gluten market consist primarily of three other domestic producers and producers in the European Union, Australia and certain other regulated countries (the Foreign Exporters).
Mill By-Products. We own and operate a flour mill at the Atchison plant. The mills output of flour is used internally to satisfy a majority of the raw material needed for the production of our starch, protein and vital wheat gluten. In addition to flour, the wheat milling process generates mill feeds or midds. Midds are sold to processors of animal feeds as a feed additive.
Our Atchison and Pekin plants process corn and/or milo, mixed with the starch slurry from starch and gluten processing operations, into food-grade alcohol, fuel-grade alcohol, distillers feed and carbon dioxide.
Food-grade alcohol consists of beverage alcohol and industrial food-grade alcohol that are distilled to remove impurities. Fuel-grade alcohol, or ethanol, is grain alcohol that has been distilled to remove all water to yield 200 proof alcohol suitable for blending with gasoline.
Since the reconstruction in 2004 of our Atchison distillery following an explosion that occurred approximately two years earlier, the majority of the distillerys capacity has been dedicated to the production of high quality, high purity food grade alcohol for beverage and industrial applications. The remainder has been dedicated to the production of fuel grade alcohol, commonly known as ethanol. The new state-of-the-art equipment that was installed during the reconstruction has resulted in improved alcohol production efficiencies at the Atchison plant. Conversely, the majority of our capacity at our Pekin, Illinois distillery has historically been dedicated to the production of fuel grade alcohol. Additional efforts to further improve efficiencies at both distilleries, particularly relating to energy usage, have been initiated through recent capital projects. During fiscal 2008, we generally operated at full production capacity for our food grade alcohol, but experienced underutilization of our fuel grade alcohol capacity.
Food Grade Alcohol. Food-grade alcohol sold for beverage applications consists primarily of grain neutral spirits and gin. Grain neutral spirits are sold in bulk quantities at various proof concentrations to bottlers and rectifiers, which further process the alcohol for sale to consumers under numerous labels. Our gin is created by redistilling grain neutral spirits together with proprietary customer formulations of botanicals or botanical oils.
We believe that in terms of fiscal 2008 net sales, we are one of the three largest bulk sellers of food grade alcohol in the United States. Our principal competitors in the beverage alcohol market are Grain Processing Corporation of Muscatine, Iowa and Archer-Daniels-Midland Company of Decatur, Illinois.
Much consolidation in the beverage alcohol industry has occurred at the customer level over the past two decades. As these consolidations have come about, we have maintained a strong and steady presence in the market due to longstanding relationships with customers and our reputation for producing very high quality, high purity alcohol products.
We market food-grade alcohol which is not sold as beverage alcohol as food-grade industrial alcohol. We sell food-grade industrial alcohol for use as an ingredient in foods (e.g., vinegar and food flavorings), personal care
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products (e.g., hair sprays and deodorants), cleaning solutions, biocides, insecticides, fungicides, pharmaceuticals, and a variety of other products. Although grain alcohol is chemically the same as petroleum-based or synthetic alcohol, certain customers prefer a natural grain-based alcohol. We sell food-grade industrial alcohol from both of our Atchison and Pekin plants in tank truck or rail car quantities direct to a number of industrial processors.
Historically, synthetic alcohol dominated the food grade industrial alcohol market. In recent years, however, the use of grain-based alcohol has exceeded synthetic alcohol in this market. Our principal competitors in the grain-based food grade industrial alcohol market are Grain Processing Corporation of Muscatine, Iowa and Archer-Daniels-Midland Company of Decatur, Illinois. Competition is based primarily upon price, service and quality factors.
Fuel Grade Alcohol. Fuel grade alcohol, which is commonly referred to as ethanol, is sold primarily for blending with gasoline to increase the octane and oxygen levels of the gasoline. As an octane enhancer, ethanol can serve as a substitute for lead and petroleum-based octane enhancers. As an oxygenate, ethanol has been used in gasoline to meet certain environmental regulations and laws relating to air quality by reducing carbon monoxide, hydrocarbon particulates and other toxic emissions generated from the burning of gasoline (toxics). Because ethanol is produced from grain, a renewable resource, it also provides a fuel alternative that tends to reduce the countrys dependence on foreign oil.
To encourage the production of ethanol for use in gasoline, the Federal government and various states have enacted tax and other incentives designed to make ethanol competitive with gasoline and gasoline additives. Under the internal revenue code, and until the end of 2010, gasoline that has been blended with ethanol provides sellers of the blend with certain credits or payments. Until the end of 2008, these amount to $0.51 per gallon of ethanol with a proof of 190 or greater that is mixed with the gasoline; during 2009 and 2010, they amount to $0.45 per gallon. Although these benefits are not directly available to us, they allow us to sell our ethanol at prices which generally are competitive with less expensive additives and gasoline.
On August 8, 2005, President Bush signed the Energy Policy Act of 2005 (Energy Act), a comprehensive energy bill that includes a provision for establishing a renewable fuels standard. The Energy Act amended the Clean Air Act to provide for the adoption of regulations whose purpose, subject to other provisions of the Energy Act, was to ensure that gasoline sold or introduced into commerce in the continental United States contained on an annual average basis 4.0 billion gallons of renewable fuel commencing in 2006 and increasing incrementally to 7.5 billion gallons in 2012. These standards were amended by the Energy Independence and Security Act of 2007. As amended, the Clean Air Act now provides for the adoption within one year of regulations whose purpose is to ensure that transportation fuel sold or introduced into commerce in the continental United States contains on an annual average basis 9.0 billion gallons of renewable fuel commencing in 2008 and increasing incrementally to 36 billion gallons in 2022. Of these amounts, the maximum applicable average volume of ethanol ranges from 9.0 billion gallons in 2008 to 15 billion gallons in 2015 and continuing thereafter to 2022.
While the Energy Act eliminated the federal oxygen standard in reformulated gasoline, it did not provide for an MTBE liability protection clause. With the elimination of the need for oxygenates in gasoline, refiners do not have a legal basis to continue the use of MTBE, a known carcinogen. Therefore, refiners elected to discontinue virtually all use of MTBE by May 7, 2006. Refiners continue to have a need for octane in gasoline and, without the use of MTBE, their only viable alternative at this point is to increase the use of ethanol and other renewable fuel sources. As a result of the renewable fuels standard, we believe ethanol use will continue to grow.
Because of concerns over MTBE, state and federal policies promoting cleaner air and state and federal production incentives and tax programs, the ethanol industry has grown substantially in recent years. Based on data compiled by the Renewable Fuels Association, fuel ethanol production capacity at the end of our 2008 fiscal year amounted to approximately 9.3 billion gallons of capacity compared to approximately 6.5 billion gallons at the end of fiscal 2007. Additionally, there were approximately 4.2 billion gallons of capacity in various stages of planning or construction at the end of fiscal 2008.
According to information published by the Renewable Fuels Association, as of June 30, 2008, there were approximately 162 ethanol production facilities in the United States and approximately 41 more under construction or being planned in addition to 7 under expansion. The majority of these facilities are located in the Midwestern
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corn producing states. The fuel-grade alcohol market is dominated by Archer-Daniels-Midland Company, with our Company being among the smaller of a few other larger second-tier ethanol producers. We compete with other producers of fuel-grade alcohol on the basis of price and delivery service. We believe the proximity of our plants to our markets gives us an advantage over many of our competitors.
Although we believe the future for ethanol remains promising, there can be no assurance that the use of renewable fuels will increase as significantly as contemplated by the Energy Act or that ethanol prices will improve as a result of this new law. Industry capacity already exceeds the level of renewable fuels mandated through 2008 in the Energy Act, and the Act encourages further expansion of the industry. If that expansion occurs at a more rapid pace than the schedule for implementing the renewable fuels standard, ethanol prices could be affected.
Distillery Co-Products. The bulk of fiscal 2008 sales of alcohol co-products consisted of distillers feed. Distillers feeds are the residue of corn, milo and wheat from alcohol processing operations. The residue is dried and sold primarily to processors of animal feeds as a high protein additive. We compete with other distillers of alcohol as well as a number of other producers of animal food additives in the sale of distillers feed. During fiscal 2008, prices for distillers feed were depressed relative to corn prices as a result of increased fuel alcohol capacity combined with decreased demand in the European Union due to the E.U.s non-approval of several varieties of genetically modified corn commonly grown in the U.S.
The balance of alcohol co-products consists primarily of carbon dioxide. During the production of alcohol, we trap carbon dioxide gas that is emitted in the fermentation process. The gas is purchased and liquefied on site by three principal customers, one at the Atchison Plant and two at the Pekin Plant, who own and operate the carbon dioxide processing and storage equipment under long-term contracts with us. The liquefied gas is resold by these processors to a variety of industrial customers and producers of carbonated beverages.
Produced from the further processing of certain of our wheat proteins and wheat starches (and other plant sources), our plant-based biopolymers and composites can be used to produce a variety of eco-friendly products, while our resins have been manufactured for use primarily in pet treat applications.
Polymers and Resins
· MGPI Terratek®. MGPI Terratek® protein and starch resins are our environmentally-friendly biopolymers that can be molded to produce a variety of formed objects. Applications include disposable eating utensils, golf tees, food and feed containers and similar type vessels, as well as non-degradable hard plastic-like products. We hold a license under U.S. Patent No. 5,321,064 expiring in 2011 that relates to these products.
· MGPI Chewtex® and MGPI Pet-Tex®. MGPI Chewtex®, produced from wheat protein and wheat starch, is used as a commercial raw material for the production of pet treats and chews. We hold U.S. Patent No. 5,665,152 expiring in 2016 relating to the methods of grain protein-based solid articles that we use in the production of such products. MGPI Pet-Tex® is our textured wheat protein that is produced and sold for use in pet food products.
As previously stated, at the completion of the third quarter of fiscal 2008, we undertook a review of our long-lived assets in our other segment and concluded that an impairment charge on these assets was appropriate. Our pet business has suffered since we lost a major customer in late 2006, but high wheat prices, changing consumer preferences and failure to obtain previously anticipated new business led to this decision. Our pet business assets are located at a joint use facility, and in the course of our review we also concluded to write-down all the assets at that facility, including those associated with certain of our Wheatex® textured wheat proteins. We recorded an $8.1 million impairment charge related to these combined assets of which $4.7 million related to assets allocated to our other segment. We are evaluating the strategic alternatives for the plant and equipment at our Kansas City facility, and are pursuing the sale of these assets, which are included in our other segment.
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We are involved in a number of patent-related activities. For at least the past seven years, we have regularly been filing patent applications to protect a range of inventions made in our expanding research and development efforts, including inventions relating to applications for our products. Our most significant patents or patent licenses are described below.
In 2003, we licensed, on an exclusive basis, certain patented technology from The Kansas State University Research Foundation relating to U. S. Patent No. 5,855,946, which describes and claims processes for making food-grade starches resistant to alpha-amylase digestion, as well as products and uses for the resistant starches. The license relates to products derived from plant-based starches and is a royalty-bearing, worldwide license whose term, subject to termination for material, uncured breaches or bankruptcy, extends until the patent rights expire in 2017. Royalties generally are based on net sales. The patent rights relate to the referenced U.S. patent and any corresponding foreign patent application, which has been filed in Australia. Under the license, we can make, have made, use, import, offer for sale, and sell licensed products within the scope of a claim of the patent rights or which are sold for a use within the scope of the patent rights and may, with approval of the licensor, grant similar rights to sublicensees. We have granted National Starch and Chemical Investment Holding Corporation and certain of its affiliates a royalty bearing sublicense under the patent and related technology to make high amylose maize starch and to sell it anywhere except in the United States. We have granted Cargill Incorporated a royalty bearing sublicense to use the patented process in the production of tapioca-based starches for use in food products. We have granted Penford Products Co. a royalty bearing sublicense to make potato-based starches in the United States for use in food products and to sell such starches in the United States and elsewhere.
We hold U.S. Patent No. 5,665,152 expiring in 2016 relating to the methods of grain protein-based solid articles that we use in the production of pet chew products.
We hold U.S. Patent No. 5,610,277 expiring in 2015 relating to the alcohol-free wet extraction of gluten dough into gliadin and glutenin.
We are exclusively licensed by the University of Minnesota under U. S. Patent No. 5,321,064, which relates to biodegradable interpolymer compositions made from biodegradable natural and synthetic polymers. The license expires on June 14, 2011, as does the licensed patent.
During the last three fiscal years, we have spent an aggregate of $8.9 million on research and development activities, all in the ingredient solutions and other segments, as follows: 2008-$3.2 million; 2007- $2.8 million; and 2006-$2.9 million.
Our sales subsequent to 2002 have not been seasonal.
Our output is transported to customers by truck, rail and barge transportation equipment, most of which is provided by common carriers. We lease 462 rail cars, which may be dispatched on short notice. We offer customers shipment by barge through our barge loading facilities on the Illinois River.
Our principal raw material is grain, consisting of wheat, which is processed into all of the products that we manufacture, and corn and milo, which are processed into alcohol, animal feed and carbon dioxide. We purchase grain directly from surrounding farms, primarily at harvest time, and throughout the year from or through grain elevators. To assure supplies, we may enter into contracts to take future delivery within 30 days. These are fixed
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price contracts which are based on prices of future contracts and specify the amount, type and class of grain and the price. We can call for delivery at any time within thirty days of the contract. Historically, the cost of grain is subject to substantial fluctuations depending upon a number of factors which affect commodity prices in general, including crop conditions, weather, government programs and purchases by foreign governments. Such variations in grain prices have had and are expected to have from time to time significant adverse effects on the results of our operations. This is primarily due to a variety of factors. Fuel grade alcohol prices, which historically have tracked the cost of gasoline, do not usually adjust to rising grain costs. It generally has been difficult for us to compensate for increases in grain costs through adjustments in prices charged for our vital wheat gluten due to subsidized European Union wheat gluten, whose artificially low prices are not affected by such costs. However, recent increases in demand resulting from contaminated imported wheat flour misrepresented as gluten have resulted in what we believe will be short-term increases in gluten prices and a more balanced global supply/demand relationship.
During fiscal 2008, market prices for grain increased substantially. The average price that we paid per bushel for wheat increased 63 percent in fiscal 2008 compared to fiscal 2007, while the average price for a bushel of corn that we paid increased 38 percent over the same period.
We engage in the purchase of commodity futures to hedge economic risks associated with fluctuating grain and grain products prices. During fiscal 2008, we hedged approximately 75 percent of corn processed, compared to 40.7 percent in 2007. Of the wheat that we processed in fiscal 2008, none was hedged compared to 2.5 percent hedged in fiscal 2007. See Item 1A Risk Factors and Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Practices Hedging Activities, for a discussion of a recent change that we made in the manner in which we account for our hedges. Also see Item 7A - Quantitative and Qualitative Disclosures About Market Risk.
Because energy comprises a major cost of operations, we seek to assure the availability of fuels for the Pekin and Atchison plants at competitive prices.
We use natural gas to operate boilers that we use to make steam heat. We procure natural gas for the Atchison plant in the open market from various suppliers. We can purchase contracts for the delivery of natural gas in the future or can purchase future contracts on the exchange. Depending on existing market conditions, at Atchison we have the ability to transport the gas through a gas pipeline owned by a wholly-owned subsidiary. In Pekin, we can either procure natural gas through Central Illinois Light Company (aka AmerenCILCO) or through other suppliers. We have a multi-year agreement with AmerenCILCO that expires on August 31, 2009 under which the utility will transport natural gas to our Pekin plant on the utilitys pipeline. In order to control energy costs, we have a risk management program whereby, at pre-determined prices, we will purchase a portion of our natural gas requirements for future delivery.
In 1995, we entered into an arrangement with AmerenCILCO and one of its subsidiaries (collectively CILCO) with respect to our Pekin, Illinois plant. Under the arrangement, we have leased a portion of our plant facility to CILCO for a term which, as extended, ends in February 2029. CILCO constructed a gas fired electric and steam generating facility on ground leased from us and agreed to provide steam heat to the Pekin plant under a related steam heat service agreement pursuant to which we have agreed to purchase our requirements for steam heat from CILCO until February 2011. We must make adjustable minimum monthly payments over the term of the service agreement, currently $141,000, with declining fixed charges for purchases in excess of minimum usage, and are responsible for fuel costs and certain other expenses. However, CILCO also uses the boilers to run electric generating units that it constructed on the leased site and pays us for a portion of the fuel costs that we incur for the production of steam, based on savings realized by CILCO from electricity generated at the facility. CILCO has advised that it does not want to renew the stream heat service contract after February 2011.
Our current electricity agreement expires in December 2008. Historically, we have negotiated a fixed price agreement with AmerenCILCO as the electricity provider. Illinois is a deregulated market, which provides us with alternative sources to supply our electrical needs.
