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.
GENERAL INFORMATION
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 and has two reportable segments, ingredients and distillery products. Ingredients consist of specialty ingredients, consisting primarily of specialty wheat starches and specialty wheat proteins for food and non-food applications, commodity ingredients, including commodity wheat starches and vital wheat gluten, and mill feeds. Distillery products consist of food-grade alcohol, including beverage alcohol and industrial alcohol, fuel alcohol, commonly known as ethanol, and distillers grain and carbon dioxide, which are by-products of our distillery operations.
We 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, which we use primarily to process into specialty wheat proteins. Vital wheat gluten and 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 gluten and wheat proteins to extract premium wheat starch, which we dry into powder and sell in packaged or bulk form, either as commodity wheat starch or, after further processing, as specialty wheat starch. We mix the remaining slurry with corn and/or milo 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 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. Our principal subsidiaries are MGP Ingredients of Illinois, Inc., through which we own our Pekin facility, and Kansas City Ingredient Technologies, Inc., through which we operate our Kansas City facility.
In December, 2005, we broke ground for the construction of a new technical innovation center and corporate office building in Atchison. Construction of both buildings is expected to be completed by February, 2007 at an estimated total cost of $4.7 million. The technical center will provide improved accommodations and a better environment for us to pursue research and development and product application initiatives and to host and work directly with customers in developing specialized product formulations. Upon completion of the buildings, the address of our corporate headquarters will be 100 Commercial Street, Atchison, Kansas 66002.
FISCAL 2006 DEVELOPMENTS
Distillery Products
Our improved results in fiscal 2006 were driven by our distillery products segment, This improvement was primarily due to a nearly 30 percent increase in distillery products sales, which resulted from higher unit sales and prices for food grade alcohol for industrial and beverage applications and increased prices for fuel grade alcohol, which offset a small decline in fuel alcohol unit sales.
Since the reconstruction of our Atchison distillery following an explosion that occurred in September, 2002, the majority of the distillery’s 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 continued to be 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 recently approved capital projects.
On March 16, 2006, our Board of Directors approved plans for an $11.1 million capital project that is expected to improved production efficiencies and fulfill air emission control requirements at our Pekin, Illinois distillery. The project involves the purchase and installation of a new dryer system for the manufacture of distillers feed, the principal by-product of the alcohol production process. The new dryer system is expected to result in cost savings related to energy usage and maintenance needs. It also will permit us to meet Environmental Protection Agency requirements in a consent decree filed during fiscal 2006. We chose the dryer over less costly alternatives because of the improved plant efficiencies it is expected to provide. Work on the dryer project is expected to be completed by the fall of 2007.
The installation of new equipment for processing distillers feed at the Atchison distillery and for the installation of new distillation equipment at the Pekin plant were completed just prior to the first quarter of fiscal 2006. Approved by our Board of Directors on March 4, 2004, these projects were completed at costs of approximately $12 million and $4 million, respectively, and both are expected to strengthen our ability to realize additional improvements in alcohol production efficiencies, especially in regard to energy usage. The new equipment at the Atchison distillery also includes new, state-of-the-art emission control technology for continued compliance with government environmental standards.
Specialty Ingredients for Food Applications
Although sales of our specialty ingredients for food applications experienced modest growth in fiscal 2006 compared to fiscal 2005, they remained below the peak level reached in fiscal 2004. The increase over fiscal 2005 was mainly due to higher sales of our Fibersym® resistant starches, certain of our Pregel™ instant starches and Wheatex® textured wheat proteins. Sales of our Arise wheat protein isolates, however, declined compared to fiscal 2005.
Because our specialty proteins and starches are wheat-based, the profitability of our food ingredients area was affected by increased wheat costs compared to fiscal 2005.