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We are currently exploring alternative sources of energy for our Pekin, Illinois plant in the form of a coal-fired steam generation facility. We have applied for approvals for the construction of a 330,000 pound per hour high pressure solid fuel boiler cogeneration facility at the plant. The proposed facility will utilize coal as the primary fuel. The cost of the project is estimated at $90 million to $100 million. We are seeking a third party energy provider to fund, own and operate the facility, and would expect to enter a multi-year energy supply agreement with the energy provider.
The Illinois Environmental Protection Agency (IEPA) held a public hearing regarding the fuel boiler cogeneration facility on July 14, 2008. This hearing represented one step toward receiving a permit for the facility. The hearing was followed by a written public comment period, which ended on August 13. If the IEPA determines to issue a construction permit, it will be effective 35 days after the date of issue to allow for an appeal period for interested parties. Barring an appeal, we would expect to receive a construction permit at the end of the 35-day waiting period. After a construction permit is granted and a third party energy provider is identified to build the facility, we anticipate that it would take approximately two years to construct and put the facility into operation.
The facility is proposed to be located on a site that we would lease to the provider which is located on our plants 49-acre site. It will be utilized to produce steam to power the plants distillery, wheat gluten (protein) and wheat starch production processes. In addition, a portion of the generated steam will be used to supply the plants electrical needs. Excess energy will be available for sale by the provider to others.
As of June 30, 2008, we had 482 employees, 258 of whom are covered by collective bargaining agreements with one labor union. One agreement, which would have expired on August 31, 2008 and which covers 147 employees at the Atchison Plant, has been extended by the Company for 15 days. Another agreement, which expires on October 31, 2011, covers 89 employees at the Pekin plant. A collective bargaining agreement with employees at our Kansas City facility covers 22 employees and expires on September 25, 2009. As of July 1, 2007, we had 460 employees.
We consider our relations with our personnel to be good and have not experienced a work stoppage since 1978.
Our beverage and industrial alcohol business is subject to regulation by the Alcohol and Tobacco Tax and Trade Bureau (TTB) and the alcoholic beverage agencies in the States of Kansas and Illinois. Such regulation covers virtually every aspect of our alcohol operations, including production facilities, marketing, pricing, labeling, packaging, and advertising. Food products are also subject to regulation by the Food and Drug Administration. TTB regulation includes periodic TTB audits of all production reports, shipping documents, and licenses to assure that proper records are maintained. We are also required to file and maintain monthly reports with the TTB of alcohol inventories and shipments.
We are subject to extensive environmental regulation at the federal, state and local levels. The regulations include the regulation of water usage, waste water discharge, disposal of hazardous wastes and emissions of volatile organic compounds, nitrogen oxides, sulfur dioxides, particulates and other substances into the air. Under these regulations, we are required to obtain operating permits and to submit periodic reports to regulating agencies. For the Atchison and Kansas City, Kansas plants, the air quality is regulated by both the U.S. Environmental Protection Agency (USEPA) and the Division of Environment of the Kansas Department of Health and Environment (the KDHE). The KDHE regulates all air emissions. We also were required to obtain a Class I air operating permit from the KDHE and must obtain KDHE approval to make plant alterations that could modify the emission levels. The KDHE also regulates the discharge water quality at the Atchison plant. This includes process water, non-contact water and storm water. We monitor process water and non-contact water discharge on a daily basis and submit monthly reports to the KDHE documenting the test results from these water discharges. The USEPA and KDHE also monitor hazardous waste disposal for the Atchison and Kansas City plants. We also are required to submit annual reports pursuant to the Kansas and Federal Emergency Planning Community Right-to-Know Acts.
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Local officials, such as the local emergency planning committees in the Atchison and Kansas City communities, also receive copies of these annual reports.
Similar environmental regulations apply to the Pekin, Illinois facility. Air quality at the Pekin plant is regulated by both the USEPA and the Illinois Environmental Protection Agency (the IEPA). The IEPA regulates all air emissions. We have permits to make certain emissions, and the IEPA has the right to do on-site testing to verify that emissions comply with these permits. Also, the IEPA regulates waste water, cooling water and storm water discharge at the Pekin plant. We test wastewater effluent quality twice each week and file monthly reports with the IEPA. We also file an Annual Emissions Report and a Toxic Release Inventory annually with the IEPA. The Pekin facility is also required to submit periodic reports pursuant to the Illinois and Federal Emergency Planning Community Right-to-Know Acts.
During 1997, the IEPA commenced an action against our Illinois subsidiary with respect to alleged noncompliance of the Pekin Plant with certain air quality regulations. In 2002, the USEPA began an enforcement initiative relating to air emissions standards, focusing on all ethanol producers in its Midwestern region. In connection with the USEPA enforcement initiative relating to our Pekin facility, we entered a consent decree and paid a federal penalty of $172,000. In connection with the IEPA proceedings, we entered a Stipulation and Proposal for Settlement pursuant to which we made a total payment of $500,000, including a contribution to a state special project fund. Both the consent decree and the Stipulation required us to undertake specified compliance activities. As a result of these proceedings and a desire to make our operations more efficient, we made capital expenditures of $11.1 million at the Pekin facility. We could have complied with environmental requirements in Pekin by only installing necessary pollution control equipment to an existing dryer, which we expect would have cost approximately $2 million. However, we elected instead to install a new, emission-controlled dryer/evaporator system that will both address regulatory requirements and increase plant efficiency. In January 2006 we entered a consent agreement with the KDHE resolving past allegations relating to permits, emissions levels and compliance with pollution regulations. We agreed to pay a civil penalty and to undertake certain modifications to our Atchison facility over two and one-half years, including replacing a dryer, replacing or modifying our boilers and modifying certain emission controls. We had previously installed the emission-controlled dryer in Atchison that we will use to process distillers feed at an estimated cost of $12 million. During fiscal 2008 we made additional capital expenditures of $1,823,000 for new boiler burners and emission controls and anticipate making an additional $633,000 in expenditures during fiscal 2009 for such measures.
On July 2, 2007 we acquired a 50% interest in a German joint venture company which will produce and distribute our Wheatex® products in the EU and elsewhere. If the venture succeeds, the new company may build its own plant in the EU. We have leased an extruder to the new company for future use and licensed the new company to practice our Wheatex® technology and sell the product in the EU and certain countries that are proximate to the EU. Presently we anticipate production will begin in the second quarter of fiscal 2009. As of June 30, 2008 our total capital commitment to the joint venture is $750,000, of which we had contributed $375,000.
On July 12, 2004, we entered into a business alliance with Cargill, Incorporated for the production and marketing of a new resistant starch called Fibersym® HA that is derived from high amylose corn. Under this alliance, which has an initial term of five years, Cargill agreed to manufacture Fibersym® HA under U.S. patent No. 5,855,946, which has been licensed exclusively to us. The new starch is to be marketed by both companies under the Fibersym® brand name with all revenues from such sales recognized by us. We and Cargill are to share profits from sales of the new product. In connection with the arrangement for the new corn product, we also granted Cargill a royalty bearing sublicense to use the patented process for the life of the patent in the production of tapioca-based starches for use in food products. We also agreed that if we determined to use the patented process to produce starches derived from other types of corn or to have a third party make product under the patent from other plant sources (other than wheat or potato), we would offer Cargill an opportunity to participate with us. Cargill has started to market its tapioca-based starch product under the sublicense from us but we have only received nominal royalties to date. As part of the transactions mentioned above, we licensed Cargill to use the technology disclosed and claimed in certain patent applications relating to uses for the patented resistant starch.
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Although we originally hoped to introduce Fibersym®HA starch into the market at the end of 2004, due to litigation brought by National Starch and Chemical Investment Holding Corporation, Penford Australia, Ltd. and Penford Holdings Pty. in November 2004, we put the sale and additional production of the product on hold. The litigation was resolved in September 2006. We are engaged in discussions with Cargill about modifying our arrangements with them.
Our business is subject to certain risks and uncertainties. The following identifies those which we consider to be most important:
RISKS THAT AFFECT OUR BUSINESS AS A WHOLE
Covenants in our credit facility could hinder our ability to operate. Our failure to comply with covenants in our credit facility could result in the acceleration of the debt extended under such facility, limit our liquidity and trigger other rights.
Our credit agreement with our banks contains a number of financial and other covenants, including provisions that require us to meet certain financial tests and that limit or restrict our ability to:
· incur additional indebtedness;
· pay dividends to stockholders or purchase stock;
· make investments;
· dispose of assets;
· make capital expenditures;
· create liens on our assets; or
· merge or consolidate or dispose of all or substantially all of our assets.
These covenants may hinder our ability to operate and reduce our profitability, and a breach of any of these covenants or requirements could result in a default under our credit agreement. If we default, and if such default is not cured or waived, our lenders could, among other remedies, reduce our borrowing base, decline to extend us further credit and/or accelerate our debt and declare that such debt is immediately due and payable. If our bank lenders were to terminate our credit, we may not have sufficient funds available to us to operate. If they were to accelerate our debt, we may not be able to repay such debt or borrow sufficient funds to refinance. Even if new financing is available, it may not be on terms that are acceptable.
Certain of our other secured debt instruments contain cross default provisions such that an event of default under our credit agreement may result in an event of default under these other debt instruments.
As of June 30, 2008, our credit agreement required us to maintain minimum tangible net worth and specified financial ratios, including a working capital ratio, a fixed charge coverage ratio and a leverage ratio. As of June 30, we did not meet our tangible net worth requirement or our fixed charge coverage or leverage ratios. As a result of our default, our lenders were entitled, among other remedies, to reduce our borrowing base, decline to extend further credit to us and/or accelerate our debt and foreclose on their collateral. However, they did not do so but instead have agreed to amendments which, among other matters, eliminate the term loan component of the credit agreement, increase the revolving credit component from $40 million to $55 million and impose new financial covenants that apply over an interim standstill period. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation Liquidity and Capital Resources Line of Credit. They also have shortened the term of the revolving credit component of the credit facility and agreed to a 60-day standstill period,
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during which time we must deliver the banks a report from an outside auditor regarding our inventory and accounts receivable and reconciling of our grain positions. Additionally, the banks may review our commodity positions and hedging strategy. If we do not default under the terms of the amendment, the lenders may, in their sole discretion, extend the standstill period but are under no obligation to do so. If they elect to do so, the lenders may exercise all their rights and remedies under the credit agreement at the end of the standstill period or sooner if we default under the terms of the amendment during the standstill period. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation Liquidity and Capital Resources Line of Credit. Although we would hope that if we continue to meet these new covenants, our lenders will not terminate the credit agreement and will continue to honor our draws, there can be no assurance that they will do so or that they will renew our credit agreement upon its scheduled expiration date, in which case we may be required to seek new financing in order to continue to operate. As noted above, there is no assurance that we could obtain such financing or, if obtained, that it would be on favorable terms. There can be no assurance we will be able to meet the new financial covenants.
As a result of recent operating losses we have incurred significant debt.
During fiscal 2008 we incurred operating losses, as a result of which we had to borrow significant amounts under our credit facilities in order to have sufficient cash to operate. Our interest rates will increase over our fourth quarter levels as a result of our default and the recent amendment to our credit agreement. Accordingly, our debt service requirements are greater than in recent history and the amount of debt we have incurred may have important consequences, including the following:
· We will have to use a substantial portion of our cash flows from operations to pay principal and interest on our debt, which will reduce the funds that would otherwise be available to us for our operations, capital expenditures, future business opportunities and dividends; and
· We will be adversely affected by increases in prevailing interest rates.
Our profitability is affected by the cost of grain that we use in our business, and the availability and cost of such agricultural products are subject to weather and other factors beyond our control.
Grain costs are a significant portion of our costs of goods sold, and historically the cost of grain is subject to substantial fluctuations depending upon a number of factors which affect commodity prices in general and over which we have no control, including crop conditions, weather, government programs and purchases by foreign governments. These fluctuations can be sudden and volatile at times. From the third quarter of fiscal 2008 to the fourth quarter of fiscal 2008, for example, our cost per bushel of corn, after hedging, increased from $3.54 to $4.54 , and our cost per bushel of wheat increased from $6.22 to $10.36. Such variations in grain costs have had and are expected to have, from time to time, significant adverse effects on the results of our operations, as we are not always able to keep pace proportionately with price increases due to several factors, such as the terms of supply agreements that limit our ability to raise prices, price competition from substitute products and competition from global competitors with different input commodity prices due to subsidies, tariffs, or other unique advantages.
Although we engage in the purchase of commodity futures to hedge economic risks associated with fluctuating grain prices, we may not be successful in fully limiting our exposure to market fluctuations in the cost of grain.
Our profitability is affected by the cost of natural gas.
Natural gas is a significant input cost, and comprised approximately 18 percent of our costs of goods sold in fiscal 2008 and 15.4 percent of our cost of goods sold in fiscal 2007. We use natural gas extensively in our operations and the price of natural gas fluctuates, based on anticipated changes in supply and demand, weather and the prices of alternative fuels. During fiscal 2008 for example, the average quarterly price of natural gas fluctuated from a low of $7.27/MMBtu to a high of $10.05/MMBtu. This compared to a low of $6.87/MMBtu to a high of $7.54/MMBtu in fiscal 2007. Historically, prices of natural gas have been higher in the late fall and winter months than during other annual periods. We are not always able to pass on increases in energy costs to our customers, and margins and profitability have been and could continue to be adversely affected by fluctuations in the price of natural gas.
16
Hedging transactions involve risks that could harm our profitability.
In an attempt to minimize the effects of the volatility of corn and wheat costs on operating profits, we take hedging positions in corn and wheat futures markets by entering into readily marketable exchange-traded commodity futures and option contracts to reduce the risk of future grain price increases. We also hedge the purchase price of natural gas used in the distilling process. These are steps we take to attempt to reduce the risk caused by price fluctuation. The effectiveness of such hedging activities is dependent upon, among other things, the cost of corn, wheat and natural gas, as well as our ability to sell sufficient amounts of products to utilize all of the grain subject to futures contracts. Hedging activities can result in costs because price movements in grain contracts are highly volatile and influenced by many factors beyond our control. Some of the general risks associated with hedging are described in the paragraphs below.
Transactions in futures can involve a great deal of risk. The amount of initial margin that we are required to maintain is small relative to the value of a futures contract, so that our futures transactions are leveraged. A relatively small market movement will have a proportionately larger impact on the funds we have deposited or will have to deposit. This can harm us as well as benefit us. We may sustain a total loss of initial margin funds and any additional funds deposited with our broker to maintain our position. If the market moves against our position or margin levels are increased, we may be called upon to pay substantial additional funds on short notice to maintain our position. If we fail to comply with a request for additional funds within the time prescribed, our position may be liquidated at a loss and we will be liable for any resulting deficit.
Transactions in options also carry a high degree of risk. Selling (writing or granting) an option generally entails considerably greater risk than purchasing options. Although the premium received when we sell an option is fixed, we may sustain a loss well in excess of that amount. We will be liable for additional margin to maintain the position if the market moves unfavorably. We may also be exposed to the risk of the purchaser exercising the option and we will be obligated to either settle the option in cash or to acquire or deliver the underlying interest. If the option is on a future, we will acquire a position in a future with associated liabilities for margin (see the preceding). If we cover the option by holding a corresponding position in the underlying interest or a future or another option, we may reduce this risk. If we do not cover an option, our risk of loss can be unlimited.
Our risk may also be increased by illiquid markets or market rules that suspend trading in a contract or contract month because of price limits. Such conditions may make it difficult or impossible for us to effect transactions or liquidate/offset positions.
As a result of the rising compliance costs and the complexity associated with the application of hedge accounting, effective April 1, 2008 we discontinued the use of hedge accounting for our commodity derivative positions. Accordingly, the changes in the values of these derivatives will be recorded in earnings currently, resulting in volatility in both gross margin and net earnings. Gains and losses on our derivative transactions will be reported in cost of sales in our Consolidated Statements of Income. This volatility could cause results reported in any period to differ from our expectations. Our net earnings over the life of the derivative contracts remain unchanged.
The use of certain commodity contracts reduces our ability to take advantage of short-term reductions in raw material costs. If one or more of our competitors is able to reduce their costs by taking advantage of any reductions in raw material costs, we may face pricing pressures from these competitors and may be forced to reduce our selling prices or face a decline in sale volumes, either of which could have a material adverse effect on our business, results of operations and financial condition.
Work stoppages at our facilities could have a material adverse effect on the profitability of our business.
Most of our work force is unionized. The contract at our Pekin facility expires in 2011. The contract at our Atchison facility was scheduled to expire on August 31, 2008, but has been extended by 15 days. Presently, we are engaged in negotiations with the union representing employees at our Atchison facility. If our unionized workers were to engage in a strike, work stoppage or other slowdown in the future at either facility, we would be unable to
17
operate our plant and it is likely that we would experience a significant disruption of our operations, which could have a material adverse effect on us.
We may require significant cash flow to make capital expenditures.