Specialty Ingredients for Non-Food Applications
Sales of our protein-and starch-based resins, which are used in the manufacture of pet chews and related treats, declined in fiscal 2006 compared to fiscal 2005. This decline was partially attributable to higher gas costs and a weakened labor market during our first quarter of fiscal 2006, which contributed to weaker consumer spending and lower consumer confidence and a slowdown in pet industry sales during that period. However, the decline wasdue primarily to reduced sales to one major customer whose business was sold during our fourth quarter of fiscal 2006. See Item 3. “Legal Proceedings.” We continue to work to broaden our customer base and have strengthened our production and service capabilities in this area of our business.
We are in the process of evaluating how to best structure our specialty ingredients for personal care product uses in the total framework of our strategic objectives. We have recently decided to discontinue development of new personal care ingredients and instead concentrate on supplying current customers from our existing line of personal care ingredients. In line with this decision, we have realigned sales functions and redefined research and development responsibilities and are considering the sale of this business.
Our plant-based biopolymers 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.
On September 30, 2005, we acquired a facility in Onaga, Kansas to utilize for the production of our plant-based biopolymers for use in the manufacture of degradable and non-degradable plastic-like products. The facility, which primarily had been used by the previous owner to manufacture wood composites, was purchased for $750,000. We have since upgraded the facility at a cost of approximately $1.9 million to enhance our biopolymer production capabilities while also maintaining wood composite manufacturing capabilities.
FINANCIAL INFORMATION ABOUT SEGMENTS
Note 12 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.
BUSINESS STRATEGY
Our strategy is to focus on the development and marketing of specialty protein and starch 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 grain. As such, we seek to provide ingredient solutions across a range of food and non-food product applications while strengthening our ability to effectively supply the marketplace with both food grade and fuel grade alcohol products.
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, accelerated pet industry growth and increased 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 capacity to grow our specialty ingredients business if the market for such products improves further. We seek to develop a more profitable product mix, which is especially critical during times when we face higher wheat costs, such as we encountered during fiscal 2006. We continue to concentrate on growing specific high end, highly functional ingredient solutions for our customers. Simultaneously, we strive to reduce the adverse impact that lower valued commodity wheat gluten and wheat starches have on our profit performance. Recently, we have taken steps to size the ingredients portion of our business, particularly in the food area, to more appropriately align with current production and sales requirements. These steps have included adjustments in the size of our workforce across multiple disciplines within our organization. We are also 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 research and development efforts and are revamping the responsibilities of our technical applications scientists, who in the future will perform a significantly more integral role as solutions providers to our customers.
As a result of our focus on being a leading innovator of highly functional proteins and starches, from fiscal 2001 to fiscal 2006 sales revenues from our specialty ingredients have increased from $32,918,000, or 14.4 percent of our total revenues, to $70,066,000, or 21.7 percent of our total revenues. Although we continue to produce gluten and commodity starch as by-products of our production of specialty wheat proteins and starches, the significance of these products to our business has substantially diminished over the past six years, declining from $44,751,000, or 19.5 percent, of our total revenues in fiscal 2001 to $13,571,000, or 4.2 percent, of our total revenues in fiscal 2006.
Although our business in recent years has placed increased emphasis on specialty ingredient sales, 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 the Atchison distillery’s 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 distillery’s capacity has been dedicated to the production of fuel ethanol.
While we experienced significant strengthening in the fuel grade alcohol market in fiscal 2006, we have also experienced favorable conditions in our food grade alcohol markets and are dedicated to 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 Company’s founding in 1941 and intend to maintain a solid presence in the food grade as well as fuel grade area.
PRODUCT SALES
The following table shows our sales from continuing operations by each class of similar products during the past three fiscal years ended 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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2006 |
2005 |
2004 |
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(thousands of dollars) |
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|
Amount |
% |
Amount |
% |
Amount |
% |
|||||||||||
|
Ingredients: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||
|
Specialty Food Ingredients |
$ |
46,149 |
14.3 |
|
$ |
43,910 |
|
15.9 |
|
$ |
60,904 |
|
22.5 |
|
||
|
Specialty Non-Food Ingredients |
23,917 |
7.4 |
|
34,077 |
|
12.4 |
|
24,354 |
|
9.0 |
|
|||||
|
Commodity Ingredients |
13,571 |
4.2 |
|
13,464 |
|
4.9 |
|
13,749 |
|
5.1 |
|
|||||
|
Mill Feed and Other Mill Products |
1,869 |
0.6 |
|
1,044 |
|
0.4 |
|
3,704 |
|
1.3 |
|
|||||
|
Total Ingredients |
85,506 |
26.5 |
|
92,495 |
|
33.6 |
|
102,711 |
|
37.9 |
|
|||||
|
Distillery Products: |
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|
|
|
|
|
|
|
|
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|
|
|
|
|
|
|
|
|
|
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|
Food-grade Alcohol |
$ |
79,893 |
24.8 |
|
$ |
55,733 |
|
20.3 |
|
$ |
36,817 |
|
13.6 |
|
||
|
Fuel-grade Alcohol |
128,824 |
39.9 |
|
99,241 |
|
36.1 |
|
102,005 |
|
37.7 |
|
|||||
|
Distillery By-products |
28,254 |
8.8 |
|
27,708 |
|
10.0 |
|
29,140 |
|
10.8 |
|
|||||
|
Total Distillery Products |
236,971 |
73.5 |
|
182,682 |
|
66.4 |
|
167,962 |
|
62.1 |
|
|||||
|
Net Sales |
$ |
322,477 |
100.0 |
|
$ |
275,177 |
|
100.0 |
|
$ |
270,673 |
|
100.0 |
|
Substantially all of our ingredient and distillery sales are made directly or through distributors to manufacturers and processors of finished goods. Sales to customers are usually evidenced by short-term agreements under which products are usually ordered, produced, sold and shipped within 60 days. Varying amounts of our fuel grade and food grade alcohol and certain specialty ingredients are sold under longer term contracts. During fiscal 2006, our five largest distillery products customers accounted for 34.6 percent of our consolidated revenues and our five largest ingredients products customers accounted for 12.5 percent of our consolidated revenues. Valero Energy, a fuel grade alcohol customer, accounted for 13.4 percent of our consolidated revenues in fiscal 2006. No other customer accounted for more than 10 percent of our consolidated revenues in the fiscal year.
INGREDIENTS
Ingredients consist primarily of specialty wheat starches and wheat proteins for food applications and non-food applications, commodity starches and proteins, consisting of commodity wheat starches and vital wheat gluten, and mill feeds. In recent years, specialty products have accounted for a significant share of our total ingredient sales. This primarily has been due to the following factors: 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 Ingredients
Specialty Wheat Starch . 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 uniquespecialty wheat starches designed for special applications in niche markets. 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 customer’s 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 for use in personal care products 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, personal care and biopolymer products, and for use in the manufacture of adhesives, paper coatings, carbonless paper, and wall board.
Both commodity and specialty 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 and chemical 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. 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 as in fiscal 2003, increases in grain and fuel prices outpaced market price increases in the specialty wheat starch market .
Specialty Wheat Proteins . In recent years, we began the development of 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 Wheatex®, HWG 2009 TM , FP TM and Arise® series and Pasta Power ® . Non-food applications include wheat proteins designed for use primarily in pet product applicationsand biopolymers that can be molded to form a variety of degradable and non-degradable plastic-like objects. 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 a number of our specialty wheat proteins have been launched, some products are in the test marketing or development stage.
Specialty Ingredients for Food Applications
· 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.
· 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.
· 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 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 TM 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 .
· FiberRite™ RW Resistant Starch. FiberRite™ RWis 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.
· HWG 2009. Thisis 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.
Specialty Ingredients for Non-Food Applications
· 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 a 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.
· Cosmetics and Personal Care Proteins and Starches.