Over the course of the next few years we may need to make substantial capital expenditures. See Item 1. Business of the Company - Energy and Regulation and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Cash Flow Information Investing Cash Flows. We may require additional long term financing to meet certain of these requirements, but have not determined the amount, type or source of such financing. We cannot assure you that we will be able to arrange such financing on favorable terms, if at all.
We are subject to extensive regulation, and compliance with existing or future laws and regulations may require us to incur substantial expenditures or require us to make product recalls.
We are subject to a broad range of federal, state, local and foreign laws and regulations intended to protect public health and the environment. Our operations are also subject to regulation by various federal agencies, including the Alcohol and Tobacco Tax Trade Bureau, the Occupational Safety and Health Administration, the Food and Drug Administration and the Environmental Protection Agency, and by various state and local authorities. Such regulation covers virtually every aspect of our operations, including production facilities, marketing, pricing, labeling, packaging, advertising, water usage, waste water discharge, disposal of hazardous wastes and omissions and other matters. Violations of any of these laws and regulations may result in administrative, civil or criminal penalties being levied against us, permit revocation or modification, performance of environmental investigatory or remedial activities, voluntary or involuntary product recalls, or a cease and desist order against operations that are not in compliance. These laws and regulations may change in the future and we may incur material costs in our efforts to comply with current or future laws and regulations or to affect any product recalls. These matters may have a material adverse effect on our business. See Item 1. Business-Regulation where we discuss environmental proceedings in which governmental agencies sought fines from us and required significant capital expenditures.
If we lose certain key personnel, we may not be successful.
We rely on the continued services of key personnel involved in management, product development, sales, manufacturing and distribution, and, in particular, upon the efforts and abilities of our executive management team. The loss of service of any of the members of our executive management team could have a material adverse effect on our business, financial condition and results of operations. We do not have key personnel life insurance covering any of our employees.
RISKS SPECIFIC TO OUR DISTILLERY PRODUCTS SEGMENT
Volatile corn and gasoline prices affect our profitability.
Historically, the price of fuel grade alcohol, or ethanol as it is commonly known, has had some relation to the price for gasoline. According to Oil Price Information Service (www.opisnet.com) and historical pricing information from the Chicago Board of Trade, over the ten year period ended July 1, 2007, the price of ethanol averaged approximately $0.40 a gallon over that of gasoline; however, during fiscal 2008, the average cost of ethanol was $0.38 per gallon lower than the average cost of gasoline. Nonetheless, the price of fuel grade alcohol has tended to increase as the price of gasoline increases, and the price for fuel grade alcohol tends to decrease as the price of gasoline decreases. A substantial portion of our operating income is dependent on the spreads between alcohol and corn prices. The spreads between alcohol and corn prices decreased significantly in fiscal 2008 from their levels in fiscal 2007 due to increases in the price of corn and, in the case of fuel alcohol, lower prices. Reduced spreads, either as a result of increased corn prices or reduced prices for alcohol, adversely affects our financial performance.
18
The relationship between the price we pay for corn and the sales prices of our co-products can fluctuate significantly and affect our results of operations.
Distillers dried grain, or distillers feed, is the principal co-product of our ethanol production process and can contribute significantly to the profitability of our distillery products segment. We sell distillers feed for prices which historically have tracked the price of corn. Recently, however, the value of these co-products has lagged behind the significant and rapid increase in corn prices. We believe that in part this resulted from decreased demand in the European Union due to the E.U.s non-approval of several varieties of genetically modified corn commonly grown in the U.S. Further, certain of our co-products compete with similar products made from other plant feedstock whose cost may not have risen as corn prices have risen. As a result, the profitability of this product to us could be affected.
The recent rapid growth of production capacity in the ethanol industry creates some market uncertainly for portions of our business and the ethanol industry.
Approximately 46 percent of our fiscal 2008 distillery product sales and 56 percent of our fiscal 2007 distillery product sales were fuel grade alcohol, or ethanol. The ethanol industry continues to grow and there is significant competition among ethanol producers. From June 2007 to June 2008, industry capacity grew from approximately 6.5 billion to 9.3 billion gallons, or 43%. As of June 30, 2008, existing construction at new and expanding ethanol plants was predicted to increase ethanol production capacity by approximately 4.2 billion gallons. This would increase the existing nationwide production capacity as of such date by approximately 45% percent. There also is increasing competition from international suppliers. Although there is a tariff on foreign produced ethanol that is slightly higher than the federal ethanol tax incentive, ethanol imports equivalent to up to 7% of total domestic production from certain countries were exempted from this tariff under the Caribbean Basin Initiative to spur economic development in Central America and the Caribbean.
At a minimum, increased capacity creates some uncertainty for the ethanol industry. Oil companies must continue to invest in modifications to existing gasoline terminals to allow ethanol access to new and larger gasoline markets such as Florida and other East coast states. To the extent new markets are accessible at the same rate as the ethanol supply grows, we do not expect ethanol pricing to weaken relative to gasoline prices. If new markets are not opened at the same rate, we expect ethanol prices to fall relative to gasoline.
Although there has been an increase in the demand for ethanol following the adoption of the Energy Policy Act of 2005, we cannot provide any assurance or guarantee that there will be any material or significant increases in the price for ethanol. If the production of ethanol exceeds either the demand for ethanol or the petroleum industrys ability to blend ethanol with gasoline, then we would expect the price of ethanol to fall, and such a fall in ethanol prices could be significant. In that case, our revenues could decrease.
The increased production of ethanol has had other adverse effects as well. For example, we believe the increased production of ethanol has resulted in increased demand for corn, which has lead to higher prices for corn, resulting in higher costs of production and lower margins. Also, the increased production has led to increased supplies of co-products from the production of ethanol, such as distillers feed. Those increased supplies have contributed to lower prices for those co-products in relation to corn prices. Although demand for distillers feed has increased roughly in proportion to supply, were prices to fall, it might have an adverse affect on our business.
Federal regulations concerning tax incentives could expire or change which could reduce our revenue.
To encourage the production of ethanol for use in gasoline, the Federal government has enacted tax and other incentives designed to make ethanol competitive with gasoline and gasoline additives. Under the internal revenue code, and until the end of 2008, gasoline that has been blended with ethanol provides sellers of the blend with certain credits or payments that amount to $0.51 per gallon of ethanol with a proof of 190 or greater that is
19
mixed with the gasoline. As a result of recent reductions, in 2009 and 2010 such credits or payments will amount to $0.45 a gallon.
These federal tax benefits are important to the ethanol industry and our business. Such benefits have supported a market for ethanol that might disappear without the credit. These benefits are scheduled to expire in 2010 and may not continue beyond their scheduled expiration date or, if they continue, the incentives may not be at the same level. The revocation or amendment of these benefits could adversely affect the future use of ethanol in a material way, and we cannot guarantee that these benefits will be continued. If the federal ethanol tax incentives are eliminated or sharply curtailed, the demand for ethanol may decrease and our business may be materially adversely affected.
RISKS SPECIFIC TO OUR INGREDIENT SOLUTIONS SEGMENT
We have incurred impairment losses and may suffer future impairment losses.
We review long-lived assets, mainly equipment, for impairment at year end or if events or circumstances indicate that usage may be limited and carrying values may not be recoverable. Should events indicate the assets cannot be used as planned, the realization from alternative uses or disposal is compared to the carrying value. If an impairment loss is measured, this estimate is recognized. Considerable judgment is used in these measurements, and a change in the assumptions could result in a different determination of impairment loss and/or the amount of any impairment. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Estimates. We recognized a non-cash impairment loss of $8.1 million at the end of the third quarter of fiscal 2008, of which $4.7 million related to the pet treat resin component of our other segment and $3.4 million related to ingredient solutions equipment at our related Kansas City, Kansas production facility. We may incur further impairment losses with respect to these assets if the assumptions that we made when we performed our analysis prove to be incorrect or if we determine that we need to change our assumptions. Further, we have experienced operating losses in our ingredient solutions segment in each of the last three fiscal years and anticipate that such losses will continue into at least a portion of fiscal 2009. If continued high commodity prices or other factors result in continuing losses in our ingredient solutions segment beyond our expectations, we may incur additional impairment losses related to that segment.
Business Strategy Risks
Our business strategy for our ingredient solutions segment includes focusing our efforts on the production of specialty proteins and starches and expanding our geographic reach, both domestically and internationally. We have reconfigured our ingredient solutions technology platforms around our customers and the bulk of our research and development is now customer focused. We have narrowed our product lines to drive towards a higher-value product mix. We also intend to make acquisitions and develop strategic alliances. There can be no assurance that our ingredients business will be profitable with our changed research focus and fewer product offerings or that we will be successful in identifying appropriate acquisition candidates or joint venture partners. We may need to incur additional indebtedness (which may be long-term), expend cash or use a combination thereof for all or part of the consideration to make acquisitions or be in future joint ventures, and there can be no assurance that we will have the requisite cash flow or access to funding. While we periodically evaluate potential acquisition and joint venture opportunities, apart from a start up joint venture in Germany to make Wheatex and a strategic alliance with Cargill that we are trying to renegotiate, we currently have no present commitments or agreements with respect to any material acquisition or joint venture. There can also be no assurance that our ingredients business strategy will prove to be profitable.
The markets for our protein and starch products are very competitive, and our results could be adversely affected if we do not compete effectively.
The markets for starches and proteins in which we participate are very competitive. Our principal competitors in these markets have substantial financial, marketing, and other resources. In some product categories, we compete not only with other wheat based products but also with products derived from other sources. Competition is based on such factors as product innovation, product characteristics, product quality, price, color and name. If market conditions make our specialty ingredients too expensive for use in consumer goods, our revenues
20
could be affected. If our large competitors were to decrease their pricing, we could choose to do the same, which could adversely affect our margins and profitability. If we did not do the same, our revenues could be adversely affected due to the potential loss of sales or market share. Our revenue growth could also be adversely impacted if we are not successful in developing new products for our customers or through new product introductions by our competitors.
RISKS SPECIFIC TO OUR OTHER SEGMENT
We have incurred impairment losses in our pet treat resin business and may suffer future impairment losses.
As noted above in our discussion of our ingredient solutions segment, during fiscal 2008 we recognized an impairment loss with respect to the pet resin business in our other segment. We are attempting to dispose of the assets that we used in that business. We may incur further impairment losses with respect to these assets if the assumptions that we made when we performed our analysis prove to be incorrect or if we determine that we need to change our assumptions.
Our plant-based biopolymers and wood based resins may not prove to be profitable.
Plant-based biopolymers and wood- based resins continue to represent an emerging area of our business. While commercialization of these products has begun, they continue to undergo further research and development as we explore additional enhancements to expand their functionality and use capabilities. To date, they have not contributed significant revenues or proved profitable.
OTHER RISKS
Common stockholders have limited rights under our Articles of Incorporation.
Under our Articles of Incorporation, holders of our Preferred Stock are entitled to elect five of our nine directors and only holders of our Preferred Stock are entitled to vote with respect to a merger, dissolution, lease, exchange or sale of substantially all of the Companys assets, or on an amendment to the Articles of Incorporation, unless such action would increase or decrease the authorized shares or par value of the Common or Preferred Stock, or change the powers, preferences or special rights of the Common or Preferred Stock so as to affect the holders of Common Stock adversely. Generally, the Common Stock and Preferred Stock vote as separate classes on all other matters requiring stockholder approval. A majority of the outstanding shares of our Preferred Stock is held by the MGP Ingredients Voting Trust, whose trustees are Cloud L. Cray, Jr., Richard B. Cray and Laidacker M. Seaberg.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
21
We maintain the following principal plants, warehouses and office facilities:
Location |
|
Purpose |
|
Plant Area |
|
Tract Area |
|
|
|
|
|
(in sq. ft.) |
|
(in acres) |
|
|
|
|
|
|
|
|
|
Atchison, Kansas |
|
Grain processing, distillery, warehousing, and research and quality control laboratories. (Distillery Products and Ingredient Solutions) |
|
494,640 |
|
26 |
|
|
|
|
|
|
|
|
|
|
|
Principal executive office building (Corporate) |
|
18,000 |
|
1 |
|
|
|
|
|
|
|
|
|
|
|
Technical Innovation Center (Ingredient Solutions) |
|
19,600 |
|
1 |
|
|
|
|
|
|
|
|
|
Kansas City, Kansas |
|
Specialty protein and starch further processing and extrusion facility and warehouse. (Ingredient Solutions and Other) |
|
83,200 |
|
27 |
|
|
|
|
|
|
|
|
|
Pekin, Illinois |
|
Grain processing, distillery, warehousing and quality control laboratories. (Distillery Products and Ingredient Solutions) |
|
462,926 |
|
49 |
|
|
|
|
|
|
|
|
|
Onaga, Kansas |
|
Production of plant-based polymers and wood composites. (Other) |
|
23,040 |
|
3 |
|
Our facilities are generally in good operating condition, are currently in normal operation, and are generally suitable for the business activity conducted therein and have productive capacities sufficient to maintain prior levels of production. The Atchison, Pekin and Onaga production facilities are owned. The Kansas City facility is leased from the Unified Government of Wyandotte County, Kansas City, Kansas, and the executive offices and technical innovation center in Atchison are leased from the City of Atchison, pursuant to an industrial revenue bond financings. We also own or lease transportation equipment and facilities and a gas pipeline described under Business Transportation and Energy. Our loan agreements contain covenants that limit our ability to pledge our facilities to others.
The Company is not a party to any material legal proceeding required to be disclosed under Item 103 of Regulation S-K.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters have been submitted to a vote of stockholders during the fourth quarter of the fiscal year covered by this report.
22
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
Our Executive Officers are as follows:
Name |
|
Age |
|
Position |
Laidacker M. Seaberg |
|
62 |
|
Chairman of the Board |
|
|
|
|
|
Timothy W. Newkirk |
|
40 |
|
President and Chief Executive Officer |
|
|
|
|
|
Robert J. Zonneveld |
|
43 |
|
Vice President of Finance and Administration and Chief Financial Officer |
|
|
|
|
|
Brian T. Cahill |
|
54 |
|
Executive Vice President, Distillery Products |
|
|
|
|
|
Clodualdo Ody Maningat, Ph.D. |
|
53 |
|
Vice President, Application Technology and Technical Services |
|
|
|
|
|
Marta L. Myers |
|
48 |
|
Corporate Secretary and Executive Assistant to the President |
|
|
|
|
|
Steven J. Pickman |
|
55 |
|
Vice President, Corporate Relations and Marketing Services |
|
|
|
|
|
David E. Rindom |
|
53 |
|
Vice President, Human Resources |
|
|
|
|
|
Randy M. Schrick |
|
58 |
|
Vice President, Engineering, and Corporate Director of Distillery Products Manufacturing |
|
|
|
|
|
William R. Thornton |
|
56 |
|
Vice President, Quality Management and Internal Legal Counsel |
Mr. Seaberg joined the Company in 1969 and has served as Chairman of the Board since October 2006. He had also previously served as Chief Executive Officer from September, 1988 to March, 2008. He had served as the President of the Company from 1980 to October, 2006. He is the son-in-law of Mr. Cray, Jr.
Mr. Newkirk has served as President and Chief Executive Officer since March, 2008. He previously had been President and Chief Operating Officer since October, 2006 and Vice President of Operations and Chief Operating Officer since April, 2006. He first joined the Company in 1991, serving initially as a distillery shift manager and later as a process engineer, project engineer and quality control manager at the Atchison, Kansas plant. He became manager of the Companys Pekin, Illinois plant in 1997. From 2000 to 2002, he was Vice President of Operations for the former High Plains Corporation, an ethanol production company located in Wichita, Kansas. He became Vice President of Global Operations for Abengoa Bioenergy S.L. following that companys acquisition of High Plains in January, 2002. He then served as Chief Operating Officer of Abengoa Bioenergy Corporation from August, 2003 until his return to MGP Ingredients as Director of Operations in 2005.
Mr. Zonneveld joined the Company as Vice President of Finance and Administration and Chief Financial Officer in August, 2007. Just prior to that, he served for over two years as Chief Financial Officer of the Gowan Company, Yuma, Arizona. From 1995 to 2005, he was employed in executive capacities with Standard Commercial Corp., Wilson, North Carolina, including six years as Vice President of Finance. He had previously served for two years as a Consolidation Accountant for Dimon, Inc., Danville, Virginia, and for two years as Controller for TEIC U.S., a subsidiary of Dimon. He also served for one year as a staff auditor for BDO Seidman, Greensboro, North Carolina.
23
Mr. Cahill has served as Executive Vice President of Distillery Products since October, 2007. He had formerly served as Vice President Finance and Administration and Chief Financial Officer since October 2002. Prior thereto he served as General Manager of the Companys Pekin facility since 1992.
Dr. Maningat joined the Company in 1986. He has served as Vice President of Application Technology and Technical Services since June 2002. Previously, he was Corporate Director of Research and Development and Technical Marketing from 1997 to 2002. He served as Corporate Director of Research and Development and Quality Control for the Company from 1993 to 1997.
Ms. Myers joined the Company in 1996. She has served as Secretary since October 1996 and as Executive Assistant to the President since 1999. Previously, she was executive secretary for Superintendent of Schools for Unified School District 409, Atchison, Kansas.
Mr. Pickman joined the Company in 1985. He has served as Vice President, Corporate Relations and Marketing Services since June 2000. Previously he was Executive Director of Corporate Relations from 1999 to June 2000 and prior to that Corporate Director of Public and Investor Relations. Between 1985 and 1989 he served as the Director of Public Relations and Marketing Administration for the Companys former subsidiary, McCormick Distilling Company, Weston, Missouri.
Mr. Rindom joined the Company in 1980. He has served as Vice President, Human Resources since June 2000. He was Corporate Director of Human Relations from 1992 to June 2000, Personnel Director from 1988 to 1992, and Assistant Personnel Director from 1984 to 1988.
Mr. Schrick, a Director since 1987, joined the Company in 1973. He has served as Vice President of Engineering and Corporate Director of Distillery Products Manufacturing since June, 2008. He previously was Vice President, Manufacturing and Engineering since July 2002. He served as Vice President - Operations from 1992 until July 2002. From 1984 to 1992, he served as Vice President and General Manager of the Pekin plant. From 1982 to 1984, he was the Plant Manager of the Pekin Plant. Prior to 1982, he was Production Manager at the Atchison plant.
Mr. Thornton joined the Company in 1994. He has served as Vice President of Quality Management since June 2000 and as Internal Legal Counsel since 2007. He was Corporate Director of Quality Management from 1997 to June 2000, and Corporate Director of Continuous Quality Improvement from 1994 to 1997.
24
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDERS MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our Common Stock has been traded on the NASDAQ Stock Market (formerly the National Market System) since November 1988. Our trading symbol is MGPI.
The table below reflects the high and low closing prices of our Common Stock for each quarter of fiscal 2008 and 2007:
|
|
|
|
Sales Price |
|
||||
|
|
|
|
High |
|
Low |
|
||
2008 |
|
|
|
|
|
|
|
||
|
|
|
|
|
|
|
|
||
|
|
First Quarter |
|
$ |
18.10 |
|
$ |
10.13 |
|
|
|
Second Quarter |
|
10.30 |
|
6.13 |
|
||
|
|
Third Quarter |
|
10.28 |
|
6.16 |
|
||
|
|
Fourth Quarter |
|
8.10 |
|
5.80 |
|
||
|
|
|
|
|
|
|
|
||
2007: |
|
|
|
|
|
|
|
||
|
|
First Quarter |
|
$ |
25.16 |
|
$ |
17.99 |
|
|
|
Second Quarter |
|
23.44 |
|
20.25 |
|
||
|
|
Third Quarter |
|
23.08 |
|
18.12 |
|
||
|
|
Fourth Quarter |
|
20.73 |
|
15.76 |
|
Under our credit agreement, as amended on September 3, 2008, we cannot pay dividends without the consent of the lenders under the credit agreement.
We paid an annual cash dividend of $0.20 per share in October 2006 and semi-annual cash dividends of $0.10 per share in April 2007, $0.15 per share in October 2007 and $0.10 per share in April 2008. After we are free of restrictions in our credit agreement, any future dividends permitted by the terms of any future credit arrangement will be paid at the discretion of the Board of Directors, which will consider various factors, including our operating results and cash requirements, in making any decision respecting dividends.
At June 30, 2008, there were approximately 607 holders of record of our Common Stock. We believe that the Common Stock is held by approximately 6,181 beneficial owners.
PURCHASES OF EQUITY SECURITIES BY ISSUER
We did not repurchase any shares of our stock during the three months ended June 30, 2008.
25
Fiscal Year (1) (2) (3) |
|
2008 |
|
2007 |
|
2006 |
|
2005 |
|
2004 |
|
|||||
|
|
|
|
(as restated) |
|
(as restated) |
|
(as restated) |
|
(as restated) |
|
|||||
Income Statement Data: |
|
|
|
|
|
|
|
|
|
|
|
|||||
Net sales |
|
$ |
392,893 |
|
$ |
367,994 |
|
$ |
322,477 |
|
$ |
275,177 |
|
$ |
270,673 |
|
Cost of sales |
|
388,662 |
|
320,721 |
|
276,498 |
|
249,449 |
|
235,333 |
|
|||||
Gross profit |
|
4,231 |
|
47,273 |
|
45,979 |
|
25,728 |
|
35,340 |
|
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Selling, general and administrative expenses |
|
24,235 |
|
20,319 |
|
23,811 |
|
19,318 |
|
20,339 |
|
|||||
Write-off of assets |
|
1,546 |
|
|
|
|
|
|
|
|
|
|||||
Loss on impairment of assets |
|
8,100 |
|
|
|
|
|
|
|
|
|
|||||
Income (loss) from operations |
|
(29,650 |
) |
26,954 |
|
22,168 |
|
6,410 |
|
15,001 |
|
|||||
Other income, net |
|
515 |
|
1,490 |
|
137 |
|
890 |
|
1,450 |
|
|||||
Gain on settlement of litigation, net of related |
|
7,046 |
|
|
|
|
|
|
|
|
|
|||||
Interest expense |
|
(1,490 |
) |
(964 |
) |
(1,482 |
) |
(1,393 |
) |
(1,088 |
) |
|||||
Equity in loss of unconsolidated subsidiary |
|
(14 |
) |
|
|
|
|
|
|
|
|
|||||
Income before income taxes |
|
(23,593 |
) |
27,480 |
|
20,823 |
|
5,907 |
|
15,363 |
|
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Provision (benefit) for income taxes |
|
(11,851 |
) |
9,914 |
|
6,963 |
|
2,047 |
|
6,069 |
|
|||||
Net income |
|
$ |
(11,742 |
) |
$ |
17,566 |
|
$ |
13,860 |
|
$ |
3,860 |
|
$ |
9,294 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Basic earnings per common share |
|
$ |
(0.71 |
) |
$ |
1.07 |
|
$ |
0.86 |
|
$ |
0.24 |
|
$ |
0.60 |
|
Cash dividends per common share |
|
$ |
0.25 |
|
$ |
0.30 |
|
$ |
0.15 |
|
$ |
0.15 |
|
$ |
0.08 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Weighted average basic common shares outstanding |
|
16,531 |
|
16,428 |
|
16,106 |
|
15,975 |
|
15,473 |
|
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Balance Sheet Data: |
|
|
|
|
|
|
|
|
|
|
|
|||||
Working capital |
|
$ |
46,864 |
|
$ |
47,565 |
|
$ |
43,454 |
|
$ |
39,737 |
|
$ |
39,054 |
|
Total assets |
|
225,932 |
|
225,023 |
|
204,584 |
|
189,500 |
|
187,037 |
|
|||||
Long-term debt, less current maturities |
|
1,301 |
|
8,940 |
|
12,355 |
|
16,785 |
|
12,561 |
|
|||||
Stockholders equity |
|
134,015 |
|
147,009 |
|
133,897 |
|
119,636 |
|
117,452 |
|
|||||
Book value per share |
|
$ |
8.09 |
|
$ |
8.91 |
|
$ |
8.23 |
|
$ |
7.49 |
|
$ |
7.38 |
|
26
|
(1) |
Fiscal years 2004, 2005, 2006 started on July 1 and ended on June 30. On June 8, 2006 the Board of Directors amended the Companys Bylaws to effect a change in the fiscal year from a fiscal year ending June 30 to a 52/53 week fiscal year. As a result of this change, fiscal 2007 ended on July 1, 2007. On March 6, 2008, the Board of Directors amended the Companys bylaws to effect a change in the fiscal year so that it would again end on June 30 each year. |
|
|
|
|
(2) |
Amounts for the fiscal years 2004 through 2007 have been adjusted to reflect a restatement of those years. See Note 18 in Notes to Consolidated Financial Statements set forth in Item 8 for additional information and analysis. |
|
|
|
|
(3) |
Amounts for the fiscal year 2008 include a write-off of assets of $1.5 million, a write-down of inventory of $1.3 million and a loss on the impairment of assets of $8.1 million, partially offset by a gain on the settlement of litigation of $7.0 million and the removal of the $3.0 million state tax valuation allowance ($2.0 million net of taxes). For further discussion, see Notes 5, 9, 10 and 11 in Notes to Consolidated Financial Statements set forth in Item 8, and Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Fiscal 2008 Compared to Fiscal 2007 Cost of Sales. |
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
We are a fully integrated producer of certain ingredients and distillery products and have three reportable segments, an ingredient solutions segment, a distillery products segment and an other segment. Products included within the ingredient solutions segment consist of starches, including commodity wheat starch and specialty wheat starch, and proteins, including commodity wheat gluten, specialty wheat proteins, and mill feeds. Distillery products consist of food grade alcohol, including beverage alcohol and industrial alcohol, fuel grade alcohol, commonly known as ethanol, and distillers feed and carbon dioxide, which are co-products of our distillery operations. Products in our other segment consist of plant-based resins and biopolymers and wood composites.
Our principal raw material is grain, consisting of wheat, which is processed into all of our products, and corn, which is processed into alcohol, animal feed and carbon dioxide. The cost of grain is subject to substantial fluctuations depending upon a number of factors which affect commodity prices in general, including crop conditions, weather, government programs and purchases by foreign governments. Such variations in grain prices have had and are expected to have from time to time significant adverse effects on the results of our operations, as we are not always able to keep pace proportionately with price increases due to several factors, such as the terms of supply agreements that limit our ability to raise prices, price competition from substitute products and competition from global competitors with different input commodity prices due to subsidies, tariffs, or other unique advantages We enter into readily marketable exchange-traded commodity futures and option contracts to reduce the risk of future grain price increases. We elected to discontinue the use of hedge accounting for all commodity derivative positions effective April 1, 2008. Since April 1, 2008, we have recorded all changes in the value of derivatives in cost of sales in our Consolidated Statements of Income. See Critical Accounting Policies below.
Energy comprises a major cost of operations, and seasonal increases in natural gas and other utility costs can affect our profitability. Except for fiscal 2007, in each fiscal year since fiscal 2002, energy costs have been higher than in the previous fiscal year.
Substantially all of our sales are made directly or through distributors to manufacturers and processors of finished goods. Sales to our customers purchasing food grade alcohol are made on a spot, monthly, quarterly and annual basis depending on the customers needs and market conditions. However, depending on market conditions, we sell varying amounts of our fuel alcohol under longer term contracts. Contracts with ingredients customers are generally price and term agreements which are fixed for quarterly or six month periods, with very few agreements of twelve months duration or more. In the past, we have benefited from tax and other incentives offered by the United States and various state governments to encourage the production of fuel alcohol. One of these involves a program that was implemented by the U.S. Department of Agriculture in December, 2000 to provide cash incentives for ethanol producers who increase their grain usage over comparable quarters to raise fuel alcohol production. Under this program, we received a final payment of approximately $190,000 in fiscal 2006, at which time our eligibility to participate in the program ended.
We also have benefited from a United States Department of Agriculture program in effect from June 1, 2001 to May 31, 2003 to support the development and production of value-added wheat proteins and starches. Current and prior period results reflect the recognition of revenue from this grant. See Critical Accounting Policies-USDA Grant. We also benefit indirectly from tax incentives provided gasoline marketers and producers to encourage the use of ethanol. These incentives presently are scheduled to expire at the end of 2010.
In preparing financial statements, management must make estimates and judgments that affect the carrying values of our assets and liabilities as well as recognition of revenue and expenses. Managements estimates and judgments are based on our historical experience and managements knowledge and understanding of current facts and circumstances. The policies discussed below are considered by management to be critical to an understanding of our financial statements. The application of certain of these policies places significant demands on managements
28
judgment, with financial reporting results relying on estimations about the effects of matters that are inherently uncertain. For all of these policies, management cautions that future events rarely develop as forecast, and estimates routinely require adjustment and may require material adjustment.
Hedging Activities. From time to time, we enter into readily marketable exchange-traded commodity futures and option contracts to reduce the risk of future grain price increases. Derivative instruments related to our hedging program are recorded as either assets or liabilities and are measured at fair market value. Consistent with application of hedge accounting under Statement of Financial Accounting Standards No. 133 as amended (SFAS 133), prior to April 1, 2008 changes in the fair market value of the derivative instruments designated as cash flow hedges were recorded either in current earnings or in other comprehensive income, depending on the nature of the hedged transaction. Gains or losses recorded in other comprehensive income were reclassified into current earnings in the periods in which the hedged items were consumed. Any ineffective portion of a hedged transaction was immediately recognized in current earnings.
We elected to discontinue the use of hedge accounting for all commodity derivative positions effective April 1, 2008. Accordingly, changes in the value of derivatives subsequent to March 31, 2008 have been recorded in cost of sales in our Consolidated Statements of Income. Additionally, derivative instruments entered into during the third and fourth quarter were not designated as hedges. The change in the market value of these instruments also has been recorded in cost of sales in our Consolidated Statements of Income. As of June 30, 2008, the mark-to-market adjustment included in accumulated other comprehensive income with respect to derivatives originally designated for hedging under FASB 133 and subsequently de-designated in April 2008 will remain in accumulated other comprehensive income as a component of equity until the forecasted transactions to which the specific hedged positions relate occur. At that time, the accumulated comprehensive income will be reclassified to earnings. Regardless of accounting treatment, we believe all commodity hedges are economic hedges.
USDA Grant. As discussed in Note 1 to the Notes to Consolidated Financial Statements, we received a grant from the United States Department of Agriculture Commodity Credit Corporation totaling approximately $25.6 million over the two-year period June 1, 2001 to May 31, 2003. The funds were awarded for research, marketing, promotional and capital costs related to value-added wheat gluten and starch products. Of the amount awarded, we allocated approximately $8.1 million to operating costs and $17.5 million to capital expenditures. Management has exercised judgment in applying grant proceeds to operating costs and capital expenditures in accordance with the terms of the grant. Funds applied to current operating costs were considered revenue as those costs were incurred during fiscal years 2002 and 2003. Funds applied to capital expenditures are being recognized in income over the periods during which applicable projects are depreciated. Substantially all of the funds applied to capital expenditures will be recognized in this manner over approximately the next four to five years.
Impairment of Long-Lived Assets. We review long-lived assets, mainly equipment, for impairment at year end or if events or circumstances indicate that usage may be limited and carrying values may not be recoverable. Should events indicate the assets cannot be used as planned, the realization from alternative uses or disposal is compared to the carrying value. If an impairment loss is measured, this estimate is recognized. Considerable judgment is used in these measurements, and a change in the assumptions could result in a different determination of impairment loss and/or the amount of any impairment. We recognized a non-cash impairment loss of $8.1 million at the end of the third quarter of fiscal 2008, of which $4.7 million related to the pet business component of our Other segment and $3.4 related to the ingredients equipment at our related Kansas City, Kansas production facility. We may incur further impairment losses with respect to these assets if the assumptions that we made when we performed our analysis prove to be incorrect or if we determine that we need to change our assumptions. Further, we have experienced operating losses in our ingredient solutions segment in each of the last three fiscal years and anticipate that such losses will continue into fiscal 2009. If continued high commodity prices or other factors result in continuing losses in our ingredient solutions segment beyond our expectations, we may incur additional impairment losses related to that segment.
Defined Benefit Retirement Plan. We sponsor two funded, noncontributory qualified Defined Benefit Retirement Plans that cover substantially all our union employees. The benefits under these plans are based upon years of qualified credited service. Our funding policy is to contribute annually not less than the regulatory minimum and not more than the regulatory maximum amount deductible for income tax purposes. The
29
measurement and valuation date of the plans is June 30 of each year. We make various assumptions in valuing the liabilities and benefits under the plan each year. We consider the rates of return on long-term, high-quality fixed income investments using the annualized Moodys AA bond index. Assumptions regarding employee and retiree life expectancy are based upon the 2008 IRS Combined Mortality Table.
Other Post-Retirement Benefits. We also provide certain other post retirement health care and life insurance benefits to certain retired employees. Currently, the plan covers approximately 540 participants, both active and retired. We fund the post retirement benefit plans on a pay-as-you-go basis and there are no assets that have been segregated and restricted to provide for post retirement benefits. We pay claims as they are submitted for both the medical and life insurance plans. We provide varied levels of benefits to participants depending upon the date of retirement and the location in which the employee worked. The medical and life plans are available to employees who have attained the age of 62 and rendered the required number of years of service ranging from five to ten years. All health benefit plans provide company-paid continuation of the active medical plan until age 65. At age 65, we either provide the retiree with Medicare Supplement coverage until death or we pay a lump sum advance premium on behalf of the retiree to the MediGap carrier of the retirees choice. The employee retirement date determines which level of benefits is provided.