· Specialty wheat proteins for personal care product applications include proteins that have been hydrolyzed or otherwise altered to become soluble in water and other liquids. This enables their use in such applications as shampoos, conditioners, styling aids, skin lotions and similar products. These include:
· Foam Pro®, 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® Select WAA, 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 , an additive for shampoo that helps repair damaged hair and improves shine, luster and smoothness;
· Aqua Pro® QWL , which enhances the functionality of hair conditioners; and
· Omni-Smooth® , which is a natural skin tightening agent used in anti-wrinkle treatments.
· Specialty wheat starches for personal care and cosmetics applications include the following:
· Skin Flow TM , a hydrophobic starch powder that helps reduce the oily or greasy feeling in creams and lotions, leaving a silky, soft product; and
· MGPI Cosmogel® , a highly refined wheat starch that can replace talc in a number of applications, including eye shadows, body powders, blushes, deodorants and anti-perspirants.
· MGPI Terratek TM . MGPI Terratek TM protein and starch resinsare 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.
Commodity Ingredients
Commodity Wheat Starch . In addition to specialty wheat starches, our premium wheat starches include commodity wheat starches. As is the case with specialty wheat starches, commodity wheat starches have both food and non-food applications, but such applications are more limited than those of specialty wheat starches and commodity wheat starches sell for a lower price in the marketplace. As noted above, commodity wheat starches compete primarily with corn starches, which dominate the marketplace, and commodity wheat starch price fluctuations generally track the fluctuations in the corn starch market.
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. Gliadin is also used in a number of cosmetics and personal care products described above under Specialty Ingredients for Non-Food Applications.
We produce vital wheat gluten from modernized facilities at the Atchison and Pekin plants. Because of the depressed market for vital wheat gluten that has resulted from subsidized foreign imports, we generally only sell vital wheat gluten that we are not able to further process into specialty wheat proteins. 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.
Vital wheat gluten is considered a commodity, and therefore competition is based primarily 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”). Because of subsidies and other protective measures afforded certain Foreign Exporters by their host governments, we are not able to profitably compete with the Foreign Exporters and generally only produce gluten as a by-product in our production of specialty starches and proteins.
Mill Feed and Other Mill Products
We own and operate a flour mill at the Atchison plant. The mill’s output of flour is used internally to satisfy a majority of the raw material needed for the production of our ingredients products.
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.
DISTILLERY PRODUCTS
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, distiller’s 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.
Food-grade Alcohol
Beverage Alcohol . Food-grade beverage alcohol 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 2006 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.
Industrial Alcohol . 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 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.
Synthetic alcohol historically has 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 country’s 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 that amount to $0.51 per gallon of ethanol with a proof of 190 or greater that is mixed with the gasoline. Although these benefits are not directly available to us, it allows us to sell our ethanol at prices which 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 provides for the adoption within a year of regulations whose purpose, subject to other provisions of the Energy Act, will be to ensure that gasoline sold or introduced into commerce in the continental United States contains 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. For this purpose, in addition to grain-based ethanol that we make, renewable fuels also includes cellulosic biomass ethanol, biodiesel, and other motor vehicle fuel that is produced from biomass such as starch, sugarcane, sugar beets or potatoes as well as natural gas produced from a biogas source, such as a landfill, that is used to replace or reduce the quantity of fossil fuel present in a fuel mixture used to operate a motor vehicle. Each gallon of cellulosic biomass ethanol will count as 2.5 gallons of renewable fuel under the renewable fuel volume requirements.
While the Energy Policy 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, the effective date of the renewable fuels standard. Refiners will 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. As a result, we believe ethanol usage will grow through 2012 as refiners continue the search for octane to extend the gasoline pool and provide for increasing demand for gasoline in the U.S. market.
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 reached 3.9 billion gallons in calendar 2005, an increase of 500 million gallons, or approximately 15 percent, above production in calendar 2004. Importantly, however, according the Renewable Fuels Association, as of June 2006 there were approximately 4.8 billion gallons of capacity compared to 4.3 billion at the end of 2005 and approximately 2.2 billion gallons of capacity under construction.