Prior to the fiscal year ended June 30, 2008, the plan measurement and valuation date was May 31 of each year. Beginning with the fiscal year ended June 30, 2008, we changed the plan measurement and valuation date to June 30. In accordance with Statement on Financial Accounting Standard No. 158 Employers Accounting for Defined Benefit Pension and Other PostRetirement Plans (as amended) (SFAS 158), we have made a $60,000 adjustment to retained earnings to reflect the adjustment related to adoption of the new measurement date. We make various assumptions in valuing the liabilities and benefits under the plan each year. We consider the rates of return on currently available, high-quality fixed income investments, using the annualized Moodys AA bond index. (Long term rates of return are not considered because the plan has no assets.) For fiscal 2008, the accumulated post retirement benefit obligation (APBO) remained relatively unchanged at $7.7 million. Assumptions regarding employee and retiree life expectancy are based upon the 2008 IRS Combined Mortality Table. We also consider the effects of expected long term trends in health care costs, which are based upon actual claims experience and other environmental and market factors impacting the cost of health care in the short and long-term.
Other Significant Accounting Policies. Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the financial statements. These policies require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. See Note 1 in Notes to Consolidated Financial Statements set forth in Item 8 for other significant accounting policies.
In the quarter ended September 30, 2007, we expanded the number of our operating segments from two to three. Following a review of our business, we concluded that it would be more appropriate and would provide our shareholders with better information if we were to include our pet treat resins and plant-based biopolymers in a separate segment. These are now reported within the other segment (other). The ingredients segment has been re-titled ingredient solutions, to better reflect our integrated approach to providing comprehensive solutions to our ingredient solutions customers. The ingredient solutions segment continues to report vital wheat gluten, commodity starch, specialty proteins and starches as well as mill products, currently consisting of wheat flour and mill feeds primarily sold for agricultural purposes. The distillery products segment continues to report food grade alcohol (consisting of beverage and industrial alcohol), fuel grade alcohol and distillery co-products, consisting principally of distillers feed.
For the quarter ended December 30, 2007, we further refined the methodology for assessing identifiable assets and earnings (loss) before income taxes for all segments resulting in greater allocation to operating segments of identifiable assets and earnings (loss) before income taxes versus non-allocated corporate. Amounts previously disclosed as identifiable assets as of July 1, 2007 and June 30, 2006 and earnings (loss) before income taxes for fiscal years ended July 1, 2007 and June 30, 2006 have been adjusted to reflect this revision.
30
DEVELOPMENTS IN THE INGREDIENT SOLUTIONS SEGMENT
As reported previously, the trends of convenience and health & wellness continue to be principal drivers for the global food industry. In their development efforts, food manufacturers gravitate towards suppliers who can supply functional, healthy and natural ingredients. During fiscal 2008, we added technical specialists in our sales organization and have embarked on a more aggressive selling effort. With our expanded selling effort, we are calling on more of the 50 largest North American food companies and consulting on how our wheat-based protein and starch specialty ingredients can improve their new products and speed their development. We have also, in concert with our distributors, reinvigorated our sales growth efforts, in Asia and Europe. Our technical talent and facilities are enabling us to pursue closer relationships with customers.
As important as our customer focus is to growing our top line, our dedication to improving our process capabilities is critical to improving our standard cost structure. Using tools and skills from continuous improvement processes such as our investment in the Six Sigma program, we are implementing process improvements in select protein and starch unit operations. These improvements should begin to pay off for us in lower standard costs for some of our most important product lines. We will continue to deploy human talent and effort on our manufacturing operations to drive costs out of our system. We also are dedicating significant effort into improving the productivity of our enterprise by reducing defects in our internal processes.
Since wheat is the primary raw material in our business, high wheat prices continue to impact the cost of sales in the ingredient solutions segment. We anticipate that given growing global demand for agricultural crops, wheat prices may not decline to historical lower levels in the foreseeable future. Because of that, we will continue to focus on improving our productivity across our entire business so that we can sustain our position in the industry.
As noted in previous reports, the March 2007 recall of pet food products containing Chinese wheat flour misrepresented as wheat gluten has caused heightened demand for our vital wheat gluten. We have met this increased demand with increased vital wheat gluten production from our Atchison, Kansas and Pekin, Illinois manufacturing facilities. This increase in demand, combined with improved pricing, is also providing a significant impact on revenues of our ingredient solutions segment. We continue to believe this development to be a short-term trend only and in parallel will continue to maintain our long-term focus on the continued development and commercialization of our value-added wheat protein solutions.
As noted below in the discussion of our other segment, developments in our pet business have led us to conclude at the end of the third quarter that our pet business assets are impaired. We also concluded that certain of our textured wheat protein assets at a shared manufacturing facility in Kansas City, Kansas are also impaired. Of the total impairment charge recognized, $3.4 million relates to assets allocated to our ingredient solutions segment.
DEVELOPMENTS IN THE DISTILLERY PRODUCTS SEGMENT
Profit margins in the distillery products segment were adversely impacted by the effect of higher corn prices, ethanol selling at a discount to gasoline and, in the fourth quarter of fiscal 2008, higher natural gas prices. As industry-wide ethanol production capacity continued to expand, corn prices continued to reflect increased demand related to this increased ethanol production. As a result of these developments in raw material costs, sales of fuel ethanol dropped during the fourth quarter compared to previous quarters due to reduced production. Our hedging program, consisting of derivatives and cash purchases, softened the impact of rising corn prices during the fiscal year ended June 30, 2008.
The demand for ethanol could be affected by new biofuel requirements contained within the energy bill signed by President Bush on December 19, 2007. The bill, which became effective for the calendar year 2008, will require the blending of 9.0 billion gallons of biofuel (such as ethanol) in calendar year 2008 and 11.1 billion gallons in calendar year 2009. However, corn prices could be further adversely impacted as a result of increased ethanol production related to the biofuel requirements, further increasing our cost of sales.
31
During the quarter ended December 30, 2007, measures implemented in fiscal 2007 to improve capacity and strengthen alcohol production efficiencies at our distillery operations in both Atchison, Kansas and Pekin, Illinois were completed and became operational. Additionally, during the quarter ended December 30, 2007, an $11.1 million dryer system for the manufacture of distillers feed became fully operational.
The purpose of this dryer was to improve production efficiencies and lower energy costs as well as fulfill emission control standards. These factors have expanded production capacity, yet we encountered certain fermentation and other issues during the year related to the alcohol production process at our Pekin facility that resulted in a production level below maximum capacity. The fermentation issues were addressed and corrected during the second quarter of fiscal 2008, but our third quarter production remained at less than capacity due to other production issues at our Pekin facility. During the fourth quarter of fiscal 2008, we implemented a planned reduction in fuel grade production in the face of increased raw material costs for corn and higher natural gas prices, and also due to the fact that fuel alcohol prices were at levels representing a major discount to gasoline prices.
We did not reduce our production of food grade alcohol because of customer requirements and generally more favorable conditions in this market. Our long-term strategy is to shift a portion of existing capacity from the production of fuel grade alcohol towards increased production of food grade alcohol.
We are currently exploring alternative sources of energy for our Pekin, Illinois plant in the form of a coal-fired steam generation facility. We have applied for approvals for the construction of a 330,000 pound per hour high pressure solid fuel boiler cogeneration facility at the plant. The proposed facility will utilize coal as the primary fuel. The cost of the project is estimated at $90 million to $100 million. We are seeking a third party energy provider to fund, own and operate the facility, and would expect to enter a multi-year energy supply agreement with the energy provider.
The Illinois Environmental Protection Agency (IEPA) held a public hearing regarding the fuel boiler cogeneration facility on July 14, 2008. This hearing represented one step toward receiving a permit for the facility. The hearing was followed by a written public comment period, which ended on August 13. If the IEPA determines to issue a construction permit, it will be effective 35 days after the date of issue to allow for an appeal period for interested parties. Barring an appeal, we would expect to receive a construction permit at the end of the 35 day waiting period.
After an operating license is granted and a third party energy provider is identified to build the facility, we anticipate that it would take approximately two years to construct and put the facility into operation.
The facility is proposed to be located on a site that we would lease to the provider which is located on our plants 49-acre site. It will be utilized to produce steam to power the plants distillery, wheat gluten (protein) and wheat starch production processes. In addition, a portion of the generated steam will be used to supply the plants electrical needs. Excess energy will be available for sale by the provider to others.
DEVELOPMENTS IN THE OTHER SEGMENT
Although sales of our plant-based biopolymers increased substantially compared to sales in fiscal 2007, they continue to represent an emerging area of our business. Our biopolymers continue to undergo further research and development as we explore additional enhancements to expand their functionality and use capabilities.
As reported in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2008, at the completion of the third quarter of fiscal 2008, we undertook a review of our long-lived assets in our other segment and concluded that an impairment charge on these assets was appropriate. Our pet business has suffered since we lost a major customer in late 2006, but high wheat prices, changing consumer preferences and failure to obtain previously anticipated new business led to this decision. Our pet business assets are located at a joint use facility and, in the course of our review, we also concluded to write-down all the assets at that facility, including those associated with certain of our Wheatex® textured wheat proteins. We recorded an $8.1 million impairment charge related to these combined assets of which $4.7 million related to assets allocated to our other segment. We are evaluating the
32
strategic alternatives for the plant and equipment at our Kansas City facility, and are pursuing the sale of the assets included in our other segment.
The following is a summary of revenues and pre-tax income (loss) allocated to each reportable operating segment for the three fiscal years ended June 30, 2008, July 1, 2007 and June 30, 2006 (See Note 13 in our Notes to Consolidated Financial Statements in Item 8 for additional information regarding our operating segments.)
(dollars in thousands) |
|
2008 |
|
2007 |
|
2006 |
|
|||
|
|
|
|
|
|
|
|
|||
Ingredient Solutions |
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|||
Net Sales |
|
$ |
100,994 |
|
$ |
67,791 |
|
$ |
66,293 |
|
Pre-Tax Income (Loss) |
|
(15,395 |
) |
(5,515 |
) |
|
(1) |
|||
|
|
|
|
|
|
|
|
|||
Distillery Products |
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|||
Net Sales |
|
285,738 |
|
294,393 |
|
236,971 |
|
|||
Pre-Tax Income |
|
2,546 |
|
38,666 |
|
|
(1) |
|||
|
|
|
|
|
|
|
|
|||
Other |
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|||
Net Sales |
|
6,161 |
|
5,810 |
|
19,213 |
|
|||
Pre-Tax Income |
|
(7,155 |
) |
(6,224 |
) |
|
(1) |
|||
Years Ended, |
|
June 30, 2008 |
|
July 1, 2007 |
|
June 30, 2006 |
|
|||
Income (loss) before Income Taxes |
|
|
|
|
|
|
|
|||
Ingredient solutions |
|
$ |
(22,550 |
) |
$ |
(11,739 |
) |
$ |
(11,966 |
) |
Distillery products |
|
2,546 |
|
38,666 |
|
36,954 |
|
|||
FISCAL 2008 COMPARED TO FISCAL 2007
GENERAL
Although net sales increased by $24,899,000, from $367,994,000 in fiscal 2007 to $392,893,000 in fiscal 2008, consolidated earnings for fiscal 2008 declined by $29,308,000 with net income of $17,566,000 in fiscal 2007 to a net loss of $11,742,000 in fiscal 2008. The decline was principally due to a decline in the profitability of our distillery products segment resulting from continued higher corn prices coupled with reduced ethanol prices and unit sales. Losses in the ingredient solutions segment increased over the prior year primarily as a result of the impact of rising wheat costs. Rising wheat costs also negatively impacted the other segment, consisting primarily of developing business lines for pet product and plant-based biopolymer applications.
During the year ended June 30, 2008, there were several non-recurring events which impacted our results, as set forth below.
· We realized a net gain on the settlement of our two-year patent infringement and contract litigation of $7,046,000, net of related professional fees of $954,000 incurred during fiscal 2008.
· We reassessed the need for a valuation allowance which previously offset the deferred tax asset related to certain state tax credit carryforwards. We determined that the valuation allowance was no longer appropriate and therefore removed it, resulting in a net tax benefit of approximately $2.0 million.
· We determined that the assets at our Kansas City, Kansas facility exceeded their estimated realizable fair value. Accordingly, we recorded a non-cash pre-tax charge of $8.1 million related to the impairment of these assets, of which $4.7 million related to our other segment and $3.4 million to our ingredient solutions segment.
33
· During the fourth quarter of fiscal 2008, we completed a complete assessment of our property, plant and equipment and concluded that assets with a cost of approximately $30.0 million with related accumulated depreciation of approximately $28.5 million should be written off. Accordingly, a related non-cash charge to earnings of $1.5 million has been recorded in the fourth quarter of fiscal 2008.
INGREDIENT SOLUTIONS
Total ingredient solutions sales revenue for the year ended June 30, 2008 increased by $33.2 million, or 49.0 percent, compared to the year ended July 1, 2007. Revenues for specialty ingredients, consisting of specialty proteins and specialty starches, increased by $12.0 million, or 25.9 percent, during the year ended June 30, 2008 compared to the year ended July 1, 2007. Revenues for specialty proteins increased as a result of higher unit sales as well as increased per unit prices. Revenues for specialty starches rose as the result of improved pricing and unit sales. Revenues for vital wheat gluten, which increased $17.8 million, or 130.0 percent, were a result of both increased sales volume as well as higher per-unit pricing. Revenues for commodity starch decreased $315,000, or 7.8 percent, as a result of reduced sales volume, consistent with the implementation of our strategy of continued development and commercialization of our value-added wheat proteins and starches. This decrease in commodity starch unit sales was partially offset by improved per-unit pricing. While sales revenue for the ingredient solutions segment improved overall, margins continued to be significantly impacted by increased cost of sales related to record high wheat prices. The per bushel cost of wheat for the year ended June 30, 2008 increased by 63 percent over the year ended July 1, 2007.
DISTILLERY PRODUCTS
Total distillery products sales revenue for the year ended June 30, 2008 decreased $8.7 million, or 2.9 percent, compared to the year ended July 1, 2007. This decrease was due to reduced revenues for fuel grade alcohol of $32.2 million due to reduced ethanol prices, reduced production levels in the second and third quarters related to fermentation and other production problems and reduced production levels during the later part of the fourth quarter of fiscal 2008 due to higher corn costs and lower ethanol prices. Decreases in revenues for fuel grade alcohol were partially offset by increased revenue from food grade alcohol of $15.0 million attributable to increased per-unit prices as well as improvements in unit sales. Distillers grain revenue for the year ended June 30, 2008 increased $8.1 million, or 26.0 percent, over the year ended July 1, 2007 as a result of improved pricing offset partially by reduced unit sales. In addition to reduced revenues for distillery products for the year ended June 30, 2008, margins were significantly impacted by increased cost of sales related to increased corn prices compared to the year ended July 1, 2007. For the year ended June 30, 2008, the per-bushel cost of corn, adjusted for the impact of our hedging practices, was 23 percent higher than the year ended July 1, 2007. These increased costs, coupled with reduced revenues, yielded a substantially reduced profit for the segment.
OTHER PRODUCTS
For the year ended June 30, 2008, revenues for other products, consisting primarily of pet treats and plant-based biopolymers, increased $351,000, or 6.0 percent, compared to the year ended July 1, 2007, primarily as a result of increased unit sales and improved per-unit prices for biopolymer products, partially offset by reduced unit sales of pet treat products. Selling prices for pet treat products improved over the year ended July 1, 2007.
SALES
Net sales for the year ended June 30, 2008 increased $24.9 million, or 6.8 percent, compared to the year ended July 1, 2007 as a result of increased sales in the ingredient solutions segment related to improvements in unit sales as well as overall improvements in pricing for both commodity and specialty products. These increases were partially offset by reduced revenues in the distillery products segment resulting principally from reduced per unit prices and unit sales for fuel grade alcohol. For fuel grade alcohol, the per-unit price declined 3.0 percent while unit sales declined over 17.2 percent. Per unit prices for food grade alcohol improved approximately 6.3 percent during the year while unit sales improved approximately 8.1 percent. Revenues for distillers feed improved as a result of increased per-unit pricing. Net sales for our other segment increased $351,000 for the reasons stated above.
34
COST OF SALES
For the year ended June 30, 2008, cost of sales rose $67.9 million (21.2 percent) compared to the year ended July 1, 2007. This increase was primarily the result of higher grain costs and higher costs of other inputs used in the manufacturing process combined with the impact of changes in production rates. For the year ended June 30, 2008, the per-bushel cost of corn, adjusted for the impact of our hedging practices, was 23 percent higher than the year ended July 1, 2007 (the actual price for corn, unadjusted for the effects of hedging, increased 38 percent). For the year ended June 30, 2008, the per-bushel cost of wheat averaged 63 percent higher than the year ended July 1, 2007, while the average cost for natural gas rose 14.8 percent.
During the year ended June 30, 2008, we identified a portion of our inventory that we felt was either outdated or in need of additional processing to meet necessary quality standards, resulting in a charge to earnings of $1.3 million.
Included within the cost of sales for the year ended June 30, 2008 were mark-to-market adjustments on undesignated derivative instruments outstanding at June 30, 2008 resulting in a reduction to cost of sales expense of $838,000.
As described in Note 1 of our Notes to Condensed Consolidated Financial Statements, incorporated herein by reference, effective April 1, 2008, we elected to discontinue the use of hedge accounting for all commodity derivative positions. Accordingly, changes in the value of all derivatives subsequent to March 31, 2008 were recorded in cost of sales in the Companys Consolidated Statements of Income. As of June 30, 2008, the remaining mark-to-market adjustment of $3.5 million (or $2.2 million, net of tax of $1.3 million) included in accumulated other comprehensive income related to previously designated derivatives will remain in accumulated other comprehensive income until the forecasted transactions to which the specific hedged positions relate occur, which we anticipate to be approximately $2.3 million in the first quarter and $1.2 million in the second quarter of fiscal 2009.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the year ended June 30, 2008 increased by $3.9 million to $24,235,000 from $20,319,000, for the year ended July 1, 2007. In the year ended June 30, 2008, we incurred increased costs related to the implementation of certain information technology and communication systems, increased employee health care benefits costs as well as increased occupancy costs, including depreciation, related to our new administrative offices and technology center. We also incurred increased costs related to legal, accounting and other professional fees and increased compensation expense related to higher administrative level staffing as well as higher research and development staffing. These factors, which contributed to increased selling, general and administrative expenses, were partially offset by lower compensation costs related to the Companys management incentive programs.
We adjusted our selling, general and administrative expenses for the year ended June 30, 2008 for a reduction of $954,000 to reclassify first and second quarter legal and professional expenses related to the gain on settlement of litigation from selling, general and administrative to the gain on settlement of litigation.
35
WRITE-OFF OF ASSETS
During the quarter ended June 30, 2008, in connection with the preparation of our financial statements for the year ended June 30, 2008, we undertook a review of our property, plant and equipment records in order to identify assets that were no longer in service or had been abandoned in place. The focus of this review was identifying assets that were fully depreciated to determine the propriety of continued inclusion within the property, plant and equipment records. In performing our review, we considered such factors as salvage values, current asset implementation and potential future asset implementation. Upon completion of our review, we noted assets with a cost of approximately $30.0 million and related accumulated depreciation of approximately $28.5 million that had been abandoned or were no longer in active service. Accordingly, we recorded a charge to operating earnings of $1.5 million for the year ended June 30, 2008.
LOSS ON IMPAIRMENT OF LONG-LIVED ASSETS
In connection with the preparation of our financial statements for the quarter ended March 31, 2008, we undertook a review of our long-lived assets contained within our other and ingredient solutions segments in accordance with Statement of Financial Accounting Standards No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144). The review took into account the impact of the rising trend of commodity prices on existing contracts and consumer preferences, anticipated sales to existing customers, the failure of anticipated business to develop, recent decisions to cease R&D activities on pet treats and reduce staffing in the pet treat area and plans to shift production of certain texturized wheat proteins to third parties. Based upon this review, management estimated that the carrying value of the assets comprising its Kansas City manufacturing facility (KCIT facility) exceeded the estimated realizable fair value of these assets. In accordance with SFAS No. 144, we recorded a non-cash pre-tax charge of $8.1 at the end of the third quarter related to the impairment of these assets. Of this amount, $4.7 million relates to assets allocated to our other segment and $3.4 million relates to assets allocated to our ingredient solutions segment. We have evaluated strategic alternatives for the plant and equipment at our KCIT facility, and are currently pursuing a sale of those assets included within our other segment.
OTHER INCOME, NET
Other income net, for the year ended June 30, 2008, decreased $975,000 compared to the year ended July 1, 2007. This decrease was primarily related to changes in interest capitalized as well as the effect of certain other non-recurring, non-operating revenue items. It is our practice to credit other income for interest incurred that is capitalized.
EQUITY IN LOSS OF JOINT VENTURE
Equity in the loss of our joint venture was $14,000 for the year ended June 30, 2008. On July 17, 2007, we completed a transaction with Crespel and Dieters GmbH & Co. KG for the formation and financing of a joint venture, D.M. Ingredients, GmbH (DMI) located in Ibbenburen, Germany. DMIs primary operation is the production and tolling of the Wheatex series of textured wheat proteins made from vital wheat gluten for marketing by MGPI domestically and, through our partner and third parties, internationally. Currently, the joint venture is utilizing a third party toller in the Netherlands to produce the Wheatex products. We own a 50% interest in DMI, and account for it using the equity method of accounting. As of June 30, 2008, we had invested $375,000 in DMI since July, 2007.
For the year ended June 30, 2008, DMI incurred a net loss of $28,000 related to costs incurred for the initial implementation of operations. No sales revenue was reported. As a 50% joint venture holder, our equity in this loss was $14,000.
DMIs functional currency is the European Union Euro. Accordingly, changes in the holding value of the Companys investment in DMI resulting from changes in the exchange rate between the U.S. Dollar and the European Union Euro are recorded in other comprehensive income as a translation adjustment on unconsolidated foreign subsidiary net of deferred taxes.
36
GAIN ON SETTLEMENT OF LITIGATION
On December 27, 2007, the Company settled its two-year patent infringement and contract litigation. Under the terms of the settlement, the Company agreed to dismiss its lawsuit with prejudice and was paid $8 million, which was received on December 28, 2007. In connection with the settlement, the Company also granted the other parties in the lawsuit a non-exclusive license under its U.S. Patent No. 5,665,152. During fiscal 2008, the Company incurred professional fees of $954,000, related to this litigation. This amount has been netted against the gross proceeds for a net amount of $7,046,000. The Company has recorded the settlement as a separate line item below income from operations. The Company used the proceeds from the settlement to reduce the amount outstanding under its line of credit.
INTEREST EXPENSE
Interest expense for the year ended June 30, 2008 increased $526,000 compared to the year ended July 1, 2007. These increases were the result of higher balances on our outstanding line of credit compared to the same periods in the prior year. These increases were partially offset by reduced balances on our long-term notes payable.
INCOME TAXES
For the year ended June 30, 2008, our income tax benefit was $11,851,000 for an effective rate of (50.2) percent compared to a provision of $9,914,000 for the year ended July 1, 2007 for an effective rate of 36.1 percent. Excluding certain one-time discrete items applicable to this year, our effective rate was 42.2 percent.
As of the close of the second quarter of fiscal 2008, we had approximately $3.0 million in unused Kansas State Income Tax Credits (tax credits) related to capital investments we have made at our Atchison, Kansas facility. During the quarter, management reassessed the need for a valuation allowance which previously offset the deferred tax asset related to the credit carryforwards. It was determined that the valuation allowance was no longer appropriate and it was therefore removed, resulting in a new tax benefit for the year ended June 30, 2008 of approximately $2.0 million. In making this determination, we considered whether it was more likely than not that we would be able to continue meeting wage base and training requirements in an annual recertification process. We also considered whether it was more likely than not that we would have sufficient taxable income to utilize the carryforwards. Based on our analysis as of December 31, 2007, we concluded that it was more likely than not that the credits would be available to us. The tax credit carryforwards will expire as follows: $1.7 million generated in fiscal year 2005 will expire in fiscal year 2014 and $1.3 million generated in fiscal year 2006 will expire in fiscal year 2015.
NET INCOME
As the result of the foregoing factors, we experienced a net loss of $11,742,000 for the year ended June 30, 2008 compared to net income of $17,566,000 for the year ended July 1, 2007.
FISCAL 2007 COMPARED TO FISCAL 2006
GENERAL
Driven primarily by increased profitability in the distillery products segment, our total earnings in fiscal 2007 improved significantly compared to fiscal 2006. For the year ended July 1, 2007, consolidated net sales increased by $45,517,000, from $322,477,000 in fiscal 2006 to $367,994,000 in fiscal 2007. For the year ended July 1, 2007, net earnings increased $3,706,000, from $13,860,000 in fiscal 2006 to $17,566,000 in fiscal 2007. This occurred despite dramatically higher prices for corn, the principal raw material used in our alcohol production process. Our performance in the ingredients and other segments were negatively affected by increased raw material prices for wheat compared to the prior year contributing to the losses in these segments. Sales of specialty ingredients declined slightly compared to fiscal 2006. Performance in our other segment was also adversely affected by the loss of a significant customer for its pet resin products.
37
INGREDIENT SOLUTIONS
Total ingredient sales in fiscal 2007 increased by approximately $1.5 million, or 2.2 percent, compared to the prior year. Sales of commodity ingredients rose by approximately $4.9 million, or 31.7 percent. This was due to an increase of approximately $4.6 million, or 51.9 percent, in sales of commodity gluten, which was partially offset by a $599,000, or 12.9 percent decline in sales of commodity starch. Sales of mill feed and other mill products increased by $856,000, or 45.8 percent. These factors, which led to an increase in ingredient solutions sales were partially offset by a $2.5 million, or 5.4 percent, decrease in sales of specialty ingredients through decreased sales of both specialty starches and well as specialty proteins.
DISTILLERY PRODUCTS
Total sales of our distillery products in fiscal 2007 rose by approximately $57.4 million, or 24.2 percent, compared to fiscal 2006. This improvement was due to a $35.5 million, or 27.5 percent, increase in sales of fuel grade alcohol and a $19.3 million, or 24.1 percent, increase in sales of food grade alcohol. The increased sales of fuel grade alcohol resulted from higher average selling prices and higher unit sales. In the food grade area, sales of alcohol for industrial applications rose by $17.6 million, or 30.1 percent, as the result of higher unit sales and prices. Sales of food grade alcohol for beverage applications increased by $1.7 million, or 7.9 percent, due to improved prices, which offset slightly lower unit sales. Sales of distillers feed, the principal by-product of the alcohol production process, increased by approximately $2.7 million, or 9.5 percent, also as a result of higher selling prices.
OTHER PRODUCTS
For the year ended July 1, 2007, revenues for other products, consisting primarily of pet treats and plant-based biopolymers decreased $13.4 million or 69.8 percent compared to the year ended June 30, 2007. This decrease was primarily the result of a decline in sales of our Chewtex® protein- and starch-based resins for use in pet industry products due to loss of sales to a major customer.
SALES
Net sales in fiscal 2007 increased by $45.5 million, or 14.1 percent, above net sales in fiscal 2006. This improvement was due primarily to increased distillery products sales. Sales of ingredient solutions products in fiscal 2007 also increased compared to the same period the prior year by $1.5 million, or 2.2 percent. The increase in distillery products sales resulted from higher unit sales and prices for both fuel grade and food grade alcohol combined with improved prices for distillers feed. The increase in ingredient solutions products was primarily due to an increase in sales of commodity ingredients, partially offset by lower sales of specialty ingredients attributable to decreased units sales of both specialty starches and proteins. The increase in sales of commodity ingredients resulted from higher sales of commodity gluten, which offset reduced sales of commodity starch. The rise in commodity gluten sales was due to improved prices, which offset lower unit sales. Commodity starch prices also improved, but were offset by reduced unit sales compared to the prior fiscal year. Decreased sales in our other segment were primarily the result of a decline in sales of our Chewtex® protein- and starch-based resins for use in pet industry products due to loss of sales to a major customer.
COST OF SALES
The cost of sales in fiscal 2007 rose by approximately $44.2 million, or 16.0 percent, over cost of sales in fiscal 2006. This increase was mainly due to higher grain costs and higher costs of supplies used in our manufacturing processes combined with the impact of changes in production rates, partially offset by a decrease in energy costs related to lower natural gas prices. Additionally, the increase was a function of higher maintenance and repairs related to planned plant outages associated with work on our distillery upgrades and higher depreciation expense resulting from a higher depreciable asset base due to certain assets being placed in service in the prior fiscal year. The higher costs of manufacturing-related grain and supplies were primarily due to increased prices. Wheat prices averaged approximately 24 percent higher per bushel than those experienced in fiscal 2006. Wheat costs were not hedged in fiscal 2007. The per-bushel cost of corn, adjusted for the impact of our hedging practices, averaged 50 percent higher compared to the prior year. For fiscal 2007, the cost of natural gas, adjusted for the impact of our hedging practices, decreased approximately 17.5 percent compared to the prior year.
38
In connection with the purchase of raw materials, principally corn and wheat, for anticipated operating requirements, we enter into commodity contracts to hedge the risk of future grain price increases. During fiscal 2007, we hedged approximately 40.7 percent of corn processed compared with approximately 46.3 percent of corn processed in fiscal 2006. Raw material costs in fiscal 2007 included a net hedging loss of approximately $2.4 million compared to a net hedging loss of $1.9 million in fiscal 2006. During fiscal 2007, we experienced no losses on ethanol futures, compared to a loss of $24,000 on ethanol futures during the prior fiscal year.
These hedge transactions are highly effective. Accordingly, nearly all related losses were entirely offset by reduced raw materials costs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses in fiscal 2007 decreased by approximately $3.5 million compared to fiscal 2006. Increased costs related to the implementation of our Enterprise Resource Planning system and administrative activities were offset by reduced salary and management incentive costs. Additionally, during fiscal 2006, we accrued costs related to the unvested portion of our stock option incentive plan of approximately $450,000. During fiscal 2007, these costs were minimal as all outstanding stock options have vested.
OTHER INCOME, NET
Other income increased approximately $1.4 million in fiscal 2007 compared to fiscal 2006. This increase was principally attributable to changes in interest capitalized as well as the effect of certain other non-recurring, non-operating revenue items. It is our practice to credit other income for interest incurred that is capitalized.
INTEREST EXPENSE
Interest expense in fiscal 2007 decreased compared to the prior year.. This was primarily due to the impact of a make-whole premium paid in the first quarter of fiscal 2006 related to the refinancing of our notes with the Principal Mutual Life Insurance Company. Additionally, we maintained lower balances on our outstanding debt during fiscal 2007 than in the prior year.
TAXES AND INFLATION
For fiscal 2007, our income tax provision was $9,914,000, for an effective rate of 36.1 percent, compared to a provision of $6,963,000, for an effective rate of 33.4 percent in fiscal 2006. These changes were primarily the result of changes in permanent differences between income for financial reporting purposes and taxable income.
NET INCOME
As the result of the foregoing factors, we experienced net income of $17,566,000 in fiscal 2007 compared to net income of $13,860,000 in fiscal 2006.
QUARTERLY FINANCIAL INFORMATION
Our sales have not been seasonal during fiscal years 2008 and 2007. The table below shows quarterly information for each of the years ended June 30, 2008 and July 1, 2007.
Quarter |
|
1st Quarter |
|
2nd Quarter |
|
3rd Quarter |
|
4th Quarter |
|
Total |
|
|||||
(dollars in thousands, except per share |
|
|
|
|
|
|
|
|
|
|
|
|||||
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Fiscal 2008 |
|
|
|
|
|
|
|
|
|
|
|
|||||
Sales: |
|
$ |
87,977 |
|
$ |
93,995 |
|
$ |
106,694 |
|
$ |
104,227 |
|
$ |
392,893 |
|
Gross profit |
|
5,860 |
|
3,196 |
|
3,740 |
|
(8,565 |
) |
4,231 |
|
|||||
Net income |
|
(353 |
) |
5,229 |
|
(6,629 |
) |
(9,989 |
) |
(11,742 |
) |
|||||
Earnings per share (diluted) |
|
$ |
(0.02 |
) |
$ |
0.31 |
|
$ |
(0.39 |
) |
$ |
(0.60 |
) |
$ |
(0.70 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|||||
Fiscal 2007 (as restated) |
|
|
|
|
|
|
|
|
|
|
|
|||||
Sales: |
|
$ |
84,995 |
|
$ |
87,645 |
|
$ |
93,807 |
|
$ |
101,547 |
|
$ |
367,994 |
|
Gross profit |
|
15,482 |
|
16,446 |
|
8,087 |
|
7,258 |
|
47,273 |
|
|||||
Net income |
|
6,943 |
|
6,807 |
|
2,148 |
|
1,668 |
|
17,566 |
|
|||||
Earnings per share (diluted) |
|
$ |
0.41 |
|
$ |
0.40 |
|
$ |
0.13 |
|
$ |
0.10 |
|
$ |
1.04 |
|
39
LIQUIDITY AND CAPITAL RESOURCES
The following table is presented as a measure of our liquidity and financial condition as of June 30, 2008 and July 1, 2007: (Dollars in thousands)
|
|
2008 |
|
2007 |
|
||
|
|
|
|
(as restated) |
|
||
Cash and cash equivalents |
|
$ |
|
|
$ |
3,900 |
|
Working capital |
|
46,864 |
|
47,565 |
|
||
Amounts available under lines of credit |
|
17,000 |
|
13,000 |
|
||
Credit facility, notes payable and long-term debt |
|
33,493 |
|
20,091 |
|
||
Stockholders equity |
|
134,015 |
|
147,009 |
|
||
Certain components of our liquidity and financial results for the years ended June 30, 2008, July 1, 2007 and June 30, 2006 were as follows: (Dollars in thousands)
|
|
2008 |
|
2007 |
|
2006 |
|
|||
|
|
|
|
|
|
|
|
|||
Depreciation and amortization |
|
$ |
15,172 |
|
$ |
14,467 |
|
$ |
12,655 |
|
Capital expenditures |
|
7,432 |
|
23,188 |
|
18,517 |
|
|||
EBITDA |
|
$ |
(6,931 |
) |
$ |
42,911 |
|
$ |
34,960 |
|
EBITDA equals earnings before interest, taxes, depreciation and amortization.