According to information published by the Renewable Fuels Association, as of June 2006, there were approximately 101 ethanol production facilities in the United States and approximately 34 more then under construction. The majority of these facilities are located in the Midwestern 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 may already exceed the level of renewable fuels mandated through 2007 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 By-Products
The bulk of fiscal 2006 sales of alcohol by-products consisted of distillers feeds. 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 feeds.
The balance of alcohol by-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.
PATENTS
We are involved in a number of patent-related activities. For at least the past six 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 United States Patent 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 hold a 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 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 United States Patent 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.
RESEARCH AND DEVELOPMENT
During the last three fiscal years, we have spent an aggregate of $8.3 million on research and development activities, all in the ingredients segment, as follows: 2006-$2.9 million; 2005-$3.0 million; and 2004-$2.4 million.
SEASONALITY
Our sales subsequent to 2002 have not been seasonal except for variations affecting beverage alcohol. Food-grade alcohol sales tend to peak in the fall as beverage alcohol distributors order stocks for the holiday season.
TRANSPORTATION
Our output is transported to customers by truck, rail and barge transportation equipment, most of which is provided by common carriers. We lease 402 rail cars, which may be dispatched on short notice. We offer customers shipment by barge through our barge loading facilities on the Illinois River.
RAW MATERIALS
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 grain elevators. To assure supplies, we may enter into contracts to take future delivery within 30 days. These are fixed 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. We do not have any long-term contracts with any raw materials suppliers.
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. Similarly, prices of commodity wheat starches generally track the prices of corn starch and usually do not adjust to rising wheat prices. It is 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.
During fiscal 2006, market prices for grain increased. The average price that we paid per bushel for wheat increased 5.6 percent in fiscal 2006 compared to fiscal 2005, while the average price for a bushel of corn that we paid decreased 3.9 percent from the same period. However, corn prices increased in the second half of fiscal 2006, rising 1.8 percent in the third quarter and 6.3 percent in the fourth quarter of fiscal 2006.
We engage in the purchase of commodity futures to hedge economic risks associated with fluctuating grain and grain products prices. During fiscal 2006, we hedged approximately 46 percent of corn processed, compared to 41 percent in 2005. Of the wheat that we processed in fiscal 2006, 1 percent was hedged compared to none in fiscal 2005. The contracts are accounted for as hedges and, accordingly, gains and losses are deferred and recognized in cost of sales as part of contract costs when contract positions are settled and related products are sold. For fiscal 2006, raw material costs included a net hedging loss of approximately $1.9 million on contracts settled during the year compared to a net hedging loss of approximately $3.5 million for fiscal 2005. See Item 7A - Quantitative and Qualitative Disclosures About Market Risk .
ENERGY
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 gas in the future or can purchase future contracts on the exchange. Depending on existing market conditions, 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 Central Illinois Light Company that expires on August 31, 2009 under which the utility will transport gas to our Pekin plant on the utility’s 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 a long-term 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 ending in February 2010. CILCO constructed a new gas fired electric and steam generating facility on ground leased from us and agreed to provide steam heat to the Pekin plant. If we fail to renew the lease for 19 years at the end of the lease term, we must pay CILCO the net book value of the boiler plant and cogeneration facility, which we estimate will be $10.6 million. Under a related steam heat service agreement, we have agreed to purchase our requirements for steam heat from CILCO until at least February 2010. Either party may terminate the service agreement at the end of the initial term or thereafter upon two years notice. Also, if gas prices have risen to a level such that operating a steam facility with alternative fuel would be more attractive and the payback period for a new facility would be five years or less, we may terminate the service agreement prior to the end of the initial term upon two years notice by making a specified payment to CILCO , currently approximately $820,000. We must make adjustable minimum monthly payments over the term of the service agreement, currently $138,000, 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 .
We also have a contract, which expires in December 2006, to purchase electricity from AmerenCILCO at fixed rates.