EBITDA
We have included EBITDA because we believe it provides investors with additional information to measure our performance and liquidity and is a key indicator of our ability to meet our bank covenants which are EBITDA based. EBITDA is not a recognized term under generally accepted accounting principles (GAAP) and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, it is not intended to be a measure of free cash flow for managements discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Because not all companies use identical calculations, this presentation may not be comparable to other similarly titled measures of other companies.
The following table sets forth a reconciliation of net income to EBITDA for the years ended June 30, 2008, July 1, 2007 and June 30, 2006 (Dollars in thousands):
|
|
2008 |
|
2007 |
|
2006 |
|
|||
|
|
|
|
|
|
|
|
|||
Net income (loss) |
|
$ |
(11,742 |
) |
$ |
17,566 |
|
$ |
13,860 |
|
Provision (benefit) for income taxes |
|
(11,851 |
) |
9,914 |
|
6,963 |
|
|||
Interest expense |
|
1,490 |
|
964 |
|
1,482 |
|
|||
Depreciation |
|
15,172 |
|
14,467 |
|
12,655 |
|
|||
EBITDA |
|
$ |
(6,931 |
) |
$ |
42,911 |
|
$ |
34,960 |
|
40
The following table sets forth a reconciliation of EBITDA to cash flows from operations for the years ended June 30, 2008, July 1, 2007 and June 30, 2006 (Dollars in thousands):
Fiscal year ended |
|
June 30, |
|
July 1, 2007 |
|
June 30, |
|
|||
|
|
|
|
|
|
|
|
|||
EBITDA |
|
$ |
(6,931 |
) |
$ |
42,911 |
|
$ |
34,960 |
|
Benefit (provision) for income taxes |
|
11,851 |
|
(9,914 |
) |
(6,963 |
) |
|||
Interest expense |
|
(1,490 |
) |
(964 |
) |
(1,482 |
) |
|||
Non-cash charges against (credits to) net income: |
|
|
|
|
|
|
|
|||
Deferred income taxes |
|
(4,569 |
) |
234 |
|
(1,528 |
) |
|||
Loss (gain) on sale of assets |
|
5 |
|
(103 |
) |
(22 |
) |
|||
Loss on impairment of assets |
|
8,100 |
|
|
|
|
|
|||
Fixed asset write-off |
|
1,546 |
|
|
|
|
|
|||
Equity in loss of unconsolidated subsidiary |
|
14 |
|
|
|
|
|
|||
Changes in operating assets and liabilities |
|
(13,876 |
) |
(17,425 |
) |
2,261 |
|
|||
Cash flow from operations |
|
$ |
(5,350 |
) |
$ |
14,739 |
|
$ |
27,226 |
|
CASH FLOW INFORMATION
Summary cash flow information follows for the years ended June 30, 2008, July 1, 2007 and June 30, 2006, respectively: (Dollars in thousands)
|
|
2008 |
|
2007 |
|
2006 |
|
|||
Cash flows provided by (used for) |
|
|
|
|
|
|
|
|||
Operating activities |
|
$ |
(5,350 |
) |
$ |
14,739 |
|
$ |
27,226 |
|
Investing activities |
|
(7,955 |
) |
(23,001 |
) |
(18,420 |
) |
|||
Financing activities |
|
9,405 |
|
(2,333 |
) |
(4,695 |
) |
|||
Increase (decrease) in cash and cash equivalents |
|
(3,900 |
) |
(10,595 |
) |
4,111 |
|
|||
Cash and cash equivalents at beginning of year |
|
3,900 |
|
14,495 |
|
10,384 |
|
|||
Cash and cash equivalents at end of year |
|
$ |
|
|
$ |
3,900 |
|
$ |
14,495 |
|
During the fiscal year ended June 30, 2008, our consolidated cash decreased $3,900,000 compared to a decrease of $10,595,000 during the year ended July 1, 2007. The current years decrease was primarily a result of reduced operating cash flow resulting from an increase in inventory carrying costs, increased refundable income taxes, and reduced net income from $17,566,000 to ($11,742,000). The reduced net income included the following one-time after-tax items: (i) $4.7 million litigation settlement and (ii) $2 million tax credit, the effects of which were offset by (iii) a $4.9 million impairment charge, (iv) $929,000 of inventory write-downs and (v) $1.1 million in the write-off of assets. The net after-tax impact of these items was ($0.2 million), or ($0.02) per diluted share. The impact of reduced operating cash flow was partially offset by reduced cash outflows related to capital expenditures during the year ended June 30, 2008 compared to the year ended July 1, 2007. During the year ended July 1, 2007, we made investments of $23,188,000 in capital expenditures, including expenditures related to distillery upgrading at our Atchison plant, the acquisition of feed dryers at our Pekin, Illinois plant, injection molding and packaging equipment at our Kansas City, Kansas facility, equipment to improve the efficiency of our alcohol production facilities at Pekin as well as construction costs related to our new corporate headquarters and technology center in
41
Atchison. Capital expenditures in the year ended June 30, 2008, while significantly lower than fiscal 2007, reflect routine and sustaining capital projects. Additionally, net proceeds from our line of credit provided a source of cash. Historically, the principal sources of cash are operating cash flow, proceeds from stock plans and the issuance of long-term debt. Principal uses of cash are capital expenditures, payment of debt and the payment of dividends. We believe that our anticipated operating cash flow together with our line of credit, as amended, should be sufficient to provide for our operating needs for the remainder of fiscal 2009. See Line of Credit.
Operating Cash Flows. Summary operating cash flow information for the years ended June 30, 2008, July 1, 2007 and June 30, 2006, respectively is as follows: (Dollars in thousands):
|
|
2008 |
|
2007 |
|
2006 |
|
|||
|
|
|
|
(as restated) |
|
(as restated) |
|
|||
Net income |
|
$ |
(11,742 |
) |
$ |
17,566 |
|
$ |
13,860 |
|
Depreciation |
|
15,172 |
|
14,467 |
|
12,655 |
|
|||
Loss (gain) on sale of assets |
|
5 |
|
(103 |
) |
(22 |
) |
|||
Write-off of assets |
|
1,546 |
|
|
|
|
|
|||
Loss on impairment of assets |
|
8,100 |
|
|
|
|
|
|||
Deferred income taxes |
|
(4,569 |
) |
234 |
|
(1,528 |
) |
|||
Equity in loss of unconsolidated subsidiary |
|
14 |
|
|
|
|
|
|||
Changes in: |
|
|
|
|
|
|
|
|||
Restricted cash |
|
3,333 |
|
(1,045 |
) |
(2,291 |
) |
|||
Accounts receivable |
|
211 |
|
(2,101 |
) |
(4,100 |
) |
|||
Inventories |
|
(16,478 |
) |
(12,216 |
) |
531 |
|
|||
Accounts payable and accrued expenses |
|
8,693 |
|
3,767 |
|
3,131 |
|
|||
Deferred credit |
|
(1,412 |
) |
(1,317 |
) |
(1,372 |
) |
|||
Income taxes payable/receivable |
|
(8,206 |
) |
(4,574 |
) |
6,832 |
|
|||
Other |
|
(17 |
) |
61 |
|
(470 |
) |
|||
Net cash provided by operating activities |
|
$ |
(5,350 |
) |
$ |
14,739 |
|
$ |
27,226 |
|
Cash flow from operations for the year ended June 30, 2008 decreased $20,089,000 to ($5,350,000) from $14,739,000 for the year ended July 1, 2007. This decline in operating cash flow was primarily related to the following:
· A reduction in net income of $29,308,000, from $17,566,000 for the year ended July 1, 2007 to a net loss $11,742,000 for the year ended June 30, 2008.
· Cash outflow for inventories of $16,478,000 for the year ended June 30, 2008 compared to $12,216,000 for the year ended July 1, 2007. (Total inventory changed by $21,025,000, of which $4,547,000 represents a non-cash change as a result of mark-to-market adjustments to our derivative instrument values.)
· Inventory for the year ended June 30, 2008 increased by $21,025,000.
42
· Of this increase, $3,238,000 was related to higher raw material inventories, which increased by $7,357,000 due to higher prices offset by a $4,119,000 reduction resulting from lower volume;
· $11,832,000 was related to higher finished goods inventories, which increased $5,566,000 due to increased costs and $6,266,000 due to higher volumes; and
· $5,955,000 was related to changes in other inventory items consisting of maintenance and packaging materials as well as investments in derivative instruments.
· $4,547,000 resulted from non-cash mark-to-market adjustments to our derivative values.
· Adjustments to net loss related to increases in refundable income taxes as well as deferred taxes also served to reduce operating cash flow.
These factors, which served to reduce operating cash flow, were partially offset by a non-cash adjustment to net loss for the loss on impairment of assets of $8,100,000 and a non-cash write-off of assets of $1,546,000. Additionally, operating cash flow was impacted by the timing of cash receipts and disbursements resulting in a decrease in accounts receivable and an increase in accounts payable.
Cash flow from operations during the fiscal year ended July 1, 2007 decreased $12,487,000 to $14,739,000 from $27,226,000 for the fiscal year ended June 30, 2006. This decrease in operating cash flow was primarily the result of increased inventory costs related to higher commodity prices and higher volumes for both raw materials and finished goods as well as cash payments related to our income taxes payable. These factors, which led to a reduction in operating cash flow, were partially offset by an increase in net income adjusted for non-cash depreciation expense of $5,518,000. For fiscal 2007, accounts receivable as well as accounts payable and accrued expenses increased as a result of higher sales with related higher production costs.
Investing Cash Flows. Net investing cash outflow for the year ended June 30, 2008 was $7,955,000 compared to $23,001,000 for the year ended July 1, 2007 for a net decrease of $15,046,000 in investing cash outflows. During the year ended June 30, 2008, we invested $7,432,000 in capital expenditures related to our property, plant and equipment. Additionally, during fiscal 2008, we invested $375,000 in DMI GmbH, our foreign joint venture. During the year ended July 1, 2007, we made investments of $23,188,000 in capital expenditures, including expenditures related to distillery upgrading at our Atchison plant, the acquisition of feed dryers at our Pekin, Illinois plant, injection molding and packaging equipment at our Kansas City, Kansas facility, equipment to improve the efficiency of our alcohol production facilities at Pekin as well as construction costs related to our new corporate headquarters and technology center in Atchison. Capital expenditures in the year ended June 30, 2008, while significantly lower than fiscal 2007, reflect routine and sustaining capital projects.
Net investing cash outflow was $23,001,000 for the fiscal year ended July 1, 2007 compared to $18,420,000 for fiscal 2006. This $4,581,000 increase was the result of increased capital expenditures of $4,671,000 partially offset by increase proceeds from the disposition of equipment of $90,000.
Financing Cash Flows. Net financing cash inflow for the year ended June 30, 2008 was $9,405,000 compared to net financing cash outflow of $2,333,000 for the year ended July 1, 2007 for a net increase in cash flow of $11,738,000. During the year ended June 30, 2008, we had net proceeds of $16,000,000 under our operating line of credit. Additionally, we received loan proceeds of $1,600,000 for the purchase of a corporate business aircraft during the fourth quarter of fiscal 2008. During the year ended June 30, 2008, we made principal payments on long-term debt of $4,198,000 and paid dividends of $4,233,000. During the year ended July 1, 2007, we purchased 80,500 shares of our common stock at an average price of $24.09 per share for a total of $1.9 million in connection with tax elections made by participants in our option and restricted stock plans. No such transactions occurred in the year ended June 30, 2008. Proceeds from stock plans decreased significantly to $236,000 from $1,904,000 in fiscal 2007 due to a reduced number of stock options being exercised during fiscal 2008.
For fiscal 2007, net financing cash outflow was $2,333,000 compared to $4,695,000 in fiscal 2006. During the first quarter of fiscal 2007, we purchased 80,500 shares of our common stock at an average price of $24.09 per
43
share for a total of $1,939,000 by paying the taxes withheld on 230,000 shares of restricted stock that been previously had been awarded to the participants under the Companys long term incentive plan which had vested. Additionally, we paid $5,036,000 in dividends for a total per share dividend of $0.30 compared to $0.15 in fiscal 2006. These factors, which yielded negative cash flows, were partially offset by debt transactions and proceeds from the exercise of outstanding stock options. In fiscal 2007, we made principal payments on debt of $4,262,000 and made net draws of $7,000,000 on our revolving credit facility for net cash flows related to debt transactions of $2,738,000 compared to net cash flows related to debt transactions of ($5,339,000) in fiscal 2006. Proceeds from the exercise of outstanding stock options were $1,904,000 in fiscal 2007 compared to $3,126,000 for fiscal 2006.
CAPITAL EXPENDITURES
For the year ended June 30, 2008, we incurred $7,432,000 in capital expenditures primarily related to completion of distillery expansion projects, general production capacity maintenance as well as the purchase of a corporate business aircraft. During fiscal 2007, we incurred $23,188,000 in capital expenditures. These expenditures included equipment to improve our alcohol production facilities at our Pekin, Illinois and Atchison, Kansas. We also made upgrades and improvements to injection molding and packaging equipment at our Kansas City facility and made feed drying and other equipment acquisitions at our Atchison, Kansas facility. Additionally, we completed construction of our new corporate headquarters and technical innovation center in Atchison during fiscal 2007, incurring related costs. For fiscal 2009, we have budgeted $7.5 million in capital expenditures related to improvements in and replacements of existing plant and equipment. As of June 30, 2008, we had contracts to acquire capital assets of approximately $1.5 million.
CONTRACTUAL OBLIGATIONS
Our contractual obligations at June 30, 2008 are as follows (dollars in thousands):
|
|
2009 |
|
2010 |
|
2011 |
|
2012 |
|
2013 |
|
Thereafter |
|
Total |
|
|||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
Long-term debt (1) |
|
$ |
8,960 |
|
$ |
318 |
|
$ |
336 |
|
$ |
343 |
|
$ |
303 |
|
$ |
|
|
$ |
10,260 |
|
Capital leases (2) |
|
376 |
|
15 |
|
16 |
|
4 |
|
|
|
|
|
411 |
|
|||||||
Operating leases |
|
3,278 |
|
2,734 |
|
1,884 |
|
1,796 |
|
1,389 |
|
2,964 |
|
14,045 |
|
|||||||
Energy contract (3) |
|
1,692 |
|
1,692 |
|
1,128 |
|
|
|
|
|
|
|
4,512 |
|
|||||||
Post-retirement benefits |
|
470 |
|
515 |
|
552 |
|
611 |
|
640 |
|
3,756 |
|
6,544 |
|
|||||||
Defined benefit retirement plan |
|
23 |
|
40 |
|
68 |
|
118 |
|
149 |
|
1,297 |
|
1,695 |
|
|||||||
Open purchase commitments (4) |
|
9,883 |
|
|
|
|
|
|
|
|
|
|
|
9,883 |
|
|||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||
Total |
|
$ |
24,682 |
|
$ |
5,314 |
|
$ |
3,984 |
|
$ |
2,872 |
|
$ |
2,481 |
|
$ |
8,017 |
|
$ |
47,350 |
|
(1) Long-term debt at June 30, 2008 included the following:
(i) A $5.0 million secured promissory note dated September 24, 2004 payable in monthly installments of $139,777, with the final payment due in October, 2011. The note bears interest at 5.26% per annum. Long term debt also includes a $3.5 million secured promissory note dated September 29, 2005 payable in monthly installments of $135,071, with the final payment due in September 2010. The note bears interest at 5.92 percent per annum. We may prepay each note at any time, subject to payment of a prepayment penalty of 3 percent of the original principal, declining to 0 percent if prepayment occurs after the third anniversary of the note being repaid. These notes are secured by all of our equipment at our KCIT facility in Kansas City, Kansas. We have agreed to indemnify the secured parties against any claim arising in connection with the collateral. Due to the anticipated sale of the facilities serving as security for these notes, we have reclassified them as a current liability on our balance sheet and are showing all amounts owed under them as due in 2009. As a result of cross default provisions in the related security agreements, we were in default under these notes as of June 30,
44
but our lenders under these notes have advised that they will waive the defaults if requested.
(ii) A $1.6 million secured promissory note dated April 9, 2008, bearing interest at 5.45% per annum and payable in 60 equal monthly installments of $30,525. We may prepay the note in whole, but not in part, after the first anniversary of the note subject to the payment of a prepayment premium of 3% of the original principal amount of the note if the note is paid after the first anniversary of the note and declining to 1% after the third anniversary of the note. Because of our breach under our credit agreement described below, we were in default at June 30 under the cross default provisions of the related security agreement, but our lender has waived this default.
(2) Amounts shown under capital lease arise principally under an industrial revenue bond lease relating to our Kansas City, Kansas facility. The lease was modified in July 2003 in connection with which certain tax-related covenants were eliminated. Monthly principal payments are $77,381 through September 2008. Interest is also payable monthly at a rate of 5.26 percent per annum. Upon optional prepayment or acceleration upon default the amount due from us would also include a premium of 1 percent on the outstanding principal component of the remaining lease payments. At June 30, we were in default under one or more of the financial covenants of this facility, but our lender has advised that it will waive the default if requested. This capital lease is secured by the plant at our KCIT facility in Kansas City, Kansas and certain equipment. We have agreed to indemnify the secured parties against any claim arising in connection with the collateral.
In connection with implementation of the our new enterprise resources planning system (ERP), $1.2 million in costs incurred during development of the system have been funded by Winthrop Resources Corporation under various capital lease agreements with rates ranging from 4.56% to 5.54%. These agreements, which are unsecured, have maturities ranging from September, 2007 to March, 2009.
Additionally, we financed $71,000 in equipment purchases through a capital lease with Delage Corporation at 7.15%. This capital lease is secured by the equipment purchased and matures in October, 2011.
(3) Amounts shown under Energy Contract arise under a long-term arrangement with AmerenCILCO and a subsidiary (collectively CILCO). We have leased a portion of our Pekin, Illinois plant facility to CILCO for a term ending in February 2029. CILCO constructed a gas fired electric and steam generating facility on ground leased from us and agreed to provide steam heat to our plant under a related steam heat service agreement pursuant to which we have agreed to purchase our requirements for steam heat from CILCO until February 2011. We must make adjustable minimum monthly payments over the term of the service agreement, currently $141,000, with declining fixed charges for purchases in excess of minimum usage, and are responsible for fuel costs and certain other expenses. However, CILCO also uses the boilers to run electric generating units that it constructed on the leased site and pays us for a portion of the fuel costs that we incur for the production of steam, based on savings realized by CILCO from electricity generated at the facility. CILCO has advised that it does not want to renew the stream heat service contract after February 2011.
(4) Amounts shown under open purchase commitments consist of commitments to purchase grain to be used in our operations during the first 12 weeks of fiscal 2009 as well as capital expenditure commitments.
LINE OF CREDIT
Our credit agreement as amended currently provides a $55 million revolving credit facility that is available for general working capital needs in addition to permitted capital expenditures, investments, acquisitions and stock repurchases, as defined in the credit agreement. As amended, our credit agreement expires on the earlier of October 31,
45
2008 (subject to extension by our lenders) or September 3, 2009. As of September 9, 2008, we had $48.3 million in outstanding borrowings under the credit agreement.
As of the most recent measurement date, June 30, 2008, we were in default under our covenants related the leverage ratio, the fixed charge coverage ratio and the tangible net worth requirements of our credit agreement. The lenders under our credit agreement could, among other remedies, have reduced our borrowing base under the credit agreement, declined to extend us further credit and/or accelerated our debt and declared that such debt was immediately due and payable. This could have resulted in the acceleration of our debt to other lenders. If our bank lenders were to have terminated our credit, we might not have had sufficient funds available to us to operate. If they were to have accelerated our debt, we would not have been able to repay such debt from our own funds and might not have been able borrow sufficient funds to refinance. However, our lenders did not take these actions. Our lenders have not terminated our credit or accelerated our debt, but have continued to honor our draws under the revolving credit component of our credit agreement. On September 3, 2008, our lenders agreed to amend the credit agreement in several respects, including the following:
· increasing the revolving line of credit to $55 million and reducing its term from three years to the earlier of September 3, 2009 and the expiration of a standstill period, as described below;
· eliminating the term loan and accordion features of the credit agreement;
· increasing the interest rate on base rate loans to the Agents prime rate plus 50 basis points, increasing the margin on libor loans by 75 basis points and fixed the applicable margin for non use-fees at 0.30%;
· providing for additional collateral, including our equipment not already pledged, our investment property (other than our investment in our German joint venture),our general intangibles and our Pekin facility;
· revising other covenants, including those governing our ability to make acquisitions and other investments and incur other debt;
· prohibiting dividends without the lenders consent;
· imposing new, monthly interim minimum adjusted EBITDA requirements (as defined in the credit agreement) of $(7,500,000) for July, $(2,500,000) for August and $(1,400,000) for September, and minimum tangible net worth requirements (as defined in the credit agreement of $125,000,000 at the end of July, $123,000,000 at the end of August and $121,000,000 at the end of September;
· requiring payment of a $150,000 amendment fee to the banks; and
· providing for a 60 day standstill period ending October 31, 2008, during which time we must deliver the lenders a report from outside auditors regarding our inventory and accounts and reconciling our grain positions and the lenders may review our commodity positions and hedging strategy. If we do not default under the terms of the amendment, the lenders may, in their sole discretion, extend the standstill period but are no obligation to do so; and
· providing that if they elect to do so, the lenders may exercise all their rights and remedies under the credit agreement at the end of the standstill period or sooner if we default under the terms of the amendment during the standstill period.
FINANCIAL COVENANTS
In connection with our credit and capital lease agreements, we are required to comply with certain covenants, a summary of which is as follows:
Under our capital lease agreement with the City of Kansas City, Kansas,
46
· we must maintain a current ratio (current assets to current liabilities) of 1.5 to 1;
· we must maintain minimum consolidated tangible net worth (stockholders equity less intangible assets) equal to the greater of (i) $70 million or (ii) the sum of $70 million plus 50 percent of consolidated net income since March 31, 1993; and
· we must maintain at the end of each fiscal quarter a fixed charge ratio (generally, the ratio of (x) the sum of (a) net income [adjusted to exclude gains or losses from the sale or other disposition of capital assets and other matters] plus (b) provision for taxes plus (c) fixed charges, to (y) fixed charges) for the period of the four consecutive fiscal quarters ended as of the measurement date of 1.5 to 1.
Under our credit agreement, prior to its amendment on September 3, 2008, we were required to maintain a fixed charge coverage ratio (adjusted EBITDA minus taxes and dividends to fixed charges) of not less than 1.5 to 1 on a trailing four quarter basis and were required to maintain at the end of each fiscal quarter;
· working capital (current assets minus the sum of current liabilities and the unpaid principal balance of the revolving credit loans to the extent not a current liability) of $40 million;
· tangible net worth of not less than $135 million plus (i) an amount equal to 50% of consolidated net income (but not loss) subsequent to June 30, 2008 minus (ii) cumulative stock purchases after June 30, 2008; and
· a leverage ratio (senior fund debt to adjusted EBITDA (EBIDTA plus non cash losses, minus non-cash gains, minus or plus, as the case may be, extraordinary income or losses).
As noted above under Line of Credit, as of June 30, 2008, we were in default under one or more of the financial ratio covenants of our capital lease and credit agreement. Our lenders have agreed to amend the credit agreement in several respects and to provide for a 60-day standstill period ending October 31, 2008. During the standstill period, we are subject to interim financial covenants imposing new, monthly interim minimum adjusted EBITDA requirements (as defined in the credit agreement) of $(7,500,000) for July, $(2,500,000) for August and $(1,400,000) for September, and minimum tangible net worth requirements (as defined in the credit agreement) of $125,000,000 at the end of July, $123,000,000 at the end of August and $121,000,000 at the end of September.
Our credit agreement contains various other covenants, including ones limiting our ability to incur liens, incur debt, make investments, make capital expenditures, dispose of assets, issue stock, or purchase stock. While the intital agreement permitted us to pay dividends in the ordinary course, we were required remain in compliance with our financial covenants. Due to market conditions and our resulting negative cash flow from operations, at June 30, 2008 we could not pay dividends as a result of the fixed charge coverage ratio maintenance requirement in our credit agreement. Under the September 3, amendment, we are prohibited from paying dividends without the consent of our lenders.
As discussed elsewhere herein under Item 1. Business Strategic Relationships, we have entered a business alliance with Cargill, Incorporated for the production and marketing of a new resistant starch derived from high amylose corn. We have sold only an insignificant amount of the product, and therefore the significance of the agreement with Cargill cannot be determined at this time. If we do not renew the arrangement after its initial five year term or terminate the arrangement before the expiration of 18 months following certain force majeure events affecting Cargill, or if Cargill terminates the arrangement because of a breach by us of our obligations, we will be required to pay a portion (up to 50 percent) of the book value of capital expenditures made by Cargill to enable it to produce the product. This amount will not exceed $2.5 million without our consent. Upon the occurrence of any such event, we also will be required to give Cargill a non-exclusive sublicense to use the patented process for the life of the patent in the production of high amylose corn-based starches for use in food products. The sublicense would
47
be royalty bearing provided we were not also then making the high amylose corn-based starch. We are engaged in discussions with Cargill about modifying our arrangements with them.
The Company purchases its corn requirements for one of its plants through a single elevator company. If the Company fails to purchase 13 million bushels each 12 months, commencing September 2007, it must pay the elevator company $0.02 per bushel for each bushel less than 13 million purchased. The elevator company may terminate if the Company fails to purchase specified minimums, in which case the Company would be obligated to pay the elevator company $260,000 plus its costs incurred in contracting for delivery of corn purchased for the Company pursuant to previously issued Company delivery orders. The Companys practice has been to only order corn for a month at a time.
On December 28, 2006, we engaged in an industrial revenue bond transaction with the City of Atchison, Kansas in order to receive a ten-year real property tax abatement on our newly constructed office building and technical center in Atchison, Kansas. At the time of this transaction, the facilities were substantially completed and had been financed with internally generated cash flow. Pursuant to this transaction, the City issued $7.0 million principal amount of its industrial revenue bonds to us and then used the proceeds to purchase the office building and technical center from us. The City then leased the facilities back to us under a capital lease, the terms of which provide for the payment of basic rent in an amount sufficient to pay principal and interest on the bonds. Our obligation to pay rent under the lease is in the same amount and due on the same date as the Citys obligation to pay debt service on the bonds which we hold. The lease permits us to present the bonds at any time for cancellation, upon which our obligation to pay basic rent would be cancelled. We do not intend to do this until their maturity date in 2016, at which time we may elect to purchase the facilities for $100. Because we hold all outstanding bonds, management considers the debt de-facto cancelled and, accordingly, no amount for our obligations under the capital lease is reflected on our balance sheet. In connection with this transaction, we agreed to pay the city an administrative fee of $50,000, which is payable over 10 years. If we were to present the bonds for cancellation prior to maturity, the $50,000 fee would be accelerated.
In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 141(R), Business Combinations (SFAS 141(R)) and SFAS No. 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (SFAS 160). SFAS 141(R) replaces SFAS 141, Business Combinations. SFAS 141(R) and SFAS 160 change the financial accounting and reporting of business combination transactions and noncontrolling (or minority) interests in consolidated financial statements. Under SFAS 141(R) , entities will be required to recognize, with certain exceptions, 100 percent of the fair values of assets acquired, liabilities assumed, and any remaining noncontrolling interests in acquisitions of less than a 100 percent controlling interest when the acquisition constitutes a change in control of the acquired entity, measuring acquirer shares issued and contingent consideration arrangements in connection with a business combination at fair value on the acquisition date with subsequent changes in fair value reflected in earnings, and expensing as incurred acquisition-related transaction costs. SFAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It also amends the consolidation procedures of Accounting Research Bulletin No. 51, Consolidated financial Statements for consistency with the requirements of SFAS 141(R). We will be required to adopt SFAS 141(R) for business combination transactions for which the acquisition date is on or after July 1, 2009. We will also be required to adopt SFAS 160 on July 1, 2009. Management has not yet assessed the impact of the adoption of these standards on its financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a framework for measuring fair value in generally accepted accounting principles, and expands required disclosures regarding the use of fair value measurements. SFAS 157 does not require any new fair value measurements in generally accepted accounting principles. We will adopt SFAS 157 for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) effective as of the fiscal year beginning July 1, 2008. We have not completed our evaluation of the impact of adopting SFAS 157 on our financial statements. The adoption of SFAS 157 may require modification of our fair value measurements and may require expanded disclosures in our notes to the consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 allows entities to voluntarily choose, at specified election dates, to measure many financial assets and financial liabilities at fair value. The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, SFAS 159 specifies that all subsequent changes in fair value for that instrument shall be reported in earnings. We will adopt SFAS 159 as of the fiscal year beginning on July 1, 2008 and do not believe such adoption will have a significant impact on our financial statements.
48
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities an amendment of FASB Statement No. 133 (SFAS 161). SFAS 161 expands and disaggregates the disclosure requirements in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). The disclosure provisions of SFAS 161 will apply to all entities with derivative instruments subject to SFAS 133 and will also apply to related hedged items, bifurcated derivatives, and nonderivative instruments that are designated and qualify as hedging instruments. SFAS 161 will require an entity with derivatives to disclose how and why it uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133, and how derivative instruments and related hedged items affect the entitys financial position, financial performance, and cash flows. Tabular disclosures of the location, by line item, of amounts of gains and losses reported in the statement of earnings will be required. We will be required to adopt SFAS 161 effective the beginning of our third quarter on January 1, 2009. The adoption of this standard will require expanded disclosure in the notes to our consolidated financial statements but will not impact financial results.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We make our products primarily from wheat and corn and, as such, are sensitive to changes in commodity prices. We use grain futures and/or options, which we account for as cash flow hedges, as a hedge to protect against fluctuations in the market. Fluctuations in the volume of hedging transactions are dictated by alcohol sales and are based on corn and gasoline prices. We have a risk management committee, comprised of senior management members, that meets bi-weekly to review futures contracts and positions. This group sets objectives and determines when futures positions should be held or terminated. A designated employee makes trades authorized by the risk management committee. The futures contracts that are used are exchange-traded contracts. We trade on the Kansas City and Chicago Boards of Trade and the New York Mercantile Board of Exchange. For inventory and open futures, the table below presents the carrying amount and fair value at June 30, 2008 and July 1, 2007. We include the fair values of open contracts in inventories or other accrued liabilities in our balance sheet.
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At June 30, 2008 |
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At July 1, 2007 |
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As of June 30, |
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Carrying |
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Fair Value |
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Carrying |
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Fair Value |
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Inventories |
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|
|
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|
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|
|
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Corn |
|
$ |
6,485,147 |
|
$ |
7,311,379 |
|
$ |
3,667,660 |
|
$ |
3,044,848 |
|
Wheat |
|
$ |
3,499,541 |
|
$ |
3,069,123 |
|
$ |
6,794,119 |
|
$ |
6,975,457 |
|
|
|
Description and |
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Fair Value |
|
Description and |
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Fair Value |
|
||||
Corn Options |
|
|
|
|
|
|
|
|
|
||||
Contract Volumes (bushels) |
|
2,000,000 |
|
|
|
6,000,000 |
|
|
|
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Weighted Average |
|
|
|
|
|
|
|
|
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Strike Price/Bushel |
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|
|
|
|
|
|
|
|
||||
Long Calls |
|
$ |
5.40 |
|
$ |
4,387,500 |
|
$ |
4.00 |
|
$ |
1,360,000 |
|
Short Calls |
|
$ |
6.20 |
|
$ |
(2,990,000 |
) |
$ |
5.00 |
|
$ |
(490,000 |
) |
Short Puts |
|
$ |
|
|
$ |
|
|
$ |
3.50 |
|
$ |
(1,665,000 |
) |
Contract Amount |
|
$ |
|
|
$ |
1,397,500 |
|
$ |
|
|
$ |
(795,000 |
) |
|
|
Description and |
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Fair Value |
|
Description and |
|
Fair Value |
|
||
Corn Futures |
|
|
|
|
|
|
|
|
|
||
Contract Volumes (bushels) |
|
|
|
|
|
3,500,000 |
|
|
|
||
Weighted Average |
|
|
|
|
|
|
|
|
|
||
Strike Price/Bushel |
|
|
|
|
|
$ |
3.7355 |
|
$ |
3.4622 |
|
Contract Amount |
|
|
|
|
|
$ |
13,068,963 |
|
$ |
12,115,000 |
|
49
|
|
Description and |
|
Fair Value |
|
Description and |
|
Fair Value |
|
||||
Wheat Futures |
|
|
|
|
|
|
|
|
|
||||
Contract Volumes (bushels) |
|
400,000 |
|
|
|
|
|
|
|
||||
Weighted Average |
|
|
|
|
|
|
|
|
|
||||
Strike Price/Bushel |
|