EMPLOYEES
As of June 30, 2006, we had 462 employees, 268 of whom are covered by collective bargaining agreements with one labor union. One agreement, which expires on August 31 , 2008 , covers 153 employees at the Atchison Plant . Another agreement, which expires on October 31, 2007, covers 88 employees at the Pekin plant. A collective bargaining agreement with employees at our Kansas City facility covers 27 employees and expires on September 25, 2009. As of June 30, 2005, we had 479 employees.
We consider our relations with our personnel to be good and have not experienced a work stoppage since 1978.
REGULATION
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. 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 IPEA 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. As a result of these proceedings and a desire to make our operations more efficient, we are making 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 have elected instead to install a new, emission-controlled dryer/evaporator system that will both address regulatory requirements and increase plant efficiency. We remain in discussions with the IEPA regarding the amount of the penalty which it seeks. See Item 3. Legal Proceedings.
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 the next 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, and will be making additional capital expenditures of $2 to $4 million for new boilers and emission controls.
STRATEGIC RELATIONSHIPS
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 will manufacture Fibersym® HA under United States patent 5,855,946, which has been licensed exclusively to us. The new starch will be marketed by both companies under the Fibersym® brand name with all revenues from such sales recognized by us. We and Cargill will 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. We understand
that Cargill has started to market its tapioca-based starch product under the sublicense from us but has had no significant sales 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. We believe that the arrangements with Cargill are subject to termination if the high amylose product should be determined to be commercially unviable, although Cargill might contest our right to terminate the arrangements on this ground.
Although we originally hoped to introduce Fibersym®HA starch into the market at the end of 2004, due to pending litigation, we put the sale and additional production of the product on hold. The litigation is still pending, but we have resumed limited marketing efforts. See Item 3. Legal Proceedings – Other matters .
To complement offerings in our Fibersym® resistant starch line, in the fourth quarter of fiscal 2004 we began marketing a new potato-based resistant starch, Fibersym® 80 ST, for use in fiber enhanced and reduced carbohydrate food applications. The ingredient is being produced for us by Penford Corporation, using patented processes described in United States patent 5,855,946 and licensed exclusively to us by KSURF. Under our agreement with Penford, we were required to purchase $6.2 million of product during fiscal 2005. Penford extended our period for taking delivery through August of 2005; although this agreement resulted in an excess of inventories of the potato-based resistant starch, we expect to work through these inventories by the end of the third quarter of fiscal 2007.
ITEM 1A. RISK FACTORS
Our business is subject to certain risks and uncertainties. The following identifies those which we consider to be most important.
The availability and cost of agricultural products that we use in our business are subject to weather and other factors beyond our control .
In fiscal 2005 and 2006, approximately 44 percent and 42 percent, respectively, of our costs of goods sold were for grain, principally wheat, corn and milo. 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, as prices for fuel grade alcohol and commodity wheat starches and gluten do not usually adjust to rising grain prices. We engage in the purchase of commodity futures to hedge economic risks associated with fluctuating grain prices. Despite these hedging activities, we may not be successful in limiting our exposure to market fluctuations in the cost of grain.
Our profitability is affected by the cost of natural gas.
Natural gas comprised approximately 16.2% percent of our costs of goods sold in fiscal 2005 and23.9 % of our cost of goods sold in fiscal 2006. 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. 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.
Volatile gasoline prices affect our profitability.
The price of fuel grade alcohol, or ethanol as it is commonly known, has some relation to the price for gasoline. The price of fuel grade alcohol tends to increase as the price of gasoline increases, and the price for fuel grade alcohol tends to decrease as the price of gasoline decreases. Changes in gasoline prices will likely also lead to changed prices for fuel grade alcohol and could affect our operating results.
The loss of major customer could have an adverse effect on our results of operations.
During fiscal 2005 and 2006, our five largest distillery products customers accounted for approximately 33 percent and 35 percent, respectively, of our consolidated revenues, and our five largest ingredients customers
accounted for an aggregate of approximately 18 percent and 13 percent, respectively, of our consolidated revenues. If we lost one or more of our major customers, or if one or more of our customers significantly reduced its orders, sales and results of operations could be adversely affected. In the fourth quarter of 2006, one of our major ingredients customers was sold, and we have received no orders from the customer for product since May. See Item 3. Legal Proceedings.
The rapid growth of production capacity in the ethanol industry creates some market uncertainly for the ethanol industry.
Approximately 54 percent of our fiscal 2005 and fiscal 2006 distillery product sales were fuel grade alcohol, or ethanol. The ethanol industry continues to grow and there is significant competition among ethanol producers. At June 30, 2006, existing construction at new and expanding ethanol plants was predicted to increase ethanol production capacity by approximately2.2 billion gallons per year. This would increase the existing nationwide production capacity by approximately 45% percent. We expect this increase in capacity to continue in the near future. We cannot determine what effect this increase in production will have upon the demand or price of ethanol. At a minimum, this increased capacity creates some uncertainty for the ethanol industry.
Although we believe that there will be an increase in the demand for ethanol in the future as a result of 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 demand for ethanol. If the production of ethanol exceeds either the demand for ethanol or the petroleum industry’s ability to blend ethanol with gasoline, then the price of ethanol would be expected to fall, and such a fall in ethanol prices could be significant. In that case, our revenues could decrease.
The increased production of ethanol could have other adverse effects as well. For example, the increased production will also lead to increased supplies of by-products from the production of ethanol, such as distillers feed. Those increased supplies could lead to lower prices for those by-products. Also, the increased production of ethanol could result in increased demand for corn, which could in turn lead to higher prices for corn, resulting in higher costs of production and lower revenues.
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 2010, 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 mixed with the gasoline.
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.
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 and Item 3, Legal Proceedings where we discuss current environmental proceedings in which governmental agencies are seeking fines from us and requiring significant capital expenditures.
We may require significant cash flow to make capital expenditures and pay our debt.
Over the course of the next few years we may need to make substantial capital expenditures. Although some of these would be discretionary, we expect others will be required to comply with environmental regulations. See – Regulation , Item 3. Legal Proceeding 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.
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. Hedging means protecting the price at which we buy corn and wheat and the price at which we sell our products in the future. It is a way 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 and wheat and our ability to sell sufficient amounts of products to utilize all of the grain subject to futures contracts. Although we attempt to link hedging activities to sales plans and pricing activities, such hedging activities can themselves result in costs because price movements in grain contracts are highly volatile and influenced by many factors beyond our control.
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.
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.
Work stoppages at our facilities could have a material adverse effect on the profitability of our business.
Most of our work force is unionized. If our unionized workers were to engage in a strike, work stoppage or other slowdown in the future, we could experience a significant disruption of our operations, which could have a material adverse effect on us.
We may suffer future impairment losses.
We review long-lived assets if events or circumstances indicate that usage may be limited and carrying values may not be recoverable. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” Should events indicate such assets cannot be used as planned, whether because of saturated markets, overcapacity or other causes, we could be required to recognize an impairment loss.
Lenders may require us to abide by restrictive loan covenants that may hinder our ability to operate and reduce our profitability .
The loan agreements governing our debt contain a number of restrictive affirmative and negative covenants. These covenants limit our ability to, among other things:
· incur additional indebtedness;
· pay dividends to stockholders;
· make various investments;
· create liens on our assets; or
· merge or consolidate or dispose of all or substantially all of our assets.
We also are required to maintain specified financial ratios, including a current ratio, minimum consolidated tangible net worth, debt to tangible net worth and a fixed charge coverage ratio. A breach of any of these covenants or requirements could result in a default under our debt agreements. As an example, if we default, and if such default is not cured or waived, a lender could, among other remedies, accelerate our debt and declare that such debt is immediately due and payable. If this occurs, 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. No assurance can be given that our future operating results will be sufficient to achieve compliance with such covenants and requirements, or in the event of a default, to remedy such default.
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 Company’s 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